Vol. 91, No. 5 DOI: 10.2308/accr-51376 September 2016
pp. 1363–1390
Financial Reporting Quality of Chinese Reverse Merger
Firms: The Reverse Merger Effect or the Weak Country
Effect?
Kun-Chih Chen
National Taiwan University
Qiang Cheng
Singapore Management University
Ying Chou Lin
Southeastern Oklahoma State University
Yu-Chen Lin
National Cheng-Kung University
Xing Xiao
Tsinghua University
ABSTRACT: In this paper, we examine why Chinese reverse merger (RM) firms have lower financial reporting quality than U.S. IPO firms. We find that the financial reporting quality of U.S. RM firms is similar to that of matched U.S. IPO firms, but Chinese RM firms exhibit lower financial reporting quality than Chinese ADR firms. We also find that Chinese RM firms exhibit lower financial reporting quality than U.S. RM firms. These results indicate that the use of the RM process is associated with poor financial reporting quality only in firms from China, where legal enforcement and investor protection are weak. In addition, we find that compared with Chinese ADR firms, Chinese RM firms have weaker bonding incentives (as measured by CEO turnover-performance sensitivity) and poorer corporate governance. These factors, in turn, contribute to the lower financial reporting quality of Chinese RM firms. Overall, our results suggest that the less scrutinized RM process allows the Chinese firms with weak bonding incentives and poor governance to gain access to U.S. capital markets, resulting in poor financial reporting quality. Keywords: reverse mergers; Chinese firms; financial reporting quality; bonding hypothesis; cross-listings. JEL Classifications: G15; G24; G34; G38.
I. INTRODUCTION
I
n this paper, we examine why Chinese reverse merger (RM) firms listed in the U.S. have lower financial reporting quality than U.S. initial public offering (IPO) firms. This examination is motivated by the recent popularity of Chinese RM firms and by the accounting problems associated with these firms during the past few years. In an RM deal, a U.S. public shellWe thank Chih-Ying Chen, Xia Chen, Ole-Kristian Hope, Siqi Li, Xi Li, Hai Lu, Mingyi Hung, Steven Matsunaga, Dan Segal, and Yoonseok Zang. We also thank the conference participants at the 2012 American Accounting Association Annual Meeting, the 2012 FMA Annual Meeting, the 2012 PBFEAM Conference, the 2013 FARS Midyear Meeting, and workshop participants at The Hong Kong University of Science and Technology, National Chiao Tung University, National Taiwan University, and Singapore Management University for their helpful comments. The authors acknowledge financial support from the School of Accountancy Research (SOAR) at Singapore Management University and from the National Science Council in Taiwan (NSC 101-2410-H-006-044). The first author is thankful for a research award by the E. SUN Bank in Taiwan for the conduct of this work.
Editor’s note: Accepted by Bin Ke.
Submitted: November 2012 Accepted: January 2016
firm acquires a private operating firm. Although the original U.S. public shell firm survives, the original private firm’s shareholders maintain control.1Since the 1990s, RMs have been the most popular alternative to IPOs for firms to go public in the U.S. (e.g.,Floros and Shastri 2009a). In recent years, many foreign firms, particularly those from China, have entered the U.S. equity markets via RMs. Overall, there were 448 Chinese RM deals in the 2000–2011 period.2About 72 percent of all foreign RM firms are from China, and over 90 percent of those listed on major U.S. stock exchanges are Chinese RM firms. Despite its popularity, the RM process has been criticized as a ‘‘backdoor’’ or ‘‘shortcut’’ to going public, because RM firms bypass the scrutiny of the Securities and Exchange Commission (SEC) in the listing process. Many observers suspect that foreign RMs only ‘‘rent’’ the benefits of being listed in the U.S., without actually improving their corporate governance or financial reporting quality. These concerns are particularly noteworthy for Chinese RM firms, which are subject to weaker legal enforcement and investor protection. In 2010 and 2011, many Chinese RM firms restated their financial statements, and many shareholders sued Chinese RM firms for fraudulent accounting (e.g.,Siegel and Wang 2013). These scandals triggered a rapid decline in the value of Chinese RM firms. From mid-2010 to mid-2011, these firms lost 80 percent of their market value
(Templin 2012).
In this paper, we examine whether the low financial reporting quality of Chinese RM firms is related to their use of the less scrutinized RM method (i.e., the RM effect), the weak legal enforcement over Chinese firms (i.e., the weak country effect), or both. If the RM effect is significant, then we should expect both U.S. and Chinese RM firms to have lower financial reporting quality than their respective counterparts (i.e., U.S. IPO firms and Chinese ADR firms). If the weak country effect is significant, then we should expect Chinese RM firms to have lower financial reporting quality than U.S. RM firms. Relying on the cross-listing literature, we further hypothesize that the less scrutinized RM process allows Chinese firms with weaker bonding incentives to access the U.S. capital markets. In that case, Chinese RM firms should show poorer corporate governance and lower financial reporting quality than Chinese ADR firms.
We investigate these questions by analyzing a sample of 287 Chinese RM firms that are traded on U.S. stock exchanges or the over-the-counter (OTC) bulletin board and have the relevant data available. Due to the inherent difficulty in capturing financial reporting quality, we follow previous research (e.g.,Dechow, Ge, and Schrand 2010;Hope, Thomas, and Vyas 2013) and use a wide range of measures, namely, the likelihood of accounting restatements and four accrual-based measures. To ensure that the differences in financial reporting quality are not driven by differences in firm characteristics, we control for a comprehensive list of factors that affect financial reporting quality.
We document three major empirical results. First, we find that the financial reporting quality of U.S. RM firms is comparable with that of U.S. IPO firms matched by their trading venue, industry, year, and size. However, the financial reporting quality of Chinese RM firms is lower than that of Chinese ADR firms. This result is interesting because the conditions of legal enforcement are the same for both Chinese RM and ADR firms, and the regulatory requirement for ongoing disclosure is arguably more stringent for Chinese RM firms than for Chinese ADR firms. These results indicate that the RM effect is associated with lower financial reporting quality for Chinese firms, but not for U.S. firms.
Second, we find that the financial reporting quality of Chinese RM firms is lower than that of U.S. RM firms. Given that both types of firms adopt the same listing method (i.e., the RM process), this result indicates that among RM firms, those that are subject to weak legal enforcement have lower financial reporting quality. These results, combined with the above-described results, indicate that the less scrutinized RM process leads to lower financial reporting quality only when the RM firms are subject to weak legal enforcement. In other words, both the RM effect and the weak country effect contribute to the lower financial reporting quality of Chinese RM firms.
Third, we examine the differences in the strength of bonding incentives and corporate governance features between Chinese RM and Chinese ADR firms. Consistent with our prediction, we find that Chinese RM firms have lower CEO turnover-performance sensitivity (a measure of bonding incentives) than Chinese ADR firms. Chinese RM firms also have higher insider ownership, lower foreign ownership, smaller boards, higher likelihood of CEO-chairman duality, and lower CEO option-based compensation. These findings indicate that Chinese RM firms have weaker bonding incentives and engage in fewer bonding activities than Chinese ADR firms. Last, but not least, we confirm that the likelihood of using RM transactions (as explained by the governance variables) is associated with the lower financial reporting quality of Chinese RM firms.
Based on these analyses, we conclude that firms self-select their listing choices (RM versus IPO), and the less scrutinized RM process allows foreign firms with weak bonding incentives and poor financial reporting quality to enter the U.S. markets. In contrast, foreign firms with stronger bonding incentives and better financial reporting quality tend to enter the U.S. capital markets via the IPO process. In other words, the self-selection of listing options reveals firm types and differential levels of
1
A public shell company is defined as a public registrant that has no operations or assets, or only nominal operations and assets (SEC Securities Act Release No. 33-8587 (July 15, 2005, available athttps://www.sec.gov/rules/final/33-8587.pdf).
