Management & Engineering Ultimate Controlling Stake and Earnings Conservatism—Based on

Management & Engineering 21 (2015) 1838-5745
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Management & Engineering
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Ultimate Controlling Stake and Earnings Conservatism—Based on
the Empirical Data of the Listed Companies of China
Lihui LIANG 1,2
1. Economics and Management School, Southwest Jiaotong University, Chengdu 610031, China
2. Economics and Management School, Sichuan University of Science and Engineering, Zigong 643000, China
KEYWORDS
Ultimate controlling shareholder,
Earnings conservatism,
Two rights deviation,
Cash flow right,
Control right
ABSTRACT
Taking the listed companies of China’s A-share markets from the year 2004 to 2011 as a
sample, this paper intends to research the impact of ultimate controlling stake on earnings
conservatism from the perspective of cash flow right deviating from control right (i.e. two
rights deviation). The research finds: (1) The two rights deviation of ultimate controlling
shareholder of the listed companies is very common; (2) The accounting of the ultimate
controlling stake companies is generally conservative, however, the two right deviation
decreases the earnings conservatism; (3) The nature of equity right of ultimate controlling
shareholder’s has an significant impact on the earnings conservatism; the accounting of the
listed State-Owned-Enterprises (SOE) is much more conservative than that of Non-SOEs.
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1 Introduction
Basu (1997) interpreted earnings conservatism as resulting in earnings reflecting ‘bad news’ goes more quickly than ‘good news’.
Basu put forward a concept to the earnings conservatism from the perspective of information timeliness and it becomes a key content
of accounting conservatism. Accounting conservatism is not limited to the study of deliberately undervalued net profit under the
established norms, but studies in-depth the difference of accounting confirmation timeliness, which results from the different
requirements of accounting message confirming verifiability under the situation of uncertain economic activities, and its impact on
the governance of a company. Earnings conservatism becomes an important mechanism of company governance due to its function
in the aspect of contract, litigation, supervision, and taxation (Watts, 2003). The conservative accounting can decrease information
asymmetry through timely confirming loss and delaying confirming earnings under the uncertainty, and restrain the negative impact
of cash flow right and control right’s deviation on company value and external investors. However, not all company can adopt the
earnings conservatism to solve the issue of company proxy. Different deviation degree between ultimate controlling shareholding
right and control right as well as the nature of ultimate controlling shareholder can affect accounting conservatism.
Equity structure is an important factor that affects earnings conservatism. The previous study on the relationship between ownership
structure and accounting conservatism is mainly aimed at the direct ownership, i.e. the common stock owned by managers,
individuals and institutions (Lafond and Roychowdhury, 2008; Haw et al., 2010; Ramalingegowda and Yu, 2011). The research in
recent years shows the ownership mode of modern companies is completely different from that of Berle and Means’ (1932), a widely
accepted mode. The ownership of world companies is relatively concentrated and most of the listed companies have ultimate
controlling shareholder (La Porta et al., 1999; Claessens et al., 2000; Lins, 2003; Claessens et al., 2002; Faccio and Lang, 2002).
English edition copyright © ST. PLUM-BLOSSOM PRESS PTY LTD
DOI:10.5503/J.ME.2015.21.010
59
Hence, the study on the impact of ultimate controlling ownership on accounting conservatism becomes the leading subject of the
theoretical research on accounting. Taking the listed companies from the year 1996 to 2006 of Spain as an example, Sánchez et al.
(2011) found there is a negative relation between the deviation of cash flow right and accounting conservatism, and there is a
negative relation between the deviation degree of the two rights and accounting conservatism as well. Liu Chang and Yang Xingquan
(2008) found there is a negative relation between the two right deviation and earnings conservatism after studying the listed
companies in China from the year 2004 to 2006, and the proportion of cash flow right has no significant impact on the degree of
earnings conservatism. After studying the listed companies in China from 2003 to 2009, Yang Kezhi and Xie Zhihua (2010) found
only when the ultimate controlling shareholder are non-SOE ones, the bigger the separation degree between control right and cash
flow right is, the lower the conservatism of it; there represents a significant negative relation between the ratio of shareholding of
ultimate controlling shareholder (i.e. cash flow right) and earnings conservatism.
