Development of hypotheses

According to Jensen and Meckling (1976), “to the extent that security analysis activities reduce the agency costs associated with the separation of ownership and control, they are indeed socially productive”. One such benefit is that financial analysts are effective in constraining earnings management practices, because they are well trained to go through numerous financial statements and track firms on a regular basis, which enables the improvement of corporate transparency and the identification of financial reporting irregularities (Yu, 2008). Analysts are also reported to monitor managerial behavior and make it difficult for managers to expropriate company wealth (Lang, Lins and Miller, 2004; Dyke, Morse and Zingales, 2010). This leads to our first hypothesis:

H1a: Analyst coverage improves the financial reporting quality of Chinese listed firms as reflected by the reduced propensity to receive MAOs.

Prior studies show that investment banking incentives and other self-interests to access private information f r o m management motivate analysts to provide biased

earnings forecasts and stock recommendations (i.e., Michaely and Womack, 1999; Lim, 2001; Irvine, 2004; Agrawal and Chen, 2008). Empirically, Irvine (2004) finds that forecasts that deviate more from the consensus (‘‘bold’’ forecasts) are associated with increase