2 In contrast, during the same period, there were only 135 newly listed Chinese ADRs (American Depositary Receipt [ADR] firms) on major stock exchanges, and an additional 107 unsponsored (or Level 1) Chinese ADRs.
financial reporting quality. This self-selection argument implies that the financial reporting quality of Chinese RM firms is lower than that of Chinese ADR firms. Note that we are not suggesting that the RM processcauses lower financial reporting quality.
The above-stated analyses focus on the level of financial reporting quality, not on investors’ perceptions of it. When we use the earnings response coefficient based on quarterly earnings announcements to capture investors’ perceptions of financial reporting quality, we find that Chinese RM firms do not differ from other firms. However, we find that throughout the year, the market reacts less positively to the changes in earnings reported by Chinese RM firms.
This paper contributes to the literature in several important ways. First, it sheds light on why Chinese RM firms have lower financial reporting quality than U.S. IPO firms and, thus, answers the call for more research on the financial reporting quality of RM firms (Public Company Accounting Oversight Board [PCAOB] 2011). Our findings should be of interest to regulators engaged in designing rules to enhance the financial reporting quality of foreign RM firms and to those investors who trade on the shares of these firms.
Second, our paper contributes to the literature on the financial reporting quality of U.S.-listed foreign firms by investigating the effect of the most popular listing method in recent years, the RM, which has generally been excluded in prior research
(Lang, Raedy, and Yetman 2003;Lang, Raedy, and Wilson 2006;Leuz 2006;Ndubizu 2007). In particular, the paper builds on
and extends the Lang et al. (2006) study in several important dimensions. First and foremost, althoughLang et al. (2006)
compare the financial reporting quality of ADRs and U.S. domestic firms, we investigatewhy Chinese RM firms have lower financial reporting quality than U.S. IPO firms. Second, although one can infer from the conclusion ofLang et al. (2006)that weak legal enforcement and weak investor protection in China lead Chinese firms to have lower financial reporting quality than U.S. firms (i.e., the weak country effect), their analysis does not shed light on the RM effect. Our analyses enhance our understanding of how the RM process affects U.S. firms and Chinese firms in different ways. Furthermore, we document that Chinese RM firms have weaker bonding incentives and poorer corporate governance than Chinese ADR firms, and that these differences contribute to the lower financial reporting quality of Chinese RM firms.
Third, this paper contributes to the cross-listing literature (Licht 2003;Siegel 2005;Lang et al. 2006). Our analysis of Chinese RM and ADR firms is particularly interesting because it highlights the importance of listing choices. Our results suggest that when alternative listing choices are available, some firms choose the more stringent IPO listing method, adopt better corporate governance mechanisms, and improve their financial reporting quality. Other firms choose the less stringent RM listing method to bypass the scrutiny of regulators and the market.
This paper is related to several concurrent studies that examine various issues surrounding Chinese RM firms, but our paper differs from these studies in several significant ways. By focusing on the fundamentals,Lee, Li, and Zhang (2015)find that Chinese RM firms are more likely to survive and perform better than other RM firms or exchange-industry-size matched U.S. firms. LikeLee et al. (2015), we also find that Chinese RM firms have better accounting performance (ROE) than U.S. RM firms or matched U.S. IPO firms. However, our paper complements that of Lee et al. (2015)by addressing related, but different, research questions. WhileLee et al. (2015)focus on the performance of Chinese RM firms, we focus on the financial reporting quality of these firms.3Better performance does not necessarily imply better financial reporting quality (Ang, Jiang,
and Wu 2016;Darrough, Huang, and Zhao 2015).
Our paper is closely related to a concurrent study, namely, that ofGivoly, Hayn, and Lourie (2014), who also find that Chinese RM firms have lower financial reporting quality than matched U.S. IPO firms. These authors attribute their finding to the broad cultural and institutional differences between the U.S. and China, without providing any direct evidence. Unlike
Givoly et al. (2014), we conduct a more comprehensive analysis. In addition, we compare Chinese RM and Chinese ADR firms
in terms of bonding incentives and corporate governance. Overall, our findings suggest that the lack of scrutiny associated with the RM process enables the firms with weak bonding incentives from China to list in the U.S., and that such practice contributes to low financial reporting quality.
Siegel and Wang (2013)also examine the governance and reporting quality of RM firms. They find that early adopters of
RMs and RM firms hiring a Big 4 auditor exhibit superior corporate governance outcomes, including a lower likelihood of restatements. However, their study differs from our paper in three important dimensions. First,Siegel and Wang (2013)focus on the variations within non-U.S. RM firms, and they do not investigate the difference between these RM firms and other types of firms (e.g., U.S. IPO firms, Chinese ADR firms, or U.S. RM firms). Second,Siegel and Wang (2013)include both RMs involving shells and RMs involving two operating companies. For example, more than half of the RM firms in their sample are
3
There are also several other studies on Chinese RM firms, but these studies do not examine financial reporting quality issues. For example,Darrough et al. (2015)examine the spillover effects of Chinese firms that have been implicated in fraud. They find that Chinese firms that were not implicated in fraud also experienced a significant drop in stock prices in late 2010 and early 2011.He, Wong, and Young (2013)andAng et al. (2016)arrive at a similar conclusion, and they show that many Chinese firms were delisted after the 2010–2011 drop in stock prices.
Canadian RM firms, the majority of which are not RM firms involving shell companies. In contrast, our paper and other concurrent studies focus on RMs involving shells. Last, unlike Siegel and Wang (2013), we examine how firm-level governance affects firms’ listing choices, and how these choices relate to financial reporting quality. As such,Siegel and Wang
(2013)and the above-mentioned studies, including ours, complement each other.
The rest of this paper is organized as follows. Section II discusses the background of Chinese RM firms, reviews the related research, and develops the hypotheses. Section III explains the sample selection, variable measurements, and descriptive statistics. Section IV presents the empirical results with regard to the financial reporting quality of Chinese RM firms. Section V reports our analysis concerning the strength of the bonding incentive among U.S.-listed Chinese firms, and how this incentive relates to financial reporting quality. Section VI examines the market perception of financial reporting quality. Section VII concludes.
II. BACKGROUND, RELATED RESEARCH, AND HYPOTHESIS DEVELOPMENT Background on Chinese RM Firms
Foreign firms, including Chinese firms, have various incentives for seeking access to U.S. capital markets. The most frequently cited reasons are to obtain cheaper capital and increase liquidity (e.g.,Pagano, Ro¨ell, and Zechner 2002;Licht 2003). Other benefits include an increased shareholder base, greater visibility, growth, diversification, and economies of scale. As noted by theSEC’s (2011) Investor Bulletin: Reverse Mergers, obtaining access to the U.S. capital markets also improves a company’s reputation with its customers and potential acquirers. Finally, in China, having a company listed on a U.S. stock exchange is sometimes regarded as a trophy that increases the CEO’s social status (Gillis 2011). In a similar vein,Hung, Wong,
and Zhang (2012) find that state-owned enterprises with strong political connections are more likely to list on overseas
exchanges because it can increase the managers’ private benefits, such as receiving media coverage and being promoted to senior government positions. All of these potential benefits prompt Chinese firms to list in the U.S.
In recent years, the RM has become the most popular method for foreign firms, including Chinese firms, to go public in the U.S. In a typical Chinese RM transaction, a U.S. public shell company acquires a Chinese private firm through a share exchange. The U.S. public firm survives, but its directors and managers are replaced by the executives of the Chinese private firm. One of the reasons for the recent popularity of RMs is that compared with other approaches (e.g., IPOs), the RM process is faster and cheaper. Adjei, Cyree, and Walker (2008) estimate that the cost of setting up a public shell company and completing the RM transaction can be as low as $50,000, compared to the millions of dollars it can cost to complete an IPO. Also, a typical RM can be done within six months. In contrast, an IPO commonly takes nine to 12 months to complete, and the process can be cancelled if the market situation changes unfavorably. Therefore, smaller, younger, and less profitable firms are more likely to undertake RM transactions (Adjei et al. 2008; Jindra, Voetmann, and Walkling 2012). Thus, despite the disadvantages of RMs, such as less access to funding, less support from market intermediaries, and being traded on the OTC market (Feldman 2009), the number of RM firms has grown rapidly in the past decade.
