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Earnings management and the role of the audit committee: an investigation of the influence of cross-listing and government officials on the audit committee

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Abstract

This paper extends research on the corporate governance practices of transitional economies by examining whether the ability of the audit committee to constrain earnings management in Chinese firms is associated with the listing environment and the presence of government officials on the audit committee. Despite considerable regulatory reforms by the Chinese Securities Regulatory Commission, there remain incentives for Chinese firms to manage earnings. However, government initiatives to encourage domestic firms to cross-list on the Hong Kong Stock Exchange are accompanied by improved governance. We find that the expertise and independence of the audit committee for cross-listed (CL) Chinese firms are associated with lower abnormal accruals, our measure of earnings management. Both domestic only listed firms and CL Chinese firms appoint government officials as independent members on the audit committee. However, due to the political connection between government officials and the controlling shareholder (the State), these appointments can severely mitigate audit committee independence. Subsequently, we find a significant and positive association between audit committee independence and experience and earnings management when there are government officials on the audit committee.

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Notes

  1. Publications include: The Code of Corporate Governance for Listed Companies in China (2001), The Recommendation for the Institution of Independent Directors in Listed Companies (2001) and The Regulations on Information Disclosure of Listed Companies (2007).

  2. Lin et al. (2008) find that various stakeholders perceive the audit committee as a ceremonial decoration acting to lift the image of good corporate governance.

  3. Incentives include future career advancement, delisting threats for underperformance and offering future quotas.

  4. According to Sect. 3, Recommendation for establishment of independent director system in Chinese listed firms' (CSRC, 2001).

  5. The region loses the means to fund economic growth and the firm loses future rent-seeking opportunities.

  6. As of June 18 2009 there are 470 Chinese mainland firms listed on the HKEX (http://english.peopledaily.com.cn/90001/90778/90857/6681729.html).

  7. The Top 100 are classified according to market capitalisation in Hong Kong dollars.

  8. A silhouette measure of cohesion and separation was performed on the matching variables of industry, year and total assets of the two samples. The silhouette coefficient, which is a measure of both cohesion and separation, is close to the maximum value of 1 (near 90 %), which means the within-cluster distances are small and the between-cluster distances are large.

  9. Tests for multicollinearity are run simultaneously with each regression. Variance inflation factors are within acceptable levels in all cases (<2) and are subsequently not reported in the Tables.

  10. We also run the analysis using the proportion of government officials to independent audit committee directors and find the results remain the same.

  11. A firm choosing aggressive accounting choices may accelerate revenue recognition or delay expense recognition. Using these aggressive accounting techniques can lead to income-increasing accruals.

  12. A firm selecting conservative accounting choices may postpone revenue recognition or speed up expense recognition and this can result in income-decreasing accruals.

  13. Available at http://www.kpmg.com/cn/en/issuesandinsights/articlespublications/newsletters/china-boardroom-update/pages/china-boardroom-update-1302-01-audit-committee-priorities.aspx.

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Acknowledgments

First we would like to thank the editor for his assistance and the two anonymous reviewers for their comments and guidance. We would also like to thank Lawrence Gordon, Ferdinand Gul, Tom Smith, Stephen Cox, David Tan, the participants at the 2009 Asian Finance Association International Conference, Brisbane Australia and the participants at the 2009 Accounting and Finance Association of Australia and New Zealand Conference, Adelaide, Australia for their helpful comments.

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Authors and Affiliations

  1. Xiamen University, Xiamen, China

    Teng Lin

  2. Queensland University of Technology, Brisbane, Australia

    Marion Hutchinson

  3. Department of Accounting, Finance and Economics, Griffith University, Nathan, Brisbane, 4111, Australia

    Majella Percy

Authors
  1. Teng Lin
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  2. Marion Hutchinson
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  3. Majella Percy
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Corresponding author

Correspondence to Majella Percy.

Appendix: Audit committee requirements

Appendix: Audit committee requirements

 

Hong Kong Exchanges and Clearing Limited (HKEX), 2008

http://www.hkex.com.hk/eng/exchange/corpgov/cgstructure/key_principles_ac.htm

China Securities Regulatory Commission (CSRC), 2001

http://www.ecgi.org/codes/documents/code_en.pdf

Composition

It consists of 5 independent non-executive directors. They must be either qualified accountants or professionals with extensive experience in financial management

The firm may establish an audit committee. Composed solely of directors. Chaired by an independent director. Consist of a majority of independent directors. At least one independent director from the audit committee shall be an accounting professional

Major roles and functions

To serve as a focal point for communication between the Directors, external auditors and internal auditors

To assist the Board in fulfilling its responsibility by providing an independent review and supervision of financial reporting, and monitoring and reviewing the effectiveness of the Group’s internal controls (including the adequacy of resources, qualifications and experience of staff of the Group’s accounting and financial reporting function, and their training programmes and budget) and the adequacy of the external and internal audits

To review the appointment of external auditors on an annual basis ensure continuing auditors independence

To develop and monitor the applications of the policies on the engagement of the external auditors to perform non-audit services (other than tax-related services) and the hiring of the employees or formal employees of the external auditors

To recommend the engagement or replacement of the company’s external auditing institutions

To review the internal audit system and its execution

To oversee the interaction between the company’s internal and external auditing institutions

To inspect the company’s financial information and its disclosure

To monitor the company’s internal control system

Operating mode

At least 4 times a year with additional meetings as the work of the Audit Committee demands

Not provided

Audit Committee Report

The work of the Audit Committee during each financial year is summarized in the Audit Committee Report contained in the annual report

Not provided

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Lin, T., Hutchinson, M. & Percy, M. Earnings management and the role of the audit committee: an investigation of the influence of cross-listing and government officials on the audit committee. J Manag Gov 19, 197–227 (2015). https://doi.org/10.1007/s10997-013-9284-3

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