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Accounting conservatism and stock pricing: an analysis based on Chinas split-stock reform
Song Zhu
School of Economics and Business Administration, Beijing Normal University, Beijing, China, and

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Received 2 August 2010 Revised 12 October 2010 Accepted 1 November 2010

Donglin Xia
School of Economics and Management, Tsinghua University, Beijing, China
Abstract
Purpose Chinas securities market is growing gradually as well as the investors, analysts, intermediates and regulation authorities. Accounting earnings is a key determinant among the factors inuencing stock prices, which even overreacts to earnings. Split-stock reform (all-circulation reform) in China provides a chance for investors to revaluate the stock prices. The purpose of this paper is to investigate the market reaction during the reform from the perspective of accounting conservatism. Design/methodology/approach Using the data of companies completing the split-stock reform, this paper empirically investigates how the accounting conservatism inuences the market reaction around re-open day after the reform. Findings Accounting information plays its role on stock pricing through the reform of split-stock reform in the China securities market, evident in the signicantly positive relation between the proxies of accounting conservatism and cumulative abnormal returns for one day, three days, ten days and 30 days around re-open day after the reform. Also, the protability of listed rms in the past will further improve the positive relation between conservatism and market reaction. Originality/value There is ample theoretical work on stock pricing of accounting conservatism but empirical work is scarce, so this paper provides more evidence for the role of stock pricing of accounting conservatism, especially in emerging markets. Second, current research on accounting conservatism in China is focusing on whether conservatism exists and how the conservatism varies; this paper further extends the research eld of conservatism from the pricing perspective. Third, researches based on the determinants of stock compensation and market reaction on stock reform lack theoretical analysis, while this paper provides a theory basis for the market reaction during the stock reform. Keywords China, Securities markets, Stock prices Paper type Research paper

1. Introduction Accounting conservatism implies that measurement errors tend to underestimate the earnings and net assets. If two estimates of earnings or assets to be received or paid in the future are approximately equally likely, then conservatism dictates that the less optimistic one be used (Statement of Financial Accounting Concepts No. 2, Financial Accounting Standard Board, FASB). Conservatism indicates the inter-inuence among the contractual parties (Watts, 2003; Ball et al., 2003) and determines how the prot is distributed among those contractual parties (Ahmed et al., 2002; Francis et al., 2004; Ahmend and Duellaman, 2007; LaFond and Watts, 2008). Both the Financial Accounting Concepts of FASB and the Chinese General Accepted Accounting Principle (GAAP)

Nankai Business Review International Vol. 2 No. 1, 2011 pp. 23-47 q Emerald Group Publishing Limited 2040-8749 DOI 10.1108/20408741111113484

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consider accounting conservatism as one of the important information qualities. So how does the accounting conservatism affect the efciency of market, the effectiveness of rm operation and the economic decision of investors? This issue is the important one for investors and standard setting authorities and is the basis of researches on conservatism. In this paper, we investigate the valuation effect of accounting conservatism in the context of Chinas split-share structure reform[1]. Using the data of companies completing the split-share structure reform, we nd that accounting information plays its role throughout the reform. The market recognizes the role of accounting conservatism on stock pricing, evidently shown by the signicantly positive relationship between conservatism proxies and cumulative abnormal returns (CARs) for one day, three days, ten days and 30 days around re-open day after the reform. Also, the protability of listed rms in the past will further improve the positive relation between conservatism and market reaction. All in all, accounting conservatism has signicant inuence on stock pricing, affecting the decision making and expectation of investors. Theoretical works on the valuation effect of accounting conservatism have been done for many years (Ohlson, 1995; Feltham and Ohlson, 1996; Penman and Zhang, 2002; Watts, 2003); however, there has been little empirical work (Li, 2007; Balachandran and Mohanram, 2008; Kim and Pevzner, 2010). Therefore, rst, our work provides more evidence of the role of accounting conservatism on stock pricing. Also, our work looks at the situation of China, a typical emerging market, supplementing the research carried out in the USA. Second, current researches on accounting conservatism in China are focusing on whether conservatism exists and how the conservatism varies (Xia and Zhu, 2009; Chen et al., 2010), whereas our work further extends the research eld of conservatism from the perspective of stock pricing. Third, research based on the determinants of stock compensation and market reaction for the split-share structure reform in China are lack of theoretical analysis, while our work provides more theory basis for the market reaction during the stock reform. Section 2 introduces the characteristics of stock valuation and development of China securities market, and then we elaborate Chinas split-share structure reform issue in Section 3. Section 4 gives our hypothesis. Empirical analysis is in Section 6 and Section 7 concludes our paper. 2. The characteristics of stock valuation and development of China securities market The development of Chinas A-share stock market has three evident seedtimes (Liang, 2003). The rst phase is before 1995 since the set up of the Shanghai Exchange on November 26, 1990, the early stock market had developed slowly. The distinct characteristics are small size of market scale and the increasing conict between stock supply and demand. The development of the market is under the process of blindness. The second phase is from 1995 to 1998. During this phase, when the number of listed companies doubled, the securities market expanded with great speed. While this period was a time highly regulated by the authority, when the price-earning (PE) ratio is under controlled by less than 15 times in initial public offering (IPO), contrast with that after IPO by one sixth. The third phase is after 1998. Since 1998, the securities market had stridden to a standard phase. However, Chinas securities market is an emerging market of less than 20 years; an unsound and normative securities system cannot supervise and guide

the behaviors of speculators and investors. Though the stock market was founded in 1990, the ofcial security law, The Security Law of People of Republic of China, was not implemented until July 1, 1997. As the judicial/law system and related regulations are rapidly developing, it still cannot meet the need of constructing an efcient capital market. Regarding the enforcement aspect, Chinas securities market still has some problems, especially those illegal affairs without restrictive punishment. On the other hand, the number of canonical institutional investors is few and the number of small investors is large, leading to the deciency of investor structure. This deciency results in a lack of stability in the market, providing conditions for minority institutional speculators to manipulate the stock price via their advantages of capitals and information. The speculation atmosphere is severe in the market, investors including the institutional investors intend to prefer the short-term trading, and some institutional investors even manipulate the trend of stock price. In addition, the consulting organizations, which should play as an intermediary to speed up the information delivery, however, prick up the information asymmetry in the securities market, further promoting the short-term trading (Tian, 2003; Tang, 2003; Tan, 2003). Stock turnover ratio in Chinas securities market, in Shanghai or Shenzhen, is much higher than that in foreign capital markets. From 1992 to 2000, the turnover ratio in A-share stock market was four times a year; some individual stock is even turned over higher to 100-200 times. While this PE ratio in foreign markets is usually around 15 times, in Chinas A-share market, the average level is above 30, for some individual stock it is hundreds of times, even thousands of times (Tian, 2003). Information promotes the market to the equilibrium. When information conveys signals to some investors, changing their prior belief about the stock price, the market will make corresponding adjustments (Grossman and Stigliz, 1976). Accounting earnings is the most popular information receiving the attentions of investors, and earnings information in annual and periodical reports guides the intrinsic value of stocks and is most valuable. Therefore, disclosure of earnings information has the most inuence on the behavior of investors. The unexpected earnings and sign of stock CAR are positively related; the abnormal return (AR) during the announcements period is positively related with the unexpected earnings (Chen et al., 1999). Also, during the earnings announcement period, there exists an abnormal turnover phenomenon, and the information is probably released ahead of schedule (Chen and Chen, 2001). Information is released in advance when signicant events happen, such as the earnings ercely uctuation, high seasoned offerings, signicant investment, ownership transferring and so on. In Chinas securities market, manipulation of stock price by the insiders with information advantage is severe. Wire-pullers with the inside information can purchase stock in advantage of their capital dominance before the release of information and sell out those stocks or continuously drive up the price after the release. Manipulation by the bankers aggravates the quality of accounting information disclosure (Chen and Qin, 2003). In other words, stock price can hardly reect the fundamental value of rms if it is manipulated by the bankers. Manipulation by the bankers leads to the over-uctuation of stock prices. The market is pervaded with the atmosphere of speculation. Investors including the institutional investors tend to prefer the short-term trading, and some institutional investors even manipulate the stock price (Zhang and Chen, 2001). The heavy speculative atmosphere in Chinas securities market leads to bubbles in stock prices. In 2001, economists, like Jinglian Wu, had a erce debate about the stock

