Challenges for Implementation of Fair Value Accounting in

Emerging Markets: Evidence from China*

XIANJIE HE, Shanghai University of Finance and Economics
T.J. WONG, The Chinese University of Hong Kong
DANQING YOUNG, The Chinese University of Hong Kong
1. Introduction
Market globalization in the past two decades has created demand for international conver-
gence in nancial reporting. As a result, more than 100 jurisdictions in both developed
and emerging markets have adopted International Financial Reporting Standards (IFRS),
1
an accounting system that is intended to provide a high degree of transparency and
comparability of nancial statements and hence an efcient functioning of the community
capital market and of the internal market (European Communities 2002: Art.1). Follow-
ing the mandatory IFRS adoptions by the European Union (EU) and other countries in
and after 2005, numerous studies have examined whether such adoptions have achieved
their intended objective of providing more transparent and comparable nancial inform-
ation (e.g., Barth, Landsman, Lang, and Williams 2010; Yip and Young 2011; Clarkson,
Hanna, Richardson, and Thompson 2011) and whether corresponding economic effects,
such as a lower cost of capital and increased foreign investment, have followed (e.g.,
Daske, Hail, Leuz, and Verdi 2008; DeFond, Hu, Hung, and Li 2011; Li 2010; Florou
and Pope 2009; Wu and Zhang 2010).
However, to the best of our knowledge, little direct evidence has been documented
regarding the unintended consequences of mandatory IFRS adoption. Such consequences
are likely to occur in markets in which nancial accounting plays a more powerful con-
tracting role than information role and those in which the institutional environment is
incompatible with IFRS (Bru ggemann, Hitz, and Sellhorn 2010). The objective of this
study is thus to address the issue of the unintended effects of IFRS adoption by studying
Chinas adoption of IFRS-based new China Accounting Standards (CAS) in 2007.
Our focus is on the implementation of fair value accounting (FVA), a key feature of
the new CAS and a fundamental change in Chinas accounting practices (Deloitte Touche
Tohmatsu 2006). We select China as our empirical setting because it is the worlds largest
emerging market and plays an increasingly signicant role in the global economy. More
importantly, the reporting incentives of Chinese managers are more inuenced by account-
ings contracting role than by its information role. For example, a rm will be delisted if it
reports a loss in three consecutive years. Such contractual terms in government regulations
* Accepted by Peter Clarkson. We appreciate helpful comments from Peter Clarkson (associate editor), the
two anonymous reviewers, and the workshop participants at University of Iowa, Shanghai University of
Finance and Economics, Nanyang Technological University and National University of Singapore, the
CUHK-Tsinghua workshop held in December 2008, the INTACCT research workshop held in Valencia,
Spain in February 2009, and the 2009 American Accounting Association Annual Meeting. Xianjie He
acknowledges the nancial support from the MOE Project of Key Research Institute of Humanities and
Social Sciences at Universities, and Shanghai Philosophy and Social Science Foundation (2009BJB020).
1. Many countries have adopted new accounting standards that are substantially in line with IFRS other
than certain modications to reect their unique circumstances and environments. For simplicity, we refer
to these countries adoption as IFRS adoption.
Contemporary Accounting Research Vol. 29 No. 2 (Summer 2012) pp. 538562 CAAA
doi:10.1111/j.1911-3846.2011.01113.x
create strong incentives for rms to manage earnings to maintain their listing status rela-
tive to incentives to provide investors with transparent information. In addition, Chinas
institutions are in many respects incompatible with FVA. The FVA concept originates in
economies in which rms engage in arms length exchanges, and thus FVA is oriented
towards providing relevant information to facilitate such exchanges. However, in China
business transactions are often carried out within social and political networks, which ben-
et little from FVA and corporate transparency in general (Piotroski and Wong 2010).
Moreover, the uneven institutional development across regions in China (e.g., the fast-
developing coastal regions versus the underdeveloped inland regions) allows us to examine
the impacts of institutions on FVA implementation within a single country.
We rst investigate how managers incentives to meet the earnings thresholds set by
government regulations reduce the intended benets of the new FVA for trading securi-
ties.
2
Under the old CAS, trading securities were measured at the lower of cost or market
(LCM) value. Following the adoption of the new CAS, trading securities are recorded at
fair value, and the corresponding change in value is included in earnings. This new FVA
rule is intended to provide investors with relevant information on a rms trading securi-
ties by indicating the fair market value of those securities on the balance sheet and the
corresponding value changes in the income statement. However, if the new FVA rule
reduces managers ability to meet regulatory earnings targets, then managers are likely to
take action to counteract that negative impact, and one possible such action is to selec-
tively sell available-for-sale (AFS) securities for a gain.
3
This method, when available, is
likely to be chosen because the sale of AFS securities can be easily carried out in active
markets,
4
has fewer effects on rms operations than other real earnings management
methods (e.g., reducing maintenance costs), and is less likely to be challenged by auditors
than accruals management.
Using a sample of Chinese listed rms that reported a fair-value change in trading
securities in the new CAS years of 2007 and 2008, we nd that rms with a negative fair-
value change in these securities are more likely to sell AFS securities for a gain relative to
their counterparts with a positive fair-value change in trading securities. We also nd this
type of FVA-induced earnings management to be more pronounced among rms with
strong incentives to avoid reporting a loss. Our results are thus consistent with the view
that the new FVA rules intended benet of producing more relevant information is likely
to be compromised in an environment in which accounting plays a powerful contracting
role that leads to strong earnings management incentives.
We next examine whether the incompatibility between Chinas institutional environ-
ment and IFRS leads to unintended consequences of applying FVA to debt restructuring.
Under the old cost-oriented CAS, when a nonnancial asset was exchanged during debt
restructuring, the recognized value of that asset was its book value, and gains were directly
credited to equity. Under the FVA-oriented new CAS, in contrast, the recognized value of
the exchanged asset is its fair value, which is often determined via negotiations between
the rm and its creditors, and the gains ow through the income statement.
5
In theory,
2. Chinese rms are required to report the combined fair-value change in trading securities, derivatives, hedg-
ing instruments, and investment properties in earnings. In our sample years, however, very few rms chose
the fair-value model for their investment properties, and very few had derivatives and hedging instruments.
For simplicity, our discussion of this earnings component thus focuses on trading securities.
3. Under the new CAS, AFS securities are measured at fair value, and the fair-value change is directly
included in equity and transferred to earnings when sold.
4. In China, nearly all AFS securities are shares of listed rms.
5. Assume that a rm owes $100 to a creditor and uses a nonnancial asset with a $50 book value to settle its
debt. Under the old CAS, the rm would report a $50 gain directly in equity, and the creditor would incur a
$50 loss in earnings. Under the new CAS, if both debtor and creditor agree that the fair value of the asset is
$100, then the former reports a $50 gain in earnings without any loss being reported by the latter.
Fair Value Accounting in Emerging Markets 539
CAR Vol. 29 No. 2 (Summer 2012)
the new FVA rule is superior to its predecessor because an asset should be recorded at fair
value in a market transaction, and any realized gains should be included in earnings.
However, a necessary condition for applying the new FVA rule is that the fair market
value of an exchanged asset is either available or can be obtained via arms length negotia-
tion between the debtor and the creditor. This condition is rarely satised in China, as the
market price of an exchanged nonnancial asset is seldom available, and debtors and
creditors are often related parties. Consequently, the new FVA for debt restructuring cre-
ates opportunities for rms to manage earnings with the help of related creditors.
6
Firms
are likely to choose this method, if available, because it can effectively increase reported
earnings as the amount of gains from debt restructuring is often large, and is less costly
when transactions are relationship based.
We rst employ data from the old CAS period, during which gains on debt restructur-
ing were directly reported in equity and hence could not be used for earnings management,
to estimate a prediction model for the gains on debt restructuring. Then, using a sample
of rms that reported gains on debt restructuring in the new CAS years of 2007 and 2008,
we compute the abnormal gains (the reported amount less the estimated amount) for each
rm. We nd these abnormal gains to be positively associated with a rms incentives to
avoid reporting a loss. An additional test also shows a positive association between the
reported gains on debt restructuring and loss-avoidance incentives when the variables used
in the prediction model, or the Altman 1968 Z-score, are directly controlled in the regres-
sion. These results suggest that managers in China take advantage of the new FVA for
debt restructuring to manage earnings, and are thus consistent with the view that FVA
may bring about unintended consequences if the necessary institutional infrastructure for
its implementation is absent.
In addition, we document evidence to suggest that the effectiveness of FVA implemen-
tation is affected by the provincial-level institutional environment and rm-level corporate
governance in China. For example, rms that are politically connected, employ nonBig 4
auditors, or are located in regions with weak institutional environments are more likely to
sell AFS securities to offset the losses resulted from negative fair-value changes in trading
securities. These rms are also more likely to use the gains on debt restructuring to meet
or beat the zero earnings threshold.