However, the research in China on the relationship between earnings conservatism of listed companies and ultimate controlling
shareholder has not considered the impact of one factor, i.e. the non-deviation of cash flow right of ultimate controlling shareholder
and the control right. In fact, it is found not all the listed companies’ cash flow right of shareholders has deviated from the control
right. In China, the proportion of the listed companies of which cash flow right does not deviate from the control right is high, and
the ultimate controlling stake structure between the companies of which the two rights deviated and did not deviate represents
significant differences as well as shown in Table 1.
Table 1 Distribution of ultimate controlling stake structure (2004 -2011)
Deviation of the two
rights
Non-deviation of the
two rights
Total samples
SOE
Non-SOE
Samples
SOE
Non-SOE
Samples
N
Ratio (%)
1611
3896
5507
3897
2148
6045
11552
13.95
33.72
47.67
33.74
18.59
52.33
100
Cash Flow
Right (%)
28.27
25.63
26.56
44.96
40.45
43.78
35.48
Control Right
(%)
42.79
38.57
40.06
44.96
40.45
43.78
42.01
Deviation Degree
(%)
14.52
12.94
13.50
0
0
0
6.54
Notes:
1. Source from CSMAR databank (2013) of Shenzhen Guotaian Info Company;
2. The samples are determined through the threshold of 20% controlling stake right, financial companies are excluded;
3. The ratio is the one between each sample’s quantity and total quantity; deviation degree=control right – cash flow right.
With reference to the study method of La Porta et al. (1999) with the threshold 20%, Table 1 makes a statistic of ultimate equity right
of the listed companies in China from the year 2004 to 2011. The Table shows, from the year 2004 to 2011, there are totally 11,552
non-financial companies of which ultimate controlling shareholder and control rights are 20% and above. Among them, companies
with the two rights deviation are 5,507, accounting for 47.67% of the total samples; companies without two rights deviation are 6,045,
accounting for 52.33% of the total samples. The cash flow right and control right of the total samples are 35.48% and 42.01%
respectively. The cash flow right is lower than the control right (i.e. two rights deviation) with degree of 6.54%. The average
deviation degree of the group with deviation is 13.50%, more than the deviation degree of the total samples. The result shows if the
deviation of the two rights is not considered when studying ultimate controlling stake right, the total deviation degree of the
companies with two rights deviation can be undervalued. Moreover, from the Table 1, the cash flow right and control rights of the
group without deviation are both 43.78%, more than the relevant figures of the group with deviation. No matter whether it is deviated
or non-deviated, both the concentration ratio (cash flow right) and control right of SOE ultimate controlling stake right is higher than
those of the non-SOE. In conclusion, Table 1 indicates the ultimate equity right between the groups with and without deviations has
significant differences. The companies without two rights deviation is more and their equity right is more concentrated and control
right is more as well. Therefore, the ultimate controlling stake structure creates a condition for studying the companies with and
without two rights deviation. This paper researches the accounting conservatism of the company of which ultimate controlling
shareholder’s cash flow right deviates from control right.
This study's contribution to the literature includes:
(1) Considering the impact on the listed companies without two rights deviation; Studying the relationship between ultimate
controlling right and accounting conservatism from the perspective of cash flow right deviation; Being helpful for overall
understanding of the equity factor of affecting accounting conservatism.
(2) Evaluating the deviation degree between ultimate controlling shareholder’s cash flow right and their control right; Studying the
impact of the nature of equity right of ultimate controlling shareholder’s on accounting conservatism; Providing theoretical analysis
and empirical evidence to accounting supervision and the internal policy of the companies.
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2 Theoretical Analysis and Research Hypothesis
2.1 The impact of cash flow right and its deviation from control right on earnings conservatism
The ultimate controlling shareholder is the actual controller of a company in China, and the equity right of a listed company is mainly
concentrated in ultimate controlling shareholder. The ultimate controlling shareholder makes the company policy, production, and
disclosure of accounting information. Under this circumstance, the private communication between the ultimate controlling
shareholder and the insiders replaces the public info disclosure, thus, proxy conflict between them is decreased. However, the conflict
between the ultimate controlling shareholder and the outsiders is worsened. The more the ultimate controlling shareholder’s cash
flow right is, the less the company raises funds from the outsiders, thus, reducing the requirement of the outsiders to accounting
conservatism.
