The impact of regulations on earnings management via related party sales in china
Creators: name: Hu, Juncheng
Publisher: name: The Australian National University
Year: 2014

description: This study examines the impact of regulations on earnings management via related party sales (RPSs) in China. RPSs have been regarded as a primary means of earnings management in China. Manipulated RPS might involve sales of product or services between related parties at distorted prices or inflated sales volumes. However, manipulating transaction prices is less costly than inflating volumes as price manipulation does not require unnecessary production and transfer costs. The abuse of RPSs was associated with a series of corporate failures and a huge decline in investor confidence at the late 1990s. These scandals were highly publicised and regulators subsequently implemented an accounting treatment regulation in 2001, aimed at reducing earnings inflation via RPSs. Despite significant regulatory changes, the scope of events that led to the passage of the 2001 RPT measurement regulation, and the consequences of the regulatory changes have yet to be studied. This thesis addresses two sets of research questions in this study. The first research question examines whether there is a change in the prevalence of price inflation in RPSs before and after the 2001 RPT measurement regulation. The second research question examines motivations for using RPSs to inflate earnings, and the effect of regulatory change on the extent of earnings management for firms with incentives to inflate earnings. To carry out the investigation, this thesis estimates earnings management using RPSs in two ways. The change measure is defined as the difference between RPSs in the current year and previous year. The change in RPSs is decomposed into the positive change in RPSs denoting income-increasing RPSs and the negative change in RPSs denoting income-decreasing RPSs. The level measure is defined as the difference between a firm's RPS and the mean RPS for all other firms in the same industry. I argue that, if there was a widespread use of transfer pricing techniques in RPSs to inflate earnings, there should be a positive association between the change in gross margin and income-increasing RPSs. The results provide evidence that income-increasing RPSs are associated with price inflation in the pre-RPT regulation period but refer mainly to volumes inflation in the post-RPT regulation period. To my best knowledge, this is the first study to examine the nature of income-increasing RPSs by considering the prevalence of price versus volumes inflation in RPSs. Moreover, this study documents that both before and after the 2001 RPT measurement regulation, the level of RPS manipulation is abnormally higher for firms with incentives to use RPSs to meet the regulatory thresholds of new equity offerings or avoid special treatment policies when compared to firms in various control samples. However, suspected earnings management firms use significantly less RPSs after the regulatory change when compared to firms in similar circumstances prior to the regulatory change. The results provide evidence that the regulation in 2001 reduced but did not eliminate earnings inflation.