This study makes several contributions to the accounting literature. First, our nd-
ings add to the literature on IFRS adoption by showing that, in emerging markets such
as China, the intended benets of improved transparency through FVA implementation
may fail to materialize or, worse, unintended consequences such as more earnings
management may arise. This study also contributes to the accounting literature by
providing direct empirical evidence of the importance of compatibility between a coun-
trys institutional setting and accounting standards. We show that IFRS, an accounting
system oriented towards providing relevant information to investors, may not t with
environments in which accounting plays a powerful contracting role in government
regulations. We also show that the lack of active markets for nonnancial assets and the
prevalence of related-party transactions provide rms with opportunities to employ FVA
for earnings management. Finally, our evidence sheds light on the debate surrounding
the merits and limitations of FVA, and may have practical implications for policy
setters.
6. For example, if a rm needs to increase earnings by $100, then it can give a nonnancial asset with a $200
book value to a creditor to offset a $300 debt. As long as both parties agree that the fair value of the asset
is $300, the rm can book a $100 gain in earnings, and the creditor incurs no losses. This type of transac-
tion can be executed more easily with a related party than with an arms length party because the debtor
can return the favor to the creditor through future transactions.
540 Contemporary Accounting Research
CAR Vol. 29 No. 2 (Summer 2012)
The remainder of the paper proceeds as follows. Section 2 provides background infor-
mation and reviews the related literature. Section 3 describes the sample and our research
design. Section 4 reports the empirical results, and section 5 reports the results of addi-
tional and sensitivity tests. Section 6 concludes the paper.
2. Background information and literature review
Literature on intended and unintended consequences of mandatory IFRS adoption
Several studies examining the intended benets of IFRS adoption in terms of greater infor-
mation comparability have provided mixed evidence. For example, Barth et al. (2010)
investigate information comparability between non-U.S. rms in 26 countries and U.S.
rms from 1995 to 2006. They nd the value relevance of earnings and the book value of
equity to be more comparable between these two groups of rms after the application of
International Accounting Standards (IAS) by non-U.S. rms. Using three different mea-
sures of comparability and data from 17 European countries, Yip and Young (2011) nd
that accounting earnings are more comparable among rms from the same industry but
different countries, following their mandatory adoption of IFRS in 2005. However, Bene-
ish, Miller, and Yohn (2009) and Lang, Maffett, and Owens (2010) report that non-IFRS
adopters also experienced a comparability improvement after 2005, thus suggesting that
IFRS adoption may not be the source of that improvement.
Other studies have compared the quality of earnings and the book value of equity
under IFRS and local accounting standards, and they too have produced mixed results.
For example, Ahmed and Goodwin (2007) and Goodwin, Ahmed, and Heaney (2007) nd
that IFRS earnings and equity are no more value-relevant than they were under Austra-
lian Generally Accepted Accounting Principles (GAAP). Horton and Serafeim (2010), in
contrast, nd signicant abnormal stock returns to be associated with earnings reconcilia-
tion between U.K. GAAP and IFRS. Gjerde, Knivsa, and Saettan (2008) show that rec-
onciliation adjustments following IFRS adoption are marginally value-relevant in Norway,
whereas Callao, Jarne, and La nez (2007) show that such adoption leads to no improve-
ment in the value relevance of nancial reporting. Using data from 14 EU countries and
Australia, Clarkson et al. (2011) also nd that IFRS adoption has failed to enhance nan-
cial reporting quality. In a study investigating 1,722 rms from nine European countries in
which early IFRS adoption was not allowed, Capkun, Cazavan-Jeny, Jeanjean, and Weiss
(2007) nd earnings reconciliation adjustments from local accounting standards to IFRS
to be value relevant.
Several recent studies examine the occurrence of certain economic effects after IFRS
adoption. Daske et al. (2008), for example, scrutinize 10,789 mandatory adopters from 26
countries (mainly in the EU) and nd IFRS adoption to be associated with improved
market liquidity and Tobins Q, although their results for the cost of capital are mixed.
Li (2010) nds declined cost of capital following mandatory adoption for EU rms in
countries with strict enforcement. DeFond et al. (2011) report that mandatory IFRS
adoption results in increased foreign investment among rms in countries with strong
implementation credibility that experience relatively large increases in uniformity. Florou
and Pope (2009) and Yu (2009) also document evidence showing IFRS adoption to result
in increased ownership by international mutual fund investors. In addition, Wu and
Zhang (2010) nd that European rms increase their use of relative performance evalua-
tion based on the accounting information of foreign peers following mandatory IFRS
adoption.
In contrast to the relatively rich body of literature on the intended consequences of
IFRS adoption, direct or indirect evidence of its unintended consequences is limited.
Exceptions include Christensen, Lee, and Walker 2009, who report that mandatory IFRS
Fair Value Accounting in Emerging Markets 541
CAR Vol. 29 No. 2 (Summer 2012)
adoption leads to wealth transfers between lenders and shareholders through its impact on
debt covenants that are based on rolling accounting standards. Wu and Zhang (2009)
show voluntary IFRS adoption to be associated with increases in the sensitivity of chief
executive ofcer (CEO) turnover and employee layoffs to accounting earnings. Chen and
Tang (2009) document evidence to suggest that mandatory IFRS adoption in Hong Kong
makes managers compensation plans more attractive. Bushman and Landsman (2010)
provide an example to show that IFRS adoption has had unintended effects on the regula-
tory capital requirements of banks in Spain. Further, several studies have suggested that
IFRS is one of the factors that affect rms allocation of pension plan assets and their
decisions to fund, terminate, freeze, curtail, or convert dened benet plans (e.g., Amir,
Guan, and Oswald 2010; Stadler and Lobe 2010).
Factors that inuence nancial reporting incentives in China
Piotroski and Wong (2010) put forth several institutional factors that inuence the supply
of and demand for information in China. First, they argue that the use of bright-line
accounting-based rules by the Chinese securities regulator creates strong incentives for
rms to manage earnings. Since 1998, if a listed Chinese rm reports two consecutive years
of losses, then it is labeled a special treatment (ST) rm. The daily stock price changes
for ST rms are restricted to 5 percent, in comparison with the 10 percent restriction on
non-ST rms. If a rm again reports a loss in the year after becoming an ST rm, then it
will be delisted. In addition, to issue equity, a rm must have reported a prot in each of
the past three years. Because rights issues are an important source of capital for listed
rms in China, it is costly for rms to lose either their listing status or the right to raise
new capital. Accounting thus plays an important contracting role in China, which in turn
creates strong incentives for rms to manage earnings to meet regulatory earnings targets.
Several studies have presented empirical evidence that is consistent with this assertion.
Aharony, Lee, and Wong (2000), for example, document the use of discretionary accruals
to inate earnings in advance of an initial public offering. Chen and Yuan (2004) and
Haw, Qi, Wu, and Wu (2005) nd that rms manage earnings to meet the regulatory tar-
get for rights issue approval, and Jian and Wong (2010) show that Chinese rms prop up
earnings through related-party transactions to avoid reporting losses.
Social and political connections also have a signicant inuence on nancial reporting
incentives in China. Well-connected rms face less demand for transparent information
and also have incentives to suppress information to avoid revealing their political connec-
tions and related-party transactions (Piotroski, Wong, and Zhang 2009). Piotroski et al.
(2009) document evidence to show that Chinese state enterprises control the release of bad
news to the market around certain political events. They suppress bad news to hide expro-
priation-related activities and mask the inefcient allocation of resources to achieve politi-
cal objectives. Social and political networks can also lead to frequent engagement in
related-party transactions, and research evidence suggests that Chinese rms often manage
earnings via such transactions. Jian and Wong (2010), for example, demonstrate that
Chinese listed rms use related-party sales to their unlisted parents to boost earnings to
meet regulatory earnings thresholds, and Jiang, Lee, and Yue (2010) show that inter-
company loans are employed to facilitate the tunneling of resources in state enterprises.
Preliminary evidence from Piotroski, Wong, and Zhang 2010 also shows that nonoperating
and operating related-party transactions are associated, respectively, with declines and
improvements in rm performance.
