Earnings Management and Capital Resource Allocation : Evidence from China's Accounting-Based Regulation of Rights Issue

From 1996 to 1998, listed companies in China were required to achieve a minimum return on equity (ROE) of 10 percent in each of the previous three years before they could apply for permission to issue additional shares. Hence, there was a heavy concentration of ROEs in the area of just above 10 percent. This paper shows that earnings management is relatively easy to detect on China's standardized income statement. In the 1996-1998 period, Chinese regulators seem to have gradually increased their scrutiny of earnings management in the approval process, and improved their ability to identify firms that subsequently performed better. However, since this scrutiny was limited, many firms were still able to gain rights issues approval through earnings management. The study shows that these firms subsequently performed worse than those which did not employ such practices. Thus, capital resources might have been allocated better had the regulators examined more closely the management of earnings