A Case Study On Chinese Listed Companies’ Earnings Management Based On Financial Instruments

In the21st century, with the increasing financial risks, financial instruments,especially the innovation of derivative financial instruments are more and more.Corporate investment and financing environment both changeprofoundly,which have contributed to update and implement new financialinstruments accounting standards. However, the new financial instrumentsaccounting standards change the method of earnings management of listedcompanies. This paper studies the motives and means of earningmanagement of Chinese listed companies and its impact on the incomestatement in three perspectives, which are classification of financial assets,changes in fair value of financial assets and hedge of derivative financialinstruments.By therotical analysis and case study, this paper found that:First,listed companies use the way of classification of financial assets forearnings management that can be divided into four specific cases, in order tothe different management purposes, when assets are classified in thebeginning, financial assets available for sale would be classified as held fortrading financial assets,or held for trading financial assets would be classifiedas financial assets available for sale; when assets are measured in thefollow-up, held-to-maturity investment or long-term equity investment would beclassified as financial assets available for sale to inflated profits.Further studies showed that companies which both have financial assetsavailable for sale and held for trading financial assets tend to classified as theformer to get more options and provide a "reservoir" for earnings managementand income smoothing. In the holding period, the bad profitability company willdisposal of financial assets available for sale to smoothing profits; goodcorporate tend to keep the capital surplus of unrealized profits in financialassets available for sale until a later year.Second, listed companies use financial assets available for sale tomanipulate earnings which make net changes in fair value into the capitalsurplus.According to the needs of production and operation, managementcould adjust the time of sale financial assets to manage earnings.Third, listed companies have not sufficient understanding the risk of derivative financial instruments and rush to invest it for reap huge profits. Thus,a direct result of the investment is the risk of derivative financial products out ofcontrol. Once the risk which magnified through the lever break out, it will bringcompanies huge hit.In response to these three aspects, this paper gives some suggestions asfollow: Firstly, in order to further improve the financial instruments accountingstandards and reduce the space of earnings management, the authorproposes to revise accounting standards. For example, we can combinefinancial assets available for sale with held for trading financial assets,introduction comprehensive income reporting system, strengthen disclosure ofderivative financial instruments, detailed the interpretation about technical andoperational points of valuation in financial instruments, strengthen the voice inthe international convergence and actively participate in internationalaccounting standards development. At the same time, standard-settinginstitution and regulatory authorities should strengthen the training ofaccounting professionals, enhance the communication of theorists andpractitioners, supervise the implementation of measure and follow confirmationof financial assets in enterprises. In addition, we could made efforts to improveauditing environment, strengthen auditing and supervision, improve the level ofaccounting staff. We can believe that, under the efforts of standard-settinginstitution, regulatory authorities, theorists and practitioners, the space forearnings management of listed companies base on financial instruments willbe further reduced, so that the reliability and usefulness of accountingstatements will also improve.