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bubble in Chinas securities market. Fureng Dong suggests that if PE ratio is compared, this ratio in China is much lower than that in Japan, where the PE rate is higher to 80 times, even 100 times. PE ratio in China seems to be high, but it is still reasonable. First, since Chinas securities market is still in its young phase, and supply of stock cannot meet the demand, this results in high stock prices. Second, stocks in China are not all circular, only one-third of those stocks can be traded in the open market[2], thus the price seems to perform well and is high. Xiaonian Xu suggests that it is not realistic to nd a reasonable PE ratio in the world. Considering the current situation in Chinas securities market, investors should admit that the PE ratio seems to be overvalued. Weiying Zhang proposes that some listed companies are decient, manipulating their accounting records and suffering loses. But why do the investors still pay much money for their stocks? It is evident that there exits some bubbles. Considering this, he supports the judgement of Jinglian Wu. Economists represented by Jinglian Wu suggest that PE ratio of, for example, 60 times is so high that the growth of the economy in any country cannot sustain such a high PE ratio. These comments and qualitative analysis by economists about the bubbles in Chinas securities market is explanatory to some extent; however, it is not enough. Though the empirical research is a few and almost indirectly test to ascertain the bubble, those can give quantitative support for existence of bubbles. Researchers investigate whether data are meeting the certain characteristics and conditions of bubbles, exemplied by the auto regression test in Zhou (1998) and Zhou and Zhang (1999). Li (2005) directly investigates the 13 years time series characteristics of the Shenzhen index from October 1992 to June 2005, starting with a description of the trend behavior of certainty bubble theory model. His results show that this model can explain the stock movement preferably, supporting the existence of bubbles in Chinas securities market. Debates among economists and the evidence in empirical research indicate bubbles in the market and the stock prices are overvalued. 3. Chinas split-stock reform Bubbles in the securities market, over speculation and kinds of adverse behaviors to investors are related to the phenomenon of ownership separation (not all-circulation of stocks) to some extent, such as the high premium phenomenon in IPOs (Liu and Li, 2000; Du et al., 2001), and the corporate governance problems related with the largest shareholders, including related party transactions (Chen and Wang, 2005), embezzling the listed companies (Li et al., 2004; Zhang and Xu, 2005; Ma et al., 2005), tunneling cash dividends (Yuan, 1999; Lv and Zhou, 2005) and changing the use of capital raised (Zhang and Zhai, 2005). Ownership separation means that not all stocks can be traded in the public market, which is disadvantageous for shareholders whose stocks cannot be traded freely. These shareholders and management with un-circular stocks cannot achieve benet of stock appreciations in the public market; on the other hand, shareholders with circular stocks, and even the market, have no power to force the controlling shareholders and management to make decisions benecial to small circular shareholders because they have less voting rights. Therefore, those controlling shareholders and management do not care about the market price of their stocks, and what they want are embezzlement and tunneling from those minorities. Current market valuation in Chinas securities market is severely distorted due to the ownership separation (Ba, 2005).

As an attempt to solve the ownership separation problem, the State Department issued Regulations on Decreasing State Ownership to Raise the Fund for Social Security in June, 2001 (State Council of China, 2001). However, this guide was vehemently opposed by the market, represented by the dramatic drop-off in prices for all stocks. Four months later, on October 22, 2001, China Securities Regulation Committee (CSRC) announced that it had ceased to implement the fth term in Regulations on Decreasing State Ownership to Raise the Fund for Social Security (State Council of China, 2001), and it would publicly collect proposals of decreasing the state ownership in listed companies and investigate the proper solutions to complete this reform. On June 23, 2002, the State Department announced that it would cease implementing the term of decreasing the state ownership in the Regulations on Decreasing State Ownership to Raise the Fund for Social Security (State Council of China, 2001) except for those companies listed abroad. Hence, the policy of decreasing state ownership was suspended ofcially. In early February 2004, the State Department issued the The State Departments Opinions about the Stable Development and Opening Reform of Capital Market (State Council of China, 2004), pointing out denitely that solve the separation of ownership stably and afrmatively. On April 29, 2005, CSRC issued Notice about the Issues related with the Ownership Separation Reform Experiment (CSRC, 2005) in the allowance of the State Department, indicating the start-up of experiments of ownership separation reform (split-stock reform). On May 9, 2005, four listed companies, including Tsinghua Tongfang, Sanyi Zhonggong, Zijiang qiye and Jinniu Energy, were on the rst tentative list to initial the all-circulation reform. On September 12, the rst list was announced including 40 listed rms. From then on, all listed companies in Chinas A-share market were beginning to launch the all-circulation reform and that thing was even put on the ofcial agenda to be nished in 2006. The following time-axle illustrates the process of the split-stock reform (Figure 1).
No-trading No-trading

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Pre-reform

Negotiation

Trading

Voting

Post-reform

Close-day

Open-day

Registration day

Re-open-day

Notes: Negotiation, the stock is closed for several days, when the un-circular shareholders are negotiating with the investors, mostly the circular shareholders, for the compensation they should pay for the liquidation of their un-circular stocks; registration, before the stock is closed again, stockholders should register their stock for the shareholders meeting; Voting, on the day of the shareholders meeting, stockholders can vote for the reform plan. If above two-thirds of those circular investors attending the meeting approve the plan, then the reform plan is passed and the compensation that un-circular shareholders pay to circular shareholders will be transferred when the stock is re-opened and traded that day; Re-open-day, on that day the stock fluctuation is not restricted within the 10 per cent, which is the bond in stock transactions during daily trading in China. And after that day stock fluctuation is still in the 10 per cent range

Figure 1. Process of split-stock reform for listed rms

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While the listed rms are beginning to launch the split-stock reform, the stock is closed for several days when the un-circular shareholders are negotiating with the investors, mostly the circular shareholders, for the compensations they should pay for the right of the liquidation of their un-circular stocks. After they decide the compensation and the reform plan, the stock is re-opened and investors can trade the stock in the market. Since in the reform plan, it will announce the time of the shareholders meeting, during which the reform plan will be voted on. Before the stock is closed again, stockholders should register their stocks for the shareholders meeting, and then on the day of the shareholders meeting, they can vote for the reform plan. If above two-thirds of those circular investors who attend the meeting agree with the plan, the reform plan is passed and the compensation that un-circular shareholders pay to circular shareholders will be transferred when the stock is re-opened and traded that day. On that day, the stock uctuation is not restricted within the 20 per cent boundary upward and downward, which is the bond in stock transactions during daily trading in China. After that day, stock uctuation is still in the 20 per cent range. Why do the un-circular shareholders pay compensation to the circular-shareholders? Because shares of un-circular shareholders are not allowed to circular in the second market before the reform (due to some complicated historical reasons), and if they want their shares to be circular in the market, they are required to compensate for the circular shareholders with their shares, or cash, or other means, to exchange for the circular right of their shares after the reform. When the compensation plan is accepted by the circular shareholders, which is approved in the formal shareholders meeting, then shares that are not circular before the reform are going to be traded freely in the second market[3]. In practice, almost all the un-circular shareholders compensate for the circular investors with their stock, cash or other means for the liquidation rights of the un-circular stocks. Figure 2 shows the market performance around the re-open day after the reform plan is passed. Daily stock uctuation in China is restricted in the range of 20 per cent, except for the re-open day during the all-circulation reform. The diamond-shaped line in Figure 2 indicates the CAR[4], the rectangular-shaped line represents the cumulative
0.5 0.4 0.3 CAR 0.2 0.1 0 CR r

Figure 2. Market performances around open-day after share reform

Notes: R, the average daily return of sample firms after considering the stock compensation, cash dividends and seasoning offerings; CAR, the cumulative abnormal return; CR, the cumulative return

30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

0.1

return (CR) and the triangle-shaped line shows the daily return (R) for a 30 days window. The market reaction for split-stock reform is upward all the time. Though the CAR in the two days after relist is adjusted, it maintains upward. For investors, shareholders fortune after re-list goes upwards. Though the whole situation is positive, individual stock shows different uctuation and change in shareholders wealth presents distinctions. Table I describes the uctuations of the 1,118 sample rms on the event day. About 69 per cent of those stocks are rising on the relist day, and 36 per cent stocks are rising and higher than 10 per cent bond. However, 31 per cent stocks are still downward, and return for 6 per cent stocks are lower than 2 10 per cent. It is evident that the fortunes for shareholders change to different extents. This shows that market and investors indeed revaluate the stocks. Table II shows the market performance of different windows for the split-stock reform, one day, three days, ten days and 30 days window around the re-open day. In a 30 days window, average CAR is nearly 22 per cent, some even jumps to 185 per cent. And the highest CAR is mostly focused within three days around re-open as shown by the maximum CAR for CAR1. Is the wealth change due to the higher un-circular stock shock to the market or the un-satisfaction of circular shareholders to the compensation, or other reasons? What about the role of accounting information in the valuation process? In the following paragraphs, we try to investigate these issues.
Number Upwards Above 10 per cent 5-10 per cent 0-5 per cent Downwards Above 10 per cent 5-10 per cent 0-5 per cent Total 773 401 155 217 345 68 106 171 1,118 Proportion in group (%) 52 20 28 20 31 50 Proportion in sample (%) 69 36 14 19 31 6 9 15 100

