Ownership structure, audit quality, board structure, and stock price crash risk: Evidence from China

doi:10.1016/j.gfj.2018.04.002

Global Finance Journal

Volume 37, August 2018, Pages 1-24

https://doi.org/10.1016/j.gfj.2018.04.002 Get rights and content

Abstract

This paper explores whether or not a Chinese firm's ownership structure, audit quality, and board structure are associated with its future stock price crash risk. We find that stronger ownership structure and higher audit quality are associated with lower stock price crash risk, and the association is stronger since the IFRS and split-share reforms than before them. The results are consistent across two different measures of crash risk, as well as robust to endogeneity tests. We also find that board structure is not significantly associated with stock price crash risk.

Introduction

Stock price crash risk has become increasingly important to regulators, academics, and investors. Research on stock price crash risk has intensified since the 2008 financial crisis. So far, most of the studies have focused on the U.S. setting, where the potential correlates investigated have included corporate governance (Andreou, Antoniou, Horton, & Louca, 2016), financial reporting quality (Francis, Hasan, & Li, 2016; Kim & Zhang, 2016), management style and compensation (Kim, Wang, & Zhang, 2016), and informal institutions, such as religion (Callen & Fang, 2015). Research in the Chinese setting is much more limited, even though the Chinese capital markets have grown to become among the largest in the world. The rapid growth of the Chinese equity markets has come with its own set of unique regulatory challenges and market volatility. Formal institutions, such as investor protection systems, corporate governance, and accounting standards are still considered to be less developed in China (Allen, Qian, & Qian, 2005), with stock markets experiencing large bubbles and crashes (Piotroski & Wong, 2012).

This study investigates the relation between crash risk in Chinese-listed firms and corporate governance attributes. Specifically, we jointly consider three dimensions of governance mechanisms: ownership structure, board structure, and audit quality, which comprise 15 individual attributes. Each of these governance attributes is intended to enhance management monitoring, promote effective decision making, and constrain opportunistic behavior (Andreou et al., 2016; Ashbaugh-Skaife, Collins, & LaFond, 2006). Accordingly, we expect that the better a firm's corporate governance is, the lower will be the information asymmetry between shareholders and management, and thus the lower the likelihood of future stock price crashes.

Following previous researchers (Chen, Hong, & Stein, 2001; Hutton, Marcus, & Tehranian, 2009; Jin & Myers, 2006), we proxy for crash risk using two measures, negative coefficient of skewness and down-to-up volatility, and a sample of 11,427 firm-year observations from 2000 to 2014. We control for firm-year and industry fixed effects (Cronqvist & Nilsson, 2003; Linck, Netter, & Yang, 2008), financial reporting opacity, firm size, and other firm-specific determinants of crash risk. We also estimate our main models with different aggregate measures of audit quality and ownership structure, as well as with the individual elements of audit quality and ownership structure, and control for endogeneity.

Our study contributes to the literature in several ways. First, the effects of ownership structure, board structure, and audit quality on crash risk have not been investigated in the Chinese setting, although other investigators have looked at the relationships between crash risk and religion (Li & Cai, 2016), analyst coverage (Xu, Jiang, Chan, & Yi, 2013), excess perks (Xu, Li, Yuan, & Chan, 2014), and management controls (Chen, Chan, Dong, & Zhang, 2017). Most of the early literature in this domain focused on the impact of a single governance characteristic on firm value and performance (Qi, Wu, & Zhang, 2000). Recently, researchers have begun developing composite measures of corporate governance unique to Chinese-listed firms (Sami, Wang, & Zhou, 2011). Our study extends this literature by using broad measures of formal corporate governance.

Second, we deepen our understanding of effective governance by analyzing the distinct impacts of our 15 corporate governance attributes on crash risk. To the best of our knowledge, this is the first study to offer firm-level insights into these relationships for Chinese-listed companies.