Interestingly, the RM approach to accessing the U.S. capital markets is particularly popular among Chinese firms as compared to other foreign firms. There are two possible reasons for this phenomenon. First, Chinese private firms have difficulties raising capital in China. According to the Organisation for Economic Co-operation and Development Economic Survey (OECD 2010), most Chinese private firms have difficulty accessing bank credit because Chinese banks focus mainly on the financing needs of large state-owned enterprises and on policy-directed lending. The still-developing bond markets are dominated by bonds issued by the central government and the central bank. In 2013, corporate bonds accounted for only 2.4 percent of the bond market. Even though the domestic stock markets have grown rapidly, private firms still have difficulties being listed on the Shanghai or Shenzhen stock exchanges due to the high standards required for listing.4These requirements prevent many small or medium-sized Chinese firms from raising capital from the public in China.
Second,Feldman (2009)argues that U.S. investors have shown a strong desire to tap into China’s fast-growing economy in recent years. To fulfill the strong demand from the market, some Wall Street bankers provide services that include accounting, legal advice, auditing, and public relations to encourage and prepare Chinese firms to enter the U.S. and raise capital there. Both the desire of U.S. investors to gain from China’s economic growth and the institutional support provided attract Chinese firms to adopt the RM approach for entering the U.S. capital markets.
Since 2010, however, Chinese RM firms, especially those listed on the major stock exchanges, have drawn significant attention due to their large number of accounting fraud cases. In early 2011, the SEC suspended trading of several Chinese RM firms’ shares and revoked the securities registrations of several others, primarily due to financial reporting concerns. Similarly,
4 For example, to be qualified for listing on the main board or the small firm board, a firm must have been in business for more than three years and have made profits over the last three consecutive years, with cumulative profits of more than 30 million yuan.
high-profile short-sellers have also targeted some Chinese RM firms. For example, in January 2011, J Capital Research issued a research report on China Green Agriculture, Muddy Waters on Sino-Forest in June 2011, and Citron Research on several Chinese RM firms in 2011. In response to these issues, the SEC issued a bulletin in July 2011 to warn investors concerning the dangers of investing in RM firms. In the same year, the Public Company Accounting Oversight Board (PCAOB) issued a research note highlighting problems with Chinese RM firms, particularly the growing concerns over these firms’ audit quality. Many commentators and regulators attribute these issues to the speed of the RM process and the loopholes in its requirements.5Unlike the IPO process, which provides ample opportunities for information dissemination, such as road shows and detailed prospectuses, less time is provided for investors and the SEC to evaluate a firm during the RM process.6Although IPO firms must file financial reports with the SEC for approval before going public, firms conducting RMs are only required to file their consolidated financial reports (Super 8-Ks) after the transaction. In addition, a Super 8-K is not as detailed as a prospectus. A Super 8-K usually provides information for the past two years, but a prospectus typically provides information for the past five years. In addition, many Super 8-Ks lack complete and detailed financial statements.
The protection that investors have against false financial statements is also much weaker in the RM than in the IPO process. As IPO cases involve the issuance of new shares, investment banks are also responsible for the representational faithfulness of the financial statements. In contrast, no underwriters are involved in RM cases, and most of the law firms or auditors involved in RM deals are small. The scrutiny from financial analysts and institutional investors is also lacking because most RM firms are traded on the OTC market.
It is important, however, to distinguish between the regulatory requirements for the listing process and the requirements for ongoing reporting. Although the RM process is characterized by weak scrutiny, RM firms are subject to the same regulatory requirements for ongoing financial reporting as firms that go public via IPOs (Licht, Poliquin, Siegel, and Li 2013). For example, on CNBC’s Fast Money, the CEO of the NASDAQ OMX Group, Bob Greifeld, emphasized that the regulatory requirements and auditing standards for Chinese RM firms are identical to those for other listed firms. Please refer toTemplin
(2012)for more detailed discussions on the regulatory and legal issues related to Chinese RM firms.
Related Research
This paper is broadly related to the cross-listing literature, and particularly to those studies that examine the effects of cross-listing on financial reporting quality. There is a long line of research that examines the effects of cross-listing on foreign firms’ corporate decisions and on firm value (e.g.,Coffee 2002;Licht 2003;Doidge, Karolyi, and Stulz 2004;Siegel 2005;
Leuz 2006;Doidge, Karolyi, Lins, Miller, and Stulz 2009). The majority of these studies are built on the bonding hypothesis
(e.g.,Coffee 1999;Stulz 1999), which states that firms with poor minority shareholder protection signal their desire to respect shareholder rights by listing in a jurisdiction with higher market scrutiny, tougher regulations, and better enforcement.
In terms of the relationship between cross-listing and financial reporting quality,Lang et al. (2003)find that firms cross-listed in the U.S. reflect bad news in a more timely manner, have a higher correlation between earnings and share prices, and are less likely to engage in earnings management than firms listed only in their home countries.Bailey, Karolyi, and Salva (2006)
also document that cross-listed firms have higher earnings response coefficients (ERCs) than firms that are not cross-listed. In addition to comparing cross-listed firms with firms listed in their own countries, previous studies have examined the financial reporting quality of cross-listed firms relative to U.S. domestic firms. For example,Lang et al. (2006)find that cross-listed firms are more likely to engage in earnings management than U.S. domestic firms. Ndubizu (2007) finds similar evidence, particularly for periods surrounding the time of cross-listing.
Hypothesis Development on the Financial Reporting Quality of Chinese RM Firms
In this section, we develop the hypotheses on why Chinese RM firms have lower financial reporting quality than U.S. IPO firms. Our argument is largely built on the cross-listing literature as discussed above. Prior research suggests three primary factors that can affect the financial reporting quality of foreign firms listed in the U.S.:
5 For example, in April 2011, Luis Aguilar, one of the SEC’s commissioners, commented that ‘‘There are a lot of different ways for companies to access the public markets, but not all of them are equal. They differ in the quality of the disclosures, the time investors and the SEC typically have to consider them, and the protections that investors have against false and fraudulent statements . . . In the world of backdoor registrations to gain entry into the U.S. public market, the use by Chinese companies has raised some unique issues . . . There appear to be systematic concerns with the quality of the auditing and financial reporting’’ (Aguilar 2011).
6
An RM transaction can progress so fast that it is possible for an RM firm to be listed on a major stock exchange before the required financial statement is filed with the SEC. For example, the Chinese firm SinoCoking merged into a shell company named Alleauctions.com on February 5, 2010. Three days later, the Form 8-K was filed and the company was quoted on the OTC market. Thirteen days later, the stock was uplisted to the NASDAQ. However, it was not until March 18 that SinoCoking amended its 8-K filings to include the required audited financial statements.
1. Enhanced disclosure requirements and market scrutiny in the U.S. These accountability structures are the foundations of the bonding mechanism that can improve the financial reporting quality of cross-listed foreign firms compared to their counterparts in their home countries (e.g.,Lang et al. 2003;Leuz 2006;Gong, Ke, and Yu 2013). However, as we are not comparing Chinese firms listed in the U.S. with those listed in China, this factor is not particularly relevant for most of our analyses.
2. Investor protection in the home country and SEC enforcement over U.S.-listed foreign firms. For foreign firms from countries with weak investor protection, being listed in the U.S. can improve their financial reporting quality. However, the combination of weak investor protection in their home countries and weak SEC enforcement over foreign firms can reduce these firms’ bonding incentives and lead to lower financial reporting quality compared to their U.S. counterparts (e.g.,Lang et al. 2003;Siegel 2005;Leuz 2006;Gong et al. 2013).
