Should earnings thresholds be used as delisting criteria in stock market?

doi:10.1016/j.jaccpubpol.2008.07.002

Journal of Accounting and Public Policy

Volume 27, Issue 5, September–October 2008, Pages 409-419

https://doi.org/10.1016/j.jaccpubpol.2008.07.002 Get rights and content

Abstract

In Chinese stock market, firms reporting two consecutive annual losses are subject to special treatment (ST), with further losses causing the firms’ stocks to be suspended from trading or to be delisted. We argue that these earnings-based delisting requirements are misconstrued. Such policies drive financially healthy firms out of stock market, and induce listed firms to engage in rampant earnings manipulation in order to avoid delisting. The results carry important public policy implications for securities market regulation.

Introduction

How should an emerging securities market be regulated? What securities laws work in an underdeveloped securities market? Could there be any unintended consequences if unnecessary rules are adopted? These are tough questions that Chinese stock market regulators have encountered since they jumpstarted the stock market within China’s central planning economy during early-1990s.

Examining the effect of securities laws on stock market development in 49 countries, La Porta et al. (2005) find little evidence that public enforcement benefit stock markets. In this paper, we study a particular provision in Chinese securities laws and regulations (special treatment and delisting of stocks for reporting consecutive accounting losses). Consistent with La Porta et al. (2005), we identify occasions where public enforcement does not benefit the development of the underdeveloped Chinese stock market.

Chinese securities laws and regulations² mandate that if a listed firm reports accounting losses (i.e., negative earnings) in two consecutive years, its stock will be put under “special treatment” status (ST). There are various trading and financial restrictions on ST stock. Its daily stock price movement is restricted to be no more than 5% in either direction, and the company’s semi-annual report must be audited, unlike other companies. Furthermore, an ST firm cannot raise additional capital from stock market. If the firm reports one more loss, it is suspended from trading on the stock exchanges, after a fourth annual loss the stock will be delisted.

In Section 2, we survey the small but growing literature on securities delisting (e.g., Macey et al., submitted for publication), and motivate this study. We argue that the ST policy in China’s securities regulations have serious unintended consequences. It could drive healthy firms out of the stock markets for temporary accounting losses (we refer to this consequence as loss of economic efficiency in that both listed firms and investors are better off with these firms staying listed). Out of fear of being specially treated, listed firms may also engage in value-destroying earnings manipulation to prevent accounting losses (we refer to this consequence as incentive distortion in that the policy induces firms to manage earnings to avoid losses). Sections 3 and 4 provide some exploratory evidence on these two unintended consequences. Section 5 concludes the paper.

Section snippets

Literature review and motivations

China re-opened its stock market in early-1990s after a four-decade hiatus. The purpose of such a move was clear: to help State-Owned Enterprises (SOEs) raise capital that the state government could no longer provide. However, in a centrally planned economy, the regulation of this new stock market was a challenge. With investor protection in mind, the regulators adopted securities laws and regulations from developed economies and made some add-on’s, ST policy being one of these add-on’s.

The

Special treatment policy and economic efficiency

In this section, we address the first unintended consequence of the ST policy. That is, we provide analytical as well as collaborative evidence to argue that the ST policy could unintentionally drive healthy firms out of stock market when the ST, suspension of trading, and delisting decisions are based on accounting earnings.

To illustrate the problem caused by the ST policy, we first present a simple model to quantify the probability of a firm reporting consecutive losses. The purpose of the

Special treatment policy and earnings manipulation

While the ST policy drives healthy firms out of the stock market at an unacceptable level of probability, it also induces currently listed firms to engage in value-destroying activities in order to avoid reporting a loss. That is, facing the possibility of ST and possibly delisting, company management has a stronger (distorted) incentive to avoid losses, even if it means manipulating earnings and deceiving investors. Ding et al., 2007, Jiang and Wang, 2003, Jian and Wong, submitted for

Concluding remarks

The purpose of this paper is simple: to document a situation where over-regulation in an underdeveloped stock market has hindered its development. The ST policy in Chinese stock market causes economic efficiency losses (driving healthy companies out of the stock market), and distorts management incentives hereby inducing rampant earnings manipulation.

After the enactment of two stock exchanges in 1990 and 1991, Chinese stock market flourished during most of the 1990s, as a new channel of

Acknowledgements

We thank John Briginshaw, Charles M.C. Lee, two anonymous referees, and workshop participants at Fudan Universities and Peking University for helpful comments, and National Natural Science Foundation of China for financial support (approval numbers 70532002 and 10771006).

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Should earnings thresholds be used as delisting criteria in stock market?

Abstract

Introduction

Section snippets

Literature review and motivations

Special treatment policy and economic efficiency

Special treatment policy and earnings manipulation

Concluding remarks

Acknowledgements

Journal of Accounting and Public Policy

Journal of Accounting and Economics

Journal of Accounting and Economics

Journal of Accounting and Economics

Journal of Corporate Finance

Profitability regulation, earnings management, and modified audit opinions: evidence from China

Auditing: A Journal of Practice and Theory

Why are earnings kinky? An examination of the earnings management explanation

Review of Accounting Studies

Earnings management to exceed thresholds

Journal of Business

Earnings management? The shapes of the frequency distributions of earnings metrics are not evidence ipso facto

Journal of Accounting Research

Private vs. state ownership and earnings management: evidence from Chinese listed companies

Corporate Governance

Economic effects of tightening accounting standards to restrict earnings management

Accounting Review