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The Journal of Applied Business Research – January/February 2013
Volume 29, Number 1
Attitudes Of Chinese Listed Enterprises
Toward Cash Flow Manipulation:
A Resource Dependence Perspective
Huiting Guo, Chang’an University, China
Fangjun Wang, Xi’an Jiaotong University, China
Junrui Zhang, Xi’an Jiaotong University, China
ABSTRACT
The prevalence of cash flow manipulation has drawn much scholarly attention in China and
worldwide, especially since the exposure of the accounting scandals at Enron, WorldCom, and
Qwest. Cash flow status also provides a sound basis for corporate valuation. Using a sample of
12,251 firm-year observations from 1999 to 2009, this study thus investigates the attitudes and
behavioral patterns of state-owned enterprises (SOEs) and non-SOEs in China toward cash flow
manipulation. From a point of departure of resource-dependence theory, we find that non-SOEs
tend to manipulate cash flow upward, whereas SOEs are more prone to manipulate cash flow
downward. We also demonstrate that non-SOEs are more inclined to manipulate their cash flow
statements compared with SOEs. The reason behind this differing behavior could be that nonSOEs are reliant on cash and funds from entities, such as governments and banks, and thus, they
falsely enhance cash flow and firm performance in order to signal their solvency and thereby
reduce financing costs. By contrast, since SOEs always receive sufficient cash inflows from both
government sources and state-owned banks, the managers of these firms are unconcerned about
cash flow shortages, which lessens their motivation to manipulate the figures. Indeed, this study
finds that these managers may even reduce reported cash flow intentionally in order to obtain
government assistance. Therefore, investors and regulators should make their judgments on the
cash flow of entities based on their status as SOEs or non-SOEs.
Keywords: Cash Flow Manipulation; State-Owned Enterprise; Non-State-Owned Enterprise; Resource Dependence
Theory
INTRODUCTION
C
ash flow is recognized as the lifeblood of a firm. All companies rely on sufficient cash flow to invest in
new projects, repay debt, pay dividends to shareholders, and provide a safety net for emergencies
(Dittmar, Mahrt-Smith, & Servaes, 2003). Cash flow status thus provides a sound basis for corporate
valuation. The importance of operating cash flow has been repeatedly emphasized over recent decades, especially its
role in appraising CEO performance and agreeing compensation packages (Aboody & Kasznik, 2000; Nwaeze,
Yang, & Yin, 2006). Operating cash flow can also improve the accuracy of investor forecasting (Hewitt, 2009;
Waldron & Jordan, 2010). In particular, demand for detailed current year and forecasted cash flow information has
increased since the exposure of the accounting scandals at Enron, WorldCom, and Qwest revealed that these
organizations were engaged in obvious cash flow manipulations (Edmonds, Edmonds, & Maher, 2011).
Cash flow manipulation is defined as the managerial tendency to use internal resources to change reported
cash flow in order to achieve predetermined goals (Zhang, Dong, & Guo, 2007). For example, managers could
increase cash inflow at year end by collecting greater amounts of accounts receivable (e.g., by offering aggressive
discounts to clients) or by delaying payments to suppliers. However, managers cannot use financing activities to
manipulate a firm’s cash flow because these are mainly constrained by creditors. On the contrary, financing
activities are always the result of cash flow manipulation. Cash flow manipulation has recently been documented in
© 2013 The Clute Institute http://www.cluteinstitute.com/
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The Journal of Applied Business Research – January/February 2013
Volume 29, Number 1
Western developed security markets (Frankel, 2005) while the prevalence of cash flow manipulation has also drawn
much scholarly attention in China (Wang, 2004a, 2004b; Fang, 2005; Chen, 2006; Zhang, 2007; Guo, Zhang, &
Dong, 2007; Zhang, Guo, & Wang, 2008; Zhang, Guo, & Xu, 2010; Guo, Zhang, & Li, 2011).
