Earnings management and agency costs: Is China different?

• Published date: 01 January 2021
• Author: Yimei Man
• DOI: http://doi.org/10.1002/jcaf.22481
• Date: 01 January 2021

J Corp Acct Fin. 2021;32:13–30. wileyonlinelibrary.com/journal/jcaf © 2020 Wiley Periodicals, Inc. 13

BLIND PEER REVIEW

Earnings management and agency costs: Is China different?

Yimei Man

Department of Accountancy and Finance,

University of Otago Business School,

Otago, New Zealand

Correspondence

Yimei Man, Department of Accountancy

and Finance, University of Otago Business

School, Otago, New Zealand.

Email: yimei.man@otago.ac.nz

Abstract

In this article, we investigate the link between agency costs (AC) and earnings

management (EM) in China. We find a significant and positive relationship

between AC and EM based on the static model that suggests opportunistic EM

in China. However, we find an insignificant relationship between AC and EM

when we use the dynamic model that takes into account the endogeneity issue.

Therefore, our results provide further support to the growing literature on the

concerns of endogeneity issues in corporate governance studies, since failing to

take these into account can lead to spurious results.

KEYWORDS

agency costs, earnings management, corporate governance

1|INTRODUCTION

Earnings management (EM) is defined as “active manip-

ulation of accounting results for the purpose of creating

an altered impression of business performance”

(Mulford & Comiskey, 2002, p. 59). EM activities are

often motivated by management incentives, such as the

ownership and management conflict (i.e., agency con-

flict). Agency costs (AC) occur in an effort to resolve

agency conflicts and better align the interests of owner-

ship and management. A high level of AC indicates inef-

ficient monitoring activities and weak corporate

governance (CG) (Jensen & Meckling, 1976; Shleifer &

Vishny, 1997). Based on agency theory, Jiraporn

et al. (2008) posit that agency conflicts could induce man-

agers to exploit the flexibility in accounting policies to

manage earnings, and they find that EM mitigates AC in

the US market.

In this article, we examine the AC/EM nexus in

China. We choose China for four reasons. First, the legal

environment in China is relatively underdeveloped com-

pared with the US and other developed countries (Chen

et al., 2006). It is important to study how the AC/EM

nexus differs in countries with a relatively underdevel-

oped legal environment, such as China, considering that

agency problems are more severe in emerging economies

than the developed economies due to weak legal protec-

tion and other governance mechanisms (La Porta

et al., 1998; La Porta et al., 2002).

Second, there is strong evidence of EM (Chen &

Yuan, 2004; Haw et al., 2005) and AC (Li et al., 2011; Li

et al., 2014) among Chinese firms. However, there is no

empirical evidence available on the relationship between

EM and AC in China. Therefore, China provides us with

an out-of-sample opportunity to examine whether

Jiraporn et al.'s (2008) findings that EM mitigates AC in

the US market can be generalized to China.

Third, the Communist Party has a strong influence

on CG in China. For example, the majority shareholder

of listed companies in China is often the state; China's

company law requires Chinese companies to establish a

supervisory board that typically includes officials from

the company's internal Communist Party committee.

Therefore, the agency problem is worsened in China

because of the weak ability of principals (i.e., Chinese cit-

izens) to monitor the performance of the agent. This cre-

ates an opportunity for managers (i.e., Communist Party

officials) to pursue their own interests instead of those of

the principals.

Finally, China is important as the largest emerging

economy and the largest recipient of foreign direct invest-

ment among developing countries (United Nations

Received: 15 April 2020 Revised: 2 November 2020 Accepted: 17 November 2020

DOI: 10.1002/jcaf.22481

J Corp Acct Fin. 2020;1–18. wileyonlinelibrary.com/journal/jcaf © 2020 Wiley Periodicals LLC 1

MAN14

structure of the market. Firms with little available infor-

mation may experience higher costs of capital. The

impact of information in influencing the costs of capital

are indicated by several studies (Botosan, 1997;

Christensen, de la Rosa, & Feltham, 2010; Easley &

O'hara, 2004; Feltham, Robb, & Zhang, 2007; Huang

& Kang, 2018; Hughes, Liu, & Liu, 2007; Lambert,

Leuz, & Verrecchia, 2012; Perera & Nimal, 2017). For

instance, the rational expectations model explains the

relationship between private information and the costs of

capital. Besides, Ahn, Horenstein, and Wang (2018)

explain the effects of asymmetric information on the

asset equilibrium price.

