Corporate payout and : Evidence from Chinese regulatory changes

Edward Lee

Manchester and Finance Group, Manchester Business School, UK

Martin Walker*

Manchester Accounting and Finance Group, Manchester Business School, UK

Jessie Y. Zhu

Manchester Accounting and Finance Group, Manchester Business School, UK Abstract

This paper examines the market reaction to and earnings management choices around changes in the regulations requiring a higher minimum dividend payout in China. We find that the market reaction is more positive for firms that paid less than the new required minimum payout than for those that paid more than the new required minimum, consistent with agency explanations of dividend payout. In addition, we find that low dividend payers exhibit a greater tendency to manage their earnings downwards to comply with the earnings-based threshold, and investors can “see through” such earnings management behaviors.

Keywords: agency ; dividend payout policy regulation; event study; earnings management; Chinese stock market

*Corresponding author: Manchester Accounting and Finance Group, Manchester Business School, Room 6.21 Harold Hankins Building, Booth Street West, Manchester M13 9QH, United Kingdom. E-mail: [email protected]

2 1. Introduction

During the last decade, the Chinese government has mandated increasingly strict levels of minimum dividend payout as a proportion of reported earnings aimed at protecting shareholders. We exploit this setting to shed new light on the determinants of corporate payout policy.

Miller and Modigliani (1961) argue that dividend payout will be irrelevant to firm value under the assumptions of frictionless markets and fixed investment policy. More recently DeAngelo and DeAngelo (2006) point out that the Miller and Modigliani (1961) assumptions automatically imply a dividend policy of full distribution. A number of studies move beyond MM’s analysis by relaxing the assumption that investment policy is fixed and allowing free flow retention.

DeAngelo, DeAngelo and Skinner (2009) (DDS hereafter) organize their survey of corporate payout policy around an asymmetric information-based theoretical framework that moves beyond MM (1961) to determine optimal payout policy. They conclude that this simple asymmetric information framework does a good job of explaining the main features of observed payout policies, while other explanations (e.g. managerial signaling motives) have at best minor influences on payout policy. Despite the theoretical importance of DDS’s arguments, it is difficult for researchers to find a setting that provides direct evidence for DDS’s conclusions. In this paper, we exploit a unique institutional setting with exogenous shocks that, we argue, permits more direct inferences than previous research.

Our setting differentiates itself in two respects from previous studies. First, although the agency cost and the signaling theories of are distinct, they both predict a positive market response to dividend surprises. Because of the similarity of their predictions, it is difficult to distinguish the two explanations in determining dividend payout policy by studying regular dividend payout announcements. An

3 important advantage of the setting of this paper is that the results are much less likely to be contaminated by the signaling effect. By observing the market reaction to regulatory dividend policy changes, we are capturing investors’ reactions to the mandatory dividend shocks that alleviate perceived agency costs, rather than the dividend surprises used as signals to convey information to outside investors by firms voluntarily. In other words, any abnormal returns found during the exogenous regulatory events we study are more likely to be attributable to agency cost alone rather than being confused with a signaling effect.

Second, although China is not the only country where dividend payout policy is regulated, our setting is unique for offering a series of changes to the minimum payout requirement on dividend payout policy. For the last decade or so, the China Security

Regulatory Commission (CSRC) has sought to encourage listed companies to establish long-term payout policies with a view to promoting dividend payout in response to media and public criticism of the poor dividend payout records of many Chinese listed firms. Such regulatory changes are consistent with the view of La Porta et al. (2000) that in countries with poor legal enforcement and investor protection, it is important to use dividend payout as a device to curb the overinvestment agency problem. In contrast, many other countries have upper bound constraints on distributions, behind which the goal of protecting debt-holders is the key driving force. Moreover, other countries introduced minimum dividend payout constraints into their corporate laws before the establishment of stock markets, so it is not possible to observe how the stock market reacted to these new laws1. Thus, a novel feature of our setting is that China established its main stock markets before introducing its minimum dividend payout regulations.

To sum up, the primary motivation of our study is that China’s regulatory dividend policy changes provide a unique setting that facilitates identification of the

1 This is discussed in detail in Section 2.3

4 overinvestment agency cost effect in determining dividend policy, where the signaling role is largely isolated and has no effect on the events. Such a setting is rarely seen in

Western developed markets that have different regulatory approaches.

Given the aforementioned arguments and DDS’s conclusion in favor of agency cost theory, we first predict that the market reaction to regulatory changes requiring a higher minimum dividend payout is more positive for firms that paid less than the new required minimum payout than for those that paid more than required minimum dividend payout. This is because of a potentially greater reduction in agency costs among low dividend payers where managerial discretion or expropriation are believed to be more severe in the view of Jensen (1986), Stulz (1990) and La Porta et al. (2000).

Second, since the required dividend payout is based on reported earnings, we are able to examine whether firms manage earnings (most likely) downward in order to comply with the minimum payout regulation. This links our paper to the literature on dividend-based earnings management (Kasanen et al., 1996; Daniel et al., 2008; Atieh and Hussain, 2012). In contrast to previous studies of Western capital markets where managers manipulate earnings upwards to justify dividend payouts, because of the upper bound constraint on the earnings-based dividends in the debt covenants, our setting leads to managers’ incentives to manage earnings downwards to minimize the regulatory payout. Therefore, we expect that firms that pay dividends lower than the required minimum payout will use downwards earnings management in order to meet the dividend threshold.

Third, we test how the market reacts to firms’ earnings management behaviors. On the one hand, we examine whether investors can “see through” earnings management for regulatory purposes and differentiate the quality of earnings in market reactions. On the other hand, we use the magnitude of earnings management as an indicator of the extent of agency problems. By examining the differential market reactions towards

5 firms with different degrees of earnings management, we are able to provide further evidence of whether the market reacts more favorably to firms where higher agency costs can potentially be reduced through restricted payout regulations.

Fourth, it is generally more reasonable for growth firms to pay lower dividends relative to mature firms, in order to invest in positive NPV2 projects. In the light of this, we test whether the market reaction and the firms’ earnings management choices reflect the firms’ life cycle. In particular, we expect investors to react more favorably to the regulatory changes for mature firms whose earnings management resulted (more likely) from agency problems, than for growth firms who may defer dividend payout in order to invest in attractive investment opportunities.

We employ event study methodology to investigate the market reactions. We use estimates of firm-year discretionary accruals to detect the earnings management responses of firms to the new regulations. Our findings are as follows. First, the overall mean abnormal returns for an eleven-day window centered on the announcement of the regulatory change show a significant difference between firms that paid higher and lower dividends than the minimum payout requirement. In particular, we find a significantly positive market reaction to the announcement of new minimum dividend payout regulations among firms that paid dividends less than the minimum payout requirement. In other words, the investors of these firms responded more favorably to the payout regulation than investors of firms that paid more than the required minimum payout who tended to be less affected by the regulation. Second, we show that firms that paid dividends lower than the minimum payout requirement managed earnings downwards to meet the threshold of the regulations based on reported earnings in order to avoid a potential regulatory penalty. Third, among firms that paid dividends lower than the required minimum payout, the positive market reactions were more pronounced

2 Net present value

6 for those that managed earnings more. This provides further evidence on investors’ perceptions of more severe agency problems among these firms, and investors’ favorable reactions to the likelihood of reduced agency cost following the issue of dividend regulations. Fourth, investors react more favorably to the mandatory dividend payouts regulations among mature firms that have a greater magnitude of downward earnings management and higher perceived agency costs. This suggests that investors can see through the earnings management behaviors and take into the firm’s lifecycle in interpreting its response to the dividend regulations.

Our results have the following implications. First, previous research on the determinants of dividend payout policy is indirect and inconclusive, due to serious inherent research design problems. By exploring a series of Chinese regulatory changes that explicitly identify the agency cost effect, we provide direct evidence of DDS’s conclusions that support the view that agency cost considerations are a first order determinant of dividend payout policy. Second, we contribute to the literature on earnings management behavior around regulatory events (Teoh et al., 1998; DuCharme et al., 2004). In particular, we extend the literature on the effects of dividend thresholds on earnings management (Kasanen et al., 1996; Daniel et al., 2008; Atieh and Hussain,

2012) by showing that firms manage earnings downwards in response to regulatory minimum payout requirements (versus previous studies of upward earnings management).

The remainder of this paper proceeds as follows. Section 2 discusses the theoretical and empirical literature, institutional background, and the regulatory events of interest.

Section 3 develops the hypotheses. Section 4 presents the research design. Section 5 reports data and summary statistics. Section 6 shows the empirical evidence. Section 7 concludes.

7 2. Literature, institutional background and regulatory changes

2.1. Theoretical and empirical literature on corporate payout policy

MM’s irrelevance theorems form the foundation of modern corporate finance theory.

With assumptions of frictionless markets and fixed investment policy, the optimal dividend policy of full distribution occurs by assumption (DeAngelo and DeAngelo,

2006). Subsequent studies move beyond MM’s analysis by relaxing the assumption that investment policy is fixed and allowing free retention. When retention is allowed, payout policy matters and investment policy is no longer the sole determinant of firm value. In other words, payout policy has first-order value consequences in the same way as investment policy (DeAngelo and DeAngelo, 2006).

DDS (2009) organize their survey of corporate payout policy around an asymmetric information-based theoretical framework that moves beyond MM (1961) to determine optimal payout policy. They argue that the payout/retention decision involves a trade-off between the adverse selection problems in Myers and Majluf (1984), which encourage retention as insider managers have an information advantage over external investors, versus the agency costs of free cash flow (FCF) in Jensen (1986), which encourage payouts to avoid over-retention and managerial opportunistic behaviors. Both problems result from information asymmetry between insider-managers and outside stockholders with regard to the firm’s earnings and investment opportunities.

Prior studies show that dividend payout plays a role in reducing the agency costs of managerial discretion and in limiting misallocation of capital (Stulz 1990; La Porta et al.

2000; Faccio et al. 2001). In particular, Stulz (1990) indicates that given management’s information advantage, managerial discretion leads to misallocation of capital (e.g. investing in negative NPV projects instead of paying dividends) when managers pursue their own objectives. Thus dividend payouts can be used to restrict such managerial discretion and reduce the costs of over-investment. Faccio et al. (2001) provide

8 evidence on the role of dividends in protecting outside shareholders from expropriation by controlling shareholders. In an international study of 33 countries, La Porta et al.

(2000) find that higher dividends are paid in countries with stronger legal protection of minority shareholders. This suggests that poor legal protection leads to misallocation of investment, which becomes part of the agency cost.

In addition to mitigating agency costs, dividends may convey information about future earnings to relatively uninformed outside investors. Numerous theoretical

(Bhattacharya, 1979; John and Williams, 1985; Miller and Rock, 1985) and empirical studies (Aharony and Swary, 1980; Asquith and Mullins, 1983; Yoon and Starks, 1995;

Nissim and Ziv, 2001) have shown that dividends have positive implications attributable to signaling effects.