3. Listing choices, firm-level bonding incentives, and governance. How a foreign firm accesses the U.S. capital markets can affect its financial reporting quality due to differences in the levels of scrutiny during the listing process. What is particularly relevant for this paper is whether the use of the RM method is associated with lower financial reporting quality. Although some firms choose the RM process because it is cheaper and faster, others might choose it because the scrutiny is less stringent. Therefore, firms with weaker bonding incentives and poorer governance may choose the RM process over the IPO process. Many studies argue that a firm’s incentives and governance have more significant effects on its financial reporting quality than the accounting rules in general (e.g., Ball, Robin, and Wu 2003; Chi,
Dhaliwal, Li, and Lin 2013), and that this is especially the case for foreign firms listed in the U.S. (Leuz 2006).
Below, we elaborate on the effects of these factors whenever they are applicable. The RM Effect
As discussed above, the potential loopholes associated with the RM process, particularly the lack of market and regulatory scrutiny, have drawn attention from both the investment community and regulators. The weak scrutiny by regulators and market participants, along with other problems with the RM process, can result in lower financial reporting quality for RM firms than for their counterparts. We are not suggesting that the RM process causes firms to reduce their financial reporting quality. Instead, we argue that firms choosing the IPO process tend to improve their financial reporting quality due to the more stringent listing standards, the more closely scrutinized process, and the concerns of auditors and underwriters over potential litigation. In contrast, the firms that select the RM process might not improve their financial reporting quality, as the registration process is less scrutinized. In addition, the less scrutinized RM process can attract firms with weak bonding incentives, again resulting in lower financial reporting quality for RM firms.
To isolate the RM effect for U.S. firms, we compare U.S. RM firms with U.S. IPO firms. As these two groups of firms differ only in their listing process, we expect that if the use of the less scrutinized RM process is the main driver for poor financial reporting quality, then U.S. RM firms should have lower financial reporting quality than U.S. IPO firms:
H1: Ceteris paribus, the financial reporting quality of U.S. RM firms is lower than that of U.S. IPO firms.
Similarly, both Chinese RM firms and Chinese ADR firms are subject to the same legal enforcement regimes (e.g., investor protection in China and the SEC’s enforcement in the U.S.) and they differ only in their listing choices. Thus, if the use of the less scrutinized RM process is the main driver, then we hypothesize the following:
H2: Ceteris paribus, the financial reporting quality of Chinese RM firms is lower than that of Chinese ADR firms. We note, however, that although the RM process is less scrutinized than the IPO-ADR process, Chinese RM firms are subject to more stringent regulatory requirements in terms of ongoing financial reporting and governance than Chinese ADR firms. ADRs are exempt from some requirements related to disclosure and corporate governance, such as the proxy and insider trading provisions of the Securities and Exchange Act of 1934, quarterly reporting requirements, and Regulation Fair Disclosure (e.g., Licht 2003; Leuz 2006). In addition, ADR firms do not need to prepare the full U.S. generally accepted accounting principles (GAAP) financial statements; they only need to prepare 20-Fs. In contrast, Chinese RM firms inherit the filing status of the U.S. shell firms, and they must file financial statements as frequently and provide disclosures that are as detailed as those required of U.S. IPO firms. These differences in regulatory requirements are likely to cause bias against finding evidence consistent with H2.
The Weak Country Effect
The weak country effect refers to the notion that U.S. regulators have difficulties in gathering evidence and U.S. investors have problems in protecting their legal rights in countries with weak investor protection (e.g.,Cheng, Srinivasan, and Yu 2014;
McMahon 2012). These problems are exacerbated by the lack of jurisdiction of the U.S. enforcement officials, and by the lack of intention and/or resources that local regulators have in monitoring and disciplining U.S.-listed firms (Jindra et al. 2012;
Siegel and Wang 2013).7These problems certainly apply to Chinese RM firms. Many Chinese RM firms openly admit that both
investor protection and legal enforcement are weak.8,9 Templin (2012)notes that regulators have weak enforcement powers over not only Chinese RM firms, but also over their Chinese auditors. Templin argues that the Chinese auditors who usually carry out audit work for the U.S. auditors hired by Chinese RM firms are commonly short of skills, and sometimes have lower ethical standards. All of these problems can lead to poor financial reporting quality.
To study the weak country effect, i.e., the effect of weak legal enforcement on the financial reporting quality of Chinese firms, one needs to control for the listing choice. For this purpose, we compare the reporting quality of Chinese RM and U.S. RM firms. Both groups of firms go through the same listing process and are subject to the same financial reporting rules. If weak legal enforcement over Chinese RM firms leads to lower financial reporting quality, then we expect Chinese RM firms to have lower financial reporting quality than U.S. RM firms:10
H3: Ceteris paribus, the financial reporting quality of Chinese RM firms is lower than that of U.S. RM firms.
Chinese RM Firms and Chinese ADR Firms: Bonding Incentives and Corporate Governance
When a Chinese firm intends to access the U.S. capital markets, it can (to some extent) choose to use either the RM approach or another approach (e.g., ADR).11 In light of this potential self-selection issue, we examine the strength of the bonding incentives and corporate governance of Chinese RM and Chinese ADR firms to better understand why financial reporting quality differs between these two groups of firms.12
Ball et al. (2003)find that when the incentive for increasing financial reporting quality is low, stringent standards do not
necessarily lead to high-quality financial reporting. Subsequent studies, such asChi et al. (2013), also find that incentives rather than rules tend to determine financial reporting quality. As such, although Chinese RM and ADR firms are subject to the same legal enforcement and investor protection, their financial reporting quality depends on their bonding incentives.
The notion of the bonding mechanism originates from the idea that in the more developed capital markets, foreign firms voluntarily subject themselves to stringent regulations and accept close monitoring from market participants in exchange for cheaper capital. However, the effectiveness of legal bonding is affected by the strength of legal enforcement and the firms’ bonding incentives. Legal enforcement actions against foreign firms are rare, and they often result in insignificant penalties (e.g., Siegel 2005; Licht et al. 2013). Such weak enforcement over foreign firms reduces the firms’ incentives to improve corporate governance or to provide high-quality financial statements. To distinguish themselves from others, high-quality firms are likely to engage in a dynamic reputation-building process through which their managers gradually form a reputation for not expropriating minority shareholders. These firms build a sound reputation by, for example, voluntarily improving corporate
7 For example,Jindra et al. (2012, 24) argue that although ‘‘the incidence of litigation appears higher for CRM [Chinese RM] firms, the cost of litigation as measured by dollar settlement amounts does not appear large, especially when compared to other settlements.’’
8
For example, with respect to the weak U.S. enforcement, China Display Technologies, Inc., states on page 19 of its prospectus (Form SB-2 filed on January 17, 2008) that ‘‘It will be extremely difficult to acquire jurisdiction and enforce liabilities against our officers, directors and assets based in China. Substantially all of our assets will be located outside of the United States and our officers and directors will reside outside of the United States. As a result, it may not be possible for United States investors to enforce their legal rights, to effect service of process upon our directors or officers or to enforce judgments of United States courts predicated upon civil liabilities and criminal penalties of our directors and officers under Federal securities laws. Moreover, we have been advised that China does not have treaties providing for the reciprocal recognition and enforcement of judgments of courts with the United States. Further, it is unclear if extradition treaties now in effect between the United States and China would permit effective enforcement of criminal penalties of the Federal securities laws.’’
9
For example, with respect to weak investor protection in China, China Crescent Enterprises, Inc., stated on page 10 of its 10-K for fiscal year 2010 that ‘‘as the Chinese legal system evolves rapidly, the interpretations of many laws, regulations, and rules are not always uniform, and enforcement of these laws, regulations and rules involve uncertainties which may limit legal protections available to you and us.’’