Some researchers have shown the role of private

information in dictating the prices of assets. Bai, Bali,

and Wen (2019) for instance build on the classic analysis

of rational expectation to elucidate the role of asymmetric

information on asset value. They find that the presence

of agents in transactions affects the risk–return tradeoffs

thus affecting the portfolios held by the informed and

uninformed investors. Besides, Dow and Gorton (1995)

explains that informed investors may profit from their

information while the uninformed investors' loss due to

lack of information. The main set back of this setback is

that it does not consider the costs of capital in its

assumption.

Another set of literature considers the role of incom-

plete information and symmetric information. Particu-

larly, Amihud (2018) investigates the effects of capital

market equilibriums in situations where the agents lack

some information about certain assets in the market. In

this model, agents who have information on the existence

of certain assets may decide on the distribution of

returns. However, the information is incomplete because

not all agents have knowledge of such information. The

analysis by Amihud shows that the value of an organiza-

tion's assets may be lower due to the existence of incom-

plete information. However, in normal circumstances,

some investors may have more knowledge about returns

than others. Besides, all the investors know about the

existence of every asset in the market through the infor-

mation that may be asymmetric.

Lastly, information disclosure by a firm may affect

the costs of capital because disclosure of private informa-

tion turns it into public information (Deno, Loy, &

Homburg, 2019). The presence of public information

means that each investor has access to information

regarding investments. Since the process of producing

information is costly, individuals ought to spend consid-

erable resources to collect information. Public informa-

tion increases the value of assets and capital since the

information lowers the risks of uninformed investors to

hold assets (Gârleanu & Pedersen, 2018). Diamond and

Verrecchia (1991) state that disclosure of information can

either improve or worsen liquidity depending on the

decisions by holders of information. The accessibility of

public information affects the riskiness or profitability of

an investment. Other researchers such as Kandelousi,

Alifiah, and Karimiyan (2016) incorporate other impor-

tant elements of information sharing such as insiders and

strategic disclosure issues.

2.2 |Cost of capital

The cost of capital is the amount expected by investors

after they have offered the capital required by a business.

Mostly, the sources of capital in a firm comprises of

investors who purchase stocks and the bondholders who

offer loans to an organization (Hertig, 2019). Conse-

quently, companies are expected to make returns that

ensure that both investors and the debt holders get

expected returns on investments. The cost of capital may

entail the mechanical calculations by financial people,

which is then used by management to come up with a

hurdle or discount rate. Businesses have to exceed the

hurdle rate in justifying investments (Anderson, Byers, &

Groth, 2000).

Mostly, the costs of capital may be slightly under the

required rate of return (McNulty, Yeh, Schulze, &

Lubatkin, 2002). The costs of capital in a firm are used to

determine the soundness of an investment. Besides,

investors use the costs of capital to assess the riskiness of

an investment. Companies only choose to commit their

finances in projects whose return exceeds the costs of

capital. As such, managers should always look for invest-

ments that exceed the costs of capital in an individual

organization (Easley, O'Hara, & Yang, 2016). Conversely,

investors look at the beta or volatility of investments to

determine whether an investment is worthwhile. The

costs of capital determine the corporate strategies and the

ability of an organization to compete in the future. Busi-

nesses may use the costs of capital to make capital

budgeting decisions to offer a strategic advantage to a

firm in the short run.

Though investment opportunities' in organizations

differ, the techniques of evaluating the financial returns

are similar. However, the value of investments made an

organization depend on the profitability of the invest-

ment portfolio undertaken by a firm. The expectations

about an investment determine whether a company will

make positive or negative returns. The costs of capital

influence the hurdle rate and the capital structure in a

firm. Also, the costs of capital may determine the opera-

tions of a firm that in turn determine the profitability

(Scott & Pascoe, 1984). According to Kandelousi

TÜREGÜN 3

structure of the market. Firms with little available infor-

mation may experience higher costs of capital. The

impact of information in influencing the costs of capital

are indicated by several studies (Botosan, 1997;

Christensen, de la Rosa, & Feltham, 2010; Easley &

O'hara, 2004; Feltham, Robb, & Zhang, 2007; Huang

& Kang, 2018; Hughes, Liu, & Liu, 2007; Lambert,

Leuz, & Verrecchia, 2012; Perera & Nimal, 2017). For

instance, the rational expectations model explains the

relationship between private information and the costs of

capital. Besides, Ahn, Horenstein, and Wang (2018)

explain the effects of asymmetric information on the

asset equilibrium price.