The dominance of state-owned enterprises (SOEs) in the Chinese stock market, where
they make up the majority of listed rms (accounting for about 65 percent of rms and
89 percent of market capitalization), is another key factor affecting rms reporting incen-
tives. According to Piotroski and Wong 2010, such an ownership structure signicantly
542 Contemporary Accounting Research
CAR Vol. 29 No. 2 (Summer 2012)
reduces the demand for and supply of transparent information in several ways. First,
government owners can employ private channels to obtain information by which to
assess managerial performance. Second, minority shareholders expect the government to
bail out nancially distressed SOEs, thereby reducing demand for information on these
rms. Third, prot maximization is not the sole objective of SOEs, and related-party
transactions are prevalent, which suppresses incentives to supply information to the pub-
lic. For similar reasons, this ownership structure also reduces demand for high-quality
audits. Wang, Wong, and Xia (2008) report that, compared with non-SOEs, local state
rms are more likely to hire small local auditors.
New CAS adoption and nancial reporting quality in China
Chinas Ministry of Finance formally issued the new CAS on February 15, 2006. With the
exception of a few modications made to reect the countrys unique environment,
7
the
new standards are substantially in line with IFRS and cover most of the topics therein.
They came into effect for listed rms on January 1, 2007. The introduction of the new
CAS has resulted in fundamental changes to nancial reporting practices in China. Del-
oitte Touche Tohmatsu (2006) identies 15 key changes in the new CAS, eight of which
are related to the use of fair value for balance sheet items and the inclusion of fair-value
changes in earnings. A recent paper by Peng and Bewley 2010 discusses FVA implementa-
tion within the historical and socioeconomic context of China. These authors argue that
the recent adoption of fair valueoriented CAS has not been accompanied by the neces-
sary changes in capital and other market infrastructure.
Several early studies examined the difference in earnings quality between CAS- and
IAS-based nancial reporting. Abdel-khalik, Wong, and Wu (1999), for example, nd a
correlation between earnings and unexpected returns for CAS-based reports but not for
IAS-based reports. In the two studies examining rms that produce nancial reports
according to the rules of both IAS and CAS, Eccher and Healy (2000) nd the infor-
mation of the former to be no more value-relevant than that of the latter, and Lin and
Chen (2005) nd that earnings and the book value of equity under the former are less
value-relevant than those under the latter.
3. Sample and research design
Initial sample
Our initial sample is obtained from the China Securities Market and Accounting Research
(CSMAR) database. It comprises all A-share listed companies in nonnancial industries.
Because the new CAS became effective on January 1, 2007 for listed rms, our sample
years are 2007 and 2008. Financial data and auditor information are also obtained from
the CSMAR database. Data on fair-value changes in trading securities, realized gains from
AFS securities, and gains on debt restructuring are all hand-collected from the footnotes
of the sample rms nancial statements. Finally, information on rms political connec-
tions (as dened by their CEO or chairman being an ex- or current government ofcial)
is also hand-collected from their annual reports, announcements on chairman (CEO)
turnover, and web sites. Apart from gains on debt restructuring, which are winsorized at
5 percent and 95 percent due to some extremely high values, we winsorize all of the afore-
mentioned continuous variables at 1 percent and 99 percent.
7. For example, whereas IFRS allow rms to revalue xed assets on a regular basis and to reverse impair-
ment losses on xed assets, the new CAS do not. IFRS also allow rms to employ the equity method or
proportionate consolidation when they consolidate joint-venture companies, whereas the latter is prohib-
ited under the new CAS.
Fair Value Accounting in Emerging Markets 543
CAR Vol. 29 No. 2 (Summer 2012)
Research design
Research design for tests related to FVA for trading securities
In the no earnings management scenario, there should be no negative correlation between
fair-value changes in trading securities and gains or losses from the sale of AFS securities.
Because positive fair-value changes in trading securities are usually not in conict with
managers incentives to meet or beat earnings thresholds, earnings management is more
likely to occur when these changes are negative. We thus employ (1) to examine whether
rms that report a negative fair-value change in trading securities are more likely to sell
AFS securities for gains to reduce the impact of that change than their counterparts with
a positive fair-value change in trading securities:
G=L
jt
b
0
b
1
FV
jt
b
2
NFV
jt
b
3
FV
jt
NFV
jt
b
4
NI G=L FV
jt
b
5
SIZE
jt
b
6
LEV
jt
b
7
CFO
jt
b
8
WC
jt
Rb
k
ID
kt
e
jt
1
where G L represents gains or losses from the sale of AFS securities, and FV is a rms
fair-value change in trading securities; both are scaled by year-end total assets. NFV is an
indicator equal to one if FV is negative, and zero otherwise. We include net income less
G L and FV (NI_G L_FV), the natural logarithm of total assets (SIZE), the ratio of total
debt to total assets (LEV), operating cash ows (CFO), working capital (WC), and indus-
try indicators (ID) dened on the basis of the China Securities Regulatory Commission
(CSRC) industry classications in the regression model. The variables NI_G L_FV, CFO,
and WC are scaled by total assets at the end of the year. Our variable of interest is the
interaction between FV and NFV. A negative coefcient on this interaction (b
3
) indicates
greater earnings management via gains on the sale of AFS securities among rms that
report negative fair-value changes in trading securities.
Such earnings management with the aim of offsetting negative fair-value changes in
trading securities, as proxied by a negative association between G L and FV, is also more
likely to occur among rms that would have reported losses if there had been no gains
from trading or AFS securities. We thus adopt (2) to test whether there is a greater associ-
ation with earnings management via gains on the sale of AFS securities among these rms:
G=L
jt
b
0
b
1
FV
jt
b
2
LA G=L
jt
b
3
FV
jt
LA G=L
jt
b
4
NI G=L FV
jt
b
5
SIZE
jt
b
6
LEV
jt
b
7
CFO
jt
b
8
WC
jt
Rb
k
ID
kt
e
jt
2
where LA_G L equals one if net income is positive but net income less FV and G L is
negative, and zero otherwise. This variable indicates rms that have strong incentives to
manage earnings to meet the zero earnings threshold. The other variables are dened as
before. The variable of interest is the interaction between FV and LA_G L. A negative b
3
suggests that this type of FVA-induced earnings management is greater among rms with
incentives to avoid reporting a loss.
Research design for tests related to FVA for debt restructuring
We rst employ data from the old CAS years (20012005) to develop a prediction model
for gains on debt restructuring.
8
A gain from such restructuring arises when a debtor is in
nancial distress and its creditor grants it a concession in accordance with a mutual
8. Although the new CAS took effect in 2007, rms may also have had incentives to manipulate earnings
through debt restructuring in 2006 because they were required to disclose their new CAS-based earnings
for that year in their 2007 nancial statements. Thus, we exclude 2006 data in estimating the prediction
model, although similar results are obtained if we include them.
544 Contemporary Accounting Research
CAR Vol. 29 No. 2 (Summer 2012)
agreement or a court judgment. We thus follow the literature on nancial distress to esti-
mate this model. In our model, the dependent variable is gains on debt restructuring that
were directly included in equity during the old CAS years. The independent variables are
the same as those in the Z-score model developed by Altman 1968. More specically,
working capital (WC), retained earnings (RE), the total market value of equity divided by
total debt (E D), sales (REV), and earnings before interest and taxes (EBIT) in year t ) 1
are employed to predict gains on debt restructuring in year t. Except for E D, all of these
variables are scaled by total assets. If a rm reported a gain from debt restructuring in
2007 or 2008, then we employ the estimated prediction model to calculate the gain it
would have reported if the old cost-oriented CAS had been used for that year. Abnormal
gains on debt restructuring are computed as the difference between the amount reported
under the new CAS and the amount estimated from the prediction model. We then test
whether there is a signicant association between these abnormal gains and earnings man-
agement incentives using the following model:
AGODR
jt
b
0
b
1
LA GODR
jt
b
2
RPT
jt
b
3
LA GODR
jt
RPT
jt
Rb
k
ID
kt
e
jt
3
where AGODR is abnormal gains on debt restructuring scaled by total assets, and
LA_GODR is loss avoidance through gains on debt restructuring. The latter variable is
equal to 1 if the rms net income is positive but that excluding the gains on debt restruc-
turing is negative, and 0 otherwise. Because we expect managers to take advantage of the
new FVA for debt restructuring to manage earnings, b
1
is predicted to be positive. We
control for the value of a rms debt-related transactions with related parties (RPT), which
is also scaled by total assets, and its interaction with the loss avoidance incentive in the
regression. The coefcient on the interaction term (b
3
) indicates whether rms with more
debt-related transactions with related parties are more likely to employ abnormal gains on
debt restructuring to manage earnings, thus providing evidence on whether the earnings
management via FVA for debt restructuring likely stems from related-party transactions.
Similar to the tests related to FVA for trading securities, we also include industry indica-
tors (ID) based on the CSRC industry classications in the model to control for industry-
specic factors.