Because more than 70% of Chinese-listed companies are state-owned, the present paper contributes to the
extant cash flow manipulation literature by shedding light on the differences between state-owned enterprises
(SOEs) 1 and non-state-owned enterprises (non-SOEs); namely, companies controlled by families, institutional
investors, and other non-SOEs. Further, because SOEs have strong political backgrounds and expect financial
support from the government, they have many varied resources, which are more adequate (including cash flow),
compared with non-SOEs. Further, compared with SOEs, non-SOEs have more difficulty accessing credit from
banks and government grants. Therefore, there are significant differences in the supply and demand of cash flow
between SOEs and non-SOEs. This raises the following important questions: 1) What are the different motivations
behind cash flow manipulation in SOEs and in non-SOEs and 2) Do SOEs and non-SOEs manipulate reported cash
flows to a similar degree?
This paper answers these two research questions by comparing the cash flow manipulation behavior of
SOEs and non-SOEs listed on the Chinese stock market. From the empirical results, we find that the degree of cash
flow manipulation is more serious in non-SOEs than it is in SOEs. An interesting observation is that non-SOEs are
more prone to increase reported cash flows, while SOEs tend to decrease reported cash flows.
LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT
Cash Flow Manipulation
Cash flow data provide important information for the assessment of a company’s value. Although earnings
are considered to be an important measure of firm performance, they can prove to be less reliable (Dechow, 1994).
Earnings are produced under accrual accounting, but the method of accruals introduces its own problems, as it gives
managers opportunities to use their discretion to manipulate the figures. Cash flow statements, on the contrary, are
more difficult to manipulate. Thus, cash flow information is viewed as more solid evidence and less susceptible to
artificial manipulation compared with actual reported accounting earnings (Edmonds et al., 2011).
Operating cash flow is playing an increasingly significant role in improving the accuracy of investors’ firm
forecasts (Hewitt, 2009). Sufficient cash flow also provides evidence of a company’s capability to repay its loans
(Dichev & Skinner, 2002). Hence, cash flow is the most efficient method for reflecting solvency. As a result, more
and more companies are intentionally increasing their degree of reporting on cash flow. However, increasing
demand for detailed cash flow information and cash flow forecasts has resulted in accounting scandals involving
cash flow manipulation (Edmonds et al., 2011).
In addition to the global accounting scandals involving Enron and WorldCom, a number of studies have
also shown the existence of cash flow manipulation practices in China’s emerging stock market. Fang (2005) and
Wang (2004a) first proposed the existence of cash flow manipulation in Chinese listed companies. Chen (2006) and
Zhang et al. (2008) then found that Chinese listed companies manipulate their cash flow statements, especially
during periods of refinancing. Evidence of cash flow manipulation was also found in management buy-outs (Guo et
al., 2007). Zhang (2007) further extended the research on this topic by using the concept of earnings thresholds to
compare cash flow manipulation in China’s emerging market with the mature market in the US. The author proved
that managers manipulate cash flow in order to beat three thresholds: current cash flow, the previous year’s cash
flow, and analysts’ cash flow forecasts. Zhang et al. (2010) and Guo et al. (2011) also found a hierarchy of these
three thresholds of cash flow manipulation in China.
1
State-owned enterprises (SOEs) are companies that are under the control of state. There are four main types of ownership in
Chinese-listed companies – State ownership, legal-person ownership held by State-owned firms or institutions, private ownership,
and foreign ownership.
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The Journal of Applied Business Research – January/February 2013
Volume 29, Number 1
Background of SOEs and Non-SOEs
Previous studies that have focused on mature markets such as the US or the UK have examined whether (i)
accruals add information to operating cash flow in order to improve earnings ability and thus explain profit returns
and (ii) discretionary and nondiscretionary accruals are priced differently (Haw, Qi, & Wu, 2001). However, the role
of operating cash flow has yet to be studied in the emerging capital market of China. Although the Ministry of
Finance in China has issued new accounting standards, these standards and practices in China are still evolving.
Moreover, the financial reporting and capital market systems are still considered to be relatively primitive and the
quality of auditing is low compared with the mature markets in the west, whose accounting systems are more
sophisticated and investors relatively well informed (Abdel-Khalik, Wong, & Wu, 1999; Aharony, Lee, & Wong,
2000). In addition, some critics argue that accounting information in emerging capital markets such as China may
not be reliable or even useful to investors, especially since choices of accounting methods and management
decisions are affected by a company’s status as an SOE or non-SOE. Thus, the closer examination of the supply and
demand of cash flow information could help us understand the problem of cash flow manipulation in China’s
emerging capital market.