10
This weak legal enforcement and investor protection applies not only to Chinese RM firms, but also to Chinese ADR firms. In the empirical analysis section, we discuss in detail whether this factor alone explains the low financial reporting quality of Chinese RM firms.
11
All private firms can theoretically choose the RM approach because they do not need to obtain approval from security regulators in China. As for ADRs, based on our untabulated analyses, we find that only 15 firms in our sample (11 percent) are incorporated in China and obtain approval from Chinese security regulators to access the U.S. markets via ADRs (e.g., China Eastern Airlines, China Telecom). The rest of the ADR firms (89 percent) are incorporated in offshore centers such as the Cayman Islands and the Virgin Islands, and they do not need to obtain Chinese regulators’ approval to issue shares overseas (e.g., Sina, Baidu, Youku). As such, a Chinese private firm can theoretically choose to be incorporated in offshore centers and access the U.S. capital markets via ADRs.
12
This type of self-selection differs from the other type of self-selection that needs to be controlled for. As discussed above, the RM process is a cheaper and faster process than the IPO process and, thus, smaller or poorly performing firms are more likely to use the RM process. These firm characteristics are also correlated with financial reporting quality. As such, we control for the confounding effect of these firm characteristics in the empirical analyses, as discussed below.
governance or by hiring reputable auditors and investment bankers (Coffee 2002;Siegel 2005;Marosi and Massoud 2008;
Carcello, Carver, Lennox, and Neal 2014).
We argue that the Chinese firms that have stronger bonding incentives and better financial reporting quality tend to enter the U.S. capital markets via the IPO process, because of the close scrutiny of the SEC and market participants and the involvement of reputable market intermediaries, such as auditors and underwriters. These IPO/ADR firms are likely to have strong bonding incentives because, as examined in Coffee (2002), the insiders of ADR firms enjoy an increased valuation premium and the existing shareholders can immediately benefit from the bonding. In contrast, the less scrutinized RM process allows Chinese firms with weaker bonding incentives and poorer financial reporting quality to enter the U.S. markets. Chinese RM firms have weak bonding incentives, likely because most of the insiders from the original private firms do not sell their shares after the RM transactions (Floros and Shastri 2009b). As such, they do not benefit from strong bonding.
Stulz (1999) argues that in a weak legal enforcement environment, adopting more effective corporate governance
mechanisms can serve as a strong signal of a firm’s bonding incentives. Therefore, we argue that the corporate governance-related decisions made by U.S.-listed Chinese firms are tied to the strength of their bonding incentives. This argument implies that Chinese RM firms have weaker corporate governance than Chinese ADR firms.
In summary, this discussion implies that bonding incentives and corporate governance are weaker for Chinese RM firms than for Chinese ADR firms. Thus, our last set of hypotheses is as follows:
H4a: Ceteris paribus, Chinese RM firms have weaker bonding incentives than Chinese ADR firms.
H4b: Ceteris paribus, the strength of corporate governance is weaker in Chinese RM firms than in Chinese ADR firms.
III. SAMPLE AND DATA Sample Selection
We rely on multiple sources to compile our sample of Chinese RM firms. We start with the list of Chinese RM firms from DealFlow Media, which tracks RM deals with U.S. shell companies starting from 2001. From the records of DealFlow Media, we identify 432 RM deals involving Chinese private companies in the 2001–2011 period. We then cross-check this list with Chinese RM firms listed on the NYSE, the NYSE-AMEX, and the NASDAQ based on a Bloomberg report published in June 2011, and a record of U.S.-listed Chinese firms included in the Halter USX China Index and in reports by CYNES.com.13To ensure that these firms are listed through the RM method, we go through these firms’ annual filings and their websites. These steps yield 16 additional Chinese RM firms, resulting in our initial sample of 448 Chinese RM firms in the 2000–2011 period. To be included in our final sample, Chinese RM firms need to satisfy the following criteria: (1) the headquarters of the firm and the majority of its operations are in China; (2) SEC filings (i.e., the first 10-K and 8-K filings) are available to verify whether a U.S. shell company is involved;14(3) the firms are not in the financial (SIC 6000–6999) or utilities (SIC 4900–4949) industries; (4) accounting data are available from Compustat or 10-K filings. As a result, six, four, 45, and 106 firms are excluded due to the above four requirements, respectively. Our final sample, therefore, includes 287 Chinese RM firms. Of these firms, 116 eventually listed on the major exchanges, and 171 were still traded on the OTC market at the time of data collection.15
Note that to increase the generalizability of the results, we include both firms traded on the major stock exchanges and on the OTC market. The drawback to including OTC firms is that these firms are, on average, much smaller than those traded on the major stock exchanges. Firms traded on the OTC market are also subject to less stringent market monitoring. These differences are likely to introduce noise to the analyses. To mitigate this effect, we match the control firms by their trading
13
The Halter USX China Index includes Chinese firms that are listed on the NYSE, NYSE-AMEX, or the NASDAQ, and have a market-cap greater than $50 million. The components of the Halter Index are updated quarterly based on the basic market value requirement and other factors. To avoid a survivorship bias, we collect a historical list of Chinese issues from quarterly reports of the Halter USX China Index since 2003.
14 We limit our sample to RM firms with shell firms for two reasons. First, an RM transaction between two operating firms is similar to a regular merger and acquisition, except that it is the target (not the acquirer) that survives. A lot of reputable firms have been established through this method, including Blockbuster, the NYSE, Texas Instruments, and Berkshire Hathaway. However, the primary objective of RMs involving shell firms is for the private firms to go public. Second, the majority of the U.S. RM deals in our sample period are conducted through merging with shell firms. Therefore, focusing on RMs with shell firms can facilitate a more appropriate comparison.
15
Compustat covers firms traded on the OTC market only if their shares are priced at $0.01 or above, and are traded fairly consistently. For OTC-traded Chinese RM firms not covered by Compustat, we hand-collect data from their 10-K filings. To ensure that our results are not affected by extremely small firms, we limit the scope of data collection to firms with positive common shareholders’ equity, non-zero sales, and with total assets of $1 million or more.
venue, as is discussed in detail later. We also conduct an untabulated sensitivity test by excluding OTC firms from the sample, and find quantitatively similar results.
The sample selection process for U.S. RM firms is similar. From DealFlow Media, we identify 1,204 RM deals involving U.S. shell companies. Applying the same criteria as previously described, we obtain 273 U.S. RM firms. Of these, 65 have uplisted to major stock exchanges and 208 are still traded on the OTC market.
We collect Chinese ADRs based on information available from the Bank of New York, JPMorgan at:https://www.adr. com/, CYNE.com, Sina.com’s historical quarterly reports, and the Halter USX China Index. We read the 20-F filings of Chinese ADR firms to identify the locations of their headquarters and businesses and to ensure that these firms are from China. We do not include ADRs traded on the OTC market because they are exempt from the SEC reporting requirements.16These steps result in a sample of 142 Chinese ADRs.
In addition to accounting data from Compustat, we obtain the price and return data from the Center for Research in Security Prices (CRSP) and the restatement data from Audit Analytics. We hand-collect CEO turnover and corporate governance variables for Chinese RM and ADR firms from their 10-Ks, 20-Fs, and proxy statements filed with the SEC.
Panel A of Table 1 reports the yearly distribution of Chinese RM firms, U.S. RM firms, and Chinese ADRs.17The greatest number of Chinese RM deals happened in the 2004–2010 period. Panel B of Table 1 presents the distribution based on the trading venue at the time of data collection. Chinese RM firms are more likely to be traded on the major exchanges than U.S. RM firms. Also, a disproportionally higher percentage of Chinese ADR firms (67 out of 142) are listed on the NYSE; the results are quantitatively similar when we control for exchange fixed effects in all regressions. Panel C of Table 1 presents the sample distribution by Fama-French industry classification. Most of the U.S.-listed Chinese firms are from the business equipment, manufacturing, healthcare, or wholesale and retail industries. Most of the U.S. RM firms are in the business equipment, healthcare, or consumer non-durables industries.
