Do Earnings Manipulations Matter Differently in Different Markets of China? Cost of Capital Consequences

This study investigates whether and how a firm’s cost of equity capital is influenced by the extent of a firm’s real earnings management (REM). Using a large sample of Hong Kong and Chinese firms over the 9-year period 2009-2017, we find that our implied cost of equity estimates are positively associated with both the extent of REM and the extent of accrual-based earnings management (AEM), but the positive association is stronger for REM than for AEM. We also provide evidence suggesting that the effect of AEM and REM on the cost of equity is more pronounced for Hong Kong firms than Chinese firms, and within Chinese firms, it is less pronounced for the state-owned enterprises (SOEs). Collectively, our results suggest that while both REM and AEM exacerbate the quality of earnings used by outside investors, REM does so to a greater extent than AEM, and thus the market demands a higher risk premium for REM activities than for AEM activities and that this cost of capital-increase effect is more prominent in a developed market like Hong Kong and mitigated by state ownership in China because of investors’ expectations for a lower level of detriments to firm fundamentals by REM due to government’s protection in a less developed market like China. JEL classification: G14, M41, M43