Research design for institutional and corporate governance impacts
We extend (1), (2), and (3) by adding two proxies for province-level institutions (legal envi-
ronment and government involvement in the economy) and two proxies for rm-level cor-
porate governance (political connections and employment of a Big 4 auditor) to the
equations. The coefcients on the interaction terms between these four variables and our
variables of interest (FV*NFV in (1), FV*LA_G L in (2), and LA_GODR in (3)) indicate
whether institutions and corporate governance affect the outcome of FVA implement-
ation.
The legal environment indicator (Legal) equals one if the rm is located in a prov-
ince with a legal environment index score in the top quintile of the sample (i.e., in a
province with a better legal environment), and zero otherwise. The government involve-
ment indicator (Gov) equals one if the rm is located in a province with a government
involvement index score in the top quintile of the sample (i.e., in a province with a low
degree of government involvement in the economy), and zero otherwise. Both index
scores were developed by Fan and Wang 2006. The political connection indicator (PC) is
equal to one if the rms CEO or chairman of the board is an ex- or current ofcial in
the central government, a local government, a state-owned bank, or the military, and
zero otherwise. Finally, the Big 4 auditor indicator (B4) equals one if the rm employs a
Big 4 auditor, and zero otherwise.
Fair Value Accounting in Emerging Markets 545
CAR Vol. 29 No. 2 (Summer 2012)
4. Results
Results for tests related to FVA for trading securities
As presented in panel A of Table 1, there are 1,275 rm-year observations that report
trading securities, AFS securities, or both in the two-year old CAS period (20052006).
Among these observations, 69.8 percent and 52.1 percent report trading and AFS securi-
ties, respectively. However, of the 1,177 rm-year observations with trading or AFS securi-
ties in the two-year new CAS period (20072008), the percentage reporting trading
securities falls to 58.1 percent, and that reporting AFS securities rises to 65.5 percent.
9
We
perform logistic regressions to compare the number of rms reporting each across the two
periods. After controlling for rm size, leverage, operating cash ows, and working capi-
tal, we nd that the number of rms with trading securities decreases but the number with
AFS securities increases across the old and new CAS periods (Z-statistics are based on
robust standard errors clustered by rm). This result is consistent with the scenario that,
under the new CAS regime, managers classify fewer nancial assets as trading securities to
reduce the impact of fair-value changes on their ability to meet earnings thresholds and
employ more AFS securities to counter the negative impacts of fair-value changes in trad-
ing securities. The results are summarized in panel B of Table 1.
We provide information on the industry distribution of the sample of 786 rm-year
observations reporting a fair-value change in trading securities in 2007 or 2008 in panel
A of Table 2. These observations are used to estimate (1) and (2). It can be seen that
about 53 percent of the sample observations are from the manufacturing sector. The
descriptive statistics for the variables in (1) and (2) are summarized in panel B of
Table 2. On average, the gains or losses on the sale of AFS securities (G L) constitute
about 0.2 percent of a rms total assets. The mean fair-value change in trading securi-
ties is )0.1 percent of total assets, and about 58 percent of the sample observations
report a negative fair-value change in trading securities. In addition, approximately 4.1
percent of rm-years are likely to have incentives to employ gains on the sale of AFS
securities to avoid losses, about 36 percent are politically connected, and 11.2 percent
employ Big 4 auditors.
The regression results for the tests of whether rms selectively sell AFS securities
for gains to offset losses from fair-value decreases in trading securities are summarized
in panel A of Table 3. The results for (1) are summarized in the model 1 column.
Those for the extended (1), which includes the institutional and corporate governance
variables, are reported in the model 2 column when the legal environment indicator is
included in the regression and in the model 3 column when the government involvement
indicator is included.
10
We nd that rms reporting a negative fair-value change in trad-
ing securities are more likely to sell AFS securities for a gain than those reporting a
positive such change (the coefcient is )0.087 with a )1.97 t-statistic). We also nd
rms located in regions with more developed legal systems to be less likely to engage in
such earnings management (the coefcient is 0.373 with a 3.11 t-statistic). The evidence
from models 2 and 3 also suggests that the employment of a Big 4 auditor reduces
earnings management.
The regression results for (2), which tests whether earnings management is more pro-
nounced among rms that would have reported losses if there had been no gains from
9. These percentages are high because we exclude rms that did not possess either of these securities from
the sample. If they had been included, then the percentage of rms with trading securities would be 32.5
percent in the old CAS period and 22.6 percent in the new CAS period.
10. Because the variables for legal environment and government involvement in the economy are highly
correlated (the correlation is 0.585), we do not include them in the model simultaneously to avoid
multicollinearity.
546 Contemporary Accounting Research
CAR Vol. 29 No. 2 (Summer 2012)
trading or AFS securities, are summarized in panel B of Table 3. These results indicate
that rms with strong incentives to avoid reporting losses are more likely to engage in
earnings management. Earnings management is also more likely to occur among rms
located in provinces with a weak legal environment and strong government involvement in
TABLE 1
Information on trading and AFS securities
Panel A: Descriptive statistics for rm-year observations that have either trading or AFS securities
during the old CAS or new CAS period
Variable
Old CAS period (20052006) New CAS period (20072008)
Mean Median Std.dev Obs. Mean Median Std.dev Obs.
TRADING 0.698 1.000 0.459 1275 0.581 1.000 0.494 1177
AFS 0.521 1.000 0.500 1275 0.655 1.000 0.476 1177
SIZE 21.386 21.318 1.005 1275 21.832 21.681 1.239 1177
LEV 0.550 0.538 0.264 1275 0.519 0.522 0.215 1177
CFO 0.053 0.052 0.078 1275 0.042 0.045 0.081 1177
WC 0.052 0.073 0.268 1275 0.088 0.092 0.249 1177
Panel B: Regression results for the following model, which examines the effect of the new CAS
adoption on the holding of trading securities (Model 1 column) and the holding of AFS securities
(Model 2 column):
TRADING
jt
=AFS
jt
b
0
b1NEW CAS
jt
b
2
SIZE
jt
b
3
LEV
jt
b
4
CFO
jt
b
5
WC
jt
Rb
k
ID
kt
e
jt
Variable
Model 1 Model 2
TRADING AFS
Coefcient z-statistic Coefcient z-statistic
NEW_CAS )0.587*** ()6.14) 0.571*** (5.99)
SIZE 0.009 (0.16) 0.180*** (2.96)
LEV 0.730* (1.85) )0.918** ()2.29)
CFO )0.408 ()0.60) )0.117 ()0.17)
WC 1.660*** (4.59) )1.529*** ()4.09)
Constant 1.985 (1.48) )5.196*** ()3.83)
Industry Controlled Controlled
Pseudo R
2
0.056 0.083
N 2452 2452
Notes:
Variable denitions: TRADING is an indicator that equals 1 if the rm reports trading securities at
the year end, and 0 otherwise; AFS is an indicator that equals 1 if the rm reports AFS
securities at the year end, and 0 otherwise; NEW_CAS is an indicator that equals 1 if it is a
new CAS year, and 0 otherwise; SIZE is the natural logarithm of total assets; LEV is total
debt to total assets; CFO is operating cash ows deated by total assets; WC is working
capital deated by total assets; and ID is an industry indicator. The dependent variables in
models 1 and 2 are TRADING and AFS, respectively. Z-statistics are based on robust standard
errors clustered by rm. *, **, and *** represent signicance levels of 0.10, 0.05, and 0.01,
respectively.
Fair Value Accounting in Emerging Markets 547
CAR Vol. 29 No. 2 (Summer 2012)
TABLE 2
Sample distribution and descriptive statistics of variables used to test FVA for trading securities
Panel A: Industry distribution by CSRC industry classication for the sample of rm-years reporting
fair-value changes in trading securities in 2007 or 2008
Industry Obs.
Farming, Forestry, Animal Husbandry, and Fishing 22
Mining 19
Manufacturing 420
Utilities 32
Construction 15
Transportation and Warehousing 45
Information Technology 62
Wholesale and Retail Trades 44
Real Estate 35
Public Facilities and Other Services 25
Communication and Cultural Industries 10
Conglomerates 57
Total 786
Panel B: Descriptive statistics
Variable Mean Median Min. Max. Std.dev Obs.
