Institutional Investors and Earnings Management Associated with Controlling Shareholders' Promises: Evidence from the Split Share Structure Reform in China

Forthcoming, Journal of Contemporary Accounting & Economics, Forthcoming; Free access provided by Elsevier (before September 6, 2022): https://authors.elsevier.com/a/1fR0B_fH-s9IfP

46 Pages Posted: 25 Jul 2022

See all articles by Mark David Wilson

Mark David Wilson

Australian National University

Kun Tracy Wang

Australian National University - Research School of Accounting

Yue Wu

Xiamen University - Accounting Department

Archie Lau

Australian National University (ANU)

Date Written: July 12, 2022

Abstract

We examine the effectiveness of institutional investors in constraining aggressive earnings management induced by strong contractual incentives. To this end we focus on the consequences of earnings-related promises (covenants) negotiated between corporate controlling shareholders and minority shareholders during China’s split-share structure reform, wherein failure to achieve profit benchmarks had the potential to transfer significant wealth from controlling to minority shareholders. Our initial analysis provides evidence that profit-promised firm-years are, on average, associated with income-increasing earnings management, and that this association is stronger for: (i) firm-years in which the profit-promise was satisfied, and (ii) firm-years in which proxies for the level of unmanaged earnings suggest that earnings management was needed to satisfy the promise. However, such benchmark-beating behavior is weaker for firms with higher levels of institutional ownership. Further analysis documents that the exit threat of institutional shareholders can discipline earnings management associated with profit promises. We also show that the effect of institutional shareholders in reducing earnings management associated with profit promises is greater for domestic mutual funds and for privately controlled firms. Interestingly, our evidence suggests that institutional investors only play an effective monitoring role over earnings management when their incentives are strongly aligned with those of other minority owners. In other cases, our evidence suggests that these investors may exacerbate the level of earnings management.

Keywords: Earnings Management, Controlling Shareholder, Institutional Ownership, Split-Share Structure Reform, China

JEL Classification: G34, G38, M41, P21, P31

Suggested Citation

Wilson, Mark D. and Wang, Kun Tracy and wu, yue and Lau, Archie, Institutional Investors and Earnings Management Associated with Controlling Shareholders' Promises: Evidence from the Split Share Structure Reform in China (July 12, 2022). Forthcoming, Journal of Contemporary Accounting & Economics, Forthcoming; Free access provided by Elsevier (before September 6, 2022): https://authors.elsevier.com/a/1fR0B_fH-s9IfP, Available at SSRN: https://ssrn.com/abstract=4160262

Mark D. Wilson

Australian National University ( email )

Canberra, Australian Capital Territory 2601
Australia

Kun Tracy Wang (Contact Author)

Australian National University - Research School of Accounting ( email )

Canberra, Australian Capital Territory 2601
Australia

Yue Wu

Xiamen University - Accounting Department ( email )

Siming South Road
Duxing Building No.2
Xiamen, Fujian 361005
China

Archie Lau

Australian National University (ANU) ( email )

Canberra, Australian Capital Territory 2601
Australia

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