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Notes: CAR, cumulative abnormal return; CAR0, CAR for the re-open day

Table I. Market performance on open-day-CAR0

CAR (2 1,1) n Mean Min Median Max 1,118 0.0696 20.3381 0.0436 1.8293 (23,3) 1,118 0.0853 2 0.3374 0.0608 1.9004 (210,10) 1,118 0.1559 20.3378 0.1153 1.7435 (230,1) 1,118 0.2000 2 0.2666 0.1551 2.0724 (230,10) 1,118 0.2024 20.3089 0.1622 2.0022 (2 30,30) 1,118 0.2197 2 0.4278 0.1717 1.8487 Table II. Market performance around relisting day

Notes: CAR, cumulative abnormal return; CAR1, CAR for one trading day around the re-open day; CAR3, CAR for three trading days window; CAR10, CAR for ten trading days window; CAR30, CAR for 30 trading days window; CAR301, CAR for 30 days before re-open and one day after re-open; CAR3010, CAR for 30 days before re-open and ten days after re-open

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4. Theory and hypothesis Quality of earnings is the focus of analyzing the relation between accounting information, particularly accounting earnings, and market reactions. Quality of accounting earnings is affected by many factors, one of which is the principle of conservatism. Commentators sometimes claim that the practice of conservatism in accounting produces higher quality earnings. Conservatism yields lower earnings, they say, and so prima facie these conservative earnings are of high quality. Feltham and Ohlsons (1995) valuation framework predicts a positive association between the valuation multiple on operation assets and the accounting conservatism. The relation between operating assets and operating accruals provides the basis for Feltham and Ohlsons (1995) further prediction of a positive association between the response coefcient to operating accruals and the accounting conservatism. Stober (1996) and Ahmed et al. (2000) present evidence that the valuation multiple on operating assets is increasing in conservatism. Hence, by investigating the relation between conservatism and the differential response to operating accruals, Mason (2004) extends the ndings of Stober (1996) and Ahmed et al. (2000) and provides additional evidence on the agreement of the Feltham and Ohlson (1995) framework. When rms are partitioned on conservatism, evidence is generally consistent with Feltham and Ohlsons (1995) prediction that as conservatism increases so does the magnitude of the response coefcient on operating accruals. Balachandran and Mohanram (2008) nd no negative impact of un-conditional conservatism on value-relevance of earnings. Greater conservatism results in a stronger market response to the accounting numbers. Specically, to the extent that conservatism reduces perceived variance of future expected cash ows (because conservatism makes estimates of such cash ows more reliable), the market should reward more conservative rms with higher valuation multiples (Kim and Pevzner. 2010). Following Balachandran and Mohanram (2008), Li (2007) shows that un-conditional conservatism reduces uncertainty in analyst forecasts. While Kim and Pevzner (2010) nd that higher current conditional conservatism is associated with lower probability of future bad news, proxy by missing analyst forecasts, earnings decreases and dividend decreases. They also nd weak evidence that the stock market reacts stronger (weaker) to good (bad) earnings news of more conditionally conservative rms, providing additional evidence that conditional conservatism affects stock prices. Therefore, both conditional conservatism and un-conditional conservatism can improve the value relevance and information contents of nancial reporting, and the market will reward more conservative rms with higher valuation multiples. Actually, the market reaction to conservatism is due to the current the future higher expected earnings. GAAP requires rms to recognize revenue only if recognition standards are satised, namely, reliably measured and matched with costs, which results in un-recognition of positive net present value projects and lower earnings. Moreover, accounting standards on measurement and recognition, like the expense of R&D, makes the book value lower than the market value (Feltham and Ohlson, 1995). However, it can be expected that future earning price will exceed the expected return, which means conservatism accounting will lead to higher protability. Ohlson (2009) suggests that with growth being expected, it follows that the rms price is at a premium relative to book values and capitalized forward earnings. In other words, growth and conservative accounting are the two sides of the same coin. Easton (2009) also suggests that more growth is expected

in future accounting earnings to complete the correction for conservatism. Therefore, the inuence of conservative accounting on stock pricing is exhibited on the will correction for future accounting performance. Before 2005, about 60 per cent of the stock of listed rms cannot be traded freely on the stock market which leads to the indifference of management and controlling shareholders for the stock price since they cannot cash their benets through the stock exchange and price appreciation. Due to the un-circular of all stocks in the Chinese securities market, the market valuation is wholly distorted (Ba, 2005). Therefore, the initiative for the stock reform is to solve the great agency issue of listed rms and improve the performance and valuation. Once the stocks are circular in the market, the interests of management and controlling shareholders will be closely related with the market value of the rm and then they will take more considerations of the consequences of their decisions and behavior on the stock price. For the eon of all circular, the stock market will be more powerful and minority shareholders can give higher pressures on management and controlling shareholders through voting with feet. Thus, the tunneling behaviors will be less and agency problems will be reduced, leading to improved performance and the market value will properly reect the value of the rm. Regulation authorities, investors and other institutions all give high expectations for the split-stock reform and hope the governance of listed rms will be improved with the same applying to performance and growth. Investors will re-evaluate the stock based on the past accounting information. While the past protability is the basis for future pricing, higher past earnings will predict the future to some extent and past growth also reects this perspective. Firms with conservative reporting in the past will release more reserve and achieve higher growth (Ohlson, 2009), namely future earnings will show higher growth to correct the conservatism (Easton, 2009). Therefore, this expectation indicates higher growth and better accounting performance, leading to higher investors wealth. On the other hand, in 2005, the Ministry of Finance Peoples Republic of China issued 22 Exposure Draft of Proposed Accounting Standards which brings the fair value measurement, including the consolidation, investment real estate, donation and subsidy, assets impairment, annuity, recognition and measurement of nancial instruments, nancial assets transfer and arbitrage. In February 2006, the Ministry of Finance Peoples Republic of China ofcially issued the new Chinese GAAP and required the listed rms to follow the new GAAP. Fair value measurement changes the past valuation model which is based on historical cost and would correct the underestimate of earnings and rm value. Moreover, rms can recognize future expected benets in their current nancial statements for some conditions. For example, the gain from fair value can increase the current earnings and net assets to a great extent. Therefore, rms with conservative reporting in the past will show higher accounting performance under fair value measurement, and the market reaction will be much stronger. Overall, we hypothesise that: H1. The more conservative of accounting information, the better market performance of listed companies around share reform re-open day. H2. Better accounting earnings will improve the positive relation between conservatism and market performance around share reform re-open day.

