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Economic Institutions, Accounting Properties and the Adoption of IFRS in China

Economic Institutions, Accounting Properties and the Adoption of IFRS in China. T.J. Wong CUHK Center for Institutions and Governance. The Chinese University of Hong Kong. Accounting Quality of Chinese Listed Firms. Feb 2009. 2nd INTACC Colloquium - U of Valencia. Low transparency

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Economic Institutions, Accounting Properties and the Adoption of IFRS in China

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  1. Economic Institutions, Accounting Properties and the Adoption of IFRS in China T.J. Wong CUHK Center for Institutions and Governance The Chinese University of Hong Kong

  2. Accounting Quality of Chinese Listed Firms Feb 2009 2nd INTACC Colloquium - U of Valencia • Low transparency • Adoption of western standards do not lead to desirable results • Flight from quality auditors after adoption of western GAAS

  3. Opacity Premium in AsiaSource: PricewaterhouseCoopers Feb 2009 2nd INTACC Colloquium - U of Valencia

  4. More Modified Opinions after new GAASDeFond, Wong, and Li (2000, JAE) Feb 2009 2nd INTACC Colloquium - U of Valencia

  5. Top 10 are more independent Feb 2009 2nd INTACC Colloquium - U of Valencia

  6. Test of Question Two Feb 2009 2nd INTACC Colloquium - U of Valencia

  7. Purpose of my talk Feb 2009 2nd INTACC Colloquium - U of Valencia To discuss the underlying forces that shape the accounting properties of Chinese listed firms Present results of recent IFRS adoption in China

  8. Outline Feb 2009 2nd INTACC Colloquium - U of Valencia • Top down approach • Institutional constraints and their effects on • Audit markets, • Related party transactions and earnings management, • Political cost and bad news suppression, • Scandals and relationship-based contracting • Overseas listing • IFRS adoption

  9. Top-down Approach Country Institutions The legal system (the court and the law) The government (regulations, public sector governance) The society (religion, ideology, custom, social norm) Markets Product, labor, manager, raw material, financial capital Firms Firm boundary (vertical integration, diversification) Ownership and control structures Governance structures and accounting Feb 2009 2nd INTACC Colloquium - U of Valencia

  10. Why top-down? Framework guides thinking Find first order effects Link fundamental framework and theories to literature Locate constraints that shape governance Come up with important topics Policy implications - identify underlying factors that slow down reforms Feb 2009 2nd INTACC Colloquium - U of Valencia

  11. US Literature Feb 2009 2nd INTACC Colloquium - U of Valencia • Jensen and Meckling (1976) • There exists agency cost between owner-manager and outside shareholders • Accounting can play an important role in the organizational architecture in reducing this contracting cost

  12. US Literature Feb 2009 2nd INTACC Colloquium - U of Valencia Fama and Jensen (1983) Different from typical family firms (owner = manager), there is separation of ownership/control and management in firms with diffuse ownership

  13. Rights Allocation Board with decision control rights External auditors provide control Arm’s length contracts & role of accounting Manager with decision management rights Feb 2009 2nd INTACC Colloquium - U of Valencia

  14. US Literature Feb 2009 2nd INTACC Colloquium - U of Valencia • Fama and Jensen (1983) • Importance of corporate governance • Board and external auditor has decision control rights • Managers have decision management rights • Arm’s length contracts and public information

  15. Institutional constraints that shape accounting information properties in China Feb 2009 2nd INTACC Colloquium - U of Valencia

  16. Government Control of Capital Markets Feb 2009 2nd INTACC Colloquium - U of Valencia Government controls the major banks and equity markets (IPO is controlled by CSRC) Bright line rules for rights offerings and delisting to reduce information cost Local governments can influence local auditors which were once state audit bureaus

  17. State Controlling Ownership of Listed Firms Feb 2009 2nd INTACC Colloquium - U of Valencia Government controls key personnel decision Many politicians serve as chairman, CEOs and board members Firms pursue social objectives Politicians seek private benefits and political capital Government bailout – a kind of insurance to investors

  18. Corporate Governance of SOE Central or local govt Govt appoints key personnel Non-arm’s length contracts Accounting less useful External auditor not necessarily independent of politicians running the firms SOE Feb 2009 2nd INTACC Colloquium - U of Valencia