G L 0.002 0.000 0.000 0.044 0.007 786
FV )0.001 0.000 )0.036 0.026 0.007 786
NFV 0.580 1.000 0.000 1.000 0.494 786
NI_G L_FV 0.031 0.028 )0.230 0.258 0.064 786
LA_G L 0.041 0.000 0.000 1.000 0.198 786
Legal 0.265 0.000 0.000 1.000 0.441 786
Gov 0.228 0.000 0.000 1.000 0.420 786
PC 0.360 0.000 0.000 1.000 0.480 786
B4 0.112 0.000 0.000 1.000 0.316 786
SIZE 21.848 21.627 19.194 26.022 1.344 786
LEV 0.502 0.512 0.070 0.916 0.193 786
CFO 0.042 0.041 )0.186 0.264 0.081 786
WC 0.125 0.113 )0.465 0.665 0.232 786
Notes:
Variable denitions: G L is gains or losses from selling AFS securities deated by total assets; FV is
fair-value change in trading securities deated by total assets; NFV is an indicator that equals 1 if
FVis negative, and 0 otherwise; NI_G L_FVis net income deated by total assets less G L and FV;
LA_G L is an indicator that equals 1 if net income is positive but net income less FV and G L is
negative, and 0 otherwise; Legal is an indicator that equals 1 if a rm is located in a province with a
legal environment index score in the top quintile of the sample, and 0 otherwise; Gov is an indicator
that equals 1 if a rm is located in a province with a government involvement index score in the
top quintile of the sample, and 0 otherwise; PC is an indicator that equals 1 if the rms CEOor
chairman of the board of directors is politically connected, and 0 otherwise; B4 is an indicator that
equals 1 if the rm employs a Big 4 auditor, and 0 otherwise; SIZE is the natural logarithm of total
assets; LEV is total debt to total assets; CFO is operating cash ows deated by total assets; and
WCis working capital deated by total assets.
548 Contemporary Accounting Research
CAR Vol. 29 No. 2 (Summer 2012)
TABLE 3
Results for tests related to FVA for trading securities
Panel A: Regression results on whether rms that report a negative fair-value change in trading
securities are more likely to sell AFS securities for gains than their counterparts with a positive fair-
value change in trading securities. The Model 1 column reports the results for the base model, and
the Model 2 and Model 3 columns report those for the extended base model by adding two proxies
for province-level institutions (Legal and Gov), two proxies for rm-level corporate governance (PC
and B4), and the interaction terms to the base equation. The base model is as follows:
G=L
jt
b
0
b
1
FV
jt
b
2
NFV
jt
b
3
FV
jt
NFV
jt
b
4
NI G=L FV
jt
b
5
SIZE
jt
b
6
LEV
jt
b
7
CFO
jt
b
8
WC
jt
Rb
k
ID
kt
ejt
Variable
Model 1 Model 2 Model 3
Coeff. t-stat. Coeff. t-stat. Coeff. t-stat.
FV 0.050 (0.91) 0.197** (2.01) 0.003 (0.03)
NFV 0.001 (0.98) 0.001 (0.75) 0.000 (0.18)
FV*NFV )0.087** ()1.97) )0.370*** ()3.31) )0.200* ()1.72)
NI_G L_FV )0.015*** ()3.60) )0.014*** ()3.43) )0.016*** ()3.72)
Legal 0.003*** (3.31)
FV*Legal )0.265** ()2.15)
NFV*Legal 0.001 (0.44)
FV*NFV*Legal 0.373*** (3.11)
Gov )0.000 ()0.39)
FV*Gov 0.109 (0.85)
NFV*Gov 0.001 (0.42)
FV*NFV*Gov 0.090 (0.73)
PC 0.001 (0.72) 0.000 (0.24)
FV*PC 0.040 (0.31) 0.162 (1.31)
NFV*PC 0.001 (0.52) 0.001 (0.67)
FV*NFV*PC 0.190 (1.47) )0.008 ()0.07)
B4 0.000 (0.21) 0.001 (0.53)
FV*B4 )0.233 ()1.25) )0.181 ()0.91)
NFV*B4 )0.000 ()0.23) )0.000 ()0.09)
FV*NFV*B4 0.368** (2.41) 0.302* (1.82)
SIZE )0.000 ()0.65) )0.000 ()0.77) )0.000 ()0.63)
LEV )0.002 ()1.24) )0.001 ()0.55) )0.002 ()1.02)
CFO )0.002 ()0.74) )0.002 ()0.74) )0.003 ()0.84)
WC )0.002 ()1.61) )0.002* ()1.65) )0.002 ()1.53)
Constant 0.004 (0.89) 0.004 (0.77) 0.004 (0.80)
Industry Controlled Controlled Controlled
Adj. R
2
0.040 0.072 0.040
N 786 786 786
(The table is continued on the next page.)
Fair Value Accounting in Emerging Markets 549
CAR Vol. 29 No. 2 (Summer 2012)
TABLE 3 (Continued)
Panel B: Regression results on the relationship between earnings management via gains on the sale
of AFS securities and the incentive to avoid reporting losses. The Model 1 column reports the
results for the base model, and the Model 2 and Model 3 columns report those for the extended
base model by adding two proxies for province-level institutions (Legal and Gov), two proxies for
rm-level corporate governance (PC and B4), and the interaction terms to the base equation. The
base model is as follows:
G=L
jt
b
0
b
1
FV
jt
b
2
LA G=L
jt
b
3
FV
jt
LA G=L
jt
b
4
NI G=L FV
jt
b
5
SIZE
jt
b
6
LEV
jt
b
7
CFO
jt
b
8
WC
jt
Rb
k
ID
kt
ejt
Variable
Model 1 Model 2 Model 3
Coeff. t-stat. Coeff. t-stat. Coeff. t-stat.
FV )0.029 ()0.60) )0.089 ()1.05) )0.156* ()1.71)
LA_G L 0.022*** (9.35) 0.023*** (5.35) 0.026*** (8.04)
FV*LA_G L )1.248*** ()6.72) )1.318*** ()4.09) )1.217*** ()5.87)
NI_G L_FV )0.008** ()2.18) )0.007* ()1.91) )0.008** ()2.20)
Legal 0.001*** (2.74)
FV*Legal 0.014 (0.17)
LA_G L*Legal 0.007 (1.43)
FV*LA_G L*Legal 0.909* (1.83)
Gov 0.000 (0.24)
FV*Gov 0.151 (1.38)
LA_G L*Gov 0.003 (0.70)
FV*LA_G L*Gov 2.039*** (2.85)
PC 0.000 (1.20) 0.000 (1.12)
FV*PC 0.157 (1.32) 0.170 (1.40)
LA_G L*PC )0.005 ()1.13) )0.005 ()0.96)
FV*LA_G L*PC )0.876** ()1.97) )2.038*** ()2.74)
B4 )0.000 ()0.40) 0.000 (0.07)
FV*B4 0.009 (0.12) 0.061 (0.83)
FV*LA_G L*B4 267.196*** (3.08) 337.111*** (3.90)
SIZE 0.000 (0.50) 0.000 (0.78) 0.000 (1.14)
LEV )0.002* ()1.69) )0.001 ()0.95) )0.002* ()1.68)
CFO )0.000 ()0.08) )0.000 ()0.23) )0.000 ()0.07)
WC )0.001 ()0.56) )0.000 ()0.07) )0.000 ()0.24)
Constant )0.001 ()0.38) )0.003 ()0.76) )0.003 ()0.96)
Industry Controlled Controlled Controlled
Adj. R
2
0.442 0.490 0.480
N 786 786 786
(The table is continued on the next page.)
550 Contemporary Accounting Research
CAR Vol. 29 No. 2 (Summer 2012)
the economy and among those that are politically connected or employ nonBig 4 audi-
tors.
11
Overall, our results indicate that when managers have strong incentives to meet reg-
ulatory earnings thresholds they will take action to reduce the negative earnings impacts
of fair-value changes in trading securities, thereby reducing the intended benets of FVA
for this purpose. Our results are also supportive of the argument that institutional factors
play an important role in FVA implementation.
Results for tests related to FVA for debt restructuring
Our sample includes 423 rm-year observations for debt restructuring. The industry distri-
bution of the sample is presented in panel A of Table 4, from which it can be seen that
about 66 percent of these observations are from the manufacturing sector. There are 129
rm-year observations disclosing information on the monthly distribution of 177 debt re-
structurings in 2007 and 2008, of which 48.59 percent occurred in December. Among the
rm-year observations that would have reported a loss had there been no gains on debt
restructuring, December occurrence constitutes about 67.06 percent, with a Chi-square test
demonstrating a signicantly greater December occurrence for loss-avoidance rms relative
to other rms. Because earnings management is more likely to occur at the end of the
accounting period, this distribution pattern is consistent with earnings management via
debt restructuring. The results for these tests are reported in panel B of Table 4.
The descriptive statistics for all of the variables used to estimate the prediction model
for gains on debt restructuring are summarized in panel A of Table 5. The rms that
reported no such gains are referred to as control rms.
12
As indicated in the table, these
control rms have higher levels of working capital, retained earnings, sales, and earnings,
and a higher ratio of the market value of equity to total debt than those reporting gains
on debt restructuring. The results of the tobit regression are summarized in panel B of
Table 5, from which it can be seen that all of the coefcients are signicant.