DDS (2009) argues that if signaling motives are pervasive then the wrong firms are doing the signaling. Prior studies (DeAngelo et al. 2004; Denis and Osobov 2008) show that most payouts are made by established firms that can communicate with investors more easily and directly without the need for costly signaling by dividends, rather than the young firms that pay few or no dividends, but who have real motives for dividend signaling. The higher payouts of mature firms are more plausibly explained by the observation that such firms generate substantial FCF so that distribution rather than reinvestment maximizes investor welfare, while growth firms’ investment opportunities make retention an optimal financing decision. Therefore, DDS (2009) conclude that their asymmetric information framework does a good job of explaining the main features of observed payout policies, while managerial signaling motives have an at best minor influence on payout policy. However, in order to directly test DDS’s arguments, it is important to separate the agency effect from other effects. The current paper provides an opportunity to do this.

The agency cost and the signaling theories of dividends are distinct, but they both

9 predict a positive market response to dividend surprises. Because of the similarity of their predictions, it is difficult to distinguish the two explanations for dividend payout using a regular dividend announcement setting. In this respect the existing literature has provided indirect or inconclusive evidence. In particular, some literature finds evidence in favor of signaling. Aharony and Swary (1980) and Asquith and Mullins (1983) model the information content of dividends by examining capital market reactions to dividend initiations and dividend surprises. Yoon and Starks (1995) examine the association between dividend changes and future investments, i.e. the direct sources of wealth effects. They find that dividend changes are positively associated with future , which is more consistent with the implications of the signaling than the free cash flow hypothesis in which the dividend changes have a negative effect on future investments. Nissim and Ziv (2001) investigate the relation between dividend changes and future profitability and find that dividend changes provide information about the level of profitability in subsequent years, incremental to market and accounting data. Thus, they believe that they provide evidence in support of the dividend signaling hypothesis. However, Nissin and Ziv’s conclusion in favor of the signaling effect has been questioned. Specifically, Grullon et al. (2005) point out that

Nissim and Ziv’s (2001) assumption of linear mean reversion in earnings is inappropriate. They argue “since assuming linearity when the true functional form is nonlinear has the same consequences as leaving out relevant independent variables, it is possible that the positive correlation documented in Nissim and Ziv (2001) between dividend changes and future earnings changes is spurious” (p. 1661).

On the other hand, some literature is more supportive of agency cost based explanations of dividends. Lang and Litzenberger (1989) show higher market reactions to dividend surprises for overinvesting firms, whose agency problem are supposedly higher, than value maximizers. In addition, they find no significant relation between

10 dividend changes and analysts’ forecast revisions, which they interpret as inconsistent with the dividend signaling hypothesis. Their findings are suggestive but not conclusive, because their research design relies heavily on an untestable assumption that uses

Tobin’s Q to identify overinvestment firms so that an identification problem cannot be avoided. More recently, some studies provide suggestive evidence in distinguishing the two alternative explanations of the determinants of corporate payout policy. DeAngelo et al. (2000, 2004) provide evidence that casts doubt on the importance of signaling motivations in explaining dividend policy in general. Specifically, DeAngelo et al.

(2000) document the disappearance of special dividends, which have historically been viewed as a signaling device. Moreover, they find that the recent emergence of common stock repurchases, the most plausible candidate for a signaling innovation, shows little evidence of connection with the disappearance of special dividends. Their findings are inconsistent with the view that particular dividend signals serve an economically important function. By showing that dividends in the US are increasingly concentrated among a small number of large payers, who arguably have a lower need to communicate with stockholders using dividend signaling, DeAngelo et al. (2004) raise doubts about signaling as a first-order determinant of dividend policy. Similar to DeAngelo et al.

(2004), Denis and Osobov (2008) provide international evidence on the determinants of dividend policy. They find a trend towards dividend concentration among larger firms for several developed financial markets, in which firms ideal for dividend signaling are precisely the firms that do not pay dividends, casting doubt on the signaling explanation for dividends. They interpret their evidence as being consistent with the agency cost-based lifecycle theory of dividend policy (DeAngelo, 2006), where firms trade off flotation cost savings against the agency costs of cash retention. Accordingly, the distribution of free cash flow is the primary determinant of dividend policy. However whilst DeAngelo et al. (2000, 2004) and Denis and Osobov (2008) cast doubt on

11 signaling explanations, their evidence is not conclusive because their research design is descriptive analysis and merely suggestive.

To sum up, previous literature on the determinants of corporate payout policy provides mixed and inconclusive results. The debate over the competing explanations for dividends is still ongoing, which calls for evidence that is more direct. In particular, the previous findings are weakened by identification and endogeneity problems. A key feature of this study is that we are able to exploit a research setting with exogenous shocks that cannot be attributable to signaling effect, thus providing more direct evidence on the determinants of dividend payouts.

2.2. Research on earnings management and dividend payouts

The literature on earnings management is well established. The previous literature defines earnings management as:

Purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain (Schipper 1989).

Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers (Healy and

Wahlen 1999).

The use of managerial discretion over (within GAAP) accounting choices, earnings reporting choices, and real economic decisions to influence how underlying economic events are reflected in one or more measures of earnings (Walker 2013).

The empirical literature has identified three principal sets of motives that influence the earnings management choices of firms (Walker 2013). In particular, there are contracting motives, capital market motives, and third-party motives for earnings

12 management (Watts and Zimmerman, 1986; Healy, 1985; Defond and Jiambalvo, 1994;

Teoh et al., 1998; Jones, 1991; DuCharme et al., 2004; Boynton et al., 1992; Cohen et al., 2008).3

The first set of motives, the contracting motives, are to achieve contractual terms or targets that are based on reported earnings (e.g. compensation schemes and debt covenants). In particular, the debt-covenant hypothesis argues that management manages earnings upwards to avoid violating debt covenants. Executive compensation contracts based on earnings performance clearly provide incentives for managers to manage earnings in their favor.

The second set of motives, the capital market motives, refers to the incentives to benefit from favorable valuation in the capital markets. In particular, there is evidence that earnings management is used to positively influence the share price prior to capital raising events (e.g. IPOs and refinancing events), or to steer the market’s expectation of future earnings thus influencing the stock price.

Studies of the capital market motives for earnings management vary according to the assumptions they make about investor rationality. Some studies assume that investors are misled by earnings management, others assume that investors are able to see through it.

Some studies assume that sophisticated investors are able to see through it, but a significant class of unsophisticated (retail) investors can be fooled by it. Previous studies seem to provide inconclusive evidence over this issue. One the one hand,

Rangan (1998) and Teoh et al. (1998) hypothesize that investors fail to recognize earnings management at the time of offerings and are misled to overpay the share prices. On the other hand, Shivakumar (2000) argues that “earnings management before equity offerings is not intended to mislead investors, but is instead the issuers’ rational

3 Refer to Walker (2013) for a recent review.

13 response to anticipated market behavior at offering announcements. Since issuers cannot credibly signal the absence of earnings management, investors treat all firms announcing an offering as having overstated prior earnings, and consequently discount their stock prices. Anticipating such market behavior, issuers rationally overstate earnings prior to offering announcements, at least to the extent expected by the market.

Earnings management by issuers and the resulting discounting by investors is a unique

Nash equilibrium in a prisoner’s dilemma game between issuers and investors. I refer to this argument for earnings management as the ‘Managerial Response’ hypothesis.” (pp.

340)

The third set of motives, the third parties motives, potentially include all stakeholders apart from investors, such as employees, customers, suppliers, tax authorities, regulators, and rival firms. The third party motives can lead to both upward or downward earnings management depending on the context. For example, highly unionized firms may manage earnings downwards to facilitate wage negotiations.

Concerns about being the target for special profit taxes by politicians may also lead to downward earnings management. If suppliers are concerned about the liabilities of the firms, this may lead to upward earnings management.

There are previous studies that link dividend payouts to earnings management.

Kasanen et al. (1996) use Finnish listed firms and show that dividends are an important determinant of earnings management. Featured as a debt-dominated capital market with concentrated ownership in the sample period of 1970-89, the Finnish market creates incentives for a stable stream of dividends to their powerful institutional owners. Therefore, firms manage earnings upwards if unmanaged earnings are lower than the prior year’s dividend payouts in order to satisfy the institutional investors. In addition, as the tax rate is high and taxable income is tied to reported earnings, firms manage earnings downwards when the unmanaged earnings are higher than the prior

14 year’s dividend payouts in order to reduce taxes. To sum up, their study provides early evidence of dividend-based earnings management.

Some dividend-related earnings management studies are attributable to the contracting motive for earnings management. For example, Daniel et al. (2008) study the relation between earnings management behavior and dividend restrictions in bond covenants. They find that firms manage earnings upwards to meet dividend expectations

(predicted as prior year’s dividend) when pre-managed earnings would show a deficit relative to the expectation. Their findings indicate that firms respond to the earnings management motive driven by the debt covenants, which restrict maximum cash distributions based on current earnings. Following Daniel et al. (2008), Atieh and

Hussain (2012) examine this issue within the UK context and find that UK dividend-paying firms are more likely to manage earnings upwards to cater for the dividend preferences of UK institutional investors, in cases where pre-managed earnings would fall below the expected dividend in order to achieve dividend thresholds, than non-dividend paying firms aiming to avoid reporting losses.

Nevertheless, as Daniel et al. (2008) has pointed out, these findings provide indicative rather than conclusive evidence of earnings management behavior in relation to dividend restrictions. Within our Chinese regulatory setting, the dividend thresholds are not empirically assumed or predicted as in previous studies. Instead, the Chinese dividend policy regulations directly restrict the dividend threshold and state the disapproval of rights issue application as the penalty.

In addition, prior research on third party motives assumes that management makes decisions in the interest of shareholders at the expense of the third parties. Our study explores an unusual third party motive in which managers, to circumvent regulations, act against the interest of shareholders to avoid higher dividend payout.

Therefore, we argue that our setting is able to provide direct and conclusive

15 evidence for earnings management behavior in relation to dividend restrictions, and extends the literature by showing the other side of the story in which specific firms have an incentive to manage earnings in the opposite direction to the existing literature, i.e. downward earnings management.

2.3. Earnings management in China

Prior literature on earnings management behavior in China explores stock market motives of initial public offerings (Aharony et al., 2000) and rights issues (Chen and

Yuan, 2004; Haw et al., 2005; Yu et al., 2006), and third-party motives such as taxation

(Tang and Firth, 2011) and regulations (Jiang and Wang, 2008).

