The International Journal of Accounting 39 (2004) 339 364

Evidence from China on the value relevance of operating income vs. below-the-line items
Shimin Chena,b,*, Yuetang Wangc
b a Department of Accounting, Lingnan University, Hong Kong Department of Accounting, University of Louisiana at Lafayette, United States c Department of Accounting, Nanjing University, China

Received 14 August 2003; received in revised form 24 February 2004; accepted 29 June 2004

Abstract This study investigates the value relevance of operating income vs. below-the-line items in the Chinese stock market. The motivations for this study are twofold. First, there is a need for empirical evidence of the value relevance of earnings components given that previous findings of value relevance in China at the aggregate level have often been questioned in the literature. Second, the reporting environment for earnings components in China provides an interesting opportunity to present additional evidence on the pricing of persistent vs. less persistent earnings. Chinese GAAP is more specific in defining the scope and specifying the format of reporting earnings components with different levels of persistence. In addition, differing from the U.S. evidence in the extant literature, below-the-line items in China is overwhelmingly incomeincreasing and frequently account for a large percentage of a firms reported net income. By linking valuation analysis with earnings time-series properties, we present additional evidence to support value relevance in China: An earnings component is impounded in stock prices as long as it is persistent and nonpersistent below-the-line items are value irrelevant. However, the timeseries properties of earnings components are not fully priced by the market. The earningsresponse coefficients are larger for below-the-line items than for operating income, although below-the-line items are less persistent and have lower predictive power. In discussing this

* Corresponding author. Department of Accounting, Lingnan University, Tuen Mun, Hong Kong. E-mail address: schen@ln.edu.hk (S. Chen). 0022-7063/$30.00 D 2004 University of Illinois. All rights reserved. doi:10.1016/j.intacc.2004.06.012

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pricing anomaly, we identify some unique institutional factors that may be responsible for the results. D 2004 University of Illinois. All rights reserved.
Keywords: Value relevance of recurring vs. nonrecurring earnings; Special items; Below-the-line items; Earningsresponse coefficients; Persistence of earnings

1. Introduction The pricing of earnings components is of universal interest because generally accepted accounting principles (GAAP) around the world require reported earnings to be disaggregated into components in income statements. Explicitly or implicitly, perceived differences in persistence among earnings components are the primary basis for various schemes of decomposition. In recent years, special attention has been given to time-series properties and the pricing structure of recurring earnings vs. nonrecurring special items due to the increasing frequency and magnitude of such items reported in the United States1 (Burgstahler, Jiambalvo, & Shevlin, 2002; DeAngelo, DeAngelo, & Skinner, 1992; Elliott & Hanna, 1996; Elliott & Shaw, 1988; Francis, Hanna, & Vincent, 1996; Hanna, 2001; Kinney & Trezevant, 1997; Moffitt & Rai, 2002). Evidence tends to show that the U.S. market places a higher valuation weight on recurring earnings than on special items. The international accounting literature contains a limited number of studies on earnings components (Giner & Reverte, 1999; Herrmann, Inoue, & Thomas, 2000; Herrmann, Inoue, & Thomas, 2001; Schadewitz, 1996). This study investigates the pricing of operating income vs. items below operating income (below-the-line items)2 in the Chinese stock market. Motivations for this study are twofold. First, there is a need for empirical evidence beyond the value relevance of aggregated accounting information in China. Due to the unique information environment, there has been a steady interest in the international accounting literature about if and/or how accounting information is reflected in stock prices in China (e.g., Abdel-khalik, Wong, & Wu, 1999; Bao & Chow, 1999; Chen, Chen, & Su, 2001; Eccher & Healy, 2000; Lee & Cao, 2002). Contrary to the expectations of many researchers, studies have consistently shown an association of accounting information with stock valuation to a degree similar to, if not stronger than, what has been documented in a mature market, such as the U.S. market. The evidence is often considered perplexing given the relatively short history of the stock market and accounting reform in China since the early 1990s. In
1 Special items in the U.S. literature are not formally GAAP-specified line items in the income statement; instead, they are Compustat-defined items consisting of certain nonrecurring items identified from the income statement and the accompanying notes. Furthermore, the terms recurring vs. nonrecurring should not be taken literally; instead, they are better considered as describing different degrees of persistence because some special items occur year by year. 2 All items below the operating-income line are generally considered less than recurring in China. While there is a large overlap between these items in China and special items in the United States, the scope of belowthe-line items examined in this study is wider than that of special items in the U.S. literature. A more detailed discussion of the Chinese reporting environment will be provided in a later section.

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addition to the value-relevance studies, many other papers have also provided detailed descriptions and analyses of events and developments related to Chinese accounting and stock markets (e.g., Chen, Sun, & Wang, 2002; and Chen & Yuan, 2001; DeFond, Wong, & Li, 2000; Xiang, 1998; Xiao, Zhang, Xie, 2000). A consensus of this literature is that the stock market in China is in its infancy, market-oriented accounting standards are still developing, and supporting infrastructure, such as preparer professionalism, quality auditing, and effective enforcement, is often inadequate. Apparently, the inconsistency between empirical and anecdotal evidence calls for additional research. Examining how market prices impound earnings components with different degrees of persistence is an important step in this direction; such a differential valuation implication requires a higher level of sophistication among market participants and a finer information environment in the market. Second, the institutional environment surrounding the reporting of recurring vs. nonrecurring items in China is vastly different from that of the extant literature that is primarily based on the U.S. market. Chinese GAAP is more specific both in defining the scope of below-the-line items and in specifying the format of reporting them. As such, there is less ambiguity between earnings components that are supposed to be more or less persistent for users of the income statement. Furthermore, in sharp contrast to special items being dominated by charges to the income statement in the United States, reported belowthe-line items in China are overwhelmingly income-increasing and often account for a large percentage of a firms reported net income. Anecdotal evidence repeatedly suggests that using below-the-line items to increase earnings and meet profitability targets is a primary tool for earnings management in the Chinese stock market. Consequently, China offers an interesting opportunity to enhance the extant literature by examining how the stock market prices operating income vs. below-the-line items in a very different environment. Based on four-year data from 1997 to 2000, we address three research questions. First, does the pricing of operating income and below-the-line items agree with perceived differences in persistence between these earnings components? Using a return and a price model, we find that both operating income and below-the-line items are value relevant, but contradictory to the perceived difference in persistence, price-earning multiples are significantly larger for below-the-line items than for operating income. Second, are the time-series properties of the earnings components consistent with perceived differences in persistence? Based on an autoregression and a one-year-ahead earnings-prediction model, our findings confirm the theoretical and perceived patterns of persistence in the sense that recurring operating income is more persistent and has significantly larger predictive power than below-the-line items. However, different from many U.S.-based studies, we find that below-the-line items in China persist into the future and are of significant predictive values. We seem to have mixed evidence from the first two research questions about pricing mechanisms in the Chinese stock market. Pricing is rational in that persistent earnings, no matter whether they are recurring operating income or below-the-line items, are reflected in stock prices. However, the time-series properties of the earnings components are not fully impounded in stock prices as demonstrated by the unexpected relative magnitudes of earnings multiples. Finally, is the evidence on persistence and pricing of below-the-line items interpretable? To answer this question, we identify various subsamples based on earnings-management

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variables and observed persistence. For three earnings-management subsamples, we obtain some evidence consistent with stock prices properly reflecting time-series properties of below-the-line items. In particular, we find that below-the-line items resulting from the bbig bathQ do not have any valuation implications because they represent an interperiod transfer of expenses. For a sample of observations containing only transitory below-theline items identified based on observed persistence, we provide strong evidence that nonpersistent below-the-line items are completely value irrelevant. In sum, we find rational pricing of operating income and below-the-line items in China: An earnings component is impounded in stock prices as long as it is persistent and nonpersistent items are value irrelevant. Such evidence is important and casts an additional vote of confidence in the ability and sophistication of Chinese investors with respect to the use of accounting information. Despite the emerging nature of the stock market, less than fully developed accounting standards, and inadequate financial-reporting infrastructure, this study provides additional evidence to support value relevance in China. Not only do stock prices impound earnings information as demonstrated in many published studies, but they also reflect some differences in persistent vs. nonpersistent earnings as shown in this study. However, the study also shows that time-series properties of earnings components are not fully reflected in stock prices. Although below-the-line items are less persistent and have a lower predictive power than operating income, earnings multiples for these items are larger than that for operating income. This is an anomalous finding. Although we do not have direct evidence, we conjecture that the larger valuation weight placed by Chinese investors on below-the-line items may be due to the institutional environment in China where listed companies are somehow able to use these items to increase earnings whenever such a need arises. A more conclusive answer awaits future research. The remainder of the paper is organized as follows. The next section discusses related literature, followed by a description of the institutional environment in China surrounding the reporting of below-the-line items. The fourth section describes data and the research design, followed by the fifth section where empirical results are presented and analyzed. The final section concludes the paper with a summary of findings.