To test H1, we need a sample of U.S. IPO firms. As small and poorly performing firms tend to use the RM process to access the capital markets, and as these firm characteristics are correlated with financial reporting quality, we use two approaches jointly to control for this potential self-selection issue. First, we use U.S. IPO firms matched on the trading venue (NYSE, NASDAQ, AMEX, or OTC), industry, year, and size as control firms. Second, as discussed below, we include a comprehensive list of variables that prior research shows to affect financial reporting quality as the control variables. We believe that these two approaches address the potential confounding effects of the differences in firm fundamentals between RM and IPO firms, and that the documented results capture the RM effect on financial reporting quality for U.S. firms.
We use the same methodology to identify matched U.S. IPO firms for Chinese RM firms. Measurement of Financial Reporting Quality
As there are no universally accepted measures of financial reporting quality, we use a wide range of measures to triangulate our results (Dechow et al. 2010). The use of multiple measures also helps to capture the different aspects of financial reporting quality. Specifically, we use both the probability of accounting restatements and several accrual-based measures to capture financial reporting quality. These measures have been used widely in accounting studies. One benefit of using the probability of accounting restatements is that it is subject to fewer measurement error issues. The drawback of this measure is that it is influenced by the effectiveness of the detection of the earnings management that ultimately leads to restatements. To the extent that Chinese RM firms have weaker bonding incentives (which can reduce the effectiveness of detection), we might not be able to find results consistent with H2 and H3.18 The analysis of accrual-based financial reporting quality measures, therefore, complements the analysis of restatements. While the accrual-based measures are likely to capture earnings management tactics within the GAAP boundaries, restatements can capture financial reporting activities beyond such boundaries (Lang et al. 2006). As such, consistent results from these analyses can enhance our confidence in the inferences.
16
ADRs (sponsored or unsponsored) that trade on the OTC market are exempt from Section 12g3-2(b) of the Security Exchange Act of 1934 registration and reporting requirements. There is also no reconciliation between financial statements prepared under the local GAAP and the U.S. GAAP. As such, the financial statements of these firms are based on local GAAP and are not comparable with those of other firms (e.g., Chinese RM firms). In addition, these firms are not under U.S. jurisdiction. See theSEC’s (2012)Investor Bulletin: American Depositary Receipts for discussions of the disclosure and reporting requirements on ADR firms.
17
There are three Chinese RM firms and 21 Chinese ADR firms that were listed before 2001. Data for U.S. RM firms involving shell firms before 2001 are not available from DealFlow Media. Excluding these 24 Chinese firms from the sample does not affect the results.
18
Srinivasan, Wahid, and Yu (2015) find that the restatement frequency of foreign firms listed on U.S. exchanges is lower than that of U.S. firms. Furthermore, they find that there is no positive association between restatement frequency and internal control weaknesses for foreign firms from countries with weak rule of law. They interpret these results as indicating that weak rule of law negatively affects the likelihood of detecting and reporting accounting misstatements.
We collect information on restatements from Audit Analytics, which covers the restatements announced since 2000. We include all restatements on which data are available in the sample. In addition, we separate errors from accounting irregularities. To identify accounting irregularities, we follow the procedure outlined byHennes, Leone, and Miller (2008)and cross-check with the fraud cases listed inJindra et al. (2012),Siegel and Wang (2013), andAng et al. (2016).
We use four accrual-based financial reporting quality measures. The following is a brief description. (Please see Appendix A for a more detailed discussion.) The first measure is the absolute value of discretionary accruals (jDAj), which is estimated from the Jones model as modified in Dechow, Sloan, and Sweeney (1995). The second measure is
TABLE 1
Descriptive Statistics of Chinese RM Firms, U.S. RM Firms, and Chinese ADR Firms Panel A: Sample Distribution by the Year of Listing
First Listing Year
Chinese RM Firms U.S. RM Firms Chinese ADR Firms 2000 and earlier 3 0 21 2001 1 3 5 2002 2 12 1 2003 8 17 0 2004 22 49 8 2005 29 48 7 2006 47 38 11 2007 54 36 20 2008 46 26 14 2009 33 15 13 2010 34 17 26 2011 8 12 16 Total 287 273 142
This panel reports the distribution of sample firms based on the year when their shares were first listed in the U.S. stock markets. Panel B: Sample Distribution by Exchanges at the Time of Data Collection
Firm Type NYSE NASDAQ AMEX OTC Total
Chinese RM firms 6 82 28 171 287
U.S. RM firms 4 39 22 208 273
Chinese ADR firms 67 74 1 0 142
Total 77 195 51 379
Panel C: Sample Distribution by Fama-French Industry Classification Industry Chinese RM Firms U.S. RM Firms Chinese Non-RM Firms Consumer Non-Durables 36 12 8 Consumer Durables 13 8 3 Manufacturing 55 23 9
Oil, Gas, and Coal Extraction and Products 7 27 5
Chemicals and Allied Products 19 9 4
Business Equipment 40 58 58
Telephone and Television Transmission 4 7 6
Wholesale, Retail, and Some Services 34 15 8
Healthcare, Medical Equipment, and Drugs 38 54 11
Others 41 60 30
based on the cross-sectional Dechow and Dichev (2002) model, as modified in McNichols (2002), Francis, LaFond,
Olsson, and Schipper (2005), and Ball and Shivakumar (2006). The absolute value of the residual from the regression
(jDDj) is used as a proxy for financial reporting quality. The third measure is the absolute value of discretionary revenue (jDRj), which is the residual estimated from a regression of accounts receivable on the change in revenue, as developed
byMcNichols and Stubben (2008)andStubben (2010). The fourth measure is based on the natural logarithm of the ratio
of the absolute value of accruals to cash flows, lnjACCR/OCFj, as developed and used by Burgstahler, Hail, and Leuz
(2006 ) and Hope et al. (2013). Firms may overstate earnings without affecting cash flows to achieve certain earnings
targets or to report good performance in specific instances through accrual choices. The higher the ratio, the lower the financial reporting quality.
We also conduct a principal component analysis to capture the common construct underlying the four accrual-based financial reporting quality measures. We define the financial reporting index (FRQ) as the principal component that has the highest eigenvalue.19
Descriptive Statistics
Table 2 reports the descriptive statistics for Chinese RM firms, U.S. RM firms, Chinese ADR firms, and the matched U.S. IPO firms. Panel A reports the distribution of restated firm-years for the full sample and by year. Chinese RM firms have a much higher likelihood of restatements (23 percent) than U.S. RM firms (9 percent), Chinese ADR firms (5 percent), or matched U.S. IPO firms (13 percent). There is no obvious year effect.
Panel B of Table 2 reports descriptive statistics on other variables. Chinese RM firms have a higher likelihood of both errors and accounting irregularities. They also have lower financial reporting quality than other types of firms, according to the accrual-based measures. In terms of the control variables used in the financial reporting quality analysis, we find that U.S. RM firms stand out as having the highest market-to-book ratio and sales growth. LikeLee et al. (2015), we find that Chinese RM firms outperform U.S. RM and IPO firms by having higher ROE. Chinese ADR firms also appear to be larger than other firms. Chinese RM firms have the highest capital needs, and the matched U.S. IPO firms have the lowest capital needs.
IV. FINANCIAL REPORTING QUALITY OF CHINESE RM FIRMS
Due to research design differences, we first present the analysis of the likelihood of restatements, and then the analysis of accrual-based financial reporting quality measures.