In particular, Aharony et al. (2000) find upward earnings management using accounting accruals around IPOs among Chinese state-owned enterprises. Chen and

Yuan (2004), Haw et al. (2005) and Yu et al. (2006) show that Chinese listed firms manage earnings upwards to meet a minimum regulatory requirement on return on equity (ROE) prior to rights issues. Chen and Yuan (2004) find evidence of earnings management using excess non-operating income, such as profits from the sale of fixed or investments that have been shown to be tools of earnings management, for the period 1996 to 1998 when listed firms were required to achieve a minimum ROE of 10 percent in each of the three years prior to a rights issue application. Specifically, they compare a “marginal group”, with after-tax operating ROE below the threshold, with a

“regular group”, with after-tax operating ROE equal to or above the threshold, to examine the use of excess non-operating income in meeting the ROE threshold. Haw et al. (2005) find that managers manipulate non-operating items and use income-increasing accruals for upward earnings management in response to the regulatory threshold in the period 1996-1998. In particular, they compare the experimental firms that just meet or beat the regulatory threshold with the control group

16 matched by industry and market-to-book ratio. Using the distribution methodology of

Burgstahler and Dichev (1997), Yu et al. (2006) find that the ROEs of Chinese firms exhibit a suspicious jump around the ROE regulation threshold. Jiang and Wang (2008) show that Chinese listed firms engage in earnings manipulation to avoid the earnings-based delisting requirements4.

Our study adds to the literature on earnings management in response to security regulations in China (Chen and Yuan, 2004; Haw et al., 2005; Yu et al., 2006; Jiang and

Wang, 2008) by focusing on regulatory changes that directly affect dividend payout policy. In contrast to prior research in China that focuses on upwards earnings management, we focus on a specific context where downwards earnings management is predicted.

2.4. Institutional background and the evolution of CSRC regulations on dividend minimum payouts in China

The Chinese stock markets were established in the early 1990s. The reason for their establishment was to raise equity capital for SOEs to facilitate the privatization reform. The government did not give up all its shares in the SOEs and still retained substantial control over a large proportion of the newly listed SOEs. Thus the Chinese government remained influential in most aspects of the economy, in contrast with the experiences of other transitional economies, e.g. Russia and Eastern Europe (Sun and

Tong, 2003; Fan et al., 2007).

Authorized by the State Council, the CSRC is designated as the regulator of securities activities to protect investors’ interests. Given the uniqueness of the reform path of China, the CSRC sets and enforces various rules and regulations that incorporate

4 The regulation is that listed firms reporting two consecutive annual losses are subject to special treatment (ST), and any further losses result in suspension of trading or even delisting.

17 the experience of Western countries whilst making allowance for the unique institutional features of China.

Whilst China overtook Japan as the world’s second-largest stock market economy by value in 2009, it remains the case that minority shareholders in China have relatively weak legal protection against expropriation (Allen et al., 2005; Jiang et al., 2010). In the light of this, the CSRC has shown increasing willingness to strengthen regulations for the protection of minority shareholders. The Chinese government recognizes that one of the ways of limiting managerial discretion and expropriation is to distribute dividends to shareholders.

Concerns about dividend payout policy started to surface in the CSRC around

2000/2001. These concerns appear to have emerged in response to public criticisms in the media of the low payouts of listed Chinese firms. Statistical evidence of low payouts in China prior to 2000 supports the public criticisms. For example, Allen et al. (2005) find that the dividend payout ratios of Chinese firms were low compared to their counterparts in countries with stronger investor protection during the 1992-2000 period.

Since 2001, the Chinese government has made a number of regulatory changes that impose increasingly demanding levels of minimum dividend payout on Chinese listed firms. These new rules applied for all firms listed on Chinese stock markets. Although

China is not the only country where dividend payout policy is regulated, this setting differentiates itself from other studies by offering a series of increasingly tighter regulations introduced into an economy with a large number of listed companies.

Some countries have legal upper bound constraints on distributions, for which the goal of protecting debt-holders is the key motivation (Leuz et al., 1998). In contrast, very few countries have minimum dividend payout policies as in China5. In addition,

5 For example, Greek corporate laws 2190/1920 and 148/1967 specifically designate the minimum amount for distribution based on the after-tax profits. In Germany, there also appears to be a minimum dividend requirement, although it can be waived at the discretion of management (La Porta et al., 2000). Specifically, the prior German 18 these few countries introduced their minimum dividend payout constraints into their corporate laws before the establishment of their stock markets, so it was not possible to test for a market response to the introduction of these laws. Thus, a novel feature of our setting is that China established its stock markets before introducing its minimum dividend payout regulations.

The rights issue is the primary source of refinancing for Chinese listed firms (Chen et al., 2008). After an initial public offering (IPO), the firms in China have limited ways to raise additional capital. In particular, the bond market in China is underdeveloped

(Allen et al., 2005; Ayyagari et al., 2010), lagging far behind the development of

Chinese stock markets. This is partly because of excessive government regulations, and the lack of institutional investors and credit rating agencies that provide pricing services.

As a result, the rights issue stands as the primary source of additional capital for

Chinese listed firms after the IPO. This creates strong incentives for managers to ensure their firms are eligible to make rights issues which require the approval of the CSRC. In particular, prior studies (Chen and Yuan, 2004; Haw et al., 2005; Yu et al., 2006) have examined how the regulatory requirement on return on equity (ROE)6 induces earnings management among listed firms to qualify for a rights issue.

To be eligible for a rights issue, a listed firm has to meet a set of regulatory requirements of the CSRC.7 In the rest of this section, we briefly review the evolution of CSRC regulations on dividend minimum payouts as part of the regulatory requirement for a rights issue illustrated in Figure 1.

Insolvency Law imposed a 35% minimum dividend requirement; the new law has no minimum dividend requirement. Therefore, La Porta et al. (2000) do not count Germany as a mandatory-dividend country. Countries classified as mandatory dividend countries in La Porta et al. (2000) include Brazil, Chile, Colombia, Greece, and Venezuela.

6 China’s listed firms need to meet the regulatory requirement on return on equity (ROE) for rights issues. In particular, the ROE threshold is minimum 10% for the period 1994-1998, 10% and 6% for the period 1999-2000, and 6% for the period 2001-2002.

7 Please see http://www.csrc.gov.cn/pub/csrc_en/ of the English version of these decrees and announcements

19 [Insert Figure 1]

First, on 28 March 2001 (Wednesday) the CSRC released and immediately implemented the “Administration Measures on New Equity Issuance by Listed

Companies” (CSRC Decree No. 01). It stated that the underwriters of the refinancing should look unfavorably on firms who failed to pay a dividend in the past three years and whose board of directors provided no justification for that. This was the first time that the CSRC formally attempted to regulate dividend payout policies for listed firms seeking new equity. Nevertheless, the CSRC did not specify the required dividend patterns in the , i.e. cash dividend or stock dividend, and the regulation was practically not restrictive as the dividend payout was not mandatory as long as the firms’ boards of directors provided justifications for the failure of paying dividends. Therefore, it seems that this event may have indicated the CSRC’s awareness of the low payout problem, and may have acted just as a signal that dividend payouts may be more strictly regulated in the future. Thus, we do not expect this regulation to have a substantial effect as it could be easily manipulated by providing plausible explanations for zero dividend payout.

Second, on 7 December 2004 (Tuesday) the CSRC released and immediately implemented the “Provisions on Strengthening the Protection of Rights and Interests of

Public Shareholders” (CSRC Issue No. 118, 2004). In addressing the profit distribution provision, the government showed their concern about the payout problem and urged firms to pay attention to dividend payouts. In particular, it specified a preference for cash dividends in the provision and stated that company refinancing (i.e. SEOs, convertible bonds, and rights offerings) would not be approved if cash dividends were not paid in the three years prior to the application. This is a more restrictive and better clarified regulation compared with the 2001 one. Therefore, we expect the second event

20 to have a substantial effect on firms’ dividend payout policies and a significant effect on the stock markets.

The draft exposure of the third regulation “Administration Measures on New

Securities Issuance by Listed Companies” (CSRC Decree No. 30) was released on 16

April 2006 (Sunday, thus the event day is set on 17 April 2006), making the market aware of the main content of the forthcoming regulation. In this regulation, the CSRC further stated that the firms intending to issue new securities should comply with the policy that their distributed dividends (either cash or stock dividend) cumulated over the three years prior to the application should be higher than 20% of the average realized annual distributable profits of the three years8. We think that the market would also react to the information released from the draft exposure, so we define it as an event as well.

The Decree No. 30 was formally announced on 6 May 2006 (Saturday) and implemented on 8 May (Monday) 2006. This is a stricter regulation than the 2004 one, because it provides an explicit threshold for the dividend payout for the first time. As the threshold is based on firms’ reported earnings, the regulation is even more practically restrictive than the previous two regulations. Therefore, we expect that the third event would materially constrain the payout policies of firms. We would expect investors to respond to this new regulation, especially investors in low dividend payout firms.

Similar to the third regulation, on 22 August (Friday) 2008 the CSRC announced the draft exposure of the fourth regulation “Notice on Amendment in Regulations for

Listed Companies’ Cash Dividend” (CSRC Decree No. 57) before the formal announcement. We define this draft exposure of the forthcoming regulation as an event and investigate the market reaction to this earlier release. The Decree No. 57 was

8 This is a 3-year moving average retained earnings.

21 formally announced and immediately implemented on 9 October (Thursday) 2008.9

The aim of this regulation was to further urge listed firms to distribute cash dividends to shareholders. It amends the third regulation by requiring firms that intend to issue new securities comply with a policy that their cumulative distributed cash dividends over the three years prior to the application should be higher than 30% of the average realized annual distributable profits of the three years. This makes two minor changes compared with the 2006 one. First, it clarifies the regulatory dividend payout preference for cash dividends. Second, it increases the threshold from 20% to 30% of the average realized annual distributable profits of the three years prior to the application. As most dividends of Chinese listed firms are paid in cash, we believe that the first amendment is just a clarification to suggest CSRC’s concentration on distributing cash as a device to protect shareholders’ rights. In addition, the increase in threshold is probably not high enough to impact firms’ dividend payout behavior. Therefore, we expect the fourth regulation to have had limited impact on the capital market.

To sum up, given the importance of rights issues in refinancing, the CSRC set dividend payouts as one of the prerequisites of rights issue to guide firms’ dividend payout policies. A failure to meet the dividend payout requirement would lead to the rejection of a rights issue application. In particular, we have a series of four regulations and six announcement events, including the draft exposures.

3. Hypotheses development

We formulate our testable hypotheses by relating the regulatory developments outlined above to the theoretical literature on payout policy.

