1.

Introduction

When the Chinese stock market was re-established, the Chinese government instituted a system of market
segmentation, the aim of which was to ensure that the market would be able to support listings by a large
number of companies; it was intended that the system would also help to boost the share prices of listed
companies, thereby enabling them to raise more capital through the stock market. In the event, this system
prevented the stock market from achieving the stable, rapid growth that has characterized the Chinese
economy as a whole.1

On 29 April 2005, the China Securities Regulatory Commission (CSRC) promulgated

the Notice Relevant to Pilot Reform on the Segmented Shares Structure of Listed Companies as part of its
efforts to promote improved corporate governance and stronger capital
markets. The notice was intended to reduce the disparity in earnings between tradable and
non-tradable shares, ensuring that all of the shareholders in a given company had a
common interest. By improving corporate governance, the CSRC aimed to reduce the decision-making
cost accompanying major decisions; at the same time, it was expected that
reforming the equity structure of listed companies would facilitate the leveraging of the
stock markets for mergers and acquisitions (M&As) activity by high-growth companies,
thereby enhancing the overall quality of China’s listed companies and strengthening the
investing public’s confidence in the stock market.

During the 1990s, while stock market segmentation was in force, the Chinese government actively
promoted the stock listing of state-owned enterprises, in order to help these companies overcome their
financial difficulties. The quality of the assets held by stateowned enterprises was highly variable; so
many state-owned firms restructured themselves
and spun off their core assets in order to implement an initial public offering (IPO), while
leaving their non-core assets, debts, and surplus manpower in the residual state-owned
company. In this way, state-owned enterprises were able to improve their chances of a
successful stock market listing. The residual enterprises normally retained control of the
new, listed entity as the largest shareholder; however, having spun off their core assets, they
were often forced to rely on the listed entity for support. The listed entity could raise capital
through seasoned equity offerings (SEOs) and bank loans, and then re-lend the funds to its
parent company. Alternatively, the listed entity’s products might be sold to the parent
company at unreasonably low prices, or the listed entity might make payments to the parent
company for “consulting services” when in fact no services had been provided. In some
cases, the listed entity even provided collateral to help the parent company obtain bank
loans. The cost of these related party transactions, which hurt the market value of the listed
entity, was borne by the smaller shareholders holding tradable shares.2

Following the promulgation of the Provisional Rules Concerning Accounting for Sales
of Assets between Affiliated Parties in 2002, basic guidelines were established to regulate
related party transactions, and restrictions were imposed on “unfair” transactions. This
significantly reduced the scope for listed companies to engage in earnings manipulation; as
a result, 2002 saw a pronounced decline in “extraordinary” related party transactions
between listed companies and their major shareholders involving the purchase or sale of
assets, entrustment, leasing, etc. (Lu and Fan 2003). However, as a result of the common
practice of state-owned enterprises restructuring themselves to secure stock market listing,
and because of the special equity structure of listed companies, many listed companies were
in fact unable to operate independently. As a result, related party transactions continued to
occur, and various measures were adopted to get round the government’s regulatory efforts.
On 15 February 2006, the Chinese government issued a new set of Accounting Standards
for Business Enterprises, which came into effect in 2007; these new regulations have
brought about some degree of improvement in the area of related party transactions and
disclosure.

Related party transactions are a widespread, long-standing form of business activity that
can have positive effects. Where related party transactions are implemented appropriately,
listed companies can make use of them to reduce transaction costs and achieve more efficient asset
utilization (Zhuo and Hu 2001). However, the motivation for engaging in related
party transactions is not always a laudable one. As a result of the widespread use of fraudulent or unfair
related party transactions for earnings management purposes or to siphon off
the assets of listed companies (and in doing so sacrificing the rights of small shareholders),
the positive aspects of related party transactions are often overlooked. The existing literature
on related party transactions involving listed companies in China – such as the studies by
Jian and Wong (2004) and Aharony et al. (2005) – has tended to ignore the relationship
between related party transactions involving the sale or supply of goods and operational
performance, and how this relationship varies depending on ownership structure. The aim
of this paper is therefore to explore the impact of the various types of related party transactions on the
operational performance of Chinese listed companies, including the way in
which varying intensities of related party transactions and different ownership structures
affect this relationship. The remainder of this paper proceeds as follows. Section 2 describes
a review of the literature and establishes the testing hypotheses. Section 3 explains the
research design. Section 4 discusses the empirical results, and the conclusions drawn from
this study are presented in Section 5.