Analysis of the Likelihood of Restatements
To test H1 ; H3, we estimate the following logit regression:
ProbðRestatementitÞ ¼ a þ b1RMitþ b2Chinaitþ b3RMit3 Chinaitþ cControlsit1þ uYear Dummies
þ hIndustry Dummies þ eit ð1Þ
The dependent variable, Restatement, is a dummy variable that equals 1 if the financial statement of firm i in year t is restated later, and 0 otherwise. The RM firm indicator variable,RM, equals 1 for Chinese or U.S. RM firms, and 0 for U.S. IPO or Chinese ADR firms. The Chinese firm indicator variable,China, equals 1 for Chinese RM or ADR firms, and 0 for U.S. RM or IPO firms. The sample includes Chinese RM firms, U.S. RM firms, Chinese ADR firms, and matched U.S. IPO firms.20The reported z-statistics are based on firm- and year-clustering adjusted standard errors. Under this specification, coefficient b1
captures the difference in the likelihood of having accounting restatements between U.S. RM and U.S. IPO firms, i.e., the RM effect for U.S. firms. Coefficient b2captures the difference in the likelihood of accounting restatements between Chinese ADR
and U.S. IPO firms, i.e., the weak country effect for ADR/IPO firms. Coefficient b3captures the incremental RM effect for
Chinese firms, i.e., the incremental weak country effect for RM firms. As such, the RM effect for Chinese firms is captured by b1þ b3, and the weak country effect for RM firms is captured by b2þ b3. The interpretations of the coefficients and hypothesis
testing are summarized as follows:
19
This is the only factor with an eigenvalue larger than 1 (2.4). It explains 48.5 percent of the sample variance and is positively correlated with each individual measure.
20
Note that we include both the matched U.S. IPO firms for Chinese RM firms, as well as those for U.S. RM firms. The inferences remain the same if we only include the matched U.S. IPO firms for U.S. RM firms. In untabulated analyses, we also conduct pairwise comparisons (Chinese RM firms with matched U.S. IPO firms, U.S. RM firms with matched U.S. IPO firms, Chinese RM firms with Chinese ADR firms, and Chinese RM firms with U.S. RM firms) and the inferences are the same. We report the pooled regression results to simplify the presentation.
TABLE 2
Descriptive Statistics on Financial Reporting Quality and Control Variables Panel A: Yearly Distribution of the Likelihood of Accounting Restatements
Year
Chinese RM Firms
U.S. IPO Firms Matched with
Chinese RM Firms U.S. RM Firms
U.S. IPO Firms Matched with
U.S. RM Firms Chinese ADR Firms
n Mean n Mean n Mean n Mean n Mean
2001 4 0.00 3 0.00 0 NA 0 NA 27 0.04 2002 3 0.33 3 0.17 2 0.50 1 0.00 28 0.00 2003 5 0.20 4 0.13 4 0.25 2 0.00 27 0.07 2004 9 0.22 8 0.13 15 0.13 8 0.12 37 0.11 2005 17 0.41 13 0.27 25 0.12 15 0.13 45 0.11 2006 36 0.22 28 0.11 36 0.06 30 0.06 55 0.04 2007 62 0.24 54 0.10 53 0.09 46 0.06 77 0.01 2008 96 0.19 84 0.11 55 0.13 46 0.10 85 0.07 2009 112 0.26 101 0.14 59 0.05 48 0.06 94 0.05 2010 93 0.20 87 0.11 54 0.06 39 0.07 113 0.02 2011 12 0.17 11 0.09 11 0.00 3 0.00 12 0.00 Total 449 0.23 396 0.13 314 0.09 238 0.07 600 0.05
This panel reports the distribution of the restated firm-years by year.
Panel B: Descriptive Statistics on Financial Reporting Quality and Control Variables
Chinese RM Firms
U.S. IPO Firms Matched with
Chinese RM Firms U.S. RM Firms
U.S. IPO Firms Matched with
U.S. RM Firms Chinese ADR Firms
Mean Median Mean Median Mean Median Mean Median Mean Median
Dependent Variables Restatement 0.23 0.00 0.13 0.00 0.09 0.00 0.07 0.00 0.05 0.00 Error 0.12 0.00 0.07 0.00 0.08 0.00 0.06 0.00 0.04 0.00 Irregularity 0.11 0.00 0.06 0.00 0.01 0.00 0.01 0.00 0.01 0.00 jDAj 0.17 0.12 0.12 0.07 0.22 0.13 0.17 0.09 0.10 0.06 jDDj 0.18 0.13 0.05 0.02 0.13 0.07 0.08 0.04 0.09 0.05 jDRj 0.12 0.07 0.05 0.02 0.10 0.04 0.07 0.03 0.06 0.03 lnjACCR/OCFj 0.44 0.29 0.49 0.46 0.54 0.57 0.53 0.48 0.45 0.44 FRQ 0.68 0.33 0.10 0.29 0.42 0.11 0.24 0.02 0.38 0.58 Control Variables M/B 2.99 1.40 3.56 1.50 5.90 3.79 4.52 2.33 2.56 1.58 Growth (%) 38.31 26.49 18.37 0.00 51.21 24.78 26.84 0.00 38.63 27.13 LEV (%) 14.03 8.11 16.99 9.72 13.94 3.67 12.98 5.15 13.55 5.59 ROE (%) 6.17 15.86 5.49 0.50 19.51 36.21 13.56 18.28 8.34 10.27 Size 4.29 4.44 4.26 4.27 2.99 2.94 2.91 2.83 6.51 6.04 Capital_Need (%) 19.21 0.00 4.66 0.00 9.46 0.00 6.83 0.00 9.59 0.02 Loss (%) 13.91 0.00 43.44 40.00 35.70 33.33 49.27 45.45 12.92 0.00 Op_Cycle 0.66 0.46 0.56 0.32 0.81 0.25 0.71 0.28 0.43 0.29 Inventory 0.10 0.06 0.14 0.11 0.08 0.002 0.08 0.01 0.06 0.02
Control variables include the variables that prior research suggests affect financial reporting quality: the market-to-book ratio (M/ B), sales growth (Growth), leverage (LEV), firm size (Size), capital needs (Capital_Need), firm performance (ROE, Loss), operating cycle (Op_Cycle), and inventory (Inventory).21Please see Appendix B for the definition of these variables. We also include industry and year dummies to control for the industry and year fixed effects. As such, we do not tabulate the coefficient on intercept.
Table 3 reports the regression results, with Model (1) of Panel A for the regression coefficients, and Panel B for hypothesis testing based on the likelihood of all restatements.
Before investigating why Chinese RM firms have lower financial reporting quality, we first confirm that they indeed have lower financial reporting quality than matched U.S. IPO firms. The difference in the likelihood of accounting restatements between Chinese RM and U.S. IPO firms is captured by b1þb2þb3. As reported in Panel B of Table 3, the sum of these three coefficients is significantly
positive (z¼ 5.32), indicating that Chinese RM firms indeed exhibit a higher likelihood of restatements than U.S. IPO firms. Test of H1 and H2: The RM Effect
To test H1, we compare the financial reporting quality of U.S. RM firms with that of matched U.S. IPO firms to investigate whether the RM effect leads to lower financial reporting quality for U.S. RM firms. As discussed above, this effect is captured by the coefficient onRM, b1. As reported in Table 3, b1is insignificantly different from zero, suggesting that U.S. RM firms do
not differ from matched U.S. IPO firms in the likelihood of restatements.
To test H2, we compare the financial reporting quality of Chinese RM firms with that of Chinese ADR firms. This effect is captured by the sum of the coefficient onRM and that on the interaction term, b1þ b3. As reported in Panel B of Table 3, b1þ
b3 is significantly positive (z¼ 5.45). This result indicates that Chinese RM firms are more likely to have accounting
restatements than Chinese ADR firms, which is consistent with H2, that the financial reporting quality of Chinese RM firms is lower than that of Chinese ADR firms.
As discussed above, we include Chinese RM firms traded on the major stock exchanges or on the OTC market, but for the Chinese ADR firms, we include only those traded on major stock exchanges due to data limitations. To ensure that the above results are not driven by the trading venue difference, we match Chinese RM firms with Chinese ADR firms based on their trading venue, industry, year, and size. The untabulated results are quantitatively similar.