2. Related literature on earnings components Many studies of earnings components examine special items in the U.S. financial reporting environment. Elliott and Hanna (1996) examine the information content of earnings in the presence of large, multiple, nonrecurring charges. They find that earningsresponse coefficients (ERCs) for earnings before special items decline following the recognition of large, special items and ERCs decline further after subsequent special items are reported. They also document a decline of ERCs for special items with an increasing frequency of special items and show that investors attach significantly less weight to special items than to earnings before special items. Their interpretation of the findings is that these special write-offs may be viewed by investors as being finite-horizon as opposed to recurring events and/or as being associated with unusual and difficult-to-interpret economic circumstances. A recent study by Moffitt and Rai (2002) reexamines the results

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of Elliott and Hanna using both seasonal random walk and analysts forecasts to estimate expected earnings. They find that ERCs for earnings before special items decline first, but then rise as the frequency of special items increases. However, they fail to document any stable patterns for ERCs on special items. Elliott and Shaw (1988) find a significant one- and two-day industry-adjusted negative return around the write-off announcement and an association of these negative returns with the size of write-offs. Francis et al. (1996) attempt to examine whether the stock-price reactions to write-off announcements depend on the nature of write-offs. Although their overall tests show negative market reactions to the write-off announcements, suggesting that the market responses are driven by write-offs revealing information about asset impairment, they find that investors responses become significantly positive to restructuring charges, which is interpreted as conveying information about future improvement in performance. Both Elliot and Shaw and Francis et al. focus on the stock-price reaction to write-off-type special items without examining the relationship between pricing of recurring earnings vs. special items. Several studies examine the time-series relationship between special items and reported or forecasted earnings without attempting to explore the pricing aspect of special items. DeAngelo et al. (1992) investigate the effect of special items on the time-series properties of earnings and find a negative association of current-period special items and next-period annual earnings, suggesting an interperiod transfer relationship between special items and future earnings. Kinney and Trezevant (1997) document firms differential reporting behavior with respect to positive vs. negative special items. They find that negative special items are more likely to be reported separately in the income statement to emphasize their transitory nature; however, positive special items tend to be reported together with others and discussed in notes to de-emphasize their transitory nature. Hanna (2001) examines the impact of special items on analysts earnings forecasts and finds an increasing error in analysts forecasts when special items exist. Burgstahler et al. (2002) simultaneously examine the time-series properties and stock market pricing of recurring earnings vs. special items. Focusing on quarterly earnings, they demonstrate that special items are less persistent than other earnings components, and show significant differences between the time-series properties of positive vs. negative special items in that negative special items are more than completely transitory, reflecting interperiod transfers, while positive special items are not completely transitory. With respect to pricing, they find that the market recognizes differences in time-series properties between special items and other earnings components as well as between positive and negative special items. However, stock prices do not fully impound the information of time-series properties in either special items or other earnings components, suggesting irrational pricing mechanisms in the U.S. market. Research on pricing and/or time-series properties of earnings components is both scarce and less focused in the international accounting literature. Using Spanish data, Giner and Reverte (1999) find that the separate disclosure of extraordinary earnings3 does not
3 As in many other countries, extraordinary items in Spain are much broader than the narrow definition adopted by U.S. GAAP. Most, if not all, of the Compustat-defined special items would be included as extraordinary items.

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provide incremental information beyond aggregate earnings. Herrmann et al. (2000) report extraordinary items in Japan to be less persistent than either operating or nonoperating income. But neither study directly examines the pricing of recurring vs. nonrecurring earnings. Schadewitz (1996) investigates the information content of interim earnings components based on Finnish data and finds higher earnings-response coefficients for perceived permanent earnings than for perceived transitory earnings. However, the study does not make a direct connection between pricing and the time-series properties of earnings components. Different from other studies, Herrmann et al. (2001) examine both the time-series properties and stock-market pricing of parent earnings vs. subsidiary earnings in Japan. Although subsidiary earnings are found to be more persistent than parent earnings, this persistence in subsidiary earnings appears to be ignored by the Japanese stock market. Similar in spirit to Burgstahler et al. (2002), this current study connects the pricing of operating income vs. below-the-line items to their time-series properties to examine whether prices reflect observed differences in persistence between these earnings components. Applying a different research design to the institutional environment in China, we provide new evidence to the international accounting literature. The findings of this study help improve the understanding of how market participants use incomestatement information to price earnings components with different levels of persistence.

3. Institutional environment in China 3.1. Stock market and accounting information China opened the Shanghai and Shenzhen Stock Exchanges in late 1990 and early 1991, respectively. Listed companies were originally authorized to issue only A-shares to domestic investors. In 1992, some companies, most of which had already issued A-shares, started to issue B-shares to overseas investors. While A-shares are traded in Renminbi, Bshares are traded in U.S. dollars on the Shanghai Exchange and Hong Kong dollars on the Shenzhen Exchange. Since the establishment of the stock exchanges, the equity capital market has grown rapidly in China. By the end of 2000, which is the last year of the period covered in this study, the two stock exchanges had 955 listed companies issuing only Ashares, 86 with both A- and B-shares, and 28 with only B-shares. The overwhelming majority of the listed companies were formerly stated-owned enterprises, and the Chinese government has normally retained a majority ownership in these firms after the initial public offering. The rapid development of the market, coupled with weak corporate governance due to government dominance in ownership, has created an environment prone to repeated corporate and/or market scandals in recent years, such as insider trading and fraudulent financial reporting. In addition, as compared with mature markets, the history of the Chinese market has not been sufficiently long to allow capitalmarket infrastructure, including professional intermediaries and legal rights and investor protection, to fully develop. Many papers in recent years (e.g., Abdel-khalik et al., 1999; Chen et al., 2001; Eccher & Healy, 2000; Xiang, 1998; Xiao et al., 2000) have identified these problems that impede efficient operation of the capital market in China.