First, we compare the difference in market reactions between firms that had dividends higher or lower than the new required minimum payout. An important

9 See Appendix A for a detailed document of this decree.

22 advantage of our setting is that the results are most unlikely to be contaminated by a signaling effect. By observing the market reactions to regulatory dividend policy changes, we are capturing investors’ reactions to an exogenous dividend shock, rather than a dividend surprise used as a signal to convey information to outside investors by the firm voluntarily. Prior research indicates that the investors appreciate regulatory changes designed to improve minority-shareholder protection and react positively in

Chinese stock markets (Berkman et al., 2011). Thus, in comparing the difference in market reactions, we are able to capture the incremental effect of mandatory dividend payouts regulations among firms that paid dividends lower than the required minimum, whose agency problems of managerial discretion or expropriation are believed to be more severe in the view of Jensen (1986), Stulz (1990) and La Porta et al. (2000), than firms that already paid higher than the required minimum. In other words, if we find that the market reactions to the regulatory dividend payout changes are indeed more positive for firms that paid less than the new required minimum payout where higher agency costs can potentially be alleviated than firms that already paid higher than the required minimum, then this would provide evidence for agency costs being an important determinant of dividend payout. On the other hand, as firms that already reached the threshold are less affected by the regulatory change, we expect little positive market reaction for these firms from the perspective of agency cost theory. Moreover, we expect that investors would even respond negatively among firms that paid higher than the new required minimum payout for fear that the fulfilling of the regulatory requirement may lower these firms’ motive for further dividend payout.

Given these arguments, we hypothesize that:

H1: The market reaction to regulatory changes requiring a higher minimum dividend payout is more positive for firms that paid less than the new required minimum payout than for those that paid more than the required minimum dividend payout.

23 Second, we examine how the firms would react in their earnings management behavior around the enforcement of regulatory changes. In previous Western literature, firms have been found to manage earnings upwards to justify high payouts (Kasanen et al., 1996; Daniel et al., 2008; Atieh and Hussain, 2012). However, in our Chinese context where regulations are aimed at protecting shareholders, firms may have incentives to manage earnings downwards to reduce the minimum required payout.

Therefore, we expect that firms that paid less than the required minimum payouts are more likely to manipulate accounting earnings to meet the threshold based on accounting earnings.

Given these arguments, we hypothesize that:

H2: Since the minimum required payout is expressed as a percentage of reported average annual earnings, firms that paid less than the required minimum payouts are more likely to use downwards earnings management in order to reduce their minimum required payout.

Third, we extend H1 to allow for the possibility that the market response will be conditioned by the earnings management practices of the firms. The degree of earnings management is to some extent an indicator of agency problems. Therefore, consistent with H1 we expect firms with potentially higher perceived agency costs to have more positive market reactions. By examining the differential market reactions towards firms with different levels of earnings management, we are able to provide further evidence that the market reacts more favorably to firms where higher agency costs can potentially be reduced through restricted payout regulations.

Given these arguments, we hypothesize that:

H3: The market reaction consistent with H1 is more pronounced for firms using earnings management as examined in H2.

One potential consequence of the mandatory payout rules is the possibility that

24 some firms may be forced to divert resources that would have been invested in positive

NPV projects to achieve the mandatory dividend payouts, leading to an unintended decrease in shareholder wealth. This possibility is more likely for younger growth firms that have higher demand for capital and expansion. Therefore, we expect investors to take into account firms’ lifecycles, and the market reaction to differ between growth and mature firms in evaluating their earnings management and agency problems. In particular, we expect investors to react more favorably to the regulatory changes for mature firms whose earnings management resulted (more likely) from agency problems, than for growth firms who delay dividend payout for the sake of good investment opportunities.

Given these arguments and following H3, we hypothesize that:

H4: The effect consistent with H3 is more pronounced for mature firms.

4. Research design

4.1. Market reaction tests for Hypothesis 1

We identify four events between 2001 and 2008 acquired from the official website of CSRC. We have discussed the events in Section 2.3 and summarized them in Figure

1.

We provide two statistics to compare the difference in the mean abnormal return between firms that had dividend payouts higher and lower than the new required minimum payout. The first is a t-test on whether the mean abnormal return for each group of firms is different from zero. The second statistics is a t-test on whether the difference in the mean abnormal return between the two groups of firms is different from zero, which takes firms that have dividend payout higher than the new required minimum payout as the control group as they are relatively less affected by the regulatory changes.

25 Following H1, we have two predictions of the market reaction tests. First, the differences in mean abnormal returns between firms that paid dividends higher and lower than the new required minimum payout are significant. Second, the mean abnormal returns for firms that had dividends lower than the new required minimum payout are significantly positive; whereas the mean abnormal return for firms that had dividend higher than the new required minimum payout are insignificant.

Additionally, we use the following regression model (1) to perform a multivariate analysis of the market response to the announcement of more restrictive dividend payout regulations.

CAR    Low  Size  BTM  Leverage  SalesGrowth  SOE  j, e 0 1 2 3 4 5 6 (1) 7Concurrent  8 BoardSize  9 Indep  10 BigFour   j , e

Where the dependent variable,CAR j, e , is a measure of the cumulative abnormal stock returns for an eleven-day window centered on the event day of interest; j indicates the firm and e is the announcement number (e=1,..,6). We report results for two slightly different measures of CAR. CAR_1 is the market-adjusted return and CAR_2 is the market model-adjusted return10. We use the Shanghai Stock Exchange (SSE) Index for firms listed in the SSE and the Shenzhen Stock Exchange (SZSE) Index for firms listed in the SZSE.

Among the independent variables, Low is the key variable of interest, which indicates whether a firm has achieved the minimum payout requirement. In particular, we define Low specific to each regulation. For example, for the 2004 regulatory change, in which firms are required that cash dividends be paid in the three years prior to the application, we set Low equal to 1 if the firm has not paid any cash dividends over the past three years, otherwise Low is set equal to 0. This definition applies to the period

10 Market-adjusted return: =

௝௧ ௠ ௧ Market-model-adjusted return:ܧ൫ܴ ൯ ܴ =∀݆ +

ܧ൫ܴ௝௧൯ ߙො௝ ߚመ௝ܴ௠26௧ before the next regulatory change is implemented; in this case, the Low definition for the 2004 regulatory change applies to the period for 2004-2005. In line with the H1, we expect that α1 is significantly positive, showing that low payers have a more positive market reaction.

In the above equation, we incorporate a set of control variables (summarized in

Table 1) that previous studies find influence dividend payout (Fama and French, 2001;

Denis and Osobov, 2008). First, we control for firm characteristics, including size, book to market ratio, leverage, and sales growth. In particular, dividend payers are much larger than non-payers so we control for Size, which is measured as the natural logarithm of total assets. Growth opportunity is one of the determinants of retention/payout decision for investment, so we control for two indicators of growth opportunity. Book to Market ratio (BTM) is the ratio of total shareholders’ equity to market value of annual shares, and Sales growth is the percentage increase in operating . Leverage shows the capital structure of the firm and indicates firms’ capital needs, which is measured as the ratio of total liabilities to total assets in our regression.

Higher leverage suggests that a firm is more reliant on debt-holders who are more reluctant to increase equity distribution. Second, we consider the important institution of state-ownership in China and include a dummy SOE for state-owned enterprise identified with the status of controlling shareholders. We control for this because ownership concentration is a proxy for the agency problem (Faccio et al., 2001).

Previous studies find that government ownership leads to poor protection for minority shareholders in China (Gul et al. 2010), thus we expect the CAR to be higher for SOEs in the light of higher mitigated agency costs. Third, we control for effects that help to mitigate agency costs inside the firms. Specifically, Concurrent is a variable indicating whether the firm’s board chairman and general manager are the same person. Board size (BoardSize) is number of directors on the board. Independence of

27 board (Indep) is measured as number of independent directors on the board. Big Four is an indicator of firms audited by Big Four firms.

The t-statistics are based on standard errors adjusted for heteroscedasticity. All variables are winsorized to 1%. The results are shown in Table 4-5, which will be discussed in Section 6.

[Insert Table 1]

4.2. Tests for Hypothesis 2

In tests for H2, we examine the difference in earnings management, measured by discretionary accruals (DA) for each regulatory change, between firms that had dividends higher (lower) than the new required minimum payout, identified by the dummy Low.

We use the following regression model (2) to perform a multivariate analysis.

DA    Low  Size  BTM  Leverage  SalesGrowth  SOE  i, t 0 1 2 3 4 5 6 (2) 7Concurrent  8 BoardSize  9 Indep  10 BigFour   j , e

Where the dependent variable is discretionary accruals (DA) for each year; i indicates the firm and t is the year. If the coefficient α1 is significantly negative, we have evidence in support of our prediction in Hypothesis 2. The results are shown in Table

6-7.

We use the same set of control variables as in Equation (1). First, we predict that the growth firms have a higher demand for retained earnings to develop and expand, so are more likely to use earnings management to avoid dividend payouts. Thus, the coefficients of BTM and Sales Growth are predicted to be negative and positive, respectively. Second, prior studies of state-ownership and accounting quality in China find a lower level of accrual-based earnings management in SOEs than non-SOEs

(Wang and Yung 2011). Thus, we predict the coefficient of SOE to be negative. Third,

28 we predict that the corporate governance plays a role in constraining earnings management. For instance, we predict the coefficient of Big Four to be negative.

We test two different periods. First, we directly test the effect of the regulatory changes on the contemporaneous years of announcement, i.e. 2001, 2004, 2006, and

2008. Second, we examine the effect during the periods including subsequent years, i.e.

2001-2003, 2004-2005, 2006-2007, and 2008-2010.11

We measure earnings management using discretionary accruals (DA), which are calculated using modified Jones Model (Dechow et al. 1995).12

First, we calculate total accruals (TA) as operating profit minus cash flow from operations, using data from the cash flow statements. Thus,

TAit = EBXIit − CFOit (3)

where EBXI stands for earnings before extraordinary items and discontinued operations and CFO stands for cash flow from operations.

Then we run the cross-sectional ordinary least squares (OLS) regressions within each industry-year group for the sample period of 2001-2010 to get estimates of the coefficients α1, α2 and α3. In particular, the following model is estimated:

TAi,,, t1  REV i t PPE i t  1  2  3 i , t (4) AAAAi, t 1 i , t 1 i , t 1 i , t  1

where TA is measured by the difference between EBXI and CFO in Equation (3),

△REV is the change in sales , and PPE is gross property, plant and equipment.

All variables are scaled by total assets at the beginning of the to control for size effect (At-1).

Second, we calculate non-discretionary accruals (NDA) using the estimates of α1,

11 We examine how the firms would react in their earnings management behavior to the enforcement of regulatory changes. Therefore, we also test the three-year period of post-event implementation.

12 In addition, we use the recent model of Stubben (2010) to calculate discretionary revenues as a measure of earnings management. The results remain unchanged.

29 α2 and α3 from the Equation (4). Note that the change in account receivables, △REC, is included in the regression following the modified Jones model (Dechow et al. 1995).