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5. Variables and data 5.1 Variables The dependent variables are CAR around re-open day (after allowing for the dividends, offerings and compensation for the reform) under nave model that AR is calculated as the daily return minus the average return on market portfolio. In order to examine different time windows, we calculate the CAR0 on the re-open day, CAR1 for one trading day around the re-open day and CAR3, CAR10, CAR30 for three, ten and 30 trading days window around the re-open day. CAR301 means CAR for 30 days before re-open and one day after re-open; CAR3010 means CAR for 30 days before re-open and ten days after re-open. CAR301 and CAR3010 are used to analyze the variations before re-open day. In order to minimize the inuence of outliers, we winsorize the top and bottom 1 per cent of CARs. Accounting information includes accounting conservatism and the protability proxy. Conservative accounting will lead to negative accruals, the bigger the amount, the more conservative is the accounting information (Givoly and Hayn, 2000), so we use three years cumulative accruals to proxy for the conservatism, as Ahmend and Duellaman (2007), Qiang (2007) and Xia and Zhu (2009). Accruals are equal to net income minus cash ow from operation then divided by total asset. Since many rms use extraordinary items to manipulate their earnings in China, we also use the net income before extraordinary items to compute the accruals. Thus, CumAcc1 is three years cumulative accruals using net income; CumAcc2 is three years cumulative accruals using net income before extraordinary items to compute the accruals. To explain the results more easily, we multiply the cumulative accruals by 2 1, Conserv1 2 CumAcc1 and Conserv2 2 CumAcc2; therefore, the larger the proxy, namely Conserv1 and Conserv2, the more conservative is the accounting information (Givoly and Hayn, 2000; Ahmend and Duellaman, 2007; Xia and Zhu, 2009). In order to minimize the inuence of outliers, we winsorize the top and bottom 1 per cent of the conservatism measures[5]. We use the conservatism measure at the prior year since investors decision is based on the past information. Protability is proxy by the average return on equity (ROE) for the past three years, where the ROE equals to net income divided by the equity at the end of period. We also use the volatility of the past earnings as a robust test, which is equal to the standard deviation of ROE (SDROE) for the past three years. Since the growth and conservative accounting are the two sides of the same coin (Ohlson, 2009), we also control for the growth effect when considering the inuence of conservatism on future performance revision by using the average revenue growth rate of the past three years (Grow). Ownership reform is a key step for the healthy development of the China securities market. It is designed to solve the severe agency problem between large shareholders, the controlling shareholders and the minority shareholders or the circular shareholders. Agency problems must have to be solved more effectively and rms are operating more efciently after the reform. Special treatment (ST) companies are problematic due to the prior worse performance and corporate governance with greater agency problems; thus, the market will consider that those companies will be improved to a greater extent and their values will go up. Then, the market will give more approbates for reforms by those companies; thus, we use a dummy variable (ST) to control. ST is a dummy variable, 1 indicates the rm is ST for the prior year before reform, and 0 otherwise.

Before the all-circulation reform, only about one-third of the stocks of Chinese listed companies are circular, leading to the overvaluation of stock price. If all the stocks are circulated, this will give a big shock to the market and return for stocks will drop signicantly. From the supply and demand perspective, bigger supply will signicantly shock the equilibrium under the demand does not change signicantly. We use the ratio of un-circular stock to proxy for this shock, and the ratio is the un-circular stock to total stock in the prior year before reform (Unliquid). In the reform plan, some rms even propose management stock incentives plans. Since managers of listed rms are low paid in China and compensations are not linked to stock price, more expropriation conducts are found before the reform and management do not care for the stock price. To alleviate this problem and give more incentive for management, some rms propose the stock incentive plans and it is sure to receive more attention and welcomed by the circular shareholders. Thus, we also control for the inuence of stock incentive plan, using a dummy variable (incentive), 1 means the reform plan includes a management incentive plan, and 0 otherwise. The compensation from un-circular shareholders to the circular shareholders for the liquidate right of their stock may signicantly inuence the market performance and the return. The higher the compensation rate, the more stock compensation circular shareholders will receive. The higher proportion of circular stock which brings bigger shock to the market, the lower wealth circular shareholders will benets and the return for all stocks. To control for the compensation effects, we use the compensation by un-circular shareholders to circular shareholders computed as the stock compensation, which is from Wind Database (Compen). Circular shareholders should vote for the proposal or the reform plan; if they accept the plan, then they will get the compensation supplied by un-circular shareholders. The participation ratio and the approval ratio show their attention and satisfactions for the plan. If they do not care for the shareholder meeting and are not satised with the plan, the market will reect their emotion. We use the participation ratio (Ltcy) and the approval ratio (Ltzc) to proxy for their emotions. All-circulation reform receives positive appraisals from many elds and investors give high expectations to the compensation rate from the un-circular shareholders. But in the atmosphere of speculation, institutional investors and other investors may take this chance for arbitrage and speculation. From the proposal of the reform plan to the completion, the longer the time span, the more opportunity for speculation and manipulation. Further, the longer time span, the more problems listed companies may encounter during the reform or have done in their prior operation. Therefore, the time span may inuence the market performance. We use the time span (Time) from the approval day, when CRSC approve the reform plan proposed by listed companies, to the re-list day. Some listed companies issue other types of stocks, like B-share, H-share or S-share. But in the process of all-circulation reform, foreign investors do not participate. They can speculate if there exist arbitrage chances. Further, those companies use the international accounting standard or US GAAP, the accounting information may be somewhat different from those only issues A-share. Hence, we add a dummy variable to control, OtherSec, 1 indicates rms that also issue other type of shares, and 0 otherwise. We also control for the size effect and leverage effect in the return regressions: the nature log form of asset at the end of prior year before reform (Size) to proxy the size and total debt ratio (Lev) to proxy the leverage. Further, some industries are heavily speculated

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by investors, like colored metal, electricity, energy exploration, nance and estate since 2005. So we also control for the industry effect. Industry is based on the CSRCs two-digit industry code excluding the nancial. Thus, we end up with 11 industries for controlling the industry effect. 5.2 Sample and data We collect the companies successfully completing the reform before December 31, 2006 and re-opened before that day. There are 1,118 samples in total. According to the documents issued by CSRC, the uctuation range of stock trading for companies who have not proposed the reform before 2007 will be restricted to 10 per cent, not the normal standard 20 per cent. To avoid difference in the uctuation of stock trading, we collect samples completing the reform and re-opened before December 31, 2006. Since the computation of accounting conservatism needs three years nancial data, we drop 114 samples who listed after 2003. And we also drop six companies in the nancial industry, 80 samples whose information is not complete such as no information on the voting results, no information on compensation for circular shareholders or some other nancial information is missing. Finally, we have 918 samples. The lists of rms launching the all-circulation reform, prospectus of reform plan and announcement of voting results and implementation of all-circulation reform are from the websites: http://gqfz.p5w.net/gqfz/index.html; http://nance.sina.com.cn/stock/ chinaggzw Stock market data, the compensation for circular shareholders and other nancial accounting data are from Wind database. 6. Empirical analysis 6.1 Descriptive statistics Table III shows the descriptive statistics of regression variables. Due to the unbounded uctuation on the re-open day, individual stock exhibits different market performance. The CAR for one-day window is 7.02 per cent, and the median return is 4.6 per cent. Even if we make them winsorized, the highest CAR is higher as 63 per cent, the lowest is about 220 per cent, there still exists a huge range. Average CAR for 30 days window goes to nearly 23 per cent, and the highest is doubled, while the lowest loses about one-fourth. Accounting conservatism proxy is 0.02 for Conerv1 and 0.03 for Conerv2; those positive numbers seem to mean that accounting report for listed rms tend to be conservative (Givoly and Hayn, 2000; Ahmend and Duellaman, 2007; Qiang, 2007). Also, there are still large variations. The minimum is 2 0.68, aggressive reporting policy; while the maximum is 0.81, more conservative. The average protability for the last three years is about 1.5 and 5.6 per cent for median sample, not high return for stockholders. Maybe after the reform, the accounting performance will be enhanced and stockholders will get more from listed rms. About 6 per cent samples are ST rms, not a large proportion. The rate of un-circular stocks to total stocks is 58.4 per cent on average a huge amount of stocks, which will circular in the market and shows a big shock. Though not all the stock will be circular in market, leaving a one or three-year bafe, all those stocks will be available for sell on the market after that time, exists a big problem. Of the sample rms, 17 per cent are proposing their management incentive program accomplishing the reform. Those rms may receive more after the reform, alleviating agency problems more efciently.

