Institutional Environment, Accrual-based and Real Earnings Management in Emerging Markets: Empirical Evidence from Chinese Listed Companies

Abstract

Earnings management behavior is yet to be effectively explained as theoretical circles largely focus on accrual-based earnings management. Cohen et al (2003) shows that with the continuous improvement of the legal system, US companies are more inclined to adopt real earnings management rather than accrual-based earnings management. As legal systems in emerging capital markets are relatively weak, thus whether the results of Cohen et al. can be applied in emerging markets is yet to be fully investigated. Based on the existing uneven development of institutional environment in China, we apply the system Generalized Method of Moments (GMM) to test the effect of the institutional environment on accrual-based and real earnings management in listed companies and explore the role of the institutional environment in the strategic choices of earnings management. Results show that sound institutional environment suppresses accrual-based and increases real earnings management in listed companies. In addition, similar to the SOX legislation in the U.S., we find that improvement of the institutional environment in China also has an effective governance impact on earnings management.

Keywords: Institutional Environment, Accrual-based Earnings Management, Real Earnings Management, Earnings Management Strategy, System GMM Estimation