This is based on the reasoning that it is easier to manage earnings by exercising discretion over the recognition of revenue on credit sales than it is to manage earnings by exercising discretion over the recognition of revenue on cash sales. Specifically:

1 ()REVi,,, t  REC i t PPE i t NDAi, t  ˆ 1 ˆ 2 ˆ 3 (5) AAAi, t 1 i , t 1 i , t 1

Third, the difference between total accruals (TA) and non-discretionary accruals

(NDA) is discretionary accruals (DA). Specifically:

TA DA i, t  NDA i,, tA i t i, t 1 (6)

4.3. Market reaction conditioned by the earnings management for Hypothesis 3

To test the market reaction conditioned by earnings management for Hypothesis 3, we first use the discretionary accruals of the previous year (PreviousDA) to proxy for firms’ agency problems before the enforcement of new regulation.

We use the following regression model (7) to perform a multivariate analysis.

CARi, t   0  1 Low  2 PreviousDA  3 Low* PreviousDA 

4Size  5 BTM  6 Leverage  7 SalesGrowth  8 SOE  (7)

9Concurrent  10 BoardSize  11 Indep  12 BigFour   j , e

Similar to H1 and H2, Low indicates whether a firm has achieved the minimum payout requirement. The interaction of Low and PreviousDA is our focus. If the coefficient α3 is significantly negative, we have evidence in support of our prediction in

Hypothesis 3 that the market reaction is greater for firms with a larger magnitude of downward earnings management, which suggests potentially higher reduced agency costs after the regulatory changes.

30 In addition, we test the sub-sample of firms that pay dividends lower than the new required minimum payout. We use the following regression model (8) to perform a multivariate analysis.

CAR    PreviousDA  Size  BTM  Leverage  SalesGrowth  i, t 0 1 2 3 4 5 (8) 6PastRET  7 SOE  8 Concurrent  9 BoardSize  10 Indep   j , e

If coefficient α1 is significantly negative, we have additional evidence in support of our prediction in Hypothesis 3. The results are shown in Table 8 and discussed in

Section 6.

4.4. Tests for Hypothesis 4

Fourth, we test for a differential market reaction in terms of firms’ lifecycles that reflect the firms’ demand for capital, H4. We identify the firms’ lifecycle as being in the mature or growth stage, based on the firm’s sales growth. In particular, we use a dummy variable labelled Mature to capture the lifecycle. A firm that grows slower than the benchmark, which is measured as the median sales growth for each year, is defined as a mature firm. Otherwise it is defined as a growth firm.

We use the following regression model (9) for our multivariate analysis.

CARi, t   0  1 Mature  2 PreviousDA  3 Mature* PreviousDA 

4Size  5 BTM  6 Leverage  7 SalesGrowth  8 SOE  (9)

9Concurrent  10 BoardSize  11 Indep  12 BigFour   j , e

The interaction of Mature and PreviousDA is the coefficient of interest. If the coefficient α3 is significantly negative, we have evidence in support of our prediction in

Hypothesis 4 – the effect consistent with H3, that the market reaction is greater for firms with a larger magnitude of downward earnings management, is more pronounced for mature firms for which it is less reasonable to retain earnings rather than pay dividends.

The results are shown in Table 9.

31 5. Data and summary statistics

5.1. Data and sample

We use stock returns share prices and accounting data from China Stock Market and (CSMAR) for 2001-2010. In line with prior studies, we exclude financial firms because they have different accounting standards and regulations.

In the sample selection procedures, we take the following steps. First, we delete observations with missing returns information in an eleven-day event window centered on the announcement of the regulatory change, and a 60 trading day estimation window.

Second, we delete observations with missing values for accounting information in estimating discretionary accruals for the four events. Third, we exclude observations for which data is missing for the control variables in the regressions discussed in Section

4.1.

Our data selection criteria result in 6964 non-financial firm-announcement observations for the six announcements associated with four events, and 12488 firm-year observations for our earnings management tests.

5.2. Summary statistics

Table 2 shows the summary statistics of the variables used in the tests. In particular, we find that around 23.3% of all firms are identified as low payers, i.e. firms that had dividends lower than the new required minimum payout. In Panel B, we find that firms that pay dividends higher than the new required minimum payout are larger and with higher quality governance measures, consistent with prior literature. More importantly, the mean cumulative abnormal returns of firms that pay dividends lower than the new required minimum payout are positive, and the mean cumulative abnormal returns of

32 firms that pay dividends higher than the new required minimum payout are negative.

This is generally consistent with the prediction of Hypothesis 1. In addition, the mean discretionary accruals (DA) of firms that pay dividends lower than the new required minimum payout are negative, and the mean discretionary accruals (DA) of firms that pay dividends higher than the new required minimum payout are positive. This is generally consistent with prediction of Hypothesis 2.

[Insert Table 2]

Table 3 shows the correlation matrix of the independent variables. The two measures of CAR are highly correlated, with a Spearman correlation of 0.8638. More importantly, the two measures of CAR are positively correlated with Low, the indicator of firms that pay dividends lower than the new required minimum payout and significant at the 5% level. This is consistent with prediction of Hypothesis 1. In addition, DA is negatively correlated with Low and significant at the 5% level. This is consistent with prediction of Hypothesis 2.

[Insert Table 3]

6. Empirical results

6.1. Results for Hypothesis 1

Table 4 shows yearly event and combined cumulative abnormal return (CAR) t-test statistics13. Columns (1) to (3) show the results with market-adjusted return (CAR_1), and columns (4) to (6) show the results with market-model-adjusted return (CAR_2).

We find that, overall, the difference between high and low payers are significant under

13 Using median tests and nonparametric tests, we get similar results.

33 both measures. In particular, the firms that pay dividends lower than the new required minimum payout have positive market reactions. This indicates that investors had a favorable reaction towards the new regulation because of potentially reduced agency costs following the regulatory changes. Consistent with the discussion in Section 2.3, we find that the second (2004) and third (2006) regulatory changes, which we expected to have the most substantial influence on dividend payout policies, show significant differences between firms that paid dividends higher and lower than the new required minimum payout using both measures. This effect is confirmed by the multivariate analysis reported in Table 5. We find that coefficient of Low (α1) is significantly positive, consistent with our prediction in Hypothesis 1.

Overall, the results of Table 4-5 support Hypothesis 1 that the market reaction to regulatory changes requiring a higher minimum dividend payout is more positive for firms that paid less than the new required minimum payout than for those that paid more than the required minimum dividend payout.

[Insert Table 4-5]

6.2. Results for Hypothesis 2

Table 6 shows yearly and combined t-tests for earnings management. We test two

different periods. Columns (1) to (3) show the results for earnings management in the

contemporaneous year of announcement, i.e. 2001, 2004, 2006, and 2008. Columns (4)

to (6) show the results for earnings management in periods including subsequent years,

i.e. 2001-2003, 2004-2005, 2006-2007, and 2008-2010. Overall, we find that the

discretionary accruals for firms that pay dividends lower than the new required

minimum payout are significantly negative, consistent with Hypothesis 2. In contrast,

the discretionary accruals for firms that pay dividends higher than the new required

34 minimum payout are positive in most events. The multivariate analysis in Table 7

shows similar results. The coefficient of Low (α1) is significantly negative, consistent

with Hypothesis 2.

Overall, the results of Table 6-7 support Hypothesis 2.

[Insert Table 6-7]

6.3. Results for Hypothesis 3

Table 8 shows the results of Equations (7) and (8) for H3. In particular, we find in

Panel A that the coefficient of interest, α3, is significantly negative at the 10% level.

This indicates that among firms that pay dividends lower than the new required minimum payout, the market reaction is more positive for firms with a greater magnitude of downward earnings management, providing further evidence that the market reacts more favorably to firms where higher agency costs can potentially be reduced through restricted payout regulations. In Panel B we show the results among firms that pay dividends lower than the new required minimum payout. The coefficient of interest, α1, is significantly negative at the 1% level, providing evidence that the market reaction to the announcement of higher minimum dividend payouts is higher for firms with a greater magnitude of downward earnings management, among those firms with potentially higher reduced agency costs after the regulatory changes.

Overall, results in Table 8 are support Hypothesis 3.

[Insert Table 8]

6.4. Results for Hypothesis 4

Table 9 shows the results of Equations (9) for H4. In particular, we find that the

35 coefficient of interest, α3, is significantly negative. This is consistent with the prediction of Hypothesis 4 that the effect of H3 is more pronounced for mature firms, for whom it is less reasonable to retain earnings rather than pay dividends. This suggests that the investors take into account firms’ lifecycles, and differ in market reactions between growth and mature firms in evaluating their agency problems and accounting choices.

Overall, the results of Table 9 support Hypothesis 4.

[Insert Table 9]

7. Conclusion

DDS argue that agency costs are a first order determinant of dividend payout policy. Previous research on this view is indirect and inconclusive, due to serious inherent research design problems. Using a unique setting involving Chinese regulatory changes, we argue that changes in minimum payout policies provide a unique setting to shed new light on the determinants of dividend payout. This is because the Chinese regulatory changes aimed at protecting shareholders and reducing agency cost facilitates identification of the agency cost effect. By observing the market reaction to exogenous regulatory dividend policy changes, which apply to all listed firms equally, we are capturing investors’ reactions to the mandatory dividend shocks that alleviate perceived agency cost, rather than the dividend surprises used as signals to convey information to outside investors by firms voluntarily.

We find that investors’ market reactions are more positive for firms that paid dividends lower than the new required minimum payout, whose perceived agency costs were believed to be higher, than for firms that paid dividends higher than the new required minimum payout and are thus less affected by the regulatory changes. As the signaling explanation is eliminated in our context, our findings support DDS’s

36 conclusion in favor of Jensen (1986) and the agency costs of FCF retention being an important part of the dividend payout story.

In addition, we examine the earnings management choices of Chinese firms in response to the change in dividend payout regulations. Consistent with our hypothesis, we find that firms that paid dividends lower than the new required minimum payout are more likely to manage earnings downwards in order to meet the requirement of the regulatory dividend threshold based on reported earnings. Therefore, we extend the literature on dividend-based earnings management by showing firms manage earnings downwards in response to regulatory minimum payout requirements (versus previous studies’ findings of upward earnings management in response to upper bound constraints on distributions in debt contracts or company law).

We also examine whether investors can “see through” earnings management, and whether they take into account firms’ lifecycle and capital needs in their market reactions. The findings show that investors react more favorably to the regulations for firms that exhibit greater earnings management and higher perceived agency costs, especially those mature firms whose earnings management resulted (more likely) from an agency problem instead of reasonable retention for good investment opportunities.

Our findings have the following implications.

From a pure corporate finance perspective, we provide a unique setting to shed new light on the determinants of corporate payout policy, and offer direct evidence to support DDS’s conclusion in favor of the agency cost hypothesis.

From a policy maker perspective, we provide insights into firm behavior in response to regulatory changes that are not experienced in Western capital markets.

These results are likely to be of interest to policy makers in emerging economies with weak investor protection. Overall we conclude that the Chinese policy experiment

37 seems to have been successful, and is worthy of consideration by other developing countries.