Some researchers have shown the role of private

information in dictating the prices of assets. Bai, Bali,

and Wen (2019) for instance build on the classic analysis

of rational expectation to elucidate the role of asymmetric

information on asset value. They find that the presence

of agents in transactions affects the risk–return tradeoffs

thus affecting the portfolios held by the informed and

uninformed investors. Besides, Dow and Gorton (1995)

explains that informed investors may profit from their

information while the uninformed investors' loss due to

lack of information. The main set back of this setback is

that it does not consider the costs of capital in its

assumption.

Another set of literature considers the role of incom-

plete information and symmetric information. Particu-

larly, Amihud (2018) investigates the effects of capital

market equilibriums in situations where the agents lack

some information about certain assets in the market. In

this model, agents who have information on the existence

of certain assets may decide on the distribution of

returns. However, the information is incomplete because

not all agents have knowledge of such information. The

analysis by Amihud shows that the value of an organiza-

tion's assets may be lower due to the existence of incom-

plete information. However, in normal circumstances,

some investors may have more knowledge about returns

than others. Besides, all the investors know about the

existence of every asset in the market through the infor-

mation that may be asymmetric.

Lastly, information disclosure by a firm may affect

the costs of capital because disclosure of private informa-

tion turns it into public information (Deno, Loy, &

Homburg, 2019). The presence of public information

means that each investor has access to information

regarding investments. Since the process of producing

information is costly, individuals ought to spend consid-

erable resources to collect information. Public informa-

tion increases the value of assets and capital since the

information lowers the risks of uninformed investors to

hold assets (Gârleanu & Pedersen, 2018). Diamond and

Verrecchia (1991) state that disclosure of information can

either improve or worsen liquidity depending on the

decisions by holders of information. The accessibility of

public information affects the riskiness or profitability of

an investment. Other researchers such as Kandelousi,

Alifiah, and Karimiyan (2016) incorporate other impor-

tant elements of information sharing such as insiders and

strategic disclosure issues.

2.2 |Cost of capital

The cost of capital is the amount expected by investors

after they have offered the capital required by a business.

Mostly, the sources of capital in a firm comprises of

investors who purchase stocks and the bondholders who

offer loans to an organization (Hertig, 2019). Conse-

quently, companies are expected to make returns that

ensure that both investors and the debt holders get

expected returns on investments. The cost of capital may

entail the mechanical calculations by financial people,

which is then used by management to come up with a

hurdle or discount rate. Businesses have to exceed the

hurdle rate in justifying investments (Anderson, Byers, &

Groth, 2000).

Mostly, the costs of capital may be slightly under the

required rate of return (McNulty, Yeh, Schulze, &

Lubatkin, 2002). The costs of capital in a firm are used to

determine the soundness of an investment. Besides,

investors use the costs of capital to assess the riskiness of

an investment. Companies only choose to commit their

finances in projects whose return exceeds the costs of

capital. As such, managers should always look for invest-

ments that exceed the costs of capital in an individual

organization (Easley, O'Hara, & Yang, 2016). Conversely,

investors look at the beta or volatility of investments to

determine whether an investment is worthwhile. The

costs of capital determine the corporate strategies and the

ability of an organization to compete in the future. Busi-

nesses may use the costs of capital to make capital

budgeting decisions to offer a strategic advantage to a

firm in the short run.

Though investment opportunities' in organizations

differ, the techniques of evaluating the financial returns

are similar. However, the value of investments made an

organization depend on the profitability of the invest-

ment portfolio undertaken by a firm. The expectations

about an investment determine whether a company will

make positive or negative returns. The costs of capital

influence the hurdle rate and the capital structure in a

firm. Also, the costs of capital may determine the opera-

tions of a firm that in turn determine the profitability

(Scott & Pascoe, 1984). According to Kandelousi

TÜREGÜN 3

Conference on Trade and Development, 2017). The estab-

lishment of the Asian Infrastructure Investment Bank

(AIIB) and implementation of the Belt and Road Initia-

tive have further boosted the interests of foreign inves-

tors, financial institutions, multinational companies, and

academics in the Chinese economy.

