Financial Reporting Quality Of Chinese Reverse Merger Firms: The Reverse Merger Effect Or The Weak Country Effect?
Singapore Management University – School of Accountancy
Singapore Management University
Southeastern Oklahoma State University – Department of Accounting and Finance
National Cheng Kung University – Accounting
In this paper, we examine why Chinese reverse merger (RM) firms have lower financial reporting quality than U.S. IPO firms. We find that the financial reporting quality of U.S. RM firms is similar to that of matched U.S. IPO firms, but Chinese reverse merger firms exhibit lower financial reporting quality than Chinese ADR firms. We also find that Chinese RM firms exhibit lower financial reporting quality than U.S. RM firms. These results indicate that the use of the RM process is associated with poor financial reporting quality only in firms from China, where legal enforcement and investor protection are weak. In addition, we find that compared with Chinese ADR firms, Chinese RM firms have weaker bonding incentives (as measured by CEO turnover-performance sensitivity) and poorer corporate governance. These factors in turn contribute to the lower financial reporting quality of Chinese RM firms. Overall, our results suggest that the less-scrutinized RM process allows Chinese firms with weak bonding incentives and poor governance to gain access to U.S. capital markets, resulting in poor financial reporting quality.
Financial Reporting Quality Of Chinese Reverse Merger Firms: The Reverse Merger Effect Or The Weak Country Effect? – Introduction
In this paper, we examine why Chinese reverse merger (RM) firms listed in the U.S. have lower financial reporting quality than U.S. IPO firms. This examination is motivated by the recent popularity of Chinese RM firms and by the accounting problems associated with these firms during the past few years. In an RM deal, a U.S. public shell firm acquires a private operating firm. Although the original U.S. public shell firm survives, the original private firm’s shareholders maintain control.1 Since the 1990s, RMs have been the most popular alternative to IPOs for firms to go public in the U.S. (e.g., Floros and Shastri 2009a). In recent years, many foreign firms, particularly those from China, have entered the U.S. equity markets via RMs. Overall, there were 448 Chinese RM deals in the 2000-2011 period.2 About 72 percent of all foreign RM firms are from China, and over 90 percent of those listed on major U.S. stock exchanges are Chinese RM firms.
Despite its popularity, the RM process has been criticized as a “back door” or “shortcut” to going public, because RM firms bypass the scrutiny of the Securities and Exchange Commission (SEC) in the listing process. Many observers suspect that foreign RMs only “rent” the benefits of being listed in the U.S., without actually improving their corporate governance or financial reporting quality. These concerns are particularly noteworthy for Chinese reverse merger firms, which are subject to weaker legal enforcement and investor protection. In 2010 and 2011, many Chinese RM firms restated their financial statements, and many shareholders sued Chinese RM firms for fraudulent accounting (e.g., Siegel and Wang 2013). These scandals triggered a rapid decline in the value of Chinese RM firms. From mid-2010 to mid-2011, these firms lost 80 percent of their market value (Templin 2012).
In this paper, we examine whether the low financial reporting quality of Chinese reverse merger firms is related to their use of the less-scrutinized RM method (i.e., the RM effect), the weak legal enforcement over Chinese firms (i.e., the weak country effect), or both. If the RM effect is significant, then we should expect both U.S. and Chinese RM firms to have lower financial reporting quality than their respective counterparts (i.e., U.S. IPO firms and Chinese ADR firms). If the weak country effect is significant, then we should expect Chinese RM firms to have lower financial reporting quality than U.S. RM firms. Relying on the cross-listing literature, we further hypothesize that the less-scrutinized RM process allows Chinese firms with weaker bonding incentives to access the U.S. capital markets. In that case, Chinese RM firms should show poorer corporate governance and lower financial reporting quality than Chinese ADR firms.
We investigate these questions by analyzing a sample of 287 Chinese reverse merger firms that are traded on U.S. stock exchanges or the OTC bulletin board and have the relevant data available. Due to the inherent difficulty in capturing financial reporting quality, we follow previous research (e.g., Dechow et al. 2010; Hope et al. 2013) and use a wide range of measures, namely the likelihood of accounting restatements and four accrual-based measures. To ensure that the differences in financial reporting quality are not driven by differences in firm characteristics, we control for a comprehensive list of factors that affect financial reporting quality.
We document three major empirical results. First, we find that the financial reporting quality of U.S. RM firms is comparable with that of U.S. IPO firms matched by their trading venue, industry, year and size. However, the financial reporting quality of Chinese reverse merger firms is lower than that of Chinese ADR firms. This result is interesting because the conditions of legal enforcement are the same for both Chinese RM and ADR firms, and the regulatory requirement for ongoing disclosure is arguably more stringent for Chinese reverse merger firms than for Chinese ADR firms. These results indicate that the RM effect is associated with lower financial reporting quality for Chinese firms, but not for U.S. firms.
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