The concentrated equity right brings synergies and entrenchment effects (Fan and Wong, 2002). When the two rights are deviated, i.e.
cash flow right is less than control right, the entrenchment effects caused by control right is more than the synergies effect caused by
cash flow right. In such a case, the controlling shareholder can gain all the earnings at a very few cost. The more the two rights
deviate, the stronger the plundering motive and ability of the controlling shareholder are. In case the pyramid structure and
cross-shareholding are used for separating cash flow right and control right, the control issue of controlling shareholder will be
exacerbated. In practice, the phenomenon is a common occurrence that the ultimate controlling shareholder “tunnels” a company. For
example, the ultimate controlling shareholder of Hongsheng Company plundered barely the interests of small shareholders. The
actual controlling shareholder tunneled in Zhejiang Haina Company. All the case is only a tip of the iceberg in such plundering
phenomena. In the relational governance between the ultimate controlling shareholder and the insiders, the deviation of ultimate
controlling shareholder’s cash flow right and control right can not only produce the entrenchment effect, but also reduce the
possibility that the controlling shareholder are perceived by supervisory authority and the outsiders when the formers are transferring
wealth. The behavior of related parties transactions, capital transfers, and other ways of damaging the value of listed companies can
be realized much more easily (Li Yunguo, Wu Xiaoyun, 2009). Meanwhile, in order to avoid the law and social supervision and
maintain company’s reputation, the ultimate controlling shareholder may make use of their control right and info advantages to
confirm the earnings earlier and more, delay confirming or even do not confirm the losses, whitewash financial report, conceal their
usurpations, and result in the decrease of earnings conservatism. Therefore, the following assumption is put forward:
H1: The negative relation between cash flow right and earnings conservatism in the case of other conditions remain unchanged.
H2: The negative relation between the two rights deviation degree and earnings conservatism in the case of other conditions remain
unchanged; the more the deviation is, the lower the earnings conservatism.
2.2 The impact of the nature of controlling shareholder on the earnings conservatism
The nature of the ultimate controlling shareholder determines the motive of the arrangement of equity right structure. China now is in
an economic transition period, driven by the government policy and economic system, the SOEs are undergoing reform with
establishing modern enterprise system as the core. The reform of the state-owned enterprises requires reducing the excessive
investment and government intervention and increases the enterprises’ vitality and market’s subjectivity. However, the government is
subject to the legal system, the ownership of the state-owned listed companies cannot be transferred freely. Therefore, the practice of
equity structure is widely adopted of delegating reliably company’s decision-making right to the management but the government
does not transfer the ownership. For example, the pyramid equity right structure is favored by the listed companies. However, natural
persons dominate Chinese non-state ultimate controlling shareholder and they have stronger motive to maximize their benefits. The
reasons are: (1) The gains plundered by the natural person are directly attributable to personal wealth; (2) The capital restraint that the
natural persons ultimately control the company is more than that of SOEs. They have a stronger demand of tying up the capital of the
listed companies’. For the motive of financing and hiding identification or transaction, the natural persons may set up a complex
structure of equity right and enhance their ability and motive of tunneling the company and damaging the interests of the mediumand small-shareholders. When they have effectively controlled a company, it means the controlling shareholder has controlled the
generation and disclosure policy of accounting information (Fan and Wong, 2002). The ultimate controlling shareholder pursuing
self-benefits always make use of their unique power and information advantage to reduce accounting information transparency,
confirm earnings in advance but delay confirming losses, thus, increase the deviation between the interests of the accounting and
corporate economic value, and the unsound accounting information is resulted in. Therefore, different from the non-SOE, the equity
right structure arrangement does not originally intend to let the listed SOE company hide its identity, rob resources, or create a
"capital empire", but delegate powers to the enterprise and strengthen the market subjectivity and management flexibility of the SOE
under the premise of not affecting the government’s control. Moreover, the supervision power of the government to the listed
company is more; the political risk and cost of officials manipulating accounting information are much higher through the
manipulation of ownership structure of accounting information. As far as the motive of equity right arrangement of the controlling
shareholder and the manipulation risk are concerned, the requirement of SOE controlling shareholder for timely and conservative
accounting information may be much higher than that of non-SOE shareholder. Therefore, it is assumed:
H3: In the case of other conditions remain unchanged, there is difference of the earnings conservatism between SOE and non-SOE
controlling shareholders; compared with the non-SOE, the earnings conservatism of SOE is more conservative.