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The development of the stock market has been a driving force behind accounting reforms. Before the 1990s, the purpose of Chinese accounting systems was to provide information to help safeguard state assets and facilitate centralized planning and control, with a focus on tangible measures, such as physical assets, production outputs, and appropriations and uses of the state funds. Profitability was never an emphasis of the prestock-market era accounting in China. The formation of the stock market created a need for value-relevant accounting information to help equity capital flow to the most efficient uses, and thus, started the process of accounting reform that is still going on today. In 1992, the Chinese government issued Accounting Regulations for Experimental Listed Companies , which moved away from the traditional fund-based accounting model and incorporated many Western accounting practices reflected in International Accounting Standards (IAS). To further move Chinese accounting in line with IAS, a revised regulation, Accounting Regulations for Listed Companies , was issued in 1998 to supersede the 1992 experimental regulation. The success of the 1998 regulation in harmonizing Chinese GAAP with IAS was well recognized both inside and outside China (Chen et al., 2002). Two years later, in 2000, the government further revised and expanded the 1998 regulation and issued Accounting Regulations for Business Enterprises , which governs financial accounting and reporting of all business enterprises (listed or not listed). Although China has made remarkable progress in standard setting within a relatively short period of time, many lingering problems exist in the areas of information environment and the infrastructure necessary for the production and dissemination of high-quality accounting information. As analyzed in many papers (e.g., Abdel-khalik et al., 1999; Chen et al., 2001; Chen et al., 2002; DeFond et al., 2000; Eccher & Healy, 2000; Xiang, 1998; Xiao et al., 2000), these problems primarily include weak corporate governance, lack of qualified accountants and professionalism, low-quality auditing, and ineffective regulatory enforcement. As a result, the quality of accounting information in China has been generally perceived as low in the literature. The different reporting requirements for A- and B-shares imposed by the Chinese government implicitly recognize this perception. While A-share annual reports are based on Chinese GAAP audited by local CPA firms, B-share reports are required to follow IAS, typically audited by large international firms, presumably to ease overseas investors concerns over the lack of quality in Chinese GAAP-based annual reports. These well-recognized problems in the stock market and financial reporting lead to two conjectures in the extant literature: (1) Value relevance of accounting information in the Chinese market should be lower than what has been observed in mature markets; and (2) Value relevance is higher for IAS-based B-share reports than for Chinese GAAPbased A-share reports. However, empirical studies (e.g., Abdel-khalik et al., 1999; Bao & Chow, 1999; Chen et al., 2001; Eccher & Healy, 2000; Haw et al., 1998; Lee & Cao, 2002), using data from different years and various valuation models, have provided consistent evidence that contradicts both expectations. Given the suboptimal information environment, researchers are typically perplexed and unwilling to accept the results as evidence for the value relevance of accounting information in China; instead, various interpretations and conjectures, some of which disagree with each other, have been offered in the literature.

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Evidently, more research is needed. One way to provide additional evidence is to examine the value relevance of disaggregated accounting information instead of aggregated earnings and/or book value of equity as done in previous research. Our current study makes an effort in this regard. Since operating income and below-the-line items are supposed to differ in persistence, this difference should be reflected in stock prices if the pricing mechanism in China properly impounds accounting information. Differential pricing of earnings components based on different levels of persistence requires investors to have higher sophistication and accounting information to be of higher quality. Consequently, such evidence will provide additional support for value relevance in China beyond previous studies. 3.2. Reporting of earnings components As reviewed earlier, the extant literature on pricing and time-series properties of earnings components is primarily based on U.S. data. However, income statements in the United States do not unambiguously separate persistent earnings from nonpersistent earnings components. Officially, extraordinary items and discontinued operations are separately reported as nonrecurring items on the face of the income statement. An item that is infrequent but not unusual is classified as nonoperating income part of income from continuing operations. However, companies are required under APB No. 30 to report material events or transactions that are either unusual or infrequent as separate line items of income from continuing operations, presumably to help users better distinguish recurring from nonrecurring earnings. These separately reported line items are the basis of the Compustat data item bspecial itemsQ that has been the subject of many studies reviewed earlier. Although there is a growing concern about how these items should be reported, there has been no GAAP to formally define these special items. No wonder practice varies with respect to reporting special items (Kinney & Trezevant, 1997). Compustats own definition includes such items as restructuring charges, current-year results of discontinued operations, natural-disaster losses, and nonrecurring gains or losses from the sales of assets, investments, and securities. Evidently, the composition of special items is heavily influenced by management discretion about which items are reported as separate line items.4
Ironically, the ambiguity regarding recurring vs. nonrecurring earnings in the U.S. income statement is a consequence of standard-setting efforts. APB Opinion No.9 (1963) was the initial U.S. GAAP in which extraordinary items were broadly defined to include events and transactions that would not be expected to recur frequently such as gains or losses from the sale or abandonment of a plant or a significant segment of the business, gains or losses from the sale of an investment not held for resale, the write-off of goodwill owing to unusual events, the condemnation or expropriation of properties, and major devaluations of currencies in a foreign country where the company was operating. Reporting abuses during the next ten years led to a review of extraordinary items in 1973 and the promulgation of APB Opinion No. 30 (1973) that substantially narrowed the scope of extraordinary items to only events and transaction that are both unusual in nature and infrequent in occurrence. Furthermore, the board specifically excluded several transactions from extraordinary items, such as write-downs of receivables, inventories, equipment leased to others, deferred research and development costs, or other intangible assets; gains or losses in foreign currency transactions or devaluations; gains or losses on disposals of segments of a business; other gains or losses on the sale or abandonment of property, plant, and equipment used in the business; effects of strikes; and adjustments of accruals on long-term contracts.
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The ambiguity of distinguishing persistent from nonpersistent earnings components seems less likely in China because Chinese GAAP takes a current-operating-performance approach to income reporting and specifies operating income as recurring persistent earnings, and all other items below the operating income line as less persistent or nonrecurring components. Specifically, four below-the-line items, including investment income, government subsidy, nonoperating revenues, and nonoperating expenses, are required to be separately reported after operating income. Presumably, this format better helps users distinguish recurring from nonrecurring or less persistent earnings.5 Investment income is related to all income or loss from external investments, including dividend income, interest income from debt securities, gains or losses from disposal of investments, and valuation adjustments. Government subsidy results from the unique ownership and socialpolitical structure in China. Because the state is the majority shareholder, local governments often view the number of listed companies in their jurisdictions as an indicator of performance and are motivated to provide assistance of various types to listed companies, especially those in financial difficulty. Specific forms of subsidy may include direct financial subsidies from local governments or state-owned enterprises acting as the majority shareholders, various tax exemptions or refunds, and debts forgiven by state-owned majority shareholders. Nonoperating income and expenses include most of the other items not included in the previous two categories, such as asset overages and shortages, gains or losses from asset disposals, revaluation gains or losses, debt restructuring gains or losses, donations received or given, approved write-offs of payables, and other irregular losses. There are many similarities between below-the-line items in China and special items in the United States, although the scope of below-the-line items is wider than that of special items.6 In addition, reported frequencies of positive vs. negative items are substantially different between the two markets. A majority of the studies reviewed earlier examine negative special items. Even for studies of both positive and negative items, composition tilts significantly toward more negative special items. For example, 78.49% of the material special items in the sample of Burgstahler et al. (2002) are negative. In comparison, belowthe-line items in China are overwhelmingly positive. In this current study, about 80% of the below-the-line items are positive, with both the mean and median statistics of positive items substantially larger than negative items. The primary reason for overwhelmingly positive below-the-line items is that listed companies are under tremendous pressure to improve profitability due to several unique
5 Some of the special items in the United States are not even reported as separate line items in the income statement; instead, they are discussed in the accompanying notes. Conceivably, it is not a trivial matter for a user to come up with a single total amount of special items as reported by Compustat. 6 Arguably, there are some below-the-line items that may be recurring year after year such as investment income. Even so, they may still differ from operating income in persistence. Operating income comes from the primary operations of the business that are determined by its long-term mix of capital deployment, while brecurringQ below-the-line items can be easily changed by short-term managerial decisions. Consequently, the ability to predict the businesss long-term profitability should be different between the two and this difference should be reflected in prices if the pricing mechanisms are efficient. In fact, some of the special items in the U.S. literature are not transitory one-time items anymore. For example, it is well known that some companies take restructuring charges, a major special item, several years in a row for a long period of time.