A salient institutional feature is that state ownership dominates listed companies in China (Sun & Tong,
2003). Most Chinese listed firms are carve-outs or spin-offs from large SOEs, in which the original firms still own a
large percentage of the total shares (Liu & Lu, 2007). Consequently, state ownership accounted for approximately
70% of total businesses in 2006 (Zou and Xiao, 2006). This distinct feature is a result of China’s “gradualist” reform
strategy as opposed to the “big bang” privatization approach taken by certain eastern European countries (Qian,
Roland, & Xu, 1999). Since its reforms and open door policy, China has made great economic progress, with SOEs
and non-SOEs playing an essential role in these economic reforms. With the gradual deepening of enterprise reform,
corporate performance has become the most important criterion for evaluating firm value and managerial capability.
As such, cash flow provides crucial information for assessing company value, and managers in SOEs and non-SOEs
are all paying more attention to cash flow than ever before.
Resource Dependence Theory and Hypotheses Development
Resource dependence theory suggests that no group is self-sufficient and that social relations commonly
entail mutual dependence between parties. These mutual needs imply that each party is in a position, at least to some
degree, to be able to grant or deny, facilitate or hinder the other’s gratification. This means that A depends on B if A
aspires to goals or gratification whose achievement is facilitated by the appropriate actions on B’s part. By virtue of
mutual dependency, it is more or less imperative to each party that he or she be able to control or influence the
other’s conduct. Thus, the power to control or influence another person resides in the control over the resources he
or she values (Emerson, 1962).
Supply and Demand of Cash Flow
Government support is important for corporate development. Market entrants that receive government
grants and loans via bank-issued shares or bonds can purchase plants, equipment, and raw materials and invest in
projects. Further, because most SOEs are ultimately controlled by the government and because of their large firm
size, high technology, and great background, their operating risk is lower and their chances of solvency higher.
Therefore, they can access government assistance and loans more easily and attract further investment. The outcome
of this is that SOEs attain adequate finance and are thus not prone to manipulating cash flow. Moreover, for social
and political reasons (e.g., with regard to maintaining employment and social stability), the Chinese government at
all levels has been reluctant to bankrupt SOEs (Zou and Xiao, 2006). This provides another reason why the
government provides a steady flow of financial support to SOEs. Indeed, some SOEs are so important to the local
economy that even if they make a loss, they can still afford to make huge investments in restructuring because of
their vast levels of financial assistance from the government.
However, because small-sized non-SOEs face greater uncertainty and higher risk in the marketplace, banks
are reluctant to lend them money and thus they face difficulties in attracting financial support. Ma and Parish (2006)
suggest that Chinese private entrepreneurs made generous donations to government welfare projects until the 1990s,
© 2013 The Clute Institute http://www.cluteinstitute.com/
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The Journal of Applied Business Research – January/February 2013
Volume 29, Number 1
gaining in exchange political access and social status via appointments to political councils. Thus, by giving
considerable charitable contributions, Chinese private entrepreneurs elicited social and political benefits in return.
Because resource dependence theory only focuses on the positive externalities of resource heterogeneity
(i.e., creating the economic rent), but neglects negative externalities, opportunistic behavior may develop. Since
corporate access to resources is based on certain factors and the context in which the organization is embedded
(Pfeffer and Salancik, 2003), these factors control some of the organizational activities they regulate. Further, in
Chinese listed companies, a mindset of the need to window dress their “shop fronts” to meet bank and other creditor
requirements can develop during the process of gaining access to cash and other investments. With this outlook,
some companies are prone to manipulate earnings management and/or cash flow in order to enhance performance.
Dichev and Skinner (2002) use a database of private corporate lending agreements to test the debt covenant
hypothesis. Debt covenants are optimally set more tightly in private lending agreements than they are in public debt
agreements (Smith and Warner, 1979), which implies that the covenants in private debt agreements are more likely
to affect managers’ financial reporting decisions. Moreover, the cost and benefits of avoiding covenant violations
are likely to be substantially larger for managers of firms that are suffering financial difficulty. Once firm
performance deteriorates, managers’ abilities to avoid debt covenant constraints are likely to reduce. For example, if
the company’s economic performance is declining, managers must make greater and more aggressive accrual
choices, thereby increasing reported earnings (especially when their accounting discretion has already been “used
up”), while real choices are likely to be constrained by declining cash flow. Hence, managers may also choose to
manipulate operating cash flow (e.g., EBIT, EBITDA) at the year end. Since debt-to-cash flow ratios are important
indicators, sufficient cash flow shows repayment capability.