  19. SOE Under Old System Central Govt SOE Feb 2009 2nd INTACC Colloquium - U of Valencia

  20. Pyramidal structureThree major types of corporate control SAMB SAMB Private SAM Co. Listed Firm Parent SOE Listed Firm Listed Firm Feb 2009 2nd INTACC Colloquium - U of Valencia

  21. Market Institutions Protection for property rights High Low Middle Missing

  22. Social and Political Networks Feb 2009 2nd INTACC Colloquium - U of Valencia Lack of market, heavy government control, weak legal protection and social norm  relationship-based, not arm’s length contracting. Importance of political networks.

  23. Audit MarketsWang, Wong, and Xia (2008 JAE) Feb 2009 2nd INTACC Colloquium - U of Valencia

  24. Institutional Constraints Feb 2009 2nd INTACC Colloquium - U of Valencia • Government control of capital markets • Political networks more important than arm’s length contracts using accounting • Bright line rules induce earnings management • Government’s influence over local auditors • Make collusion between local SOEs and local auditors easy • Government ownership • Bailout = insurance • Private benefits and political goals

  25. Results Government Ownership and Auditor Choice Local SOEs are more likely to hire small local auditors Interaction between Government Ownership and Institutions In more developed credit markets, regions with less government involvement, and regions with better legal development, SOEs hire fewer small local auditors Similar results found in change in ownership sample Feb 2009 2nd INTACC Colloquium - U of Valencia

  26. Related Party Transactions and Earnings ManagementJian and Wong (2008 CAR) Feb 2009 2nd INTACC Colloquium - U of Valencia

  27. Institutional Constraints Feb 2009 2nd INTACC Colloquium - U of Valencia Organizational structure – parent and listed subsidiaries Underdeveloped markets – vertical integration Bright line rules induce earnings management

  28. Propping via RPT Prop to maintain listing status and issue more shares Parent SOE Listed Firm Shifting profits or proceeds back through related lending Feb 2009 2nd INTACC Colloquium - U of Valencia

  29. Measuring Propping Use related party sales Tianjin Nankai Guard Co. reported 99.9% sales from RPT before 2002 Targets (0-2%, 10-12%, 6-8% after 2001) Try related purchases, no results (LIFO not allowed; use related purchase to reduce COGS, not clear if related purchase would go up or down Try different ranges 2% to 1.5% and 1% Perform pseudo-incentive analysis Feb 2009 2nd INTACC Colloquium - U of Valencia

  30. Effects on Accounting Quality Feb 2009 2nd INTACC Colloquium - U of Valencia Earnings are heavily manipulated by related party transactions Can listed firms be valued by itself ? Concept of separate entity Controlling parent SOE is typically not listed. Black box.

  31. Political Incentives and Earnings SuppressionPiotroski, Wong, and Zhang (2008) Feb 2009 2nd INTACC Colloquium - U of Valencia

  32. Institutional Constraints Feb 2009 2nd INTACC Colloquium - U of Valencia Government controls banks and equity markets Corruption and rent seeking Politicians serve as senior executives and board members Politicians pursue private benefits and political goals Less market demand for public accounting information

  33. Incentives to Suppress Negative Financial Information in China Feb 2009 2nd INTACC Colloquium - U of Valencia Managers and local politicians incur a personal cost by reporting poor performance. Suppression of bad news allows politicians and politically astute managers to • Hide inefficiencies • Hide expropriation-related activities • Mask the inefficient allocation of resources to achieve political objectives.

  34. Political Events Feb 2009 2nd INTACC Colloquium - U of Valencia The National Congress of the CCP Political promotion: turnover of local governors during our sample period - when the local governor moves to a more senior position: 1) within the same province (e.g., promotion to party secretary), 2) to another province (e.g., governor or party secretary of a larger province), and 3) to the minister level of the central government. Our measure of corruption events reflects the exposure of political corruption cases involving politicians at or above the bureau level.