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3 The Empirical Study Design
3.1 The research variables
The research of this thesis has referred to Ball and Shivakumar’s (2005) research methods. The accrued items in accounting profits
are used to regress the operational cash flow; in such a way, the earnings conservatism is measured.
The test variables in this thesis include cash flow right, the two rights deviation degree if the two rights are deviated and the nature of
the ultimate controlling shareholder. The calculation methods for cash flow right and control right have referred to the ones of La
Porta et al. (1999) and Claessens et al. (2000). That is to say, the cash flow right is sum of products of the lowest shareholding ratio in
the chain of the ultimate controlling shareholder and the listed company and is shown as CFR. The control right is the sum of the
lowest shareholding ratio in the chain of ultimate controlling shareholder and the listed company. In this thesis, control right minus
cash flow right is regarded as the proxy variable and is shown as TRS. Moreover, the nature of ultimate controlling shareholder in
this thesis is classified into SOE and non-SOE. The SOE ultimate controlling company includes the listed company of which ultimate
controlling shareholder are governments of each level, state-owned assets supervision and administration commissions, ministries,
and institutions. UCD is used to indicate the dummy variable that the ultimate controlling shareholder is SOE or non-SOE.
Meanwhile, to control the impact of industry and macro economic factors on earnings conservatism, two dummy variables, IND and
YEAR, are added in the thesis and their definitions are shown in Table 2.
Table 2 Definition of variables
Variables
Symbol
Definition of Variables
Expected
Symbol
ACC
(△inventory + △account receivable + △notes receivable + △prepayment + △other current
assets - △account payable - △notes payable - △deposit received - △other current
liabilities-depreciation)/initial total assets
?
CFO
(profit and loss in the abnormal operation period – ACC)/initial total assets
-
When CFO <0, D=1; otherwise, D=0
Control right - cash flow right, where, the cash flow right is sum of products of the lowest
shareholding ratio in the chain of ultimate controlling shareholder and the listed company; the
control right is the sum of the lowest shareholding ratio in the chain of ultimate controlling
shareholder and the listed company
When the ultimate controlling shareholder are SOE ones, UCD is 1, otherwise it is 0
Industry dummy variables used to control the impact factors of the industry; as per the category
norms of China CSRC, there are 11 industry dummy variables excluding the finance industry
?
D
TRS
UCD
IND
+
?
3.2 Sample selection and data sources
On Dec. 13, 2004, the No. 2 Information Disclosure Content and Format Guidelines for Companies Publicly Issuing
Securities---Content and Format of the Annual Report (revised in 2004) issued by China CSRC revised the company's annual report
content and format requirements. It explicitly states a listed Company should disclose the property right between the company and
the actual controllers and block diagram of control relation in its annual report and requires introducing in details the actual
controllers’ situation. This provides a feasible condition to trace the nature of the ultimate controlling shareholder of a listed company
and ownership structure. Based on the condition, this study selects the listed companies of Shanghai and Shenzhen A-share Stock
Markets in 2004-2011 to screen as per the following principles: (1) The listed financial companies are excluded; (2) The listed
companies not accessible to data are excluded; (3) The listed companies absent of data are excluded. Finally, based on the 5507 data
of the listed companies from the year 2004 to 2011, this thesis has empirically tested the impact of the deviation or no between the
ultimate controlling shareholder’ cash flow right and control right on earnings conservatism, and the relation between deviation
degree of the two rights and earnings conservatism in case there is deviation between the two rights. Moreover, whether these
impacts and relations and how they restrict the nature of the controlling shareholder has been studied as well. The data sources in this
research come from CSMAR databank (2013) of Shenzhen Guotaian Info Company.