In summary, the results from the tests of H1 and H2 indicate that although the RM effect does not lead to lower financial reporting quality for U.S. RM firms, it does for Chinese RM firms.
Test of H3: The Weak Country Effect
Next, we compare the financial reporting quality of Chinese RM firms with that of U.S. RM firms to investigate the weak country effect. As both groups of firms are subject to the same RM-related issues and filing rules, the difference between these two groups of firms, if any, should be driven by country-related factors such as legal enforcement and investor protection. As discussed above, the weak country effect for RM firms is captured by the sum of the coefficient onChina and that on the interaction term, b2þb3. As reported
in Panel B of Table 3, b2þ b3is significantly positive (z¼4.26). These results are consistent with H3, that the weak legal enforcement
and weak investor protection for Chinese RM firms lead to lower financial reporting quality for Chinese RM firms.22
21 In an untabulated sensitivity test, we also control for the standard deviation of quarterly earnings and obtain qualitatively similar results. 22
The arguments underlying our hypotheses imply that RM firms from all countries with weak legal enforcement and investor protection are likely to have lower financial reporting quality than U.S. IPO firms or ADR firms from the corresponding countries. However, it is challenging to test this prediction due to the data limitations—after imposing all the data requirements, there are only 22 firm-years from 12 foreign RM firms. Nevertheless, in an untabulated analysis, we find that foreign RM firms have similar financial reporting quality to that of foreign ADR firms and U.S. RM firms. However, these results should be interpreted with caution for two reasons: (1) the sample includes RM firms from different countries, some of which have strong investor protection, and (2) the sample size is very small. In addition, due to the small sample size, we cannot test whether RM firms from other foreign countries with lower investor protection and weaker enforcement have poor financial reporting quality.
One might argue that this result is not surprising, given the finding ofLang et al. (2006)that foreign firms listed in the U.S. have lower financial reporting quality than U.S. domestic firms.23As discussed above, b2captures the difference in financial
reporting quality between Chinese ADR and U.S. IPO firms. Also as reported in Table 3, Panel A, b2is insignificantly different
from zero. This result differs from that of Lang et al. (2006), likely due to the use of different financial reporting quality TABLE 3
Test of H1 ; H3
Analysis of Accounting Restatements Panel A: Regression Results
All Restatements (Model (1)) Errors (Model (2)) Irregularities (Model (3)) RM 0.593 0.696 0.244 (1.60) (1.48) (0.29) China 0.011 1.577** 1.114 (0.02) (2.57) (0.82) RM 3 China 1.475*** 0.178 3.399*** (2.65) (0.24) (2.58) M/B 0.002 0.016 0.026 (0.19) (1.46) (0.57) Growth 0.100* 0.070 0.087 (1.69) (0.97) (0.77) LEV 0.305 0.765 0.982 (0.43) (0.76) (0.73) ROE 0.202 0.416* 0.713 (1.06) (1.88) (1.41) Size 0.028 0.141 0.272 (0.33) (1.33) (1.64) Capital_Need 0.256* 0.185 0.110 (1.89) (1.00) (0.54) Loss 0.237 0.912 0.713 (0.52) (1.59) (0.85) Op_Cycle 0.022 0.031 0.346 (0.24) (0.28) (1.00) Inventory 0.168 0.143 1.669 (0.18) (0.13) (0.80)
Year effects Yes Yes Yes
Industry effects Yes Yes Yes
n 1,997 1,938 1,997
Pseudo R2 0.178 0.171 0.253
***, **, * Indicate statistical significance at the 1 percent, 5 percent, and 10 percent levels, respectively.
This panel reports the Logit regression of the probability of restatement on indicators for firm types and control variables:
ProbðRestatementitÞ ¼ a þ b1RMitþ b2Chinaitþ b3RMit3 Chinaitþ cControlsit1þ uYear Dummies þ hIndustry Dummies þ eit
The sample includes Chinese RM firms, Chinese ADR firms, U.S. RM firms, and U.S. IPO firms.RM equals 1 for RM firms (i.e., Chinese RM or U.S. RM firms), and 0 otherwise.China equals 1 for Chinese firms (i.e., Chinese RM or Chinese ADR firms), and 0 otherwise. In Model (1), the dependent variable, Restatementit, is a dummy variable that equals 1 if the financial statement of firm i in year t is restated later, and 0 otherwise. In Model (2) [(3)], the dependent variable isErrorit(Irregularityit), which equals 1 if the financial statement of firmi in year t is restated later and the restatement is classified as an error (irregularity), and 0 otherwise. The table reports the coefficient estimates, the corresponding z-statistics based on Wald Chi-square adjusted for firm- and year-level clustering (in parentheses), the number of observations, and the pseudo R2. All of the variables are winsorized at the 1 percent and 99 percent levels. Please see Appendix B for variable definitions.
(continued on next page)
23
As discussed inLeuz (2006), the findings ofLang et al. (2006)indicate that cross-listing and bonding incentives improve financial reporting quality, but not to the extent that the financial reporting quality of cross-listed firms is fully comparable with that of U.S. firms.Leuz (2006)argues that this difference might be attributed to differential U.S. legal enforcement between the cross-listed firms and U.S. firms, and to the differences in firm-level reporting incentives.
measures. While we use the likelihood of restatements to capture financial reporting quality,Lang et al. (2006) use accrual-based measures. As reported in Srinivasan et al. (2015), foreign firms listed in U.S. exchanges have a lower frequency of restatements. To further examine whether the weak country effect alone explains these results, we investigate the interaction of the RM and weak country effects in explaining the financial reporting quality of Chinese RM firms, b3. As reported in Panel A,
the coefficient on the interaction term is significantly positive (z¼ 2.65). This result confirms that the combination of the RM and weak country effects contributes to the lower financial reporting quality of Chinese RM firms.
Analysis of Errors and Accounting Irregularities
The above analyses are based on all accounting restatements. To investigate whether the results are driven by errors, accounting irregularities, or both, we separately analyze the likelihood of errors and irregularities and report the results in Models (2) and (3), respectively, of Table 3, Panel A. Note that when we analyze the likelihood of errors, we drop the observations with accounting irregularities from the sample, as these cases are generally regarded as worse than errors. As is common in the literature, we keep observations with errors when analyzing the likelihood of irregularities, and the dependent variable, Irregularity, is set as 0 for these observations. (Excluding these observations from the analyses leads to the same results.) We find that Chinese firms, whether RM firms or ADR firms, have a higher likelihood of accounting errors than their counterparts. There is no evidence of an RM effect for China or for U.S. firms. In contrast, when we analyze the likelihood of accounting irregularities, we find that the coefficients on RM and China are insignificantly different from zero, but the coefficient on the interaction term is significantly positive (z¼ 2.58). Overall, we find that the results documented above are driven by the likelihood of accounting irregularities.
Analysis of Accrual-Based Measures
We use the following regression model to test the hypotheses based on accrual-based measures:
FRQi;t¼ a þ b1RMitþ b2Chinaitþ b3RMit3 Chinaitþ cControlsi;tþ dYear Dummies þ hIndustry Dummies þ ei;t ð2Þ
The dependent variable,FRQ, is one of the following variables: the absolute value of discretionary accruals (jDAj), the absolute value of working capital accruals (jDDj), the absolute value of discretionary revenue (jDRj), the natural logarithm of the absolute value of the ratio of accruals to operating cash flows (lnjACCR/OCFj), or the common factor. Higher variable values
TABLE 3 (continued) Panel B: Hypotheses Testing—All Restatements
This panel summarizes the results for the test of H1 ; H3 based on the analysis of the likelihood of all accounting restatements. For the coefficients presented in Panel A, the corresponding z-statistics are presented in parentheses. For the sum of coefficients, Wald tests are conducted and the corresponding z-statistics are presented in parentheses.