34

n CAR1 CAR3 CAR10 CAR30 CAR301 CAR3010 Conserv1 Conserv2 ROE Grow ST Unliquid Incentive Compen Ltcy Ltzc Time Size Lev Othersec 918 918 918 918 918 918 918 918 918 918 918 918 918 918 918 918 918 918 918 918

Mean 0.0702 0.0862 0.1649 0.2297 0.2013 0.2078 0.0184 0.0298 0.0146 0.4762 0.0577 0.5840 0.1732 3.0041 0.3434 0.8861 59.0654 21.3906 0.5129 0.1035

Standard 0.1472 0.1656 0.2103 0.26776 0.2184 0.2336 0.2000 0.1941 0.9036 4.5352 0.2334 0.1198 0.3786 0.8575 0.1521 0.0732 25.7051 0.9858 0.2057 0.3048

Min 2 0.1968 2 0.2204 2 0.1930 2 0.2467 2 0.1616 2 0.2029 2 0.6800 2 0.6100 2 26.5777 2 0.8100 0 0.1200 0 0.2200 0.0132 0.6678 28 18.3200 0.0100 0

Median 0.0458 0.0613 0.1195 0.1768 0.1538 0.1648 0.0100 0.0200 0.0563 0.2000 0 0.6000 0 3.0000 0.3081 0.8994 51 21.3600 0.5200 0

Max 0.6292 0.7547 0.9249 1.0893 0.9357 1.0255 0.8100 0.8300 2.3022 133.42 1 0.9100 1 10.3000 1.0000 0.9994 292 26.9800 2.8600 1

Accounting conservatism

35

Notes: CAR, cumulative abnormal return; CAR1, CAR for one trading day around the re-open day; CAR3, CAR for three trading days window; CAR10, CAR for ten trading days window; CAR30, CAR for 30 trading days window; CAR301, CAR for 30 days before re-open and one day after re-open; CAR3010, CAR for 30 days before re-open and ten days after re-open; Conserv1 and Conserv2 are accounting conservatism proxy, using three years cumulative accruals multiplied by 2 1; ROE, the average ROE for the past three years; Grow, the average revenue growth for the past three years; ST, a dummy variable; 1, yes; 0, otherwise; Unliquid, the un-circular stock to total stock before share reform, proxy for the shock to the market; Incentive is a dummy variable; 1, the reform plan includes a management incentive program; 0 otherwise; Compen, the compensation paid by un-circular shareholders to circular shareholders computed as the stock compensation, which is from Wind Database; Ltcy, the participation rate of circular shareholders attending the shareholders meeting; Ltzc, the approval ratio of circular shareholders on the reform proposal; Time, the time span from the approval day, when CRSC approve the reform plan proposed by listed companies, to the re-open day; Size, the nature log form of asset at the end of last year to proxy the size; Lev, the total debt ratio (Lev) proxy the leverage; Othersec, a dummy variable, indicating whether the rm issues other type of shares, like B, S, or H; 1, yes; 0 otherwise

Table III. Variables description

Stock compensation for the liquidation rights from un-circular shareholders to circular shareholders also shows distinction, from 0.22 to 10.3 shares per 10 shares, and the average is three shares per 10 shares. Circular shareholders will get an additional three shares from un-circular shareholders under the condition that the rest stock un-circular shareholders hold will be traded in the market one or three years later. The attitude of circular shareholders to the reform plan is not unanimous. Only one-third attended the shareholders meeting and voted for their right on average, and one-tenth are still not satised with the compensation or the reform plan. It is sure to perform differently on the second market when investors are not satised with the companies. From the approval day to the implementation day, the average time span is 59 days, with the shortest for 28 days, and the longest for more than half a year. A longer time exists for speculation and arbitrage. Further, rm size and leverage also indicate much difference in rms fundamentals.

NBRI 2,1

36

6.2 Correlation analysis Table IV shows the correlation analysis between the market performance and accounting conservatism proxy. Panel A shows the correlation between CARs and Conserv1 and panel B shows the correlation for Conserv2. It shows that conservatism is signicantly positively related with the market performance, both for Spearman and Pearson correlation coefcients. The positive relation between CARs around the re-open day and conservatism is not only for short windows but also for longer windows, as 30 days. The correlation analysis in Table IV shows that CAR around the re-opened day after completing the reform is positively related with accounting conservatism. More conservative accounting will continue to be more conservative, and it will lead to high CARs, showing the pricing function of accounting conservatism. 6.3 Portfolio analysis We also divide the data into ten quintiles according to the conservatism. Market performance around the re-open day is shown in Table V. We compare for the highest quintile and the lowest one. Panel A shows the mean difference comparisons and panel B shows the median difference contrast. The CARs for the highest conservatism are much better than the lowest the differences are nearly one half of the lowest amount and for some CARs the differences are much higher. Different market performance could mean that markets react to the reform allowing for the quality of the accounting information, and here they refer to the accounting conservatism to some extent. More conservative accounting will continue to be more conservative, which will protect investors better than aggressive accounting, even though the market reaction for the reform is better for all rms. Conservative accounting will bring better returns for shareholders during the current reform and in the future. 6.4 Correlation Table VI shows the Pearson correlation coefcients for each regression variable. It turns out that correlation coefcients are not higher than 0.3, which means the multi-co linearity is not severe.

(21,1) Conserv1 Conserv2 Spearman Pearson Spearman Pearson 0.0512 0.0923 * * * 0.0379 0.0850 * * *

(23,3) 0.0766 * * 0.1084 * * * 0.0611 * 0.0994 * * *

CAR (210,10) 0.0660 * * 0.0821 * * 0.0555 * 0.0746 * *

(230,1) 0.0855 * * * 0.0988 * * * 0.0700 * * 0.0877 * * *

(230,10) 0.0829 * * 0.1041 * * * 0.0675 * * 0.0902 * * *

(230,30) 0.0775 * * 0.1008 * * * 0.0606 * 0.0883 * * *

Table IV. Correlation analysis

Notes: Signicance at: *0.10, * *0.05 and * * *0.01; CAR, cumulative abnormal return; CAR1, CAR for one trading day around the re-open day; CAR3, CAR for three trading days window; CAR10, CAR for ten trading days window; CAR30, CAR for 30 trading days window; CAR301, CAR for 30 days before re-open and one day after re-open; CAR3010, CAR for 30 days before re-open and ten days after re-open; Conserv1, Conserv2 are accounting conservatism variables, proxy by prior three years cumulative accruals, multiply by 21

(21,1) Panel A mean test Portfolio highest Portfolio lowest Difference t Panel B median test Portfolio highest Portfolio lowest Difference Mann-Whitney Z 0.1046 0.0733 0.0313 1.3351 * 0.0718 0.0602 0.0116 0.491

(23,3) 0.1361 0.0798 0.0564 2.1499 * * 0.0963 0.0491 0.0472 1.888 *

CAR (2 10,10) (2 30,1) 0.2259 0.1705 0.0554 1.6643 * * 0.1849 0.1255 0.0595 1.774 * 0.2743 0.1786 0.0956 2.8457 * * * 0.2349 0.1324 0.1025 3.039 * * *

(2 30,10) 0.2890 0.1936 0.0954 2.5342 * * * 0.2377 0.1252 0.1125 2.720 * * *

(230,30) 0.3074 0.2085 0.0989 2.3439 * * 0.2554 0.1512 0.1042 2.444 * * *

Accounting conservatism

37

Notes: Signicance at: *0.10, * *0.05 and * * *0.01; CAR, cumulative abnormal return; CAR1, CAR for one trading day around the re-open day; CAR3, CAR for three trading days window; CAR10, CAR for ten trading days window; CAR30, CAR for 30 trading days window; CAR301, CAR for 30 days before re-open and one day after re-open; CAR3010, CAR for 30 days before re-open and ten days after re-open; we divide the data into ten quintiles according to the conservatism; highest, highest conservatism; lowest, the lowest group in conservatism

Table V. Portfolio strategy

6.5 Regress analysis Table VII investigates the relation between the market performance and the accounting conservatism around the re-open day in split-stock reform for short and mediate windows. The rst two columns show the regressions for a short window, one day around the re-open day, using two conservatism proxies. The middle two columns are for three days window, and the last two columns are for ten days window. For all these windows, Conserv1, the rst proxy for accounting conservatism, is signicantly positively related with CARs in all regressions. Conserv2 and CARs are also positively related, signicant in 0.10 levels, though not signicantly in ten days window. Thus, generally speaking, the positive relation between accounting conservatism and CAR around the reform day indicates the role of conservatism in stock pricing, which means that investors will predict the future of rms based on the past conservatism of nancial reports, more conservative reporting will release more reserve in the future and achieve higher growth (Ohlson, 2009) and thus future earnings will show higher growth to correct the conservatism (Easton, 2009). Moreover, accounting performance for rms with conservative reporting will be further improved under the fair value measure; thus, the market will be more positive to the earnings increase. H1 is supported. Coefcients for cross-term of protability and conservatism, ROE Conserv, are all positive and signicant at 0.01 levels, which means better past performance will improve the positive relation between market reaction and conservative reporting. H2 is supported. Coefcients for ROE are not signicant, and it may be because the market tends to care more about the future protability reserve and growth potential. Coefcient for Grow is signicant in regression for CAR10 but not signicant for other windows. The ST group is signicantly distinguished from the non-ST group the former gains more during the reform. ST rms may have server agency problems, and after the reform, all-circulation phenomenon will bring more pressure from the market to the management, alleviating the agency cost and bringing in more benets for large shareholders and circular shareholders. The rate of un-circular stock does not have