Billings and Morton (2002) also demonstrate the importance of operating cash flow for reducing credit risk.
If a company’s earnings per share is higher than that of other companies but its cash flow is smaller, then it will still
draw the attention of analysts and investors. In this event, the company will face problems repaying its loans and
find further difficulties obtaining new loans, as it is now classified as a credit risk. Further, because cash flow is by
far the most efficient method for reflecting solvency, managers also need to maintain large amounts of cash flow
into their companies.
Paradoxically, because SOEs know that they can obtain guaranteed funding from the government, SOE
managers may purposely manipulate cash flow downward in order to show a deficit or poor profit and thus obtain
more financial support from the government. By contrast, non-SOEs might deliberately manipulate cash flow
upward even though their cash flow is poor. Since a cash surplus implies a position of solvency, lenders believe that
they can repay the money.
The foregoing analysis implies that a healthy cash flow is paramount for obtaining loans, especially for
non-SOEs because their need for cash and other funding from the government, banks, and other creditors is greater.
By contrast, SOEs want to decrease cash flow in order to obtain more financial support from the government. In
summary, from the perspective of resource dependence theory, we propose two directional hypotheses of cash flow
manipulation:
H1a:
Cash flow in non-SOEs is manipulated to appear higher than normal cash flow.
H1b:
Cash flow in SOEs is manipulated to appear lower than normal cash flow.
Manipulation Limitations/Constraints
As discussed earlier, most listed firms in China are carve-outs or spin-offs from large SOEs. Shleifer and
Vishny (1997) point out that the ownership of SOEs is controlled by corporate bureaucracy and that corporate
bureaucracies are always appointed by the government. Therefore, the managers in SOEs often hold political
positions in central and local governments. Under this constraint, they cannot manipulate cash flow to appear too
low, since very bad cash flow performance would imply poor management capability and/or inefficient investment
strategies, which would pose a threat to their positions. Displaying a very low cash flow could also make SOEs face
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The Journal of Applied Business Research – January/February 2013
Volume 29, Number 1
financial risk, leading to a difficulty obtaining bank loans. On the contrary, non-SOEs manipulate cash flow upward
without restrictions as they believe that signals their payment capability to lenders. We speculate that non-SOEs are
more prone than SOEs to manipulate cash flow in order to enhance their cash flow performance. Based on the above
discussion, we constructed a comprehensive theoretical framework to explain the determinants and motivation of
cash flow manipulation for SOE and non-SOEs as shown in Figure 1. We also propose hypothesis H2:
H2:
Cash flow manipulation is more prevalent in non-SOEs than it is in SOEs.
⑤ Constraints
① Active Supply
Government
Grant
&
Bank
Credit
SOEs
② Decrease Cash Flow
③ Passive Supply
④ Increase Cash Flow
Non-SOEs
⑥ No Constraints
1.
2.
3.
4.
5.
6.
The government and banks actively support sufficient funding to SOEs.
The managers of SOEs manipulate cash flow to appear lower than normal in order to show cash flow
shortages and thus obtain more government funding.
The government and banks are reluctant to supply funding to non-SOEs.
The managers of non-SOEs manipulate cash flow to appear higher than normal in order to show solvency
and thus receive more government funding.
The managers of SOE cannot manipulate cash flow too low since poor cash flow performance would pose a
threat to their political positions and banks may worry about the risk of non-repayment.
The managers of non-SOEs manipulate cash flow upward without restrictions.
Figure 1: Theoretical Framework of Cash Flow Manipulation Between SOEs and Non-SOEs
RESEARCH DESIGN
Data and Sample
Since 1999, the cash flow statements of listed companies have been required to be disclosed by the China
Security Regulatory Commission. Thus, the data on listed companies used for the sample in this study came from
1999, namely a period when company cash fl …
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