  35. Figure 1 Frequency of Significant Negative Stock Price Movements (excess returns < -20%) around the Announcement of Corruption Investigation Crash Month (if there is a crash week in the month) Crash weeks Feb 2009 2nd INTACC Colloquium - U of Valencia

  36. Figure 2: Frequency of Significant Negative Stock Price Movements (excess returns < -20%) around provincial-level political promotions Crash Month (if there is a crash week in the month) Crash weeks suppress release suppress release Feb 2009 2nd INTACC Colloquium - U of Valencia

  37. Figure 3: Frequency of Significant Negative Stock Price Movements (excess returns < -20%) around the National Congress of the CCP Crash weeks Feb 2009 2nd INTACC Colloquium - U of Valencia

  38. Scandals and Political Networks Feb 2009 2nd INTACC Colloquium - U of Valencia

  39. Institutional Constraints Feb 2009 2nd INTACC Colloquium - U of Valencia Government’s control of capital markets Weak development in markets and legal institutions Contracts based on social and political networks rather than arm’s length Reputation not necessary based on accounting quality and transparency

  40. Scandals and Reputation Feb 2009 2nd INTACC Colloquium - U of Valencia China Far smaller drop in firm value “Reputation” does not seem to matter or does it? Some CEOs got promoted US Firm value drop by 41% Loss in reputation affects future contracting costs Almost all CEOs dismissed

  41. Do scandals destroy firm value?(Hung, Wong, and Zhang, 2008) Feb 2009 2nd INTACC Colloquium - U of Valencia

  42. Where do the CEOs go?(Sun, Wong and Zhang, 2008) A: promotion B and C: lateral move D and E: demotion F: retired G, H and L: punished by government Feb 2009 2nd INTACC Colloquium - U of Valencia

  43. Overseas ListingHung, Wong, and Zhang (2008) Feb 2009 2nd INTACC Colloquium - U of Valencia No huge improvement in transparency for overseas listing Why? HK listing has little legal bonding effect Perhaps improved information environment provides discipline Choice of overseas listing is by government – political rather than economic reasons for listing Politically connected firms have less accounting improvement from overseas listing

  44. Challenges for Implementation of Fair Value Accounting in Emerging Markets:Evidence from IFRS Adoption in ChinaXianjie He, SUFETJ Wong and Danqing Young, CUHK

  45. IFRSs around the world Gray: Countries that require or permit IFRSs for domestic entities Blue: Countries seeking convergence with,or pursuing adoption of IFRSs

  46. Motivation and Objective • Over 100 jurisdictions have adopted or allowed the use of IFRS • Many studies have examined IFRS adoption effects in the EU and • Australia and have found some positive adoption effects • Little empirical evidence on emerging markets • The purpose of this study is to examine whether and how the adoption • effects of IFRS in emerging markets are different from those in mature • markets Feb 2009 2nd INTACC Colloquium - U of Valencia

  47. Why China? • The largest emerging market that has adopted IFRS • Market and institutional settings in China aredifferent from those in countries where IFRS rules originated Feb 2009 2nd INTACC Colloquium - U of Valencia

  48. Background information on IFRS adoption in China In 1993 the MOF began a project to develop accounting standards more inline with international practices. The new China Accounting Standards (CAS) were announced on February 15, 2006. The new CAS went into effect on January 1, 2007 for listed firms, and January 1, 2008 for enterprises owned by the central government. They will come into effect on January 1, 2009 for all large and median size firms. 15 key changes in accounting rules. 8 relate to fair value accounting. Feb 2009 2nd INTACC Colloquium - U of Valencia

  49. Research Questions and Predictions • Is the earnings quality under the new IFRS-based China Accounting Standards (CAS) higher than that of the old CAS? • Two competing views • Yes: Potential benefits of IFRS (new CAS): • More relevant and comprehensive financial information • More internationally comparable information • Improved efficiency in contracting between parties • Less “adverse selection” for small investors Feb 2009 2nd INTACC Colloquium - U of Valencia

  50. Potential issues that may limit the success of IFRS in China: • NO: New CAS doesn’t help accounting quality • Market-based arms’ length transactions in developed economies vs. relationship-based transactions in emerging markets • Market and legal institutions not ready for principle-based approach. • Market institutions not ready for fair value accounting. • Earnings quality may even be the same or lower under the new CAS. It is an empirical issue. Feb 2009 2nd INTACC Colloquium - U of Valencia

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