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44 Appendix A [CSRC Decree No.57] Notice on Amendment in Regulations for

Listed Companies’ Cash Dividend14

China Securities Regulatory Commission Decree No.57

The “Notice on Amendment in Regulations for Listed Companies’ Cash Dividend” approved at the 240th chairman’s meeting of the China Securities Regulatory

Commission (CSRC) on October 7, 2008, is hereby promulgated and will become effective as of October 9, 2008.

CSRC Chairman: Shang Fulin

October 9, 2008

Notice on Amendment in Regulations for Listed Companies’ Cash Dividend

Listed companies’ cash dividend payment, an important method for investors to gain investment returns, is significant to foster a long-term investment ideology as well as increase the attractiveness and energy of the capital market. To guide and standardize the cash dividend payment of listed companies, relevant provisions are stipulated as follows:

1. One item is added as Item 2 in Article 155 of the “Guide for the Articles of

Association of Listed Companies (Amendment in 2006)”: “Note: a company shall specify its cash dividend policy in the Articles of Association, and keep a consistent and stable profit distribution policy”.

2. One provision is added to Item 1 in Article 4 of the “Provisions on

Strengthening Protection of Rights and Interests of Holders of Public Shares”: “A listed company may conduct mid-term cash dividend payment”.

3. Item 5 in Article 8 of the “Administration Measures on Securities Issuance by Listed Companies” is amended from “The accumulatively distributed profits in cash or stocks in the recent 3 years shall not be less than 20% of the average

14 http://www.csrc.gov.cn/pub/csrc_en/laws/overRule/Decrees/200910/t20091028_166901.htm

45 annual distributable profits realized in the recent 3 years” to “The accumulatively distributed profit in cash in the recent 3 years shall not be less than 30% of the average annual distributable profits realized in the recent 3 years”.

4. Article 37 of the “Rules No.2 on Contents and Format of Information

Disclosure by Companies Publicly Issuing Securities -- Contents and Format of Annual

Reports (Amendment in 2005)” is amended: “A listed company shall disclose the scheme of profit distribution or that of capitalization from capital public . Any company, which makes profits during the reporting period with no scheme of cash profit distribution, shall give specific reasons and justify the usage for the undistributed profits.

Besides, it shall disclose the implementation of cash dividend policy during the reporting period, and list the amount of cash dividend in the past 3 years as well as its proportion to net profit”.

5. Item 1 in Article 37 of the “Rules No.3 on Contents and Format of Information

Disclosure by Companies Publicly Issuing Securities -- Contents and Format of

Semi-annual Reports (Amendment in 2007)” is amended: “A company shall disclose the implementation of the schemes of profit distribution, capitalization from capital public reserve or new shares issuance, which were previously made and are implemented in the reporting period. Meanwhile, it shall disclose the implementation of the cash dividend policy and state whether its board of directors has made the cash dividend scheme”.

6. An article is added after Article 13 as Article 14 of the “Rules No.13 on

Contents and Format of Information Disclosure by Companies Publicly Issuing

Securities -- Contents and Format of Quarterly Reports (Amendment in 2007)”: “A company shall specify the implementation of the cash dividend policy during the reporting period”.

7. The CSRC agencies, the Shanghai Stock Exchange, the Shenzhen Stock

Exchange as well as China Securities Depository and Clearing Corporation Limited

46 shall urge the listed companies to amend the Articles of Association, perform the obligation of information disclosure, implement the supervision and offer the services according to the Notice.

8. The Notice shall take effect since October 9, 2008. The “Notice on Issues of

Standardizing Listed Companies’ Activities” (Zheng Jian Shang Zi [1996] No.7) shall be abolished at the same time.

47 Figure 1 Timeline of minimum dividend payout requirements (Event dates)

Implementation date 28 March 2001 7 December 2004 8 May 2006 9 October 2008

Dividend Cash dividend 17 April 2006 22 August 2008 Draft exposure date payout in the payout in the past three past three years Dividend payout over the past Cash dividend payout over the years three years higher than 20% past three years higher than of the average realized annual 30% of the average realized retained earnings of the past annual retained earnings of the three years past three years Table 1: Variable definitions Variables Definition Dependent variables CAR Cumulative abnormal return DA Discretionary accruals

Variable of interest Low Indicator of firms that had dividends lower than the new required minimum payout specific to each regulatory change Mature A firm that grows slower than the benchmark, which is measured as the median sales growth for each year

Control variables Size Natural log of Total Assets BTM Total Shareholders’ Equity/ Annual market value Leverage Total Liabilities/ Total Assets Sales Growth Growth percentage of total operating revenue SOE Indicator of State-owned Enterprise Concurrent Whether board chairman and general manager is the same person BoardSize Number of directors on the board Indep Number of independent directors on the board Big Four Indicator of firms audited by Big Four audit firms

49 Table 2: Descriptive statistics Panel A: Total sample Obs. Mean Std.dev. Percentiles Skewness 25th 50th 75th Variables CAR_1 6964 -0.00168 0.103 -0.0520 -0.00684 0.0398 0.743 CAR_2 6964 0.000489 0.105 -0.0547 -0.000643 0.0499 0.473 DA 12488 -0.00173 0.113 -0.0506 -0.000053 0.0493 -0.162 Low 12488 0.233 0.423 0 0 0 1.263 SIZE 12488 21.38 1.118 20.64 21.27 22.01 0.514 BTM 12488 0.414 0.304 0.211 0.357 0.576 0.507 Leverage 12488 0.531 0.295 0.369 0.512 0.644 3.283 Sales Growth 12488 0.231 0.617 -0.0191 0.144 0.337 4.050 SOE 12488 0.663 0.473 0 1 1 -0.691 Concurrent 12488 0.134 0.340 0 0 0 2.152 BoardSize 12488 9.404 2.065 9 9 11 0.797 Indep 12488 3.017 1.054 3 3 4 -0.735 Big Four 12488 0.0673 0.251 0 0 0 3.453

This table presents summary statistics for 6964 observations of CAR covering the period of four events (2001, 2004, 2006, 2008), and 12488 observations of other control variables covering 2001-2010. CAR_1 refers to the eleven-day cumulated market-adjusted return centered on the event day and CAR_2 refers to the eleven-day cumulated market-model-adjusted return centered on the event day. Low is the indicator of whether the firm has achieved the minimum payout requirement. Size is measured as the natural logarithm of total assets. Book to Market ratio (BTM) is the ratio of total shareholders’ equity to market value of annual shares. Leverage is the ratio of total liability to total assets. Sales growth is the percentage of increase in operating revenue. SOE is a dummy for state-owned enterprise. Concurrent is the variable indicating whether the firm’s board chairman and general manager are the same person. Board size (BoardSize) is number of directors on the board. Independence of Board (Indep) is measured as number of independent directors on the board. Big Four is an indicator of firms audited by Big Four audit firms. The figures are in China’s currency, RMB Yuan. All variables are winsorized to 1%.

50 Panel B: Obs. Mean Std.dev. Percentiles Skewness 25th 50th 75th High payers CAR_1 5201 -0.00354 0.102 -0.0531 -0.00855 0.0381 0.710 CAR_2 5201 -0.00258 0.104 -0.0570 -0.00326 0.0457 0.446 DA 9578 0.00243 0.111 -0.0459 0.00278 0.0517 -0.0885 SIZE 9578 21.41 1.121 20.67 21.29 22.04 0.561 BTM 9578 0.419 0.305 0.212 0.361 0.583 0.551 Leverage 9578 0.519 0.292 0.357 0.499 0.632 3.309 Sales Growth 9578 0.233 0.589 -0.00525 0.150 0.338 4.176 SOE 9578 0.678 0.467 0 1 1 -0.761 Concurrent 9578 0.135 0.342 0 0 0 2.135 BoardSize 9578 9.477 2.091 9 9 11 0.787 Indep 9578 3.020 1.078 3 3 4 -0.729 Big Four 9578 0.0750 0.263 0 0 0 3.228

Low payers CAR_1 1763 0.00380 0.105 -0.0470 -0.00233 0.0445 0.827 CAR_2 1763 0.00953 0.108 -0.0459 0.00717 0.0585 0.535 DA 2910 -0.0154 0.119 -0.0675 -0.00984 0.0419 -0.319 SIZE 2910 21.27 1.103 20.54 21.19 21.94 0.351 BTM 2910 0.398 0.303 0.207 0.345 0.556 0.359 Leverage 2910 0.572 0.300 0.412 0.555 0.679 3.297 Sales Growth 2910 0.223 0.700 -0.0674 0.117 0.335 3.704 SOE 2910 0.615 0.487 0 1 1 -0.472 Concurrent 2910 0.129 0.335 0 0 0 2.211 BoardSize 2910 9.165 1.958 8 9 10 0.807 Indep 2910 3.009 0.970 3 3 3 -0.759 Big Four 2910 0.0423 0.201 0 0 0 4.550

51 Table 3: Correlation matrix

CAR_1 CAR_2 DA Low SIZE BTM Leverage Sales SOE Concurrent BoardSize Indep Big Growth Four CAR_1 1 CAR_2 0.8638* 1 DA 0.0209 -0.00760 1 Low 0.0432* 0.0737* -0.0712* 1 SIZE 0.0457* -0.0202 0.0127 -0.0445* 1 BTM 0.00880 -0.00630 0.0430* -0.0232* 0.3679* 1 Leverage -0.0468* 0.00150 -0.2002* 0.1061* 0.1758* -0.1443* 1 Sales Growth 0.0653* -0.000500 0.0768* -0.0498* 0.1765* 0.00380 0.0207* 1 SOE 0.0154 -0.00350 -0.0413* -0.0563* 0.2266* 0.1748* 0.00290 0.0155 1 Concurrent 0.00440 0.00280 0.00480 -0.00740 -0.0825* -0.0836* -0.0295* -0.0132 -0.1376* 1 BoardSize 0.00980 -0.0146 0.0160 -0.0624* 0.2177* 0.1315* 0.0223* 0.0505* 0.1936* -0.1006* 1 Indep 0.0232 -0.0333* 0.0157 -0.0160 0.2733* 0.1533* 0.0618* 0.0809* 0.0452* -0.0391* 0.5587* 1 Big Four 0.0132 -0.0106 -0.0135 -0.0552* 0.2606* 0.1254* -0.0408* 0.0295* 0.0942* -0.0361* 0.1062* 0.1090* 1

Table 3 presents Spearman correlations. The sample consists of observations covering the period 2001–2010. CAR_1 refers to the eleven-day cumulated market-adjusted return centered on the event day and CAR_2 refers to the eleven-day cumulated market-model-adjusted return centered on the event day. Low is the indicator of whether the firm has achieved the minimum payout requirement. Size is measured as the natural logarithm of total assets. Book to Market ratio (BTM) is the ratio of total shareholders’ equity to market value of annual shares. Leverage is the ratio of total liability to total assets. Sales growth is the percentage of increase in operating revenue. SOE is a dummy for state-owned enterprise. Concurrent is the variable indicating whether the firm’s board chairman and general manager are the same person. Board size (BoardSize) is number of directors on the board. Independence of Board (Indep) is measured as number of independent directors on the board. Big Four is an indicator of firms audited by Big Four audit firms. The figures are in China’s currency, RMB Yuan. All variables are winsorized to 1%.* indicates significance at the 5% level.