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institutional factors. First, the controlling shareholders of listed companies are either stateowned enterprises or government agencies, both of which rely heavily on earnings to evaluate performance of listed companies. The tenure, promotion, and political future of top management depend on earnings performance in the eyes of controlling shareholders (Chen et al., 2001; DeFond et al., 2000; Xiao et al., 2000). Second, many listed companies run into financial difficulty soon after an IPO, creating urgent incentives to use noncore activities to improve the bottom-line figure (Aharnoy, Lee, & Wong, 2000; Lee & Cao, 2002). Third, Chinese security regulations contain explicit profitability targets that govern the eligibility for raising additional capital through rights offering or determining delisting status, leading to strong incentives for earnings management (Chen et al., 2001; Chen & Yuan, 2001; DeFond et al., 2000; Lee & Cao, 2002). Finally, a documented lack of quality auditing (DeFond et al., 2000; Xiang, 1998; Xiao et al., 2000) may further exacerbate earnings management. There have been many cases reported in the Chinese media and/or accounting literature that describe how listed companies use below-the-line items to manage earnings to a desired level within this unique environment (e.g., Wei, Tan, & Lin, 2000, pp. 178190; Zhou & Jiang, 2001). Consequently, we expect a significant difference in persistence between operating income and below-the-line items. Given the clear-cut reporting format, this difference in time-series properties should be reflected in stock prices if pricing mechanisms are efficient.

4. Data and research methodology The data used in this study is taken from the Taiwan Economic Journal (TEJ) China Database. All listed A-share companies with sufficient information over a four-year period from 1997 to 2000 are included in the study, resulting in a total of 2202 firm-year observations after deleting extreme and outlying values.7 Since only A-share companies are sampled, all market data are based on A-share prices, while accounting variables are from Chinese GAAP financial statements. Both stock splits and stock dividends have been adjusted in the TEJ database. Although Chinese GAAP specifies four below-the-line items, the TEJ database reports asset revaluation gains or losses (REV) separately from nonoperating income and expenses, and also includes a residual item (OTH) to report anything that cannot be easily classified. Table 1 presents descriptive information for each of the below-the-line items. Both the frequency and magnitude of positive vs. negative items clearly demonstrate the tendency of Chinese listed companies to use below-the-line items to increase the bottom line. For example, about 80% of below-the-line items are positive, and both the mean and median statistics, either scaled by income before tax or by total assets, indicate that positive items
7

We took two steps to ensure that extreme and outlying observations would not unduly influence our results. First, we deleted observations outside five standard deviations from a mean for each variable in Table 2. A total of 2420 firm-year observations were available after this procedure. Second, both the return and price models in Table 4 were estimated for each of the four years, and an observation was further deleted if the absolute value of the Standardized Residual was greater than three or Cooks Distance greater than one, which led to the final sample of 2202 observations in this study.

S. Chen, Y. Wang / The International Journal of Accounting 39 (2004) 339364 Table 1 Reported below-the-line items in China Frequency (%) N INV SUB REV NOI NOE OTH BI 1964 1048 640 2116 2166 103 2199 1 (0.05) 49 (47.57) 473 (21.51) b0 328 (16.70) 8 (0.76) 112 (17.50) N0 1636 (83.30) 1040 (99.24) 528 (82.50) 2116 (100.00) 2165 (99.95) 54 (52.43) 1726 (78.49) NI TA NI TA NI TA NI TA NI TA NI TA NI TA Scaling variable Magnitude in % Mean b0 10.37 0.64 6.40 0.14 6.11 0.36 N0 138.11 1.26 21.13 0.68 2.70 0.25 26.70 0.39 7.70 0.35 46.65 0.57 167.97 1.80 Median b0 0.82 0.14 1.33 0.16 1.07 0.07

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N0 10.47 0.61 5.17 0.27 0.77 0.06 2.00 0.11 1.44 0.10 1.13 0.10 19.16 1.16

76.82 0.51 1.36 0.74 7.93 1.25

76.82 0.51 0.29 0.10 1.93 0.28

INV=investment income; SUB=government subsidy; REV=asset revaluation gain and loss; NOI=nonoperating income; NOE=nonoperating expense; OTH=other below-the-line items; and BI=total below-the-line items. Scaling variables: NI=income before taxes; and TA=total assets.

are substantially larger than negative items (e.g., 167.97% vs. 7.93% based on an incomedeflated mean or 19.16% vs. 1.93% based on income-deflated median). Table 2 contains descriptive statistics for all the variables used in this study and Table 3 reports correlations among earnings components. Panel A of Table 2 presents both individual and total below-the-line items using assets as a deflator. For asset revaluation (REV) and nonoperating expense (NOE), a positive number represents a loss or expense while a negative number represents a recovery or reversal of a loss or expense.8 Although we have already deleted extreme observations, descriptive statistics still show a wide variation in below-the-line items. On average, 1.14% of total below-the-line items (BI) over assets suggest a material effect of these items in China. Among the individual items, investment income (INV) is clearly the most important with a mean of 0.84% of total assets, while government subsidy (SUB) and nonoperating income (NOI) are the next two items contributing to the positive total. Panel B reports descriptive statistics for other variables used in this study, again after deleting extreme observations. The correlations in Table 3 reveal several patterns of relationship among earnings components consistent with either information reflected in the descriptive statistics of Table 2 or anecdotal evidence discussed earlier. A strong correlation of .768 between BI and INV confirms the dominance of investment income in below-the-line items. Again, government subsidy and nonoperating income are two important positive components of below-the-line items, as reflected by their significantly positive correlations of .287 and .322 with BI. The negative correlations of REV or NOE with BI (.204 and .517,
There is only one negative observation for NOE, and deleting this observation does not change any of the empirical results presented in this study.
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Table 2 Descriptive statistics Variable (A) Below-the-line INV SUB REV NOI NOE OTH BI N Mean S.D. 1.97 0.79 0.55 1.00 1.21 0.40 2.87 Min 25.17 12.61 7.59 0 0.51 10.12 59.03 Median 0.28 0 0 0.10 0.10 0 0.74 Max 19.33 7.20 16.52 27.95 37.79 12.63 27.95 items variables 2202 0.84 2202 0.31 2202 0.04 2202 0.37 2202 0.34 2202 0 2202 1.14

(B) Other variables Price 2202 Return 2202 BV 2202 OI 2202 NI 2202

10.44 22.01 2.09 0.16 0.20

4.44 46.53 0.90 0.21 0.24

1.88 69.56 0.09 1.37 1.66

9.72 14.72 1.96 0.17 0.22

31.69 279.60 6.11 1.49 1.46

INV=investment income; SUB=government subsidy; REV=asset revaluation gain and loss; NOI=nonoperating income; NOE=nonoperating expense; OTH=other below-the-line items; and BI=total below-the-line items. All below-the-line items variables in Panel A are scaled by total assets. Price=April 30th closing price; Return=buy-and-hold return; BV=book value of equity per share; OI=operating income per share; and NI=net income (before taxes) per share.

respectively) suggest the loss/expense nature of these items. Finally, the significantly positive correlation of .525 between BI and NI is consistent with below-the-line items being an important component of the bottom-line figure in China. However, the dominance of operating income is also evident as the correlation of .914 between OI and NI is substantially larger. To analyze our first research question, how the perceived difference between operating income and below-the-line items is priced in the stock market, we use both a return and a price model. The two models address related but different value-relevance questions. The return model provides information about whether an accounting amount is promptly reflected in changes in value over the return period, while the price model indicates whether an accounting amount is value relevant with respect to its association with firm value (Barth, Beaver, & Landsman, 2001). Kothari and Zimmerman (1995) specifically suggest the use of both models to permit more definitive inferences, which has become a common practice in the literature (e.g., Barth & Clinch, 1998; Easton, Eddey, & Harris, 1993; Francis & Schipper, 1999). As shown below, our return and price models are the two most frequently used models in the value-relevance literature (e.g., Amir, Harris, & Venuti, 1993; Bao & Chow, 1999; Chen et al., 2001; Collins, Maydew & Weiss, 1997; Eason & Harris, 1991; Eccher & Healy, 2000; Haw et al., 1998; Lee & Cao, 2002). We disaggregate earnings in each model for the purpose of comparing the value relevance of operating income vs. below-the-line items. We first estimate the two models with a restriction that earnings-response coefficients (ERC) are the same for different below-the-line items, and then again without this restriction. ERCs for operating income and below-the-line items are compared to examine whether the stock market