3.3 The empirical model design
Scholars have developed a variety of models for measuring the earnings conservatism. Among them, earnings regression model
designed by Basu (1997) and accrued-cash flow model designed by Shivakumar (2005) are widely used (Wang et al., 2011). The
theoretical basis and model structure of these two Models are similar. The difference of them lies in the different requirements for the
perfection degree of capital market. The earnings regression model requires the capital market is effective. In China, the capital
market is not perfect yet; the information that stocks reflect is limited; the earnings regression model may cause some errors in Model
measuring (Yang Huajun, 2007). Therefore, the accrued-cash flow Model that does not have specific requirement for capital market
perfection is adopted to measure the earnings conservatism. The Model is as the following:
62
ACCit = β 0 + β1 Dit + β 2 CFOit + β 3 Dit × CFOit + ε it
(1)
Where,
β0
is intercept;
β1 , β 2 , β 3 are regression coefficients;
β2
β2 + β3
and
reflect the sensitiveness of earnings conservatism to “good news” and “bad news” respectively;
β 3 is a key coefficient of measuring the earnings conservatism;
If β 3 >0, it indicates the accounting confirms more timely the bad news than the good news, the accounting owns the conservatism;
otherwise, the accounting is not conservative. ε it is a random error term. For the variables, see the above Table 2 the definition of
variables.
The advantage of the accrued-cash flow lies in when substituting the interactions of variables and the cash flow in the basic Model,
the impact of this variable on the earnings conservatism can be reflected simply. To test if cash flow right, the nature of the ultimate
controlling shareholder and the impact of the deviation degree of the two rights on earnings conservatism and with reference to
Models of Bushman and Piotroski’s (2006), this thesis carries out the following continuation to the above Model 1:
ACCit = β 0 + β 1 Dit + β 2 CFOit + β 3 Dit × CFOit + β 4 TVARit + β 5 Dit × TVARit
10
7
k =1
i =1
(2)
+ β 6CFOit × TVARit + β 7 Dit × CFOit × TVAR it +η  IND + λ  YEAR + ε it
Where,
β indicates intercept;
0
βi (i = 1, 2,...., 7) are regression coefficients;
η
ε it
and
λ
are regression coefficients vectors;
indicates random error terms.
In the Model, TVAR is test variables, representing cash flow right, nature of ultimate controlling shareholder, separation degree of
the two rights. For variables, see the above Table 2.
4 The Empirical Evidence
(1) Descriptive statistics of relevant variables
Table 3 Descriptive statistics of relevant variables
Variables
ACC
CFO
D
CFR
TRS
UCD
N
5507
5507
5507
5507
5507
5507
Mean Value
0.2015
0.0522
0.2400
26.5622
13.4961
0.3528
Standard Deviation
2.6102
0.6373
0.4252
15.0960
8.9789
0.4971
Minimal Value
-122.5964
-24.9739
0.0000
0.4089
0.0001
0.0000
Maximal Value
54.9116
62.7895
1.0000
97.4314
54.8204
1.0000
From the above Table 3, it can be found the fluctuation of ACC and CFO is big. The mean value of ultimate controlling shareholder’s
cash flow right is 26.5622%; the mean value of TRS, two rights deviation degree, is 13.4961%. The mean value of ultimate
controlling shareholder’s nature is 0.3528 indicating the ultimate control right is concentrated in the hands of non-SOE ultimate
controlling holders.
(2) Regression analysis
63
Table 4 All the samples’ mixed regression results
Variables
Intercept
CFO
D
D×CFO
CFR
D×CFR
CFO×CFR
D×CFO×CFR
TRS
D×TRS
CFO×TRS
D×CFO×TRS
UCD
D×UCD
CFO ×UCD
D×CFO×UCD
IND
YEAR
Adjusted R2
F
N
Model 1
Coefficient
t
Value
0.422
3.340a
-0.686
-60.910 a
0.008
0.745
0.199
17.648 a
Model 2
Coefficient
t
Value
0.290
1.943b
-0.560
-2.345 b
0.232
1.489
0.283
1.763c
0.005
1.723c
-0.007
-1.339
-0.014
-0.523
-0.026
-0.546
Model 3
Coefficient
t
Value
0.456
2.307 a
-0.733
-39.368 a
0.032
1.613 c
0.248
12.583 a
-0.030
-0.022
0.083
-0.092
Model 4
Coefficient
t
Value
0.319
2.378 a
-0.260
-1.611c
0.025
1.605c
-0.008
-0.088
-2.051 b
-0.968
3.167 a
-3.603 a
0.005
-0.017
-0.425
0.205
control
control
0.406
199.090a
5507
0.406
164.682
5507
control
control
0.407
165.626
5507
0.331
-1.100
-2.645 a
2.347 a
control
control
0.407
165.091
5507
Notes: a, b, and c indicate respectively the significance at 1%, 5%, and 10% significance levels.