The descriptive statistics for the variables used in (3) and extended (3) are summarized
in panel A of Table 6. On average, abnormal gains on debt restructuring are equal to
TABLE 3 (Continued)
Notes:
Variable denitions: G L is gains or losses from selling AFS securities deated by total assets; FV is
fair-value change in trading securities deated by total assets; NFV is an indicator that equals
1 if FV is negative, and 0 otherwise; NI_G L_FV is net income deated by total assets less
G L and FV; SIZE is the natural logarithm of total assets; LEV is total debt to total assets;
CFO is operating cash ows deated by total assets; WC is working capital deated by total
assets; Legal is an indicator that equals 1 if the rm is located in a province with a legal
environment index score in the top quintile of the sample, and 0 otherwise; Gov is an indicator
that equals 1 if the rm is located in a province with a government involvement index score in
the top quintile of the sample, and 0 otherwise; PC is an indicator that equals 1 if the rms
CEO or chairman of the board of directors is politically connected, and 0 otherwise; B4 is an
indicator that equals 1 if the rm employs a Big 4 auditor, and 0 otherwise; LA_G L is an
indicator that equals 1 if net income is positive but net income less FV and G L is negative,
and 0 otherwise; and ID is an industry indicator. *, **, and *** represent signicance levels of
0.10, 0.05, and 0.01, respectively.
11. The interaction term LA_G L*B4 is omitted from the model because it is perfectly correlated with
FV*LA_G L*B4.
12. The control rms include those that reported losses on debt restructuring as a creditor. Excluding these
rms from the sample does not change the results.
Fair Value Accounting in Emerging Markets 551
CAR Vol. 29 No. 2 (Summer 2012)
TABLE 4
Descriptive data for debt restructuring
Panel A: Industry distribution by CSRC industry classication for the sample of rm-years reporting
gains on debt restructuring in 2007 or 2008
Industry Obs.
Farming, Forestry, Animal Husbandry, and Fishing 12
Mining 8
Manufacturing 281
Utilities 11
Construction 8
Transportation and Warehousing 6
Information Technology 34
Wholesale and Retail Trades 19
Real Estate 6
Public Facilities and Other Services 7
Communication and Cultural Industries 5
Conglomerates 26
Total 423
Panel B: Monthly distribution of 177 debt restructurings that were disclosed by 129 rm-year
observations
Month
For 177 debt
restructurings related to
129 rm-years
For 85 debt
restructurings related to
60 rm-years that would
have reported losses
without gains on debt
restructuring
For 92 debt
restructurings related to
other 69 rm-years
Number Frequency Number Frequency Number Frequency
1 5 2.82% 0 0.00% 5 5.43%
2 3 1.69% 1 1.18% 2 2.17%
3 17 9.60% 5 5.88% 12 13.04%
4 8 4.52% 2 2.35% 6 6.52%
5 9 5.08% 4 4.71% 5 5.43%
6 13 7.34% 3 3.53% 10 10.87%
7 3 1.69% 2 2.35% 1 1.09%
8 6 3.39% 2 2.35% 4 4.35%
9 5 2.82% 2 2.35% 3 3.26%
10 12 6.78% 2 2.35% 10 10.87%
11 10 5.65% 5 5.88% 5 5.43%
12 86 48.59% 57 67.06% 29 31.52%
Total 177 100.00% 85 100.00% 92 100.00%
Notes:
The chi-square statistic for the test of the difference in December occurrence between loss-avoidance
rms (57) and other rms (29) is 22.336; p-value < 0.01.
552 Contemporary Accounting Research
CAR Vol. 29 No. 2 (Summer 2012)
approximately 8.7 percent of total assets in the sample of 423 rm-year observations. If
there had been no gains on debt restructuring, then about 20 percent of these observations
would have reported a loss. Roughly 27.7 percent of sample rm-years are politically con-
nected, and 2.4 percent employ Big 4 auditors.
The regression results are summarized in panel B of Table 6. In the model 1 column,
the coefcient on LA_GODR is positive and signicant (the coefcient is 0.111 with a
12.55 t-statistic), indicating that abnormal gains on debt restructuring are signicantly
associated with incentives to avoid reporting a loss. These results are thus consistent with
the view that managers opportunistically use the gains on debt restructuring to manage
earnings. The coefcient on LA_GODR*RPT is also positive and signicant, implying
that rms with more related-party transactions are more likely to employ abnormal gains
on debt restructuring for loss avoidance. This nding thus provides evidence that the
earnings management via FVA for debt restructuring likely stems from related-party
transactions.
TABLE 5
Results for estimating a prediction model for gains on debt restructuring
Panel A: Descriptive statistics for determinants of gains on debt restructuring
Variable
Firm-years with gains on debt
restructuring
Firm-years without gains on debt
restructuring
Mean Median Std.dev Obs. Mean Median Std.dev Obs.
GODR 0.013 0.000 0.034 577 0.000 0.000 0.000 5390
WC 0.002 0.063 0.333 577 0.136 0.145 0.252 5390
RE )0.193 0.022 0.555 577 0.032 0.081 0.294 5390
E D 2.358 1.565 2.821 577 3.278 2.068 3.662 5390
REV 0.485 0.389 0.386 577 0.558 0.448 0.419 5390
EBIT )0.002 0.033 0.117 577 0.040 0.049 0.074 5390
Panel B: Tobit regression results for the following prediction model:
GODR
jt
b
0
b
1
WC
jt1
b
2
RE
jt1
b
3
E=D
jt1
b
4
REV
jt1
b
5
EBIT
jt1
e
jt
Variable Predicted sign Est. coefcient t-stat.
WC ) )0.011** ()2.45)
RE ) )0.025*** ()8.53)
E D ) )0.001*** ()3.03)
REV ) )0.006** ()2.42)
EBIT ) )0.026** ()2.19)
Constant )0.048*** ()19.16)
Pseudo R
2
0.242
N 5967
Notes:
Variable denitions: GODR is reported gains on debt restructuring deated by total assets; WC is
working capital deated by total assets; RE is retained earnings deated by total assets; E D is
total market value of equity deated by total debt; REV is sales deated by total assets; and
EBIT is earnings before interest and taxes deated by total assets. *, **, and *** represent
signicance levels of 0.10, 0.05, and 0.01, respectively.
Fair Value Accounting in Emerging Markets 553
CAR Vol. 29 No. 2 (Summer 2012)
TABLE 6
Results for earnings management related to FVA for debt restructuring
Panel A: Descriptive statistics for the variables used in tests of earnings management via debt
restructuring
Variable Mean Median Min. Max. Std.dev Obs.
AGODR 0.087 0.061 )0.034 0.447 0.089 423
LA_GODR 0.201 0.000 0.000 1.000 0.401 423
RPT 0.034 0.000 0.000 1.076 0.151 423
Legal 0.215 0.000 0.000 1.000 0.411 423
Gov 0.232 0.000 0.000 1.000 0.422 423
PC 0.277 0.000 0.000 1.000 0.448 423
B4 0.024 0.000 0.000 1.000 0.152 423
Panel B: Regression results on the relationship between abnormal gains on debt restructuring and
incentives to avoid reporting a loss. The Model 1 column reports the results for the base model, and
the Model 2 and Model 3 columns report those for the extended models by adding two proxies for
province-level institutions (Legal and Gov), two proxies for rm-level corporate governance (PC and
B4), and their interactions with LA_GODR to the base model. The base model is:
AGODR
jt
b
0
b
1
LA GODR
jt
b
2
RPT
jt
b
3
LA GODR
jt
RPT
jt
Rb
k
ID
kt
e
jt
Variable
Model 1 Model 2 Model 3
Coeff. t-stat. Coeff. t-stat. Coeff. t-stat.
