Earnings Management Research In The Ipo Process Of China's Gem Companies

Growing Enterprise Market (GEM) is one of the most important platforms to promote the development of Chinese small-medium enterprises (SMEs), to impetus independent innovation and to facilitate industrial structural reorganization. It also plays an important role in Chinese economic development. Both international and domestic practice and research have demonstrated that the core of healthy development of GEM is the innovation and earnings growth of listed companies. According to "Chinese Growth Enterprise Market Issuing Management Approach", there are requirements on the minimum profitability and earnings growth rate to be listed in GEM, which will induce the potential listed companies to inflate its reported earnings to achieve "continuous growing" earnings. In addition, earnings growth rate is an important factor to influence a company's valuation and therefore determine its IPO price during listing. These two above combined would motivate potential listed companies to implement earnings management to increase profitability and growth. However, earnings management will make the accounting earnings and growth rate distorted for the listed companies on GEM, which would deteriorate information asymmetry among managements, regulatory institutions and external investors and therefore, mislead regulatory institutions and external investors of the listed companies'valuations. It will also be harmful to the development of GEM.From the perspective of growth motivation, this article investigate the earnings management during GEM listed company's IPO process to disclose the relationship between earnings management and performance growth, research the overall earnings management and its characteristics, studies key factors which influence earnings managements and specific methods of earnings management and hence, provide strategy and policy recommendations and suggestions for governmental regulatory institutions and external investors.First, this article conducts a brief analysis on the earnings growth rate of GEM listed companies during IPO process, using comparison and statistical analysis methodology. The result shows that there is obvious abnormal during the GEM listed companies IPO process---an attractive growth rate pre IPO versus a significant growth rate drop post IPO. Taking into consideration the company's motivation and influencing factor of growth rate, we believe a favorable earnings growth rate is the main driver for companies to implement earnings management and there are relationships between earnings growth and earnings management during IPO process. Second, the article studies potential listed company's earning management during GEM IPO process, including the degree, characteristics and the influencing factors, by way of empirical research. Results are as follows.Ⅰ. Degree and characteristics of earnings management:due to GEM's requirements on company's earnings growth rate, coupled with the significant drop on earnings growth rate post IPO, this article collects and studies 59 GEM listed companies which submit applications and being approved in 2009, using the Modified Jones Model to verify the company's earnings management during IPO process. We found that most of the potential listed companies will revise earnings downwards in the first year of submitting application, while revise earnings upwards in the third year of application submission and year of issuance. There is no earnings management in the second year of application submission. GEM listed companies achieve earnings management through revising down earnings pre-application while revising up post application.Ⅱ. Influencing factors of earnings management:GEM listed companies have two important characteristics—a relative high percentage of total equities held by managements and large shareholders and VC (Venture Capital) and PE (Private Equity) investing in companies commonly.Those factors above combined will take effect on the company's earnings management. Through multiple regression of the 59 samples stated previously, we found that i) the proportion of large shareholders equity stake is positive correlated to the company's earnings management; ii) MBO would decrease the degree of earnings management; iii) VC and PE which investing in the company in a latter phases (pre-IPO) would result in a high earnings management comparable to those investing in earlier phases; iv) brokerage owned VC investing would have a lower earnings management than non-brokerage owned VC investing.Third, based on investigating GEM listed companies overall earnings management and characteristics of GEM, the article makes a further analysis on the three unique ways to manage earnings during IPO process. As a whole, the article analyzes the influence of the three ways to the company's growth rate, followed by investigating of individual way's earnings management situation.Ⅰ.Stock incentive plan are not included in current expenses. Most of the GEM listed companies are private-owned enterprises. To retain talented employee, most of them will implement stock incentive plan, especially pre IPO. Various ways include issuing stock in a very low price or for free; some companies pay stocks indirectly or in the form of indirect or disguised. However, most of the companies did not put it into current expenses under the General Accepted Accounting Principle (GAAP). As per our analysis and investigation, we believe that stock incentive plan should be accounted into current expenses, no matter directly or indirectly, to reflect the actual net earnings. In addition, we use a case study to analyze the influences to the company's earnings and growth rate of such behavior.Ⅱ. A "selective business restructuring" and growth during IPO process. Most of GEM listed companies conduct mergers and acquisitions under same control pre IPO, mainly includingⅠ) branches have same business being restructured into the listed subject;Ⅱ) some of the branches being restructured into the listed subject, whiles others being written-off or disposed. Operating result of companies within the scope of mergers and acquisitions under the same control is deemed to be existed at beginning of financial year and the revenue and net profit of written-off companies will be transitted to listed subject; therefore, different restructuring scope will result in different beginning balance and hence different growth rate. We found that GEM listed companies have the motivation to management earnings and growth rate through manipulating different kind of restructuring.Ⅲ. The aggressive capitalized expenses and earnings management. Quite a few GEM listed companies will capitalize R&D expenses during IPO process. After theoretical analysis of expenses capitalizaion accounting standard, we believe to be cautious to capitalized expenses. We also use case study to investigate into the capitalized expenses of GEM listed companies and found that these companies capitalize expenses aggressively (some may even get qualified for being listed through expenses capitalization), which will therefore influence the company's earnings and growth rate.Finally, we will give out our conclusions and suggestions. We would like to introduce our basic conclusions first, followed by some suggestions base on the GEM listed companies earnings management. Our suggestions includeⅠ) improving revenue recognition, share-based payments, expenses capitalization and business M&A accounting standard and related regulations;Ⅱ) reforming GEM listing standard;Ⅲ) setting up multilevel GEM and related standards;Ⅳ) reinforcing CPA auditing;Ⅴ) strengthening sponsor responsibilities.