To examine the AC/EM relationship, we employ

static and dynamic modeling frameworks. The prevalent

endogeneity issue in CG studies often leads to spurious

results (Wintoki et al., 2012). Based on the static model,

we find that EM increases AC. However, the two-step

system generalized method of moments (GMM) dynamic

model that takes into account the dynamic nature of cor-

porate governance and other sources of endogeneity

(e.g., simultaneity, omitted variable, measurement error)

casts doubts on the causal relationship between AC

and EM.

We contribute to the corporate governance literature

in two ways. First, we provide further support to the

growing literature that has raised concerns on the endo-

geneity issue in CG studies (Pham et al., 2011; Schultz

et al., 2010; Wintoki et al., 2012), since our results indi-

cate that failing to take endogeneity issues into account

can lead to spurious results. Second, we extend the litera-

ture beyond developed markets by providing the first

empirical evidence on the role of EM in agency conflicts

in China.

The remainder of the article is organized as follows:

Section 2 provides the relevant literature on the relation-

ship between AC and EM and discusses the endogeneity

issue in CG studies; Section 3 describes data and

methods; Section 4 provides empirical results; and Sec-

tion 5 concludes the article.

2|LITERATURE REVIEW

2.1 |Agency costs and earnings

management

Research on EM originated in the US market and dates

back to the 1980s. For example, Healy (1985) finds that

managers choose accounting procedures selectively in

order to maximize the value of their compensation or

bonus. EM activities are found prior to the period of a

management buyout (Perry & Williams, 1994) and the

period of an equity offering (Teoh et al., 1998a; Teoh

et al., 1998b) to fit the stock market's purposes. EM activi-

ties are also found prevalent in the Chinese companies

where managers manage earnings to meet certain regula-

tory benchmarks and accounting thresholds to obtain

permission to issue shares (Chen & Yuan, 2004; Haw

et al., 2005; Kao et al., 2009).

Several theories explain the rationale for

EM. According to agency theory, managers are motivated

to undertake EM and resolve agency problems. Hill and

Jones (1992) extend agency theory to say that managers

act as the agent for all the interest-related parties not only

for the owners, and are therefore motivated to undertake

EM activities to coordinate the nexus of various stake-

holders. According to legitimacy theory, managers man-

age earnings to meet the expectation of the internal

stakeholder and the public to acquire and maintain the

legitimacy of the firm (Djelic, 2001; Guler et al., 2002;

Sun et al., 2010).

AC occurs through the separation between and the

divergence of ownership and management (Jensen &

Meckling, 1976). The managers (i.e., agents) tend to be

interested in pursuing their objectives, instead of always

maximizing the benefits of the shareholders

(i.e., principals). AC has been considered as one of the

fundamental problems in improving the corporate gover-

nance mechanism (Shleifer & Vishny, 1997). Even in the

advanced economies, such as the US market, where the

governance mechanism is extensively studied, there is

still ongoing debate on how to better align owner-

manager interests and to mitigate managerial expropria-

tion (Bates et al., 2009; Bebchuk et al., 2008; Harford

et al., 2012; Lazonick & O'sullivan, 2000).

Although China has borrowed the CG setups from

the developed market, only the form of CG has been

inherited not the substance (Backman, 1999). Unlike the

widespread shareholders in the developed market, the

ownership structure in Chinese listed companies is often

state-concentrated. Previous studies in developed markets

suggest that the managerial ownership may moderate

agency conflict (Ang et al., 2000; Singh & Davidson

III, 2003). However, owner management is not a panacea

for eliminating the agency problem (Schulze et al., 2001).

Especially in China, managers are rarely significant

shareholders in listed companies

1

(Jiang & Kim, 2015),

providing institutional roots for agency problems (Lin

et al., 2006; Xu et al., 2005).

Management's incentive connects AC with EM. The

practice of EM can bring reported earnings to the desired

level; hence, it is natural for the managers to engage in

EM to satisfy self-interest (Schipper, 1989; Scott, 1997).

The case for a nexus between AC and EM has been

strongly asserted in prior studies (Jiraporn et al., 2008;

Lambert, 1984). The advocates of beneficial EM argue

that EM can be used to add information value, reduce

information asymmetry, and mitigate AC (Arya

et al., 2003; Louis & Robinson, 2005; Warfield

et al., 1995). However, when managers undertake EM to

benefit themselves, EM can be used opportunistically to

deteriorate AC (Bergstresser & Philippon, 2006;

2MAN