LA_GODR 0.111*** (12.55) 0.090*** (8.35) 0.082*** (7.58)
RPT )0.004 ()0.10) )0.001 ()0.01) 0.001 (0.03)
LA_GODR*RPT 0.208*** (4.08) 0.196*** (4.03) 0.181*** (3.70)
Legal )0.012 ()1.41)
LA_GODR*Legal )0.037* ()1.91)
Gov )0.006 ()0.75)
LA_GODR*Gov 0.002 (0.10)
PC 0.012 (1.43) 0.012 (1.41)
LA_GODR*PC 0.085*** (5.05) 0.086*** (5.03)
B4 0.003 (0.13) 0.004 (0.16)
LA_GODR*B4 )0.137* ()1.89) )0.174** ()2.38)
Constant 0.084*** (4.30) 0.091*** (4.87) 0.086*** (4.55)
Industry Controlled Controlled Controlled
Adj. R
2
0.430 0.494 0.482
N 423 423 423
Notes:
Variable denitions: AGODR is abnormal gains on debt restructuring deated by total assets;
LA_GODR is an indicator for loss avoidance that equals 1 if the rms net income is positive but
its net income excluding gains on debt restructuring is negative, and 0 otherwise; RPT is the value
of debt-related transactions between the rm and its related parties deated by total assets; Legal
is an indicator that equals 1 if the rm is located in a province with a legal environment index
score in the top quintile of the sample, and 0 otherwise; Gov is an indicator that equals 1 if the
rm is located in a province with a government involvement index score in the top quintile of
the sample, and 0 otherwise; PC is an indicator that equals 1 if the rms CEO or chairman of the
board of directors is politically connected, and 0 otherwise; B4 is an indicator that equals 1 if
the rm employs a Big 4 auditor, and 0 otherwise; and ID is an industry indicator. *, **, and
*** represent signicance levels of 0.10, 0.05, and 0.01, respectively.
554 Contemporary Accounting Research
CAR Vol. 29 No. 2 (Summer 2012)
When the four institutional and corporate governance indicators are included in the
model, the rms located in regions with a more developed legal system are found to be less
likely to employ abnormal gains on debt restructuring to manage earnings (the coefcient
is )0.037 with a )1.91 t-statistic). We also nd politically connected rms more likely to
do so, thus suggesting that political connections help rms to obtain debt concessions
from related creditors. This result is consistent with prior ndings that political connec-
tions enable rms to obtain loans from banks or other state institutions and to lobby for
government assistance when they are in nancial distress (Li, Meng, Wang, and Zhou
2008; Fan, Rui, and Zhao 2008). Moreover, we nd evidence to suggest that rms that
employ Big 4 auditors are less likely to use abnormal gains to meet reporting targets,
which points to the importance of audit quality in nancial reporting.
5. Additional and sensitivity tests
Additional tests of earnings smoothing related to FVA for trading securities
Prior studies have reported that Chinese managers have incentives to report opaque infor-
mation for such purposes as covering up activities that are not in the best interests of
external shareholders, hiding good performance to avoid political costs, and hiding poor
performance to enhance the image of the central and local governments (e.g., Lin, Cai,
and Li 1996; Fisman and Wei 2004; Cai and Liu 2009; Piotroski et al. 2009; Lin 2010).
Because the new FVA for trading securities is likely to increase earnings volatility, which
may attract the scrutiny of external information users, managers are likely to take action
to reduce the impact of increased earnings volatility. We test whether this is indeed the
case using the following model:
G=L
jt
b
0
b
1
NI G=L
jt
b
2
EV
j
b
3
NI G=L
jt
EV
j
b
4
SIZE
jt
b
5
LEV
jt
b
6
CFO
jt
b
7
WC
jt
Rb
k
ID
kt
e
jt
4
where NI_G L is net income less gains or losses from the sale of AFS securities scaled by
total assets, and EV is the earnings volatility resulting from the use of FVA for trading
securities. Using eight quarterly observations for 2007 and 2008, we calculate the standard
deviation of net income scaled by the unsigned mean net income for each rm. We also
calculate the standard deviation of net income less the fair-value change in trading securi-
ties scaled by the unsigned mean value of that variable. Finally, we calculate the percent-
age difference between the two standard deviations and use it as a proxy for the
aforementioned earnings volatility increase. Our data show that FVA for trading securities
increases earnings volatility by about 7.5 percent. The other variables are dened as
before.
Following Dechow, Myers, and Shakespeare 2010, we assume that a negative associa-
tion between G L and NI_G L indicates a rms use of G L to smooth earnings. The vari-
able of interest is the interaction between NI_G L and EV. A signicant and negative
coefcient on the interaction (b
3
) indicates that a greater increase in earnings volatility
heightens rms incentives to employ realized gains or losses from AFS securities to
smooth earnings. The regression results are summarized in Table 7, from which it can be
seen that b
3
is negative and signicant. We also nd that rms with political connection
are more likely to engage in earnings smoothing.
Sensitivity test for FVA for debt restructuring
Because abnormal gains are estimated, and hence subject to measurement error, we per-
form a sensitivity test using (5). In this model, instead of using estimated abnormal gains
on debt restructuring, we employ the reported amount as the dependent variable while
controlling for the variables used to predict nancial distress:
Fair Value Accounting in Emerging Markets 555
CAR Vol. 29 No. 2 (Summer 2012)
TABLE 7
Regression results for earnings smoothing tests related to FVA for trading securities
The Model 1 column presents the regression results for the base model, which examines whether
rms sell AFS securities to reduce the earnings volatility caused by fair-value changes in trading
securities. The Model 2 and Model 3 columns report those for the extended models by adding two
proxies for province-level institutions (Legal and Gov), two proxies for rm-level corporate gover-
nance (PC and B4), and their interactions with NI_G L*EV to the base model. The base model is:
G=L
jt
b
0
b
1
NI G=L
jt
b
2
EV
j
b
3
NI G=L
jt
EV
j
b
4
SIZE
jt
b
5
LEV
jt
b
6
CFO
jt
b
7
WC
jt
Rb
k
ID
kt
e
jt
Variable
Model 1 Model 2 Model 3
Coeff. t-stat. Coeff. t-stat. Coeff. t-stat.
NI_G L )0.014*** ()3.35) )0.010* ()1.78) )0.070*** ()4.62)
EV 0.000 (0.91) 0.000 (0.52) )0.002 ()0.69)
NI_G L*EV )0.018** ()2.11) 0.009 (0.28) )0.047 ()0.61)
Legal 0.004*** (6.36)
NI_G L*Legal )0.040*** ()4.94)
EV*Legal )0.002* ()1.77)
NI_G L*EV*Legal )0.003 ()0.09)
Gov )0.002 ()1.06)
NI_G L*Gov 0.036 (1.49)
EV*Gov 0.001 (0.34)
NI_G L*EV*Gov 0.060 (0.72)
PC )0.000 ()0.05) 0.000 (0.19)
NI_G L*PC 0.014* (1.91) 0.037* (1.72)
EV*PC 0.004** (2.22) 0.012** (2.55)
NI_G L*EV*PC )0.086*** ()3.36) )0.256*** ()3.44)
B4 )0.002 ()1.57) )0.004 ()1.30)
NI_G L*B4 0.027* (1.90) 0.061 (1.53)
EV*B4 )0.000 ()0.10) 0.001 (0.31)
NI_G L*EV*B4 )0.014 ()0.41) 0.047 (0.54)
SIZE )0.000 ()0.41) )0.000 ()0.34) )0.000 ()0.23)
LEV )0.003 ()1.50) )0.001 ()0.87) 0.001 (0.17)
CFO )0.002 ()0.70) )0.003 ()0.99) )0.004 ()0.41)
WC )0.002 ()1.58) )0.002 ()1.20) )0.006 ()1.64)
Constant 0.003 (0.78) 0.003 (0.51) 0.004 (0.28)
Industry Controlled Controlled Controlled
Adj. R
2
0.044 0.133 0.102
N 786 786 786
(The table is continued on the next page.)
556 Contemporary Accounting Research
CAR Vol. 29 No. 2 (Summer 2012)
GODR
jt
b
0
b
1
LA GODR
jt
b
2
RPT
jt
b
3
LA GODR
jt
RPT
jt
b
4
WC
jt1
b
5
RE
jt1
b
6
E=D
jt1
b
7
REV
jt1
b
8
EBIT
jt1
Rb
k
ID
kt
e
jt
: 5
All of the variables are as previously dened. The regression results are summarized in
panel A of Table 8. We nd reported gains on debt restructuring to be positively associ-
ated with rms incentives to avoid reporting a loss and such an association to be more
pronounced among rms with more debt-related transaction value with related parties.
When the four institutional and corporate governance variables are included in the model,
we nd that rms with political connections are more likely to employ gains on debt
restructuring to manage earnings, whereas those located in regions with a more developed
legal system and those employing Big 4 auditors are less likely to do so.
We also calculate an Altman 1968 Z-score for each rm, and employ the following
model to test the relationship between gains on debt restructuring and the incentive to
avoid reporting a loss:
GODR
jt
b
0
b
1
LA GODR
jt
b
2
RPT
jt
b
3
LA GODR
jt
RPT
jt
b
4
Z-SCORE
jt1
Rb
k
ID
kt
e
jt
6
where Z-SCORE is calculated as 1.2*WC + 1.4*RE + 0.6*E D + 1.0*REV + 3.3*
EBIT. The results are summarized in panel B of Table 8. In line with our previous results,
we nd that gains on debt restructuring are positively associated with rms incentives to
avoid reporting a loss. Further, rms with political connections are more likely to use such
gains to manage earnings, whereas those located in regions with a more developed legal
system and those employing Big 4 auditors are less likely to do so.