38

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Conserv2 ROE Grow ST Unliquid Incentive Compen Ltcy Ltzc Time Size Lev Othersec 2 0.107 2 0.089 0.217 0.026 2 0.029 0.003 0.001 0.016 0.100 0.026 0.168 0.056 0.012 20.188 20.025 0.023 0.025 0.027 20.011 20.028 0.091 20.120 0.023 20.022 20.020 20.021 20.082 0.036 20.053 0.031 0.009 0.036 20.018 0.048 2 0.052 0.137 2 0.065 0.017 0.209 2 0.252 0.270 0.008 0.047 0.329 2 0.021 0.066 2 0.017 2 0.104 2 0.084 2 0.226 0.019 0.1681 0.114 20.040 0.067 20.039 0.034 2 0.265 0.204 2 0.099 2 0.069 0.023 0.047 0.297 0.001 0.197 20.078 0.021

Notes: Conserv1 and Conserv2 are accounting conservatism proxy, using three years cumulative accruals multiplied by 2 1; ROE, the average ROE for the past three years; Grow, the average revenue growth for the past three years; ST, dummy variable, 1, yes; 0, otherwise; Unliquid, the un-circular stock to total stock before share reform, proxy for the shock to the market; Incentive, a dummy variable; 1, the reform plan includes a management incentive program; 0, otherwise; Compen, the compensation paid by un-circular shareholders to circular shareholders computed as the stock compensation, which is from Wind Database; LTCY, the participation rate of circular shareholders attending the shareholders meeting; LTZC, the approval ratio of circular shareholders on the reform proposal; Time, the time span from the approval day, when CRSC approve the reform plan proposed by listed companies, to the re-open day; Size, the log form of asset at the end of last year to proxy the size; Lev, the total debt ratio (Lev) proxy the leverage; Othersec, a dummy variable, indicating whether the rm issues other type of shares, like B, S, or H; 1, yes; 0, otherwise

Table VI. Pearson correlation Conserv2 ROE Grow ST Unliquid Incentive Compen Ltcy Ltzc Time Size Lev 0.037 0.051 20.026 0.016 2 0.069 0.080 0.102 0.077 0.259 2 0.020

Conserv1

0.970 20.124 20.101 0.232 0.023 20.024 0.015 20.003 0.016 0.089 0.041 0.201 0.042

Show-term CAR1 (21,1) CAR3 (2 3,3) Conserv2 0.050 * 0.018 * * * 0.069 * * 0.022 * * * 0.066 * * 0.025 * * * 0.059 * 0.035 * * * Conserv1 Conserv2 Conserv1 Conserv2 CAR10 (2 10,10) Conserv1 0.053 * 0.016 * * * (1.95) (1.77) (2.30) (2.09) (1.65) 0.054 (1.46) (3.79) (3.89) (6.24) (6.13) (10.18) 0.041 * * * (9.94) 0.012 (0.84) 0.011 (0.79) 0.007 (0.45) 0.006 (0.39) 0.005 (20.26) 0.006 ( 2 0.32) 20.001 (21.05) 20.001 ( 2 1.21) 20.001 ( 2 0.37) 20.001 (20.46) 0.002 * * * (2.61) 0.001 * * (2.52) 0.067 * * (2.15) 0.068 * * (2.17) 0.087 * * * (2.61) 0.088 * * * (2.64) 0.112 * * * (3.19) 0.114 * * * (3.22) 20.013 (20.29) 20.013 (20.30) 20.018 (20.35) 20.018 (20.36) 0.001 (0.01) 0.000 (0.01) 0.034 * * * (2.62) 0.034 * * * (2.63) 0.036 * * (2.44) 0.036 * * (2.45) 0.011 (0.63) 0.011 (0.64) 0.005 (20.45) 0.004 (20.43) 0.008 (20.65) 0.008 (20.64) 0.021 (21.52) 0.021 (21.51) 0.038 (0.99) 0.037 (0.99) 0.005 (0.13) 0.005 (0.13) 20.063 (21.22) 20.063 (21.22) 0.134 * (1.70) 0.134 * (1.70) 0.282 * * * (3.08) 0.282 * * * (3.08) 0.868 * * * (7.80) 0.868 * * * (7.80) * * 0.000 (1.66) 0.000 (1.66) 0.000 (1.62) 0.000 (1.63) 0.001 (1.50) 0.001 (1.51) 20.003 (20.60) 20.003 (20.55) 20.002 (20.35) 20.002 (20.29) 20.007 (20.92) 20.007 (20.88) 0.029 (1.10) 0.031 (1.17) 0.022 (0.80) 0.025 (0.91) 0.013 (0.43) 0.016 (0.53) 0.010 (0.61) 0.010 (0.57) 0.009 (0.47) 0.008 (0.43) 0.010 (0.44) 0.010 (0.41) Control Control Control Control Control Control 918 918 918 918 918 918 3.21 3.22 3.81 3.76 8.14 7.95 0.068 0.067 0.082 0.081 0.140 0.140

Mediate-term

Variables

Expsign

Conserv ROE Conserv ROE Grow ST Unliquid Incentive Compen Ltcy Ltzc Time Size Lev OtherSec Inds n F R2

2 ? ? ? ? ?

Notes: Signicance at: *0.10, * *0.05 and * * *0.01; CAR, cumulative abnormal return; CAR1, CAR for one trading day around the re-open day; CAR3, CAR for three trading days window; CAR10, CAR for ten trading days window; CAR30, CAR for 30 trading days window; CAR301, CAR for 30 days before re-open and one day after re-open; CAR3010, CAR for 30 days before re-open and ten days after re-open; Conserv1 and Conserv2 are accounting conservatism proxy, using three years cumulative accruals multiplied by 21; ROE, the average ROE for the past three years; Grow, the average revenue growth for the past three years; ST, a dummy variable; 1, yes; 0, otherwise; Unliquid, the un-circular stock to total stock before share reform, proxy for the shock to the market; Incentive, a dummy variable; 1, the reform plan includes a management incentive program; 0, otherwise; Compen, the compensation paid by un-circular shareholders to circular shareholders computed as the stock compensation, which is from Wind Database; LTCY, the participation rate of circular shareholders attending the shareholders meeting; LTZC, the approval ratio of circular shareholders on the reform proposal; Time, the time span from the approval day, when CRSC approve the reform plan proposed by listed companies, to the re-open day; Size, the log form of asset at the end of last year to proxy the size; Lev, the total debt ratio (Lev) proxy the leverage; Othersec, a dummy variable, indicating whether the rm issues other type of shares, like B, S, or H; 1, yes; 0, otherwise; VIFs in all regressions are ,2, showing there is not severe co-linearity in our regression models; in the parenthesis are the white-t-statistics to eliminate the heteroscedasticity: CARi a b1 Conserv b2 ROE Conserv b3 ROE b4 Grow b5 ST b6 Unliquid b7 Incentive P b8 Compen b9 Ltcy b10 Ltzc b11 Time b12 Size b13 Lev b14 OtherSec bj Inds 1

