Controlling shareholders' equity pledges, earnings management, and audit monitoring

Abstract

Equity pledging has rapidly developed in China’s capital market in recent years, becoming one of the most important financing tools for controlling shareholders. The key factor of such business is stock prices. When the stock price drops to concerning levels, the lender will advise the borrower to add guarantees or redeem the pledged stocks in advance. When the stock price drops to the liquidation line, the lender will sell or auction the stocks on the secondary market. Stock prices are affected by various factors, including company accounting earnings. For a long time, information regarding company earnings has served as one of the most important determinants that investors use to value stocks. In order to manage market value and avoid stock prices falling to the liquidation line, controlling shareholders who have pledged equity are motivated to directly use their control over the company to manipulate earnings upward through earnings management when necessary. Consistent with this expectation, listed companies with high proportions of equity pledges are often found guilty of financial fraud. In 2018, in order to prevent the excessive scale of equity pledges from increased capital market volatility, regulatory authorities revised relevant equity pledge systems to ensure equity pledge repurchase business operates under stricter standardized regulations. External audit institutions, facing listed companies with high proportions of equity pledges, respond accordingly by, for example, selecting customers preferentially, increasing fees, and prudently issuing audit reports. This study focuses on controlling shareholders’ equity pledge behavior and addresses the following questions: What patterns can be found in the proportions of equity pledges made by companies with different property rights and in different industries? Do controlling shareholders’ equity pledges reduce the earnings quality of listed companies? Has the extent of the influence of controlling shareholders’ equity pledges on listed companies’ earnings quality changed due to the macro and capital market regulatory environment? How do auditors respond to companies after controlling shareholders have made equity pledges? To respond to these questions, this study selects A-share companies listed on the Shanghai Stock Exchange and the Shenzhen Stock Exchange from 2008 to 2020 as samples in this research, including 29,014 companies’ annual data from 3,545 listed companies. First, this paper analyzes the overall changes in controlling shareholders’ equity pledge ratios after the introduction of new guidelines on equity pledges. The promulgation of new guidelines effectively curbs increases in controlling shareholders’ equity pledges. In terms of property rights and regions, listed SOEs and companies in regions with fewer financing constraints are relatively less influenced by the new guidelines. This paper examines the relationship between controlling shareholders’ equity pledges and earnings management behaviors. Companies that carry out equity pledges are motivated to manage stock market value through earnings management in order to avoid the transfer risk regarding control rights and reduce pressure to add pledged equities. Empirical research results show that listed companies with controlling shareholders’ equity pledges and those with a higher proportion of controlling shareholders’ equity pledges have higher levels of abnormal non-recurring gains and losses and abnormal accrual items. These results indicate that listed companies with controlling shareholders’ equity pledges and a higher proportion of pledges are more likely to engage in earnings management behavior. After the introduction of the new guidelines on equity pledges, controlling shareholders” behavior of “leveraging” through equity pledges was curbed, which helped reduce the risks faced by listed companies. Controlling shareholders’ equity pledges on the earnings management of listed companies with equity pledges had a positive impact. The test results of a difference-in-difference (DID) model show that, after the introduction of the new guidelines on equity pledges, the positive relationship between controlling shareholders’ equity pledges and abnormal non-recurring gains and losses and abnormal accrual item indicators of listed companies became significantly weaker. This indicates that the earnings management of listed companies with controlling shareholders’ equity pledges has been suppressed to some extent after the introduction of the new guidelines. Considering that companies with controlling shareholders’ equity pledges may have higher audit risks, accounting firms with good reputations (e.g., the top 12 firms) will be more cautious when choosing customers with controlling shareholders’ equity pledges while charging higher audit fees and issuing more non-standard unqualified opinions. Empirical results from a logit model and regression models show that companies with controlling shareholders’ equity pledges and higher pledge ratios are less inclined to change their audit institutions to top 12 accounting and are more likely to be issued with non-standard unqualified opinions. At present, earnings management methods have changed but existing research on earnings management does not cover the manipulation of accounting statements through transactions. Referring only to traditional research methods based on financial information will produce bias when analyzing corporate earnings management. This paper discusses earnings management from an industrial chain perspective based on practical experience, summarizes the differences compared to related transactions customer/supplier transactions under earnings management, and analyzes auditors’ response strategies under this type of earnings management mode.