In Table 4, Model 1 reflects the overall situation of earnings conservatism of a company; Model 2 and 4 reflect respectively the
impact of cash flow right, two rights separation degree, and nature of the ultimate controlling shareholder on earnings conservatism.
From Table 4, it can be found the F-statistics values of the four Models are all relatively high and at the 1% standard significance,
which means the overall imitative effect of the Models are sound. The values of adjusted R2 are all more than 0.4, which means the
variables can interpret well the earnings conservatism.
Model 1 reflects the overall earnings conservatism of all the samples. The coefficient (0.199) of key variable D×CFO is positive and
at the level of 1% standard significance. Meanwhile, the coefficient (-0.686) of CFO coefficient is negative and at the level of 1%
standard significance as well. The results show bad news is confirmed timely in the accounting profit, good news is delayed in
confirmation, and accounting is totally conservative.
Model 2 tests the impact of ultimate controlling shareholder’s cash flow right on accounting conservatism. The coefficient of key
variable D×CFO×CFR is -0.026, and does not pass the significance test, supposing H1 does not pass the significance test. It indicates
cash flow right has no significant impact on accounting conservatism in the listed company of which the two rights are deviated.
Model 3 tests the impact of two rights deviation degree on earnings conservatism. The coefficient (-0.092) of key variable D×CFO
×TRS is negative and at the level of 1% standard significance. The coefficient (0.083) of CFO ×TRS is positive and passes the
significance test as well, supposing H2 passes the test. The statistic results of Model 3 show the two rights deviation degree has a
negative relation with accounting conservatism, the more the deviation is, the more the entrenchment effect caused by control right is,
and the ultimate controlling shareholder more possibly plunder the interests of small shareholders. To cover their plunder, the
ultimate controlling shareholder manipulate the process of accounting generation and accounting policies and delay confirming the
loss, thus, accounting profit deviates from the economic values of the company and accounting conservatism is reduced.
Model 4 tests the impact of UCD on earnings conservatism. The coefficient (0.205) of key variables D×CFO×UCD is positive and
below the level of 1% standard significance, supposing H3 is verified. CFO x UCD coefficient (0.425) is negative and at 1%
significance. The statistic result shows the nature of controlling shareholder has impact on earnings conservatism. Compared with the
listed non-SOE companies, the accounting earnings of the controlling listed SOE companies is all conservative in confirming both
good news and bad news. It indicates, based on the effective control of government to companies, delegating power through pyramid
structure of equity right increases the quality of accounting information to a certain degree.
5 Conclusion
This paper carries out the research on the earnings conservatism in Chinese listed companies of which cash flow right deviates from
control right. The research finds: (1) There is a common phenomenon of deviation of two rights of Chinese ultimate controlling
64
shareholder’s in listed companies; (2) The accounting of Chinese listed companies is totally conservatism, however, the deviation of
the two rights decreases the earnings conservatism; (3) The nature of ultimate controlling shareholder has significant impact on
earnings conservatism. The accounting of SOEs ultimate controlling companies is more conservative than that of non-SOEs ones.
This research believes the cash flow right deviating from the control right is an important approach for ultimate controlling
shareholder to realize the control target. However, it cannot interpret the behavior of ultimate controlling shareholder of the listed
companies of which the two rights do not deviate from each other. To fully understand the mechanism of function of the ultimate
controlling right to the governance of a company, besides studying the situation of the companies with two rights deviation, the
impact of motive and behavior of controlling shareholder in companies without two rights deviation on accounting information and
other company governance should be studied as well. However, this thesis does not research the earnings conservatism of the
company without two rights deviation, which remains to be a further research in the future.
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