Accounting conservatism

39

Table VII. Accounting conservatism, past earnings and CAR

NBRI 2,1

40

a signicant negative inuence to the market as a huge shock from the supply perspective. This does not mean that the shock to market does exist; we suggest that at the very beginning, investors have not realized the huge shock to the market, and their attentions are focused on the reform itself. Whether the reform plan includes an incentive for management shows their perspective of the future. Incentive programs will give investors more condence in the future, since management will be stimulated and their interest will be connected with circular investors; therefore, those rms will perform better. The stock compensation supplied by un-circular shareholders to circular shareholders is not signicantly related to market performance. Maybe this effect is also reected in their satisfaction with the reform proposal. Participation of circular shareholders in the shareholders meetings does not have much inuence on the CAR, while their satisfactions indeed affect the performance and the market will reect their emotion. The more they are satised, the better the market will reect it, evident in the signicantly positive relation between Ltzc and CARs. The longer the time span for the reform, the more opportunity to manipulate and speculate, thus signicantly inuence the market performance after relist. Results show a signicantly positive relation between the time span and CAR1, but under mediate window, this relation does not hold anymore. The size effect and leverage effect do not have signicant inuence on CARs during the reform. And rms issuing other types of shares, like B, S or H, also do not exhibit distinctions in market performance during the reform. How about the relation in a longer window? Does accounting conservatism still have a role in stock pricing for long window around the re-open day? Table VIII shows the result for a longer window, 30 days around the reform completion day. The rst two columns show the CAR for 30 days before re-open and 1 day after re-open. The middle two columns give the results for 30 days before re-open and 1 day after re-open. The last two columns investigate a longer window, 30 days around the re-open day. CAR301, CAR3010 and CAR30 are all signicantly positively related with conservatism measure (Conserv), consistent with results for short-term windows in Table VI. H1 is further supported. Coefcients for ROE Conserv are also positive and signicant in 0.01 levels, meaning higher past protability will improve the positive relation between conservatism and market valuation, supporting H2. Table IX shows the regression results for the volatility of past earnings instead of earnings level, and for different windows and two conservatism measures. Coefcients for Conserv are still signicantly positive, except for Conserv2 in CAR10 and CAR301, showing that past conservatism will be corrected during the reform and market reaction is much stronger, supporting H1. Coefcients for the cross-term of earnings volatility and conservatism, SDROE Conserv, all signicantly negative, meaning that the more volatile of the past earnings will predict lower persistence in their protability and will lower the positive relation between conservatism and market action. On the other hand, it means more persistence of accounting earnings will improve the positive relation, still supporting H2. Moreover, we also add more controlling variables, such as the characteristics of ultimate shareholders (the control right, the divergence of cash ow right and control right, the nature of ultimate shareholders), the characteristics of the board and the management ownership. The results are basically the same[6].

CAR301 (2 30,1) Conserv1 (1.94) (10.46) 2 0.022 (2 1.11) 2 0.001 (2 1.39) 0.118 * * * (3.12) 2 0.034 (2 0.50) 0.027 (1.52) 2 0.024 * (2 1.75) 0.023 (0.42) (8.77) 0.937 * * * 0.001 * * (2.17) 2 0.010 (2 1.23) 2 0.010 (2 0.30) 2 0.013 (2 0.56) Control 918 11.09 0.174 2 0.034 0.001 (0.70) 0.115 * * * (2.87) 2 0.054 (2 0.75) 0.015 (0.75) 2 0.029 * (2 1.88) 0.006 (0.10) 1.042 * * * (8.97) 0.001 * (1.73) 2 0.012 (2 1.38) 0.009 (0.26) 2 0.011 (2 0.45) Control 918 13.96 0.177 0.001 (0.58) 0.118 * * * (2.91) 2 0.054 (2 0.75) 0.015 (0.76) 2 0.029 * (2 1.86) 0.006 (0.10) 1.042 * * * (8.95) 0.001 * (1.74) 2 0.011 (2 1.30) 0.013 (0.40) 2 0.012 (2 0.48) Control 918 12.99 0.176 2 0.001 (2 1.33) 0.099 * * (2.07) 2 0.057 (2 0.71) 0.019 (0.87) 2 0.025 (2 1.47) 0.037 (0.55) 1.022 * * * (7.80) 0.000 (0.18) 2 0.001 (2 0.09) 2 0.013 (2 0.31) 2 0.032 (2 1.19) Control 918 11.29 0.142 0.075 * 0.036 * * * 0.065 (1.63) 0.041 * * * (10.16) 2 0.024 (2 1.19) 2 0.001 (2 1.52) 0.120 * * * (3.14) 2 0.034 (2 0.50) 0.027 (1.53) 2 0.024 * (2 1.74) 0.023 (0.42) 0.937 * * * (8.75) 0.001 * * (2.18) 2 0.009 (2 1.16) 2 0.006 (2 0.18) 2 0.013 (2 0.59) Control 918 10.86 0.172 0.085 * * 0.046 * * * Conserv2 Conserv1 Conserv2 Conserv1 Conserv2 (2.08) 0.071 * (1.69) 0.097 * * (2.03) 0.086 * (1.76) (13.46) 0.052 * * * (12.91) 0.050 * * * (12.30) 0.058 * * * (12.02) (2 1.60) 2 0.036 * (2 1.70) 2 0.067 * * (2 2.54) 2 0.069 * * * (2 2.61) 2 0.001 (2 1.47) 0.102 * * (2.12) 2 0.057 (2 0.71) 0.019 (0.88) 2 0.025 (2 1.46) 0.037 (0.55) 1.022 * * * (7.80) 0.000 (0.19) 2 0.000 (2 0.02) 2 0.007 (2 0.19) 2 0.033 (2 1.22) Control 918 10.77 0.141

CAR3010 (2 30,10)

CAR30 (2 30,30)

Variable

Expsign

Conserv ROE Conserv ROE Grow ST Unliquid Incentive Compena Ltcy Ltzc Time Size Lev OtherSec Inds n F R2

2 ? ? ? ? ?

Notes: Signicance at: *0.10, * *0.05 and * * *0.01; CAR, cumulative abnormal return; CAR1, CAR for one trading day around the re-open day; CAR3, CAR for three trading days window; CAR10, CAR for ten trading days window; CAR30, CAR for 30 trading days window; CAR301, CAR for 30 days before re-open and one day after re-open; CAR3010, CAR for 30 days before re-open and ten days after re-open; Conserv1 and Conserv2 are accounting conservatism proxy, using three years cumulative accruals multiplied by 2 1; ROE, the average ROE for the past three years; Grow, the average revenue growth for the past three years; ST, a dummy variable; 1, yes; 0, otherwise; Unliquid, the un-circular stock to total stock before share reform, proxy for the shock to the market; Incentive, a dummy variable; 1, the reform plan includes a management incentive program; 0, otherwise; Compen, the compensation paid by un-circular shareholders to circular shareholders computed as the stock compensation, which is from Wind Database; LTCY, the participation rate of circular shareholders attending the shareholders meeting; LTZC, the approval ratio of circular shareholders on the reform proposal; Time, the time span from the approval day, when CRSC approve the reform plan proposed by listed companies, to the re-open day; Size, the log form of asset at the end of last year to proxy the size; Lev, the total debt ratio (Lev) proxy the leverage; Othersec, a dummy variable, indicating whether the rm issues other type of shares, like B, S, or H; 1, yes; 0, otherwise; VIFs in all regressions are , 2, showing there is not severe co-linearity in our regression models; in the parenthesis are the white-t-statistics to eliminate the heteroscedasticity; aCoefcients for Compen are signicantly negative for the rst four regressions, which is inconsistent with Li et al. (2008) who nd the gift from un-circular stockholders is positive but insignicant. The possible reason is that in Li et al. (2008), they did not allow for the attitude of circular investors who prove or deny the proposal of reform. The attitude is somewhat inuenced by the share compensation they get and also determined by their judgment for the future of the rm; those two aspects inuence the market performance around the re-open day

Accounting conservatism

41

Table VIII. Accounting conservatism, past earnings and CAR-longer windows

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Variables Conserv SDROE Conserv ROE Grow ST Unliquid Incentive Compen Ltcy Ltzc Time Size Lev Othersec Inds n F R2 20.001 * * * (24.09) 0.012 (0.84) 20.000 (2 1.22) 0.068 * * (2.18) 20.014 (2 0.30) 0.034 * * * (2.63) 20.004 (2 0.41) 0.038 (1.01) 0.132 * (1.68) 0.000 * (1.67) 20.003 (2 0.57) 0.032 (1.20) 0.010 (0.58) Control 918 3.28 0.067 20.001 * * * (210.50) 20.003 (20.17) 0.001 * * * (2.59) 0.114 * * * (3.22) 20.000 (20.01) 0.011 (0.63) 20.021 (2 1.46) 20.062 (21.20) 0.864 * * * (7.77) 0.001 (1.52) 20.007 (20.93) 0.015 (0.49) 0.010 (0.45) Control 918 10.25 0.139

Variables Conserv SDROE Conserv ROE Grow ST Unliquid

Table IX. Accounting conservatism, volatility of earnings and CAR

Show-term CAR1 (21,1) CAR3 (23,3) Conserv1 0.073 * * (2.42) Conserv2 0.070 * * (2.21) Conserv1 0.065 * (1.81) CAR10 (210,10) Conserv2 0.060 (1.61) 20.001 * * * (2 10.54) 20.004 (20.22) 0.001 * * (2.50) 0.115 * * * (3.24) 20.000 (20.01) 0.011 (0.64) 20.021 (21.45) 20.062 (21.20) 0.864 * * * (7.77) 0.001 (1.52) 20.007 (20.90) 0.018 (0.59) 0.010 (0.43) Control 918 9.97 0.139 CAR3010 (230,30) Conserv1 0.106 * * 2.21 Conserv2 0.095 * 1.93 Conserv2 0.053 * (1.85) Mediate-term