S. Chen, Y. Wang / The International Journal of Accounting 39 (2004) 339364

Table 3 Correlations of earnings components BI BI INV SUB REV NOI NOE OTH OI NI 1 0.768 0.287 0.204 0.322 0.517 0.154 0.136 0.525 (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) INV 1 0.025 0.031 0.01 0.187 0.001 0.008 0.306 SUB REV NOI NOE OTH OI NI

(0.22) (0.13) (0.63) (0.00) (0.93) (0.68) (0.00)

1 0.002 0.041 0.030 0.008 0.060 0.169

(0.89) (0.05) (0.14) (0.70) (0.00) (0.00)

1 0.004 (0.81) 0.020 (0.33) (0.00) (0.97) 0.098 (0.00) 0.167 (0.00)

1 0.110 0.021 0.067 0.073

(0.00) (0.30) (0.00) (0.00)

1 0.004 (0.84) 0.311 (0.00) 0.479 (0.00)

1 0.009 (0.66) 0.055 (0.00)

1 0.914 (0.00)

BI=total below-the-line items; INV=investment income; SUB=government subsidy; REV=asset revaluation gain and loss; NOI=nonoperating income; NOE=nonoperating expense; OTH=other below-the-line items; OI=operating income, and NI=net income (before taxes). All variables are scaled by total assets. Numbers in parentheses are p -values.

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prices them differently and whether the differential pricing is consistent with perceived difference in persistence. Returnt a0 a1OIt a2BIt e Returnt a0 a1OIt a2INVt a3SUBt a4REVt a5NOIt a6NOEt a7OTHt e Pricet b0 b1BVt b2OIt b3BIt e Pricet b0 b1BVt b2OIt b3INVt b4SUBt b5REVt b6NOIt b7NOEt b8OTHt e 4 2 3 1

where Returnt is a 12-month buy and hold return ending on April 30th of year t +1 and Pricet is a closing price on April 30th of year t +1.9 The restricted models (Eqs. (1) and (3)) contain only operating income (OI) and total below-the-line items (BI), while the unrestricted models (Eqs. (2) and (4)) contain OI and six individual below-the-line items as defined in Table 1. All independent variables are on per-share basis, and those in the return model are further scaled by a closing price at the beginning of a return year. To examine our second research questionwhether the time-series properties of operating income and below-the-line items are consistent with a perceived difference in persistencewe employ both an autoregression and a one-year-ahead earnings-prediction model. The following autoregression model is estimated for the bottom-line earnings as well as for each of the earnings components, and a larger coefficient for a particular earnings item suggests a higher degree of persistence in this item. Xt a0 a1 Xt1 e 5

where X is an earnings or earnings component figure scaled by total assets. In addition, a prediction model with and without assuming coefficient equality among individual below-the-line items is estimated to examine whether earnings components have different predictive powers. Consistent results for the first two research questions provide supportive evidence that information about earnings persistence is properly impounded in stock prices. The prediction models with and without restriction on coefficient equality is as follows: NIt1 c0 c1 OIt c2BIt e NIt1 c0 c1OIt c2INVt c3SUBt c4REVt c5NOIt c6NOEt c7OTHt e 7 6

where NIt +1 is one-year-ahead net income before taxes and other variables are the same as defined earlier. All variables in models (6) and (7) are scaled by total assets.
9

April 30th is the official date by which each listed company has to issue its annual report in China.

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Finally, we partition our sample based on earnings-management variables and observed persistence, and estimate models (Eqs. (1)(7)) again on the partitioned subsamples. Earnings management presumably affects earnings persistence, and observed persistence allows us to identify companies with known transitory below-the-line items on an ex post basis. By introducing these two dimensions into the analysis, we are able to examine whether earnings management interferes with earnings persistence, how stock prices reflect this interaction, and whether the market properly discounts below-the-line items without persistence. This analysis will provide additional evidence on the robustness of the results based on the first two research questions.

5. Empirical results 5.1. Market pricing of operating income vs. below-the-line items Table 4 presents valuation results based on return models in Panel A and Panel B on price models.10 All regressions are estimated for individual years as well as for pooled firm-year observations, with White-corrected t -statistics presented in the table. Overall, each and every model is highly significant with predicted signs for most of the independent variables. In particular, operating income (OI) and total below-the-line items (BI) are consistently significant with positive coefficients in all regressions. These results confirm the role of earnings information in stock valuations in China. To compare pricing of operating income vs. below-the-line items, we examine the coefficients of OI and BI, first based on the restricted model. In Panel A, the coefficient of BI is larger than that of OI in each annual regression as well as in the pooled regression, and the difference is significant for all regressions except for 2000 according to the F -tests of coefficient equality. This suggests that the market places more weight on below-the-line items than operating income, which is contradictory to the perceived difference in persistence between the two earnings components. The results based on the unrestricted model provide a very similar picture with significant F -tests for all regressions, although details differ with respect to which below-the-line items have larger coefficients than operating income. Overall, the results of the unrestricted model seem driven by three positive items, i.e., investment income (INV), government subsidy (SUB), and nonoperating income (NOI).11

Although the return model in Panel A includes only earnings-level variables, we have also estimated the model with both the level of and change in earnings and earnings components. Since the conclusion remains the same, we present the results from the earnings-level model for the sake of parsimony. 11 Different from expectation, in both panels of Table 4, the regression coefficients on REV and NOE are mostly positive. There are two possible explanations. First, as shown in Table 1, about 18% of the REV cases are income-increasing, representing recoveries of asset write-downs. Second, many of the asset write-downs are voluntary and an important NOE item in China is a restructuring charge, both of which may signal the potential for improvement in future performance. The market responds positively to information with a signaling value. A recent study by Chen, Chen, Su, and Wang (2004) provides evidence about asset write-downs in China that is consistent with this signaling explanation.

10

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Table 4 Pricing of operating income vs. below-the-line items (A) Return models (1): Returnt =a 0+a 1OIt +a 2BIt +e ; (2): Returnt =a 0+a 1OIt +a 2INVt +a 3SUBt +a 4REVt +a 5NOIt +a 6NOEt +a 7OTHt +e 1997 (1) Intercept 5.23 OI 1.75 BI 4.79 INV SUB REV NOI NOE OTH N 392 Adj R 2 0.04 5.30 F -test1 F -test2 (2) (0.02) 11.90 (0.03) 3.08 (0.00) 6.36 5.72 3.14 12.20 23.52 6.04 392 0.08 (0.02) 3.55 1998 (1) (0.00) 17.00 (0.00) 1.61 3.59 (0.00) (0.61) (0.06) (0.03) (0.00) (0.00) 532 0.06 4.92 (0.00) (2) (0.00) 22.80 (0.00) (0.00) 2.55 (0.00) (0.00) 3.55 (0.00) 3.96 (0.07) 7.75 (0.02) 11.87 (0.00) 16.89 (0.02) 65.15 (0.06) 532 0.12 (0.02) 5.70 (0.00) 1999 (1) 54.64 (0.00) 2.85 (0.00) 8.01 (0.00) (2) 52.85 (0.00) 3.27 (0.00) 11.82 5.84 1.35 18.15 9.42 160.20 610 0.09 (0.00) (0.11) (0.67) (0.00) (0.10) (0.52) 668 0.04 1.75 (0.18) 2000 (1) 16.46 (0.00) 2.04 (0.00) 3.52 (0.03) (2) 9.81 (0.00) 2.60 (0.00) 8.71 6.78 4.52 19.29 4.07 13.50 668 0.12 (0.00) (0.14) (0.61) (0.00) (0.00) (0.06) 2202 0.05 3.41 (0.06) Pooled (1) 13.36 (0.00) 3.19 (0.00) 4.87 (0.00) (2) 6.55 (0.00) 3.92 (0.00) 7.74 6.97 7.53 15.74 7.21 6.52 2202 0.08 (0.00) (0.00) (0.00) (0.00) (0.00) (0.00)

