The impact of China's split share structure reform and convergence with International Financial Reporting Standards on the quality of reported earnings

In the first decade of the twenty-first century, China, one of the world's largest economies, undertook both share market structure and financial reporting reforms as part of the country's development towards a more international, market-based economy. The split share structure reform (SSSR), implemented in three phases over 2005-2009, made previously untradeable shares in state owned enterprises (SOEs) tradeable in the stock market from the beginning of 2009; and International Financial Reporting Standards (IFRS)-converged Chinese Accounting Standards (CAS) replaced old Chinese GAAP for periods of account beginning on or after 1st January 2007. Using accounting and market data over the period 2003-2010 (inclusive), this research investigates the impact of implementation of the SSSR and the adoption of IRFS-converged CAS on the earnings quality of Chinese listed firms. Earnings quality is considered widely, across dimensions of accrual quality, earnings persistence, earnings timeliness and earnings (and returns) value relevance. Some of the empirical models are applied/interpreted in a novel/unconventional manner – as required in Chinese context of this study. The SSSR and convergence with IFRS are considered in tandem. This study finds strong evidence to support hypotheses that SSSR-related incentives led to: (i) downwards earnings management in the first phase of the SSSR implementation (negotiation phase, 2005-2006); (ii) upwards earnings management in the second (lock-in) phase of the SSSR (lock-in phase, 2007-2008); (iii) downwards earnings management in the third phase of the SSSR implementation (trading of previously untradeable shares, 2009- 2010); and (iv) a significant reduction in earnings quality, as variously assessed. Further, that the downwards/upwards manipulation of earnings was driven into share prices over 2005- 2008 – when Chinese market was of low liquidity and questionable efficiency. In addition, the evidence shows that IFRS-convergence in China from 2007 could not (and did not) significantly curtail earnings management in response to SSSR-related incentives. Some evidence, indeed, is suggestive that earnings management activities were less constrained under IFRSconverged CAS than they were under old Chinese GAAP. In terms of specific earnings quality results, this study finds that in the first phase of SSSR (2005-06), ahead of the adoption of IFRS-converged CAS, there was a net shift away from income-increasing to income-decreasing discretionary accruals; earnings persistence and predictability decreased; earnings smoothness increased; large loss reports and timeliness of loss recognition increased; and earnings value relevance and earnings response coefficient increased. In the second phase of SSSR (2007-08), despite the adoption of IFRS-converged CAS in 2007, working capital accruals quality reduced; there was a net shift away from incomedecreasing to income-increasing discretionary accruals; earnings persistence and predictability reduced; timeliness of loss recognition reduced; and earnings value relevance and earnings response coefficient increased. In the final phase of SSSR (2007-10), post-IFRSconvergence, working capital accruals quality reduced, there was a net shift away from income-increasing discretionary accruals to income-decreasing discretionary accruals; earnings persistence and predictability reduced; earnings smoothness and large loss recognition increased; and earnings value relevance and earnings response coefficient both decreased. This research addsto the accounting literature on earnings quality/management, and, in particular, the association between earnings quality and IFRS adoption (convergence) in the context of strong Chinese institutional and country factors – in considering/investigating the joint effect of IFRS convergence and SSSR on earnings quality for the first time. The findings will be of interest aside from providing a warning to international and Chinesedomestic investors/analysts as regards the earnings quality of Chinese listed firms. The findings of this research will help academics, policy makers, regulators and professional bodies to understand better the effect of accounting and market regulatory reforms in China, thereby facilitating their ongoing development of the Chinese accounting regulation and stock market structure.