52 Table 4 Yearly event and combined CAR (t-statistics)

CAR_1 refers to the eleven-day cumulated market-adjusted return centered on the event day and CAR_2 refers to the eleven-day cumulated market-model-adjusted return centered on the event day. The t-statistics are reported in the parentheses. * significant at 10%; ** significant at 5%; *** significant at 1%

CAR CAR_1 (market-adjusted return) CAR_2 (market-model-adjusted return) (1) (2) (3) (4) (5) (6) High payer Low payer Diff High payer Low payer Diff 2001 724 172 896 724 172 896 Mean -0.00679*** -0.00587** -0.000920 0.00610*** 0.0123*** -0.00623* t-statistics (-5.413) (-2.274) (-0.321) (3.894) (4.097) (-1.763) 2004 903 305 1208 903 305 1208 Mean -0.00178 0.00428 -0.00606** -0.00459*** 0.0163*** -0.0209*** t-statistics (-1.321) (1.626) (-2.183) (-2.715) (5.108) (-6.058) 2006 1699 410 2109 1699 410 2109 Mean -0.00475 0.0158** -0.0205*** -0.00617* 0.00960 -0.0158** t-statistics (-1.466) (2.154) (-2.733) (-1.928) (1.328) (-2.126) 2008 1875 876 2751 1875 876 2751 Mean -0.00205 -0.0000767 -0.00197 -0.00170 0.00659* -0.00829* t-statistics (-0.834) (-0.0219) (-0.456) (-0.665) (1.789) (-1.837) All 5201 1763 6964 5201 1763 6964 Mean -0.00354** 0.00380 -0.00734*** -0.00258* 0.00953*** -0.0121*** t-statistics (-2.513) (1.523) (-2.600) (-1.786) (3.721) (-4.188)

53 Table 5 Yearly regression of CAR

CAR_1 is the dependent variable in all regressions of Panel A, and CAR_2 is the dependent variable in all regressions of Panel B. CAR_1 refers to the eleven-day cumulated market-adjusted return centered on the event day and CAR_2 refers to the eleven-day cumulated market-model-adjusted return centered on the event day. Low is the indicator of whether the firm has achieved the minimum payout requirement. Size is measured as the natural logarithm of total assets. Book to Market ratio (BTM) is the ratio of total assets to market value of annual negotiable shares. Leverage is the ratio of total liability to total assets. Sales growth (SalesGr) is the percentage of increase in operating revenue. Concurrent is the variable indicating whether the firm’s board chairman and general manager is the same person. Board size (BoardSize) is number of directors on the board. Independence of Board (Indep) is measured as number of independent directors on the board. Big Four is an indicator of firms audited by Big Four audit firms. The figures are in China’s currency, RMB Yuan. All variables are winsorized to 1%. Robust standard errors are in parentheses. *significant at 10%;**significant at 5%;***significant at 1%

54 Panel A (1) (2) (3) (4) (5) (6) (7) (8) (9) CAR_1 2001 2004 2006 2008 All Draft Official Combined Draft Official Combined Low 0.000 0.007*** 0.021** 0.036*** 0.028*** -0.002 -0.000 -0.001 0.010*** (0.10) (3.60) (2.25) (5.08) (4.30) (-0.90) (-0.00) (-0.26) (6.53) Size -0.000 0.002 0.026*** 0.028*** 0.027*** -0.009** 0.006 -0.002 0.008*** (-0.19) (1.26) (4.24) (4.60) (5.00) (-2.84) (1.03) (-0.36) (5.85) BTM -0.010 -0.010** -0.087*** -0.105*** -0.095*** 0.046*** -0.065*** -0.009* -0.032*** (-1.47) (-3.10) (-4.45) (-5.80) (-5.46) (5.24) (-10.57) (-2.01) (-3.49) Leverage -0.013*** -0.000 -0.100*** -0.140*** -0.118*** -0.007 -0.011 -0.009 -0.043*** (-3.13) (-0.04) (-7.43) (-10.22) (-11.19) (-0.75) (-1.77) (-1.51) (-7.26) SalesGr 0.004*** 0.003* 0.018*** 0.008 0.012** -0.003 -0.003 -0.003 0.004 (3.11) (2.20) (3.89) (1.08) (2.62) (-0.82) (-0.71) (-1.14) (1.73) SOE -0.001 0.001 0.003 0.009 0.006 0.003 -0.001 0.001 0.002 (-0.29) (0.28) (0.63) (1.02) (1.38) (0.77) (-0.41) (0.32) (1.32) Concurrent 0.001 -0.007* 0.004 0.014 0.009 -0.002 0.004 0.001 0.002 (0.18) (-2.17) (0.50) (1.66) (1.63) (-0.41) (0.48) (0.25) (1.01) BoardSize 0.000 -0.001 0.007** 0.008** 0.008*** 0.003 -0.003 -0.000 -0.000 (0.05) (-0.46) (2.80) (2.59) (3.41) (1.53) (-0.95) (-0.01) (-0.05) Indep -0.001 0.003 -0.008 -0.025* -0.016** -0.007 0.005 -0.001 0.003** (-0.92) (1.16) (-1.24) (-2.14) (-2.34) (-1.31) (0.84) (-0.21) (2.66) Big Four 0.007 0.006 -0.026 -0.055*** -0.041** 0.011 0.037*** 0.024*** -0.002 (1.28) (1.77) (-1.69) (-3.21) (-2.59) (1.02) (3.45) (3.40) (-0.48) Constant 0.009 -0.048 -0.509*** -0.486*** -0.495*** 0.170** -0.087 0.044 -0.155*** (0.26) (-1.25) (-4.13) (-4.00) (-4.65) (2.79) (-0.63) (0.47) (-4.80) Industry effect Yes Yes Yes Yes Yes Yes Yes Yes Yes Observations 896 1208 1075 1034 2109 1380 1371 2751 6964 Within R2 0.0162 0.0173 0.0989 0.1003 0.0953 0.0355 0.0286 0.0039 0.0168

55 Panel B (1) (2) (3) (4) (5) (6) (7) (8) (9) CAR_2 2001 2004 2006 2008 All Draft Official Combined Draft Official Combined Low 0.003** 0.016*** 0.019** 0.026** 0.022*** -0.002 0.008 0.003 0.013*** (2.23) (4.90) (2.27) (3.00) (3.66) (-0.56) (1.17) (0.80) (7.56) Size -0.001 -0.006*** 0.015*** 0.013** 0.014*** -0.012*** 0.002 -0.005 0.002 (-0.58) (-4.40) (3.78) (2.82) (5.06) (-3.89) (0.31) (-1.27) (1.09) BTM -0.026* 0.026*** -0.055*** -0.067*** -0.061*** 0.072*** -0.038*** 0.017*** -0.007 (-2.16) (4.53) (-3.29) (-4.77) (-4.74) (6.89) (-5.51) (4.02) (-0.90) Leverage -0.010 0.038*** -0.075*** -0.084*** -0.080*** 0.027*** 0.015* 0.021*** -0.012** (-1.43) (7.34) (-5.80) (-7.26) (-8.46) (3.46) (2.16) (4.83) (-2.34) SalesGr 0.003 -0.002 0.016*** 0.006 0.011** -0.008 -0.004 -0.006* 0.001 (1.61) (-1.28) (4.12) (0.95) (2.72) (-1.44) (-0.81) (-1.92) (0.66) SOE -0.004 0.002 -0.002 0.001 -0.000 0.005 -0.004 0.001 0.000 (-0.89) (1.25) (-0.33) (0.11) (-0.14) (1.55) (-0.93) (0.18) (0.14) Concurrent -0.002 -0.007 0.001 0.014 0.008 -0.004 0.001 -0.001 -0.000 (-0.47) (-1.71) (0.13) (1.44) (1.33) (-0.57) (0.07) (-0.22) (-0.03) BoardSize 0.000 -0.001 0.004 0.007** 0.005** 0.001 -0.006** -0.003 0.001 (0.31) (-0.85) (1.70) (2.40) (2.44) (0.50) (-2.27) (-1.44) (1.02) Indep -0.001 0.004* -0.003 -0.023** -0.012* -0.003 0.013** 0.005 -0.002 (-0.39) (1.86) (-0.49) (-2.28) (-2.09) (-0.55) (2.39) (1.64) (-1.33) Big Four 0.005 0.015*** -0.016 -0.012 -0.015 0.004 0.019* 0.011** 0.003 (0.95) (3.13) (-1.09) (-0.74) (-1.00) (0.41) (2.11) (2.80) (0.77) Constant 0.043 0.086** -0.276*** -0.205* -0.243*** 0.194*** -0.012 0.093 -0.029 (1.10) (2.71) (-3.50) (-1.99) (-4.03) (3.57) (-0.08) (1.06) (-0.82) Industry effect Yes Yes Yes Yes Yes Yes Yes Yes Yes Observations 896 1208 1075 1034 2109 1380 1371 2751 6964 Within R2 0.0177 0.0675 0.0503 0.0381 0.0416 0.0533 0.0172 0.0059 0.0039

56 Table 6 Yearly event and combined EM (t-statistics)

Discretionary accruals (DA) is calculated using modified Jones Model (Dechow et al. 1995) discussed in Section 4.2. The t-statistics are reported in the parentheses. * significant at 10%; ** significant at 5%; *** significant at 1%

EM_DA Contemporaneous year Subsequent years (1) (2) (3) (4) (5) (6) High payer Low payer Diff High payer Low payer Diff 2001 724 172 896 2461 510 2971 Mean 0.00275 -0.0353*** 0.0381*** -0.000511 -0.0128** 0.0123** t-statistics (0.764) (-3.866) (4.411) (-0.248) (-2.473) (2.408) 2004 903 305 1208 1909 604 2513 Mean 0.0107*** -0.0304*** 0.0411*** 0.0103*** -0.0301*** 0.0404*** t-statistics (3.381) (-4.279) (6.012) (4.853) (-6.521) (8.840) 2006 954 232 1186 2074 453 2527 Mean 0.00139 -0.000198 0.00159 0.00379 -0.00958* 0.0134** t-statistics (0.415) (-0.0332) (0.215) (1.500) (-1.901) (2.266) 2008 954 450 1404 3134 1343 4477 Mean -0.00629* -0.0101** 0.00376 -0.000919 -0.0118*** 0.0109*** t-statistics (-1.682) (-2.039) (0.587) (-0.412) (-3.458) (2.676) All 3535 1159 4694 9578 2910 12488 Mean 0.00198 -0.0172*** 0.0192*** 0.00243** -0.0154*** 0.0179*** t-statistics (1.135) (-5.294) (5.368) (2.141) (-7.003) (7.470)

