Governance and earnings management implications of the Chinese delisting regulation

Purpose - The purpose of this paper is to examine governance and earnings management implications of the delisting regulation in China, which designates firms with two consecutive losses as Special Treatment (ST) firms and delists such firms, should two more years of consecutive losses occur. Design/methodology/approach - Samples were selected using the matching‐sampling method, and interrupted time‐series Logit regression analyses was used to test the determinants of ST firms using corporate governance factors and earnings quality. Findings - It was found that firms which subsequently become ST firms have greater agency problems, as indicated by divergence of ownership and less independent boards, as measured by the number of independent directors. The ST firms subsequently reduce their agency costs by increasing ownership concentration and increasing the number of independent directors. Additionally, the results suggest that ST firms engage in earnings management after the first year of loss. Practical implications - The paper suggests that agency problems play an important role in financial performance, and the Chinese delisting regulation does lead to improvements in governance; nevertheless, it might force firms to engage in earnings manipulation. Originality/value - Distinct from previous empirical research that has examined earnings management, the authors study it in the context of the delisting regulation in China. Additionally, it is a longitudinal study examining how delisting regulations affect the governance of the firm under financial distress.