Many will be familiar with points touched on in this paper. It may be the first though to take a comparative approach of norms in the U.S. and compare those habits, point by point, with what happens in China today*.
[*Actually the China surveys were conducted in 2017 and 2020 but little will have changed since].
Researchers Hai Lu, Jee-Sun Shin and Mingyue Zhang of the Toronto and Waterloo Universities in Canada found four important differences between Chinese and established U.S. (i.e. Western) practices:
- Chinese firms prefer to emphasize predictive rather than verifiable earnings attributes to signal to investors firm performance
- Chinese firms like to smooth earnings. In doing this they don’t believe this is the same as ‘earnings management’
- Chinese firms don’t see public disclosure as a way of reducing the cost of firms capital. Which is not to say they recoil from the practice
- Chinese firms show no bias, unlike U.S. peers, towards conservative reporting. Bad news comes out at the same frequency as the good
Having established the biases the paper goes on to discuss what’s behind the different approach. I counted seven main points:
- China is a land of ‘stakeholder’ rather than ‘shareholder’ ownership. Companies are beholden to a complicated network unlike in the U.S.
- The smoothing of earnings is a peacock’s-tail display to the many stakeholders that the company is well connected
- Good and bad news can be treated equally as there are less litigious consequences in China for companies reporting bad news
- Not only are Chinese firms beholden to stakeholders many of those are interconnected so inside information circulates in that system
- The dominance of retail investors in the public markets leads to weak governance pressure from this group
- Nearly all Chinese companies have highly concentrated ownership structures. This further mitigates outside governance pressure
- China’s weak legal system means most company managers don’t have to consider legal liability for their actions, unlike in the U.S.
For those new to China this paper is a good primer. For more experienced investors, frustrated by some of these practices, it sheds light on why many will likely persist.
The full read can be enjoyed via this link Financial Reporting in China.
Happy Sunday.