Political Interference and Earnings Manipulation in Chinese Firms

Mainland China's economic system is in transition from a socialist system to a free economy. Chinese market standards tend to mirror those of developed countries, but unlike companies in developed markets, Chinese firms lack monitoring functions and are subject to strong political interference. The managers of firms with substantial state ownership are often designated by the state and are under strong pressure to comply with government requests for funds even when this is not in the company's interest. As this article illustrates, managers of Chinese listed firms offer rights issues to public shareholders and then transfer the proceeds to the state by distributing cash dividends. Firm income is often falsified in the financial statements issued before the rights-issue offering. During the three years prior to a rights issue, the gains from long-term investment, nonoperating income and revenue from related-party sales appear to be higher than would be expected. This implies that earnings are deliberately inflated before rights issues to meet profitability requirements set by the China Securities Regulatory Commission and implicates state ownership. Because the government has strong influence on the authorizing banks, firms with greater state ownership are less likely to manipulate earnings before rights issues.