610 0.07 7.61 (0.00)

5.04 (0.00)

5.63 (0.00)

6.38 (0.00)

(B) Price models (3): Pricet =b 0+b 1BVt +b 2OIt +b 3BIt +e ; (4): Pricet =b 0+ b 1BVt +b 2OIt +b 3INVt +b 4SUBt +b 5REVt +b 6NOIt +b 7NOEt +b 8OTHt +e 1997 (3) (4) (0.00) (0.00) (0.00) (0.00) (0.63) (0.00) (0.00) (0.00) (0.00) 1998 (3) 4.60 0.83 3.47 3.12 (0.00) (0.00) (0.00) (0.02) (4) 1999 (3) (4) 10.14 (0.00) 0.02 (0.88) 4.83 (0.00) 11.86 6.77 5.76 21.95 8.40 238.84 610 0.13 (0.00) (0.13) (0.04) (0.00) (0.21) (0.57) 668 0.08 8.42 (0.00) 2000 (3) 12.81 0.10 2.50 6.35 (0.00) (0.49) (0.00) (0.00) (4) 12.36 (0.00) 0.09 (0.00) 2.75 (0.00) 6.99 8.18 2.15 28.95 1.48 16.73 668 0.12 (0.00) (0.00) (0.72) (0.00) (0.53) (0.33) 2202 0.13 1.97 (0.16) Pooled (3) 7.11 (0.00) 1.30 (0.00) 2.51 (0.00) 3.95 (0.00) (4) 6.69 (0.00) 1.17 (0.00) 3.35 (0.00) 7.14 3.85 0.16 16.13 15.99 8.76 2202 0.17 (0.00) (0.11) (0.96) (0.00) (0.00) (0.04) S. Chen, Y. Wang / The International Journal of Accounting 39 (2004) 339364

Intercept 4.25 (0.00) 3.83 BV 1.43 (0.00) 1.19 OI 5.11 (0.00) 7.16 BI 5.27 (0.02) INV 8.87 SUB 4.23 REV 10.74 NOI 13.01 NOE 39.61 OTH 7.75 N 392 392 Adj R 2 0.34 0.45 F -test1 0.01 (0.92) F -test2 7.02

(0.00)

4.20 (0.00) 10.48 (0.00) 0.72 (0.00) 0.004 (0.98) 4.38 (0.00) 4.39 (0.00) 10.99 (0.00) 3.76 (0.00) 4.17 (0.07) 13.51 (0.03) 10.10 (0.00) 34.58 (0.00) 138.43 (0.00) 532 532 610 0.28 0.40 0.11 0.11 (0.73) 9.68 (0.00) 11.93 (0.00)

4.19 (0.00)

6.57 (0.00)

12.29 (0.00)

BV=book value of equity; OI=operating income BI=total below-the-line items; INV=investment income; SUB=government subsidy; REV=asset revaluation gain and loss; NOI=nonoperating income; NOE=nonoperating expense; and OTH=other below-the-line items. In Panel A, all independent variables are on per-share basis and further deflated by April 30th closing price. In Panel B, all independent variables are on per-share basis. F -test1 is a test of coefficient equality between OI and BI, while F -test2 is a test of coefficient equality among all earnings components, i.e., OI, INV, SUB, REV, NOI, NOE, and OTH. Numbers in parentheses are p -values.

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The findings based on the restricted and the unrestricted price models shown in Panel B are overall consistent with the return-model results. The coefficients for below-the-line items tend to be larger than operating income. Although the results of the restricted models in Panel B are weaker than Panel A, as the F -tests show an insignificant difference between OI and BI for 1997, 1998, and the pooled regression, the unrestricted models provide strong evidence that some below-the-line items have significantly larger coefficients than operating income. In sum, both the return and the price model demonstrate that, rather than placing more weight on recurring operating income, the stock market in China seems to assess a premium on below-the-line items. This evidence certainly contradicts the perceived difference in persistence. If the observed time-series properties of these earnings components confirm the perceived difference, our results then point toward mispricing in the Chinese market. 5.2. Observed persistence and predictive power of operating income vs. special items Table 5 presents the results of observed time-series properties of earnings components. Panel A presents data on whether observed persistence is consistent with perceived persistence for each component. The results clearly show that operating income is much more persistent than either total or any individual below-the-line items. The one-year-lag autoregressive model produces an R 2 of .38 and an autoregression coefficient of .64 for operating income, in comparison to an R 2 of .06 and a regression coefficient of .25 for the total amount of below-the-line items. Individually, government subsidiary (SUB) is the most persistent below-the-line item, with an R 2 of .15 and an autoregression coefficient of .37. Investment income (INV) and nonoperating income (NOI) rank as the second and the third in persistence. The results from a one-year-ahead earnings prediction model in Panels B and C are overall consistent with the evidence of observed persistence in Panel A. When comparing the ability of operating income vs. total below-the-line items to predict next year net income, Panel B shows significantly larger regression coefficients for operating income than for below-the-line items in the annual as well as in the pooled regressions according to the F -tests of coefficient equality. In fact, the BI variable is insignificant in the 2000 and pooled regressions. The results in Panel C provide qualitatively similar evidence without the restriction of an equal coefficient for individual below-the-line items. While some below-the-line items are not significant in annual or pooled regressions, operating income is always significant and tends to have a larger coefficient for predicting future earnings. Combining the market-valuation results in Table 4 and the time-series-properties evidence in Table 5, we seem to have two interesting findings. First, both operating income and below-the-line items are value relevant in the Chinese equity markets. Given that they both persist into the future to a certain degree, the results suggest a rational pricing mechanism in the market. Second, the time-series properties of operating income vs. below-the-line items are not fully reflected in stock prices. Although operating income is more persistent and has larger predictive power than below-the-line items, the market somehow places a higher premium on below-the-line items as reflected in their larger earnings-response coefficients. The next two sections present additional evidence to check the validity and robustness of our findings.

S. Chen, Y. Wang / The International Journal of Accounting 39 (2004) 339364 Table 5 Persistence and predictive power of operating income vs. below-the-line items (A) X t =a 0+a 1X t 1+e Earnings components OI BI INV SUB REV NOI NOE OTH N 2202 2202 2202 2202 2202 2202 2202 2202 Autoregression coefficients 0.64 0.25 0.33 0.37 0.13 0.23 0.23 0.02 (0.00) (0.00) (0.00) (0.00) (0.13) (0.01) (0.03) (0.16) Adj. R 2 0.38 0.06 0.12 0.15 0.01 0.10 0.02 0.01

357

(B) NIt +1=c 0+c 1OIt +c 2BIt +e 1997 Intercept OI BI N Adj. R 2 F -test1 0.01 0.80 0.41 392 0.36 8.70 (0.98) (0.00) (0.01) 1998 0.77 0.66 0.43 532 0.34 4.68 (0.13) (0.00) (0.00) 1999 0.10 0.70 0.42 610 0.28 4.23 (0.89) (0.00) (0.00) 2000 0.39 0.57 0.10 668 0.18 39.32 (0.44) (0.00) (0.56) Pooled 0.64 0.65 0.16 2202 0.27 71.93 (0.14) (0.00) (0.27)

(0.00)

(0.03)

(0.04)

(0.00)