Conserv1 0.081 * * (2.09)

20.001 * * * (2 10.29) 20.021 (21.02) 20.001 (21.40) 0.119 * * * (3.16) 20.035 (20.51) 0.027 (1.52) 20.024 * (2 1.69) 0.024 (0.44) 0.933 * * * (8.73) 0.001 * * (2.19) 20.010 (21.24) 20.008 (20.24) 20.013 (20.56) Control 918 10.80 0.173

20.001 * * * (26.87) 20.001 * * * (26.28) 0.008 (0.52) 0.007 (0.46) 20.000 (20.38) 20.000 (20.47) 0.088 * * * (2.63) 0.089 * * * (2.66) 20.018 (20.36) 20.019 (20.36) 0.036 * * (2.44) 0.036 * * (2.45) 20.007 (20.61) 20.007 (20.60) 0.006 (0.15) 0.006 (0.15) 0.280 * * * (3.06) 0.280 * * * (3.06) 0.000 (1.64) 0.000 (1.64) 20.002 (20.36) 20.002 (20.31) 0.023 (0.84) 0.026 (0.95) 0.009 (0.47) 0.008 (0.43) Control Control 918 918 4.42 3.86 0.082 0.081 Long-term CAR301 CAR3010 (230,1) (230,10) Conserv1 Conserv2 Conserv1 Conserv2 0.081 * * 2.09 0.065 1.63 0.093 * * 2.26 0.079 * 1.88

20.001 * * * 210.29 20.001 * * * 210.16 20.001 * * * 211.98 20.001 * * * 212.44 20.001 * * * 210.81 20.001 * * * 211.11 20.021 21.02 20.024 21.19 20.031 21.50 20.033 21.60 20.065 * * 22.44 20.066 * * 22.51 20.001 21.40 20.001 21.52 0.001 0.69 0.000 0.57 20.001 21.34 20.001 21.49 0.119 * * * 3.16 0.120 * * * 3.14 0.117 * * * 2.92 0.120 * * * 2.96 0.102 * * 2.12 0.104 * * 2.17 20.035 (20.51) 20.034 (2 0.50) 20.055 (20.76) 20.055 (20.76) 20.059 (2 0.72) 20.058 (20.72) (continued)

Incentive Compen Ltcy Ltzc Time Size Lev Othersec Inds n F R2

0.027 (1.52) 20.024 * (21.69) 0.024 (0.44) 0.933 * * * (8.73) 0.001 * * (2.19) 20.010 (2 1.24) 20.008 (2 0.24) 20.013 (2 0.56) Control 918 10.80 0.173

0.027 (1.53) 0.014 (0.75) 0.015 (0.75) 20.024 * (21.74) 20.028 * (21.80) 20.028 * (21.80) 0.023 (0.42) 0.007 (0.13) 0.008 (0.13) 0.937 * * * (8.75) 1.037 * * * (8.93) 1.038 * * * (8.92) 0.001 * * (2.18) 0.001 * (1.75) 0.001 * (1.76) 20.009 (21.16) 20.012 (2 1.40) 20.011 (2 1.34) 20.006 (20.18) 0.011 (0.33) 0.016 (0.49) 20.013 (20.59) 20.011 (20.45) 20.011 (2 0.46) Control Control Control 918 918 918 10.86 12.35 13.25 0.172 0.177 0.176

0.019 (0.87) 20.024 (21.40) 0.038 (0.57) 1.017 * * * (7.76) 0.000 (0.20) 20.001 (20.10) 20.010 (20.25) 20.032 (21.18) Control 918 10.88 0.141

0.019 (0.87) 20.024 (21.40) 0.039 (0.58) 1.017 * * * (7.76) 0.000 (0.20) 20.001 (20.05) 20.004 (2 0.11) 20.033 (2 1.20) Control 918 11.05 0.141

Notes: Signicance at: *0.10, * *0.05 and * * *0.01; CAR, cumulative abnormal return; CAR1, CAR for one trading day around the re-open day; CAR3, CAR for three trading days window; CAR10, CAR for ten trading days window; CAR30, CAR for 30 trading days window; CAR301, CAR for 30 days before re-open and one day after re-open; CAR3010, CAR for 30 days before re-open and ten days after re-open; Conserv1 and Conserv2 are accounting conservatism proxy, using three years cumulative accruals multiplied by 21; SDROE, the standard deviation of the average; ROE, the past three years; Grow, the average revenue growth for the past three years; ST, a dummy variable; 1, yes; 0, otherwise; Unliquid, the un-circular stock to total stock before share reform, proxy for the shock to the market; Incentive, a dummy variable; 1, the reform plan includes a management incentive program; 0, otherwise; Compen, the compensation paid by un-circular shareholders to circular shareholders computed as the stock compensation, which is from Wind Database; LTCY, the participation rate of circular shareholders attending the shareholders meeting; LTZC, the approval ratio of circular shareholders on the reform proposal; Time, the time span from the approval day, when CRSC approve the reform plan proposed by listed companies, to the re-open day; Size, the log form of asset at the end of last year to proxy the size; Lev, the total debt ratio (Lev) proxy the leverage; Othersec, a dummy variable, indicating whether the rm issues other type of shares, like B, S, or H; 1, yes; 0, otherwise; VIFs in all regressions are , 2, showing there is not severe co-linearity in our regression models; in the parenthesis are the white-t-statistics to eliminate the heteroscedasticity:

CARi a b1 Conserv b2 SDROE Conserv b3 ROE b4 Grow b5 ST b6 Unliquid b7 Incentive P b8 Compen b9 Ltcy b10 Ltzc b11 Time b12 Size b13 Lev b14 OtherSec bj Inds 1

Accounting conservatism

Table IX.

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7. Conclusion Chinas securities market is facing erce revolutions; numerous listed companies are launching their reform that all stocks, including some un-circular stocks, will be traded in the market. What inuence does the reform bring to the market and stock price? How does the market evaluate the reform of each listed company, and does accounting information have any inuence? Using the data of companies completing the split-stock reform, we nd that accounting information plays its role through the reform in Chinas securities market. The market recognizes the role of accounting conservatism, evident in the signicantly positive relation between the proxies of accounting conservatism and the CARs for one day, three days, ten days and 30 days around re-open day after the reform. Also, the protability of listed rms in the past will further improve the positive relation between conservatism and market reaction. In all, accounting conservatism really has much inuence in the stock pricing, affecting the decision making and expectation of investors.
Notes 1. It is also called all-circulation reform, split-share reform or ownership separation reform. 2. In China, on average, one-third stocks of listed companies are traded at the market quoted prices in the open capital market. In contrast, the other two-thirds are traded at the book value in another closed market with much restriction. 3. Actually, those stock which are not circular before the reform cannot be traded freely immediately after the reform, they often have a buffering period, one to three years. After one to three years, they can be traded in the open market. The different buffering period is determined in the reform plan. 4. CAR is the cumulative abnormal return around the re-open day under nave model that AR is calculated as the daily return minus the average return on market portfolio. 5. We do not use the Cscore as Khan and Watts (2009) and the M/B ratio as conservatism, since during 2001 to 2006, the Chinese stock market was declining monotonously for the regulation policy; however, the accounting performance, both ROE and cash ow, is arising. Market movement is not matched with operation, which is somewhat contradicted with the essential of Basu (1997) and Khan and Watts (2009) measures. The anther reason is that both Basu (1997) and Khan and Watts (2009) measures are actually the conditional conservatism (Beaver and Ryan, 2005), which is only a part of conservatism. M/B is much noisy as conservatism due to the market efciency. 6. To be succinct, we do not show regression results. References Ahmed, A.S. and Duellman, S. (2007), Accounting conservatism and board of director characteristics: an empirical analysis, Journal of Accounting and Economics, Vol. 43, pp. 411-37. Ahmed, A.S., Morton, R.M. and Schaefer, T.F. (2000), Accounting conservatism and the valuation of accounting numbers: evidence of the Feltham-Ohlson (1996) model, Journal of Accounting, Auditing and Finance, Vol. 15, pp. 271-91. Ahmed, A.S., Billings, B.K., Morton, R.M. and Stanford-Harris, M. (2002), The role of accounting conservatism in mitigating bondholder-shareholder conicts over dividend policy and in reducing debt costs, The Accounting Review, Vol. 77, pp. 867-90.

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