Third, we also enrich the audit quality literature. To the authors' best knowledge, this is the first study to explore the relationship between different elements of audit quality and crash risk. This is a significant contribution to the audit quality literature, especially that on China, which has tended to focus on the auditors' ability to restrain earnings management (Chen, Chen, Lobo, & Wang, 2011) or issue modified audit opinions (Chen, Su, & Zhao, 2000). Our investigation is especially important now, as the Chinese audit markets are at a crossroads with the expiration of the Big 4's Sino-Foreign Joint-Venture (JV) agreements (Deng & Macve, 2015).

Fourth, we contribute to the literature on the relationship between ownership structure and board structure. Understanding this relationship is important not only for investors, but also for Chinese regulators, who continue to put substantial effort into restructuring both the ownership and the boards of Chinese-listed companies. Regulators will find this study useful in considering future reforms, as well as evaluating the reforms already adopted concerning both ownership structure (e.g., the split-share reform, which shifted ownership from highly concentrated state ownership to a more dispersed domestic and foreign shareholder base) and board structure (e.g., the 2002 Code of Corporate Governance for Listed Firms).

The rest of this paper is organized as follows. Section 2 discusses the background literature and develops the hypotheses. Section 3 summarizes the data. Section 4 outlines the research design. 5 Empirical results, 6 Robustness tests present the empirical results and robustness checks, respectively. Section 7 provides a brief conclusion and implications for future research.

Section snippets

Stock price crash risk

A stock price crash is a large negative movement in a firm's adjusted stock return (Hutton et al., 2009). Such movements not only dampen portfolio returns but also increase the portfolio's risk profile. Crash risk became the focus of investors and regulators after a large number of high-profile corporate scandals took place in the early 2000s, and the credit crisis in 2008 has provided a strong impetus for further research into the determinants of stock price crashes.

Research to date suggests

Data

The sample used in this paper consists of firms listed on the Shanghai Stock Exchange and the Shenzhen Stock Exchange from 2000 to 2014. In 2007, Chinese-listed firms were required by the Chinese government to adopt the ASBE, which covered most of the standards under the IFRS. In addition, the Chinese stock market reform that was put in place to eliminate nontradable shares was completed in the same year. These two major changes (hereafter simplified to “the IFRS reforms”) motivate us to

Measurement of firm-specific stock price crash risk

Following Chen et al. (2001), Jin and Myers (2006), and Hutton et al. (2009), we define two crash risk measures: the “negative coefficient of skewness” and “down-to-up volatility.” Calculating the two measures requires firm-specific residual daily returns, which can be estimated as follows: $r_{i, t} = α_{i} + β_{1, i} R_{M, t - 1} + β_{2, i} R_{M, t} + β_{3, i} R_{M, t + 1} + ε_{i, t},$ where r_i,t is the return of stock i on day t, while R_M,t−1, R_M,t, and R_M,t+1 are the value-weighted market return on day t − 1, day t, and t + 1, respectively. We

Descriptive statistics

Table 1 presents the descriptive statistics for all variables used in our regressions for the entire sample. The means (standard deviations) of the two crash risk measures, NCSKEW_i,T+1 and DUVOL_i,T+1, are −0.568 (0.836) and −0.387 (0.462), respectively, and the values are consistent with those reported in previous studies in the Chinese setting (Li & Cai, 2016; Xu et al., 2013; Xu et al., 2014).

The average percentage of shares owned by the top 10 shareholders is 54.40%, while an average of

Eliminating financial firms

Our first test assesses the robustness of our results to excluding financial firms. We follow Hutton et al. (2009) and eliminate financial firms from our sample. Table 5 presents the results of estimating Eqs. (5), (6), (10), (11) after eliminating financial firms, and our findings remain robust. In particular, the relationships between ownership structure and crash risk and between audit quality and crash risk remain negative. Hence, as in the earlier findings, Hypothesis 1a, Hypothesis 1c are

Conclusion

Using a sample of 11,427 firm-year observations for Chinese firms from 2000 to 2014, we find that stronger ownership structure and audit quality are negatively associated with stock price crash risk. The findings are consistent across two different crash risk measures, as well as with different aggregate and component measures of ownership structure and audit quality, and these relationships are stronger after the IFRS reforms than before them. Board structure, on the other hand, does not seem