(0.00)

(C) NIt +1=c 0+c 1OIt +c 2INVt +c 3ONOt +c 4REVt +c 5NOIt +c 6NOEt +c 7OTHt +e 1997 Intercept OI INV SUB REV NOI NOE OTH N Adj. R 2 F -test2 0.47 (0.54) 0.84 (0.00) 0.57 (0.00) 1.16 (0.28) 0.83 (0.00) 0.50 (0.08) 1.53 (0.16) 0.39 (0.25) 392 0.37 2.80 (0.01) 1998 0.03 (0.95) 0.69 (0.00) 0.53 (0.00) 0.47 (0.10) 0.01 (0.95) 0.50 (0.06) 1.45 (0.25) 12.78 (0.00) 532 0.35 1.88 (0.08) 1999 0.20 (0.80) 0.70 (0.00) 0.51 (0.00) 0.20 (0.37) 0.07 (0.93) 0.44 (0.08) 0.94 (0.28) 8.76 (0.27) 610 0.28 3.17 (0.00) 2000 0.01 (0.98) 0.60 (0.00) 0.03 (0.81) 0.72 (0.13) 0.04 (0.97) 0.94 (0.22) 0.40 (0.24) 1.71 (0.00) 668 0.19 5.20 (0.00) Pooled 0.001 (0.99) 0.70 (0.00) 0.32 (0.00) 0.30 (0.13) 0.11 (0.76) 0.38 (0.01) 0.42 (0.27) 0.34 (0.28) 2202 0.28 7.71 (0.00)

Panel A contains autoregressions, where X is an earnings-component variable, such as OI, BI, etc. NI=net income (before taxes); OI=operating income BI=total below-the-line items; INV=investment income; SUB=government subsidy; REV=asset revaluation gain and loss; NOI=nonoperating income; NOE=nonoperating expense; and OTH=other below-the-line items. All variables are scaled by total assets. F -test1 is a test of coefficient equality between OI and BI, while F -test2 is a test of coefficient equality among all earnings components, i.e., OI, INV, SUB, REV, NOI, NOE, and OTH. Numbers in parentheses are p -values.

5.3. Additional evidence on the earnings-management sample Anecdotal evidence suggests earnings management as an important reason for the large and frequently positive below-the-line items in China. Presumably, earnings management may change the inherent pattern of earnings persistence in a company, thus

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creating one-time, transitory components within earnings. If pricing mechanisms properly reflect earnings time-series properties, we expect to observe that below-theline items resulting from earnings management are less persistent and the stock market places a discount on these items accordingly. Table 6 presents the results of such analysis based on three possible earnings-management samples. First, we use a dummy variable, Right, to define a group of companies that may use below-the-line items to meet profitability targets for stock-rights offering as specified in the Chinese security regulations. As shown in Table 6, two small profitability ranges above the ROE targets of 10% and 6% are used in different years due to a 1998 change of the stock-rights regulation in China. Before 1998, the ROE target for the eligibility of stock rights offering was 10%, and during 1998, the Chinese authority lowered the ROE target to 6% for any individual year as long as the three-year average ROE is over 10%. Second, another dummy variable, DL, is used to identify companies that may manage earnings to avoid delisting. Since companies reporting negative ROEs for three consecutive years will be delisted in China, we classify a company to this group if below-the-line items are used to turn a loss into a profit. Several studies have employed this dummy-variable approach to identifying earnings-management samples

Table 6 Additional tests: earnings-management sample Model A Intercept BV OI BI Right DL BB RightBI DLBI BBBI N Adj. R 2 F (BI+RightBI) F (BI+DLBI) F (BI+BBBI) 4.90 (0.00) 5.30 (0.00) 10.50 (0.00) 6.96 (0.16) 9.47 (0.04) 25.72 (0.00) 6.37 (0.03) 0.53 (0.85) 13.23 (0.00) 2202 0.08 1.14 (0.28) 25.77 (0.00) 1.76 (0.18) Model B 6.65 (0.00) 1.19 (0.00) 4.71 (0.00) 9.39 (0.00) 1.79 (0.00) 0.73 (0.21) 2.31 (0.00) 0.95 (0.83) 0.32 (0.92) 13.45 (0.00) 2202 0.16 5.67 (0.01) 12.26 (0.00) 2.64 (0.11) Model C 0.23 (0.62) 0.73 (0.00) 0.53 (0.00) 0.62 (0.36) 4.59 (0.00) 0.19 (0.89) 0.04 (0.83) 0.54 (0.00) 1.01 (0.00) 2202 0.31 4.55 (0.03) 50.62 (0.00) 26.36 (0.00)

Model A: Returnt =a 0+a 1OIt +a 2BIt +a 3Rightt +a 4DLt +a 5BBt +a 6rightBIt +a 7DLBIt +a 8BBBIt +e . Model B: Pricet =b 0+b 1BVt +b 2OIt +b 3BIt +b 4Rightt +b 5DLt +b 6BBt +b 7rightBIt +b 8DLBIt +b 9BBBIt +e . Model C: NIt +1=c 0+c 1OIt +c 2BIt +c 3Rightt +c 4DLt +c 5BBt+c 6rightBIt +c 7DLBIt +c 8BBBIt +e . Return=buy-and-hold return; Price=April 30th closing price; NI=net income (before taxes); BV=book value of equity; OI=operating income; and BI=below-the-line items. The independent variables are on per-share basis and further scaled by April 30th closing price in the return model, on per-share basis in the price model, and deflated by total assets in the earnings-prediction model. Right is a dummy variable with a value of one if 10%VROEV11% in 1997, or 10%VROEV11% or 6%VROEV7% in 1998, or 6%VROEV7% after 1998. DL is a dummy variable with a value of one if OIb0 and NIN0. BB is a dummy variable with a value of one if both OI and NIb0. Numbers in parentheses are p -values.

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359

based on the Chinese regulations regarding rights offering and delisting (e.g., Chen et al., 2001; Chen & Yuan, 2001; Lee & Cao, 2002). Finally, we identify a bbig bathQ sample as companies that report both negative operating income and negative belowthe-line items. We examine the impact of earnings management on pricing and time-series properties of operating income vs. below-the-line items by joining each of the three dummy variables with the total amount of below-the-line items in the return model (Model A), the price model (Model B), and the earnings-prediction model (Model C). If the pricing mechanism is efficient, we expect the dummyBI interaction to be significantly negative, which means a smaller BI coefficient for the earnings-management subsample, and/or the F -test to be insignificant, which means an inconsequential BI variable in the regression for the earnings-management subsample. Overall, this analysis leads to mixed results. For companies with earnings management to meet the ROE targets for rights offering, the return model produces a significantly negative interaction between Right and BI, suggesting that the earnings-response coefficient for BI is smaller for these companies. The F -test of [(BI+RightBI)=0] further shows that the coefficient of BI is indeed insignificant for this subsample. This evidence is consistent with price impounding time-series properties in the sense that the market only values those below-the-line items that do not result from rights-offeringmotivated earnings management. However, the price model does not provide corroborating evidence. The insignificant interaction term and the significant F -test indicate no difference in the valuation implication for BI between companies with or without earnings management motivated by rights offering. Similarly, the earnings prediction model is not able to detect any difference in the predictive power of BI between these two groups of companies. When companies are classified based on the delisting variable, DL, none of the three models provides expected results as indicated by the insignificant interaction terms and the significant F -tests. The market does not seem to distinguish below-theline items from companies with and without delisting motivated earnings management, and to the contrary, the power of below-the-line items in predicting future earnings is larger for the DL subsample as shown by the significantly positive interaction term in Model C. However, for companies taking a bbig bathQ through below-the-line items, we obtain consistent and strong evidence that the pricing of below-the-line items properly reflects their time-series properties. The significantly negative interaction terms and the insignificant F -tests from both the return (Model A) and the price model (Model B) indicate that below-the-line items resulting from bbig bathQ type of earnings management do not have any valuation implications, which is consistent with the evidence of timeseries properties from the earnings prediction model. As shown in Model C, the significant F -test [(BI+BBBI)=0] together with the larger and significantly negative interaction term, BBBI, suggests a negative relation between below-the-line items and future earnings for this bbig bathQ subsample. This is consistent with the U.S. evidence reported by DeAngelo et al. (1992) and Burgstahler et al. (2002). Negative below-the-line items represent an interperiod transfer of expenses, i.e., the larger the bbig bathQ this period, the larger the earnings next period.

