An Empirical Research On The Relation Between Earnings Management And Tunneling

The ownership structure of listed companies in China is relatively concentrated and the core of corporate governance is the conflicting interests between parent companies and minority shareholders, which is known as the Type II agency problem. Earnings management and tunneling during the IPO process are the focus of researchers. At present, the methods domestic researchers have used to examine the existence of earnings management and tunneling all have weaknesses and are not suitable to use in the latest regulation context. Furthermore, there are few studies that deeply analyze the relation between earnings management and tunneling during IPO from the perspective of Type II agency problem. Therefore, this research using new measurement methods on earnings management before IPO and tunneling after IPO and further analyzing their relation has theoretical and practical implications.Discretionary revenues from Stubben (2010) revenues model is used to measure the extent of parent company managing subsidiaries’earnings before IPO. In the latest regulation context, using Zheng et al.(2007) tunneling model, this study examines whether the trade of goods or services has become the main method of tunneling after IPO. In order to establish the direct relation between earnings management and tunneling, a new model is constructed based on the above tunneling model, further examining whether tunneling is an incentive for earnings management. The results show that to satisfy the requirements parent companies actively manage subsidiaries’ earnings before IPO and the extent of earnings management in the three-year period has a’V-shape’, earnings management in year t-3and t-1being high but in year t-2being smaller. After IPO, parent companies divert the capital collected mainly through the trade of goods or services and the extent of tunneling in the three years after IPO shows an ’Inverted V-shape’, indicating tunneling is the most serious in year t+2. The most important is that there is a positive relation between earnings management before IPO and tunneling after IPO, providing evidences that tunneling is an incentive for parent companies managing subsidiaries’earnings before IPO and this relation is the most apparent in year t+3.Based on the above findings, to reduce earnings management this study proposes: Essentially, the rights of minority shareholders should be protected comprehensively from both external legal framework and internal governance mechanism. The requirements of IPO should be gradually transferred from financial indicators to market mechanism. The Sponsors should have continuos supervision accountability for the sponsored listed companies. Furthermore, the regulations should increase the voting and supervision rights of minority shareholders on trade of goods or services after IPO.The contributions include:Use discretionary revenues from Stubben (2010) to measure the extent of earnings management before IPO, decreasing the measurement errors. Analyze that the trade of goods or services has become the main method of tunneling after IPO in the latest regulation context and measure tunneling by Zheng et al.(2007) tunneling model. Further, examine the relation between earnings management and tunneling directly through establishing a new model.Due to limited time and ability this study has its limitations and future research can focus on the following areas. For one thing, increase the expandability of results by using more large companies, longer time period and other industry data. For another thing, further analyze how parent companies use related-party transactions and financial reporting methods to manage earnings or tunnel subsidiaries except the trade of goods or services. Most importantly, the relation between earnings management and tunneling is complicated and tunneling as an incentive for earnings management is only one aspect, hence other aspects being the future research areas.