6. Conclusion
This study documents several unintended effects of mandatory IFRS adoption in China,
where rms have strong earnings management incentives and institutions are in many
respects incompatible with IFRS. First, the intended benet of employing FVA for trading
securities is to provide investors with more relevant information. However, this intended
benet may be in conict with managers incentives to meet regulatory earnings targets, as
negative fair-value changes may result in these targets being missed. We nd that rms
reporting a negative fair-value change in trading securities are more likely to sell AFS
TABLE 7 (Continued)
Notes:
Variable denitions: G L is gains or losses from selling AFS securities deated by total assets;
NI_G L is net income deated by total assets less G L; EV is the percentage difference
between the standard deviation of net income and the standard deviation of net income less a
rms fair-value change in trading securities; SIZE is the natural logarithm of total assets; LEV
is total debt to total assets; CFO is operating cash ows deated by total assets; WC is work-
ing capital deated by total assets; Legal is an indicator that equals 1 if the rm is located in a
province with a legal environment index score in the top quintile of the sample, and 0 other-
wise; Gov is an indicator that equals 1 if the rm is located in a province with a government
involvement index score in the top quintile of the sample, and 0 otherwise; PC is an indicator
that equals 1 if the rms CEO or chairman of the board of directors is politically connected,
and 0 otherwise; B4 is an indicator that equals 1 if the rm employs a Big 4 auditor, and 0
otherwise; and ID is an industry indicator. *, **, and *** represent signicance levels of 0.10,
0.05, and 0.01, respectively.
Fair Value Accounting in Emerging Markets 557
CAR Vol. 29 No. 2 (Summer 2012)
TABLE 8
Results for sensitivity tests on earnings management related to FVA for debt restructuring
Panel A: Regression results for the tests of the relationship between reported gains on debt restruc-
turing and the earnings management incentive. The Model 1 column reports the results for the base
model, and the Model 2 and Model 3 columns report those for the extended models by including
two proxies for province-level institutions (Legal and Gov), two proxies for rm-level corporate gov-
ernance (PC and B4), and their interactions with LA_GODR to the base model. The base model is
as follows:
GODR
jt
b
0
b
1
LA GODR
jt
b
2
RPT
jt
b
3
LA GODR
jt
RPT
jt
b
4
WC
jt1
b
5
RE
jt1
b
6
E=D
jt1
b
7
REV
jt1
b
8
EBIT
jt1
Rb
k
ID
kt
e
jt
Variable
Model 1 Model 2 Model 3
Coeff. t-stat. Coeff. t-stat. Coeff. t-stat.
LA_GODR 0.093*** (9.26) 0.069*** (5.95) 0.062*** (5.33)
RPT )0.015 ()0.33) )0.010 ()0.23) )0.007 ()0.18)
LA_GODR*RPT 0.200*** (3.92) 0.186*** (3.85) 0.172*** (3.53)
Legal )0.015* ()1.67)
LA_GODR*Legal )0.038* ()1.96)
Gov )0.010 ()1.11)
LA_GODR*Gov )0.006 ()0.30)
PC 0.010 (1.22) 0.010 (1.21)
LA_GODR*PC 0.091*** (5.45) 0.092*** (5.46)
B4 0.011 (0.53) 0.013 (0.59)
LA_GODR*B4 )0.134* ()1.86) )0.166** ()2.27)
WC )0.030*** ()2.63) )0.029*** ()2.73) )0.028*** ()2.66)
RE )0.031*** ()6.17) )0.032*** ()6.79) )0.032*** ()6.69)
E D )0.000 ()0.37) )0.001 ()0.45) )0.000 ()0.41)
REV )0.005 ()0.67) 0.001 (0.07) )0.000 ()0.00)
EBIT )0.091*** ()3.14) )0.093*** ()3.39) )0.096*** ()3.46)
Constant 0.033 (1.64) 0.039** (2.05) 0.035* (1.82)
Industry Controlled Controlled Controlled
Adj. R
2
0.632 0.677 0.669
N 423 423 423
Panel B: Regression results for the tests of the relationship between reported gains on debt restruc-
turing and the earnings management incentive. The Model 1 column reports the results for the base
model, and the Model 2 and Model 3 columns report those for the extended models by including
two proxies for province-level institutions (Legal and Gov), two proxies for rm-level corporate gov-
ernance (PC and B4), and their interactions with LA_GODR to the base model. The base model is
as follows:
GODR
jt
b
0
b
1
LA GODR
jt
b
2
RPT
jt
b
3
LA GODR
jt
RPT
jt
b
4
Z-SCORE
jt1
Rb
k
ID
kt
e
jt
Variable
Model 1 Model 2 Model 3
Coeff. t-stat. Coeff. t-stat. Coeff. t-stat.
LA_GODR 0.107*** (10.37) 0.085*** (6.99) 0.077*** (6.28)
RPT )0.017 ()0.36) )0.014 ()0.30) )0.011 ()0.25)
(The table is continued on the next page.)
558 Contemporary Accounting Research
CAR Vol. 29 No. 2 (Summer 2012)
securities for gains. We further nd the negative association between gains or losses on the
sale of AFS securities and fair-value changes in trading securities to be more pronounced
among rms with incentives to meet the zero earnings threshold. An additional test also
shows that rms have incentives to smooth the earnings volatility caused by FVA for trad-
ing securities. These results indicate that such earnings management and smoothing activi-
ties compromise the intended benet of FVA for this purpose.
Second, FVA for debt restructuring is intended to produce more transparent account-
ing information by recognizing the fair market value of exchanged nonnancial assets in
debt restructuring and including realized gains in earnings. However, such benets can be
realized only when the fair value of these assets is known or can be obtained through
arms length negotiation between the rm and its creditors, a condition that is frequently
violated in China, where information on the fair value of exchanged nonnancial assets is
often unavailable and rms and their creditors are often related. Our results demonstrate
TABLE 8 (Continued)
Variable
Model 1 Model 2 Model 3
Coeff. t-stat. Coeff. t-stat. Coeff. t-stat.
LA_GODR*RPT 0.221*** (4.05) 0.208*** (3.99) 0.192*** (3.66)
Legal )0.012 ()1.32)
LA_GODR*Legal )0.038* ()1.81)
Gov )0.007 ()0.73)
LA_GODR*Gov 0.007 (0.32)
PC 0.012 (1.35) 0.012 (1.34)
LA_GODR*PC 0.085*** (4.74) 0.086*** (4.71)
B4 )0.006 ()0.24) )0.005 ()0.20)
LA_GODR*B4 )0.150* ()1.92) )0.191** ()2.43)
Z-SCORE )0.013*** ()9.88) )0.013*** ()10.40) )0.013*** ()10.19)
Constant 0.059*** (2.81) 0.066*** (3.27) 0.060*** (2.96)
Industry Controlled Controlled Controlled
Adj. R
2
0.580 0.623 0.615
N 423 423 423
Notes:
Variable denitions: GODR is gains on debt restructuring deated by total assets; LA_GODR is loss
avoidance and equals 1 if the rms net income is positive but its net income excluding gains
on debt restructuring is negative, and 0 otherwise; RPT is the value of debt-related transac-
tions between the rm and its related parties deated by total assets; WC is working capital
deated by total assets; RE is retained earnings deated by total assets; E D is total market
value of equity deated by total debt; REV is sales deated by total assets; EBIT is earnings
before interest and taxes deated by total assets; Legal is an indicator that equals 1 if the rm
is located in a province with a legal environment index score in the top quintile of the sample,
and 0 otherwise; Gov is an indicator that equals 1 if the rm is located in a province with a
government involvement index score in the top quintile of the sample, and 0 otherwise; PC is
an indicator that equals 1 if the rms CEO or chairman of the board of directors is politically
connected, and 0 otherwise; B4 is an indicator that equals 1 if the rm employs a Big 4 audi-
tor, and 0 otherwise; Z-SCORE is calculated as 1.2*WC + 1.4*RE + 0.6*E D + 1.0*REV
+ 3.3*EBIT (Altman 1968); and ID is an industry indicator. *, **, and *** represent signi-
cance levels of 0.10, 0.05, and 0.01, respectively.
Fair Value Accounting in Emerging Markets 559
CAR Vol. 29 No. 2 (Summer 2012)
that this mismatch provides rms with opportunities to manage earnings by using gains
on debt restructuring to avoid reporting a loss. Finally, this study provides evidence to
show that FVA-induced earnings management activities are more pronounced among
rms operating in regions with weaker institutions (e.g., a poor legal environment and or
heavy government involvement in the economy) and those with weak corporate gover-
nance mechanisms (e.g., politically connected managers and nonBig 4 auditors).
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