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Table 7 Additional tests: nonpersistent sample a (A) Return t =a 0 +a 1 OI t +a 2 BI t +e Intercept 16.71 (0.00) OI 4.43 (0.00) BI 6.85 (0.26) (B) Price t= b 0 +b 1 BV t +b 2 OI t +b 3 BI t +e Intercept 8.72 (0.00) BV 0.48 (0.05) OI 4.00 (0.00) BI 5.57 (0.42) (C) NI t+1 =c 0 +c 1 OI t +c 2 BI t +e Intercept 1.48 (0.02) OI 0.90 (0.00) BI 4.49 (0.00) N F Adj. R 2

441

14.88 (0.00)

0.06

441

11.38 (0.00)

0.07

441

104.14 (0.00)

0.32

Return=buy-and-hold return; Price=April 30th closing price; NI=net income (before taxes); BV=book value of equity; OI=operating income; and BI=below-the-line items. The independent variables are on per-share basis and further scaled by April 30th closing price in the return model, on per-share basis in the price model, and deflated by total assets in the earnings-prediction model. The nonpersistent sample contains only observations above the 90th percentile or below the 10th percentile of DBI=(BIt BIt +1)/|BIt |. Numbers in parentheses are p -values.

5.4. Additional evidence on nonpersistence sample Finally, we repeat our three-model analysis using a sample of firm/year observations that contain only nonpersistent below-the-line items identified on an ex post basis. An observation is included in this special sample if the change in below-the-line items during a two-year period is either above the 90th percentile or below the 10th percentile threshold computed as: DBI=(BIt BIt +1)/|BIt |. This sampling procedure results in 441 observations over the four-year period with below-the-line items that are extremely transitory in the sense that they completely reverse in the next period. Table 7 presents results from all three models.12 Both the return (Panel A) and price models (Panel B) provide consistent evidence that, while operating income is value relevant, transitory below-the-line items are not, as demonstrated by the highly significant OI but insignificant BI variable. Furthermore, Panel C confirms that operating income, persisting into the future, has an expected positive coefficient in predicting next-year earnings, but below-the-line items are negatively associated with future earnings because of their transitory, reverting nature. Consequently, this analysis based on the special sample strongly suggests that stock prices properly

12 In addition to combining BI observations above the 90th percentile (BI decreases between the two years) with those below the 10th percentile (BI increases between the two years), we also analyze each group separately. The results are qualitatively similar.

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impound the time-series properties of persistent operating income vs. transitory below-theline items in China.

6. Conclusions This study investigates the value relevance of operating income and below-the-line items in the Chinese stock market. Motivations for this study are twofold. First, there is a need for empirical evidence beyond the value relevance of aggregated accounting information in China. Although previous studies consistently find value relevance in China, the findings have been questioned and often are considered counterintuitive, given the low quality of the information environment. Examining the value relevance of earnings components with different levels of persistence allows us to provide additional evidence in this area. Second, the extant literature on earnings components is primarily based on examining special items in the United States. Studies using data from other countries are both limited and less focused in the international accounting literature. By comparison, the reporting environment for nonrecurring or less persistent earnings components in China is very different from the U.S. environment. Chinese GAAP is more specific in defining the scope and specifying the reporting format of these items. The Chinese income statement is clearly divided into two sections: recurring operating income and below-the-line items that are supposed to be less persistent. Furthermore, in sharp contrast to the special items being dominated by charges to the income statement in the United States, below-the-line items in China are overwhelmingly income-increasing and often account for a large percentage of a firms reported net income. Anecdotal evidence suggests that using below-the-line items is a primary tool of earnings management in the Chinese stock market. These institutional features make China an interesting setting to examine how stock prices reflect earnings components with different levels of persistence. We report empirical results in three areas. First, we find that both operating income and below-the-line items are value relevant, but price-earning multiples are significantly larger for below-the-line items than for operating income, which is contradictory to the perceived difference in persistence between these two types of earnings. Second, we demonstrate that the time-series properties of operating income vs. below-the-line items are both consistent with and different from the perceived difference. While operating income is more persistent and has significantly larger power in predicting future earnings than below-theline items, we find that below-the-line items in China also persist into the future and are of predictive values. Combining the first two findings, we conclude that the pricing of operating income and below-the-line items in the Chinese stock market is rational to the degree that persistent earnings, no matter recurring or below-the-line items, are reflected in stock prices. However, the time-series properties of operating income and below-the-line items are not fully impounded in prices as evidenced by the unexpected relative magnitudes of earnings-response coefficients. Finally, we provide additional evidence to explain and check the validity of the first two findings. We identify three subsamples of companies that are likely to manage earnings through below-the-line items and examine whether the pricing and time-series

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properties of below-the-line items in these companies differ from other companies. Although the results are mixed, we provide some evidence consistent with the notion of stock prices properly reflecting time-series properties of below-the-line items. In particular, we find that below-the-line items resulting from a bbig bathQ do not have any valuation implications because they represent an interperiod transfer of expenses. Furthermore, we present strong evidence that transitory below-the-line items whose identity is based on observed persistence are not value relevant in China. In sum, we present additional evidence of value relevance in China beyond aggregated earnings. An earnings component is impounded in stock prices as long as persistent and nonpersistent below-the-line items are value irrelevant. This result supports both the sophistication of the pricing mechanism and the quality of earnings information. As such, our findings cast a vote of confidence in the value relevance of accounting information in China. Given the evidence of this study, we believe that the findings of previous studies on value relevance are less likely to be statistical artifacts; rather, they represent an important role that accounting information plays in the Chinese stock market. Although the information environment in China is less than perfect, accounting information is so fundamental for equity investors that stock prices reflect not only aggregated earnings, but also earnings components. However, we also show that the time-series properties of earnings components are not fully priced in the market. The earnings-response coefficients are larger for below-the-line items than for operating income, although below-the-line items are less persistent and have a lower predictive power. While this is a pricing anomaly, our finding of a partial reflection of earnings time-series properties in stock price is consistent, in spirit, with the recent evidence by Burgstahler et al. (2002) based on the U.S. data. They find that stock prices do not fully impound time-series properties for either special items or recurring components of earnings. Although we do not have direct evidence, we conjecture that Chinese investors place larger valuation weight on below-the-line items because of the unique institutional environment in which listed companies are somehow able to improve their bottom-line earnings through below-the-line items whenever such needs arise. The majority shareholders of listed companies are state-owned enterprises, and it is relatively easy and convenient for state-owned parent companies to arrange some favorable nonoperating transactions to help their listed companies boost earnings through below-the-line items. In addition, local governments often consider the number of listed companies in their jurisdictions as an important performance indicator and are motivated to help listed companies through various government subsidies when listed companies face financial difficulty. Future research can explore these issues, possibly using longer time-series data, to further enhance our understanding of the pricing of earnings components.

Acknowledgements We thank the editor, the anonymous associate editor, and the two anonymous reviewers for their helpful comments and suggestions that have improved this manuscript. Professor

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Yuetang Wang acknowledges financial support from the Chinese Ministry of Education 10th Five-Year Plan project, bAccounting Information and Resources Allocation in the Chinese Capital MarketsQ (Project No. 01JA790015).

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