2. Review of the literature and development of hypotheses

Owing to the relatively strict requirements imposed by China’s stock exchanges with regard
to the criteria for maintaining listed company status, there is an incentive for listed companies to
undertake related party transactions for the purpose of earnings management, so as
to achieve their desired levels of operational performance. China’s enterprise groups in
particular tend to make extensive use of related party transactions for earnings management,
in order to achieve the level of return on equity (ROE) required to avoid de-listing or to
issue new shares (Jian and Wong 2004). Listed companies employ different types of related
party transactions to achieve different operational performance indicator goals; for example,
related party sales may be used to achieve a given level of return on sales (ROS). Cheng and
Chen (2006) analyze the impact of related party transactions on the operational performance
of listed companies that engage in seven types of related party transactions with their
controlling parent company, comparing operational performance prior to stock market listing with
operational performance after listing. Several studies have confirmed the use of
earnings management by large numbers of listed companies in order to achieve particular
levels of ROE (Chen and Yuan 2004, Liu and Lu 2007).

Besides the use of questionable earnings management methods to achieve operational

performance goals, related party transactions may also be used in a more acceptable manner
to reduce costs, as part of the vertical or horizontal integration within an enterprise group;
listed companies can employ this type of “strategic” related party transaction to achieve
performance goals by reducing transaction costs (Coase 1937, Khanna and Palepu 1997).
Regardless of whether a listed company uses related party transactions for earnings management purposes
or for strategic reasons, such transactions can help a company to boost its
operational performance.

Transactions involving the sales constitute a normal transaction for listed companies; the
revenue from such transactions will usually represent the company’s main source of operating revenue,
and provides the basis for the calculation of many operational performance
indicators. Sales transaction data are thus often used to manipulate reported earnings performance.
Khanna and Yafeh (2005) point out that enterprise groups can use the “adjustment”
of sales volume and price data for intra-group transactions to manipulate their reported earnings. Jian and
Wong (2004) explore the use of related party transactions for earnings management purposes among
listed companies in China. They note that, as related party transactions
need only be disclosed as footnotes to a company’s financial statements, rather than being
reported directly on the income statements, and because of issues relating to processing costs
and general awareness, which make it difficult for investors to distinguish between regular
and irregular related party transactions, enterprise groups have considerable opportunity for
engaging in related party transactions that are undertaken for questionable purposes (Bloomfield 2002).
At the same time, related party transactions between companies that form part
of the same vertically or horizontally integrated enterprise group generally take the form of
the purchase or sale of materials or products; intra-group transactions of this type can help
the group as a whole to maximize profits and improve its operational performance because
of the lower transaction costs. This paper therefore establishes the following two hypotheses:

The greater the extent of related party sale transactions undertaken by

listed
Hypothesis 1- Chinese companies, the better their operational performance.
1: The greater the extent of related party purchase transactions
undertaken by
listed Chinese companies, the better their operational performance.
Hypothesis 1-
2:

Many listed companies in China are firms that were created by the spinning off of core
assets from state-owned enterprises. As a result, in most cases the controlling shares in listed companies
are held by state-owned enterprises. Jian and Wong (2004) divided
Chinese listed companies into three broad categories according to their ownership structure
and the identity of the controlling shareholder: listed companies that are themselves stateowned
enterprises, listed companies where the controlling shareholder is a state-owned
enterprise, and other listed companies. The “others” category includes “traditional” companies, joint
ventures, non-profit enterprises and various other types of company that are not
state-owned. In their study, Jian and Wong suggested that, where the largest shareholder is
a state-owned enterprise, it is likely to use related party transactions to boost the return on
assets (ROA). Related party transactions are one of the most common methods of transferring assets from
one company to another. Listed companies in China generally maintain
close ties with the state-owned enterprise from which they were spun off, and the use of
related party transactions to transfer assets from the listed company to its state-owned parent
company is widespread. Aharony et al. (2005) indicate that the parent companies of Chinese
listed companies often seek to manipulate the listed company’s surplus at the time of its IPO
and then, following the IPO, use related party transactions to transfer the listed company’s
resources to the parent company.

Many previous studies have noted that, where a controlling shareholder uses related
party transactions to siphon off a company’s resources, this has a negative impact on corporate value.
Important past research in this area includes research on the expropriation of
minority shareholders (La Porta et al. 2000), the use of cross-shareholdings to strengthen
control over the target company and exploit other shareholders (Claessens and Fan 2002),
the existence of a negative correlation between abnormal return and the size of the controlling
shareholder’s holding in a listed company (Cheung et al. 2006), and the pronounced
difference in performance between companies with highly concentrated ownership and
those with less concentrated ownership (Chen and Chien 2007). All of these studies show a
negative correlation between the level of control and corporate value. In this study,
therefore, the following hypothesis is formulated:

Hypothesis 2: Chinese listed companies that are controlled by another company will
display a higher level of related party transactions and worse operational
performance.