57 Table 7 Yearly regression of Earnings Management Panel A shows the regressions for contemporaneous event years (i.e. year 2001, 2004, 2006, and 2008). Panel B shows the regressions for both event year and its subsequent years (i.e. event 1 is 2001-2003, event 2 is 2004-2005, event 3 is 2006-2007, event 4 is 2008-2010) Discretionary Accruals is the dependent variable in all regressions. Low is the indicator of whether the firm has achieved the minimum payout requirement. Size is measured as the natural logarithm of total assets. Book to Market ratio (BTM) is the ratio of total shareholders’ equity to market value of annual shares. Leverage is the ratio of total liability to total assets. Sales growth (SalesGr) is the percentage of increase in operating revenue. SOE is a dummy for state-owned enterprise. Concurrent is the variable indicating whether the firm’s board chairman and general manager are the same person. Board size (BoardSize) is number of directors on the board. Independence of Board (Indep) is measured as number of independent directors on the board. Big Four is an indicator of firms audited by Big Four audit firms. The figures are in China’s currency, RMB Yuan. All variables are winsorized to 1%. Robust standard errors are in parentheses. *significant at 10%;**significant at 5%;***significant at 1% Panel A (1) 2001 (2) 2004 (3) 2006 (4) 2008 (5) All Discretionary Discretionary Discretionary Discretionary Discretionary Accruals Accruals Accruals Accruals Accruals Low -0.017* -0.023* -0.003 -0.007** -0.013** (-1.91) (-1.80) (-0.41) (-2.86) (-2.93) Size 0.017*** 0.000 -0.006 0.020*** 0.007*** (4.11) (0.07) (-1.58) (5.24) (3.26) BTM -0.053* -0.021* -0.016 -0.020* -0.018* (-2.00) (-2.05) (-1.45) (-2.19) (-2.01) Leverage -0.141*** -0.130*** -0.091*** -0.143*** -0.120*** (-7.01) (-7.32) (-5.63) (-8.66) (-24.65) SalesGr 0.005 -0.002 0.009*** 0.050** 0.015** (1.54) (-0.31) (3.12) (2.88) (2.46) SOE -0.022** -0.003 -0.009*** -0.020*** -0.013*** (-2.38) (-0.72) (-3.13) (-3.89) (-7.04) Concurrent -0.005 0.004 -0.017* -0.011*** -0.008*** (-1.05) (0.42) (-2.10) (-3.30) (-3.74) BoardSize 0.001 -0.002 0.002 -0.001 0.000 (0.94) (-0.71) (1.08) (-0.95) (0.24) Indep -0.006 0.008 0.003 -0.002 0.002* (-1.55) (0.86) (0.82) (-0.39) (1.96) Big Four -0.027** 0.015 0.005 -0.052*** -0.015*** (-2.42) (1.63) (0.93) (-3.55) (-3.28) Constant -0.269** 0.076 0.161* -0.326*** -0.085 (-3.10) (0.87) (1.85) (-4.18) (-1.74) Industry Yes Yes Yes Yes Yes effect Observations 896 1208 1186 1404 4694 Within R2 0.1520 0.1394 0.0872 0.1951 0.1145

58 Panel B (1) (2) (3) (4) (5) All 2001-2003 2004-2005 2006-2007 2008-2010 Discretionary Discretionary Discretionary Discretionary Discretionary Accruals Accruals Accruals Accruals Accruals Low -0.000 -0.023*** -0.017*** -0.010*** -0.013*** (-0.07) (-3.35) (-6.34) (-4.34) (-8.96) Size 0.001 -0.002 0.003 0.015** 0.006 (0.40) (-0.67) (0.92) (2.45) (1.68) BTM 0.013 -0.005 -0.019** -0.020 -0.006 (1.33) (-1.11) (-2.85) (-1.49) (-0.98) Leverage -0.116*** -0.117*** -0.098*** -0.094*** -0.102*** (-14.89) (-21.73) (-15.17) (-4.50) (-11.95) SalesGr 0.007** 0.003 -0.000 0.009 0.006 (2.73) (0.42) (-0.09) (1.02) (1.20) SOE -0.009** -0.005 -0.014** -0.023*** -0.014*** (-2.49) (-1.04) (-2.71) (-5.23) (-7.55) Concurrent 0.001 -0.005 -0.008 0.004 -0.002 (0.23) (-0.95) (-1.21) (0.98) (-1.05) BoardSize -0.000 -0.001 0.003** -0.002** 0.000 (-0.44) (-0.50) (2.59) (-2.77) (0.34) Indep 0.001 0.003 -0.003 0.003 0.001 (0.72) (0.69) (-0.69) (0.80) (0.88) Big Four -0.023*** 0.004 0.001 -0.031*** -0.014*** (-5.36) (0.42) (0.22) (-4.21) (-3.55) Constant 0.033 0.112* -0.001 -0.240* -0.064 (0.53) (2.08) (-0.01) (-2.04) (-0.89) Industry Yes Yes Yes Yes Yes effect Observations 2971 2513 2527 4477 12488 Within R2 0.1064 0.1468 0.0681 0.0619 0.0760

59 Table 8 Market reaction conditioned by the earnings management CAR_1 is the dependent variable in column (1), and CAR_2 is the dependent variable in column (2). CAR_1 refers to the eleven-day cumulated market-adjusted return centered on the event day and CAR_2 refers to the eleven-day cumulated market-model-adjusted return centered on the event day. Panel A shows the results for event years (i.e. year 2001, 2004, 2006, and 2008) among all listed firms. Panel B shows the results for event years (i.e. year 2001, 2004, 2006, and 2008) among low-paying firms only. Low is the indicator of whether the firm has achieved the minimum payout requirement. Previous Discretionary Accruals is the discretionary accruals of the previous year, indicating firms’ past earnings management magnitude proxied for agency costs. Size is measured as the natural logarithm of total assets. Book to Market ratio (BTM) is the ratio of total shareholders’ equity to market value of annual shares. Leverage is the ratio of total liability to total assets. Sales growth (SalesGr) is the percentage of increase in operating revenue. SOE is a dummy for state-owned enterprise. Concurrent is the variable indicating whether the firm’s board chairman and general manager are the same person. Board size (BoardSize) is number of directors on the board. Independence of Board (Indep) is measured as number of independent directors on the board. Big Four is an indicator of firms audited by Big Four audit firms. The figures are in China’s currency, RMB Yuan. All variables are winsorized to 1%. Robust standard errors are in parentheses. *significant at 10%;**significant at 5%;***significant at 1% Panel A (1) (2) CAR_1 CAR_2 Previous Discretionary Accruals -0.009 -0.011 (-0.49) (-0.48) low 0.010*** 0.011*** (4.10) (4.36) Low *Previous Discretionary Accruals -0.076* -0.090* (-2.17) (-2.00) Size 0.009*** 0.002 (6.56) (1.53) BTM -0.032*** -0.007 (-4.40) (-1.22) Leverage -0.042*** -0.013** (-5.83) (-2.21) SalesGr 0.004 0.001 (1.72) (0.61) SOE 0.003 0.000 (1.61) (0.20) Concurrent 0.004** 0.002 (2.62) (0.98) BoardSize 0.001*** 0.001 (3.28) (1.22) Indep -0.003** -0.001 (-2.58) (-0.98) Big Four -0.006 -0.002 (-1.22) (-0.49) Constant -0.175*** -0.034 (-6.31) (-1.25) Year and Industry effect Yes Yes Observations 4494 4494 Within R2 0.0224 0.0073

60 Panel B (1) (2) Low payers partition sample CAR_1 CAR_2 Previous Discretionary Accruals -0.080*** -0.095*** (-3.84) (-3.77) Size 0.004 -0.003 (1.18) (-0.99) BTM -0.021* 0.003 (-1.95) (0.25) Leverage -0.028*** -0.000 (-3.99) (-0.00) SalesGr 0.007 0.003 (1.49) (0.57) SOE -0.002 -0.006* (-0.63) (-1.92) Concurrent 0.001 0.003 (0.26) (0.74) BoardSize 0.002** 0.002 (2.48) (1.19) Indep -0.000 0.000 (-0.16) (0.12) Big Four -0.021** -0.020* (-2.26) (-1.86) Constant -0.081 0.061 (-1.30) (0.94) Year and Industry effect Yes Yes Observations 1152 1152 Within R2 0.0318 0.0173

61 Table 9 Market reactions conditioned by earnings management and firms’ lifecycle CAR_1 is the dependent variable in column (1), and CAR_2 is the dependent variable in column (2). CAR_1 refers to the eleven-day cumulated market-adjusted return centered on the event day and CAR_2 refers to the eleven-day cumulated market-model-adjusted return centered on the event day. Previous Discretionary Accruals is the discretionary accruals of the previous year, indicating firms’ past earnings management magnitude proxied for agency costs. Mature is the indicator of whether the firm has lower sales growth than annual median among all firms. Size is measured as the natural logarithm of total assets. Book to Market ratio (BTM) is the ratio of total shareholders’ equity to market value of annual shares. Leverage is the ratio of total liability to total assets. Sales growth (SalesGr) is the percentage of increase in operating revenue. SOE is a dummy for state-owned enterprise. Concurrent is the variable indicating whether the firm’s board chairman and general manager are the same person. Board size (BoardSize) is number of directors on the board. Independence of Board (Indep) is measured as number of independent directors on the board. Big Four is an indicator of firms audited by Big Four audit firms. The figures are in China’s currency, RMB Yuan. All variables are winsorized to 1%. Robust standard errors are in parentheses. *significant at 10%;**significant at 5%;***significant at 1% Full sample (1) (2) CAR_1 CAR_2 Previous Discretionary Accruals -0.010 -0.012 (-0.95) (-1.17) Mature -0.003 0.003 (-1.46) (1.61) Mature* Previous Discretionary Accruals -0.052** -0.061*** (-2.57) (-3.23) Size 0.008*** 0.002 (6.58) (1.15) BTM -0.029*** -0.005 (-4.40) (-0.92) Leverage -0.041*** -0.013* (-5.91) (-2.14) SalesGr 0.003 0.003 (1.28) (1.17) SOE 0.003 0.000 (1.40) (0.11) Concurrent 0.003* 0.002 (2.15) (0.80) BoardSize 0.001*** 0.001 (3.16) (1.26) Indep -0.002** -0.001 (-2.40) (-0.94) Big Four -0.007 -0.003 (-1.31) (-0.72) Constant -0.158*** -0.026 (-5.91) (-0.88) Year and Industry effect Yes Yes Observations 4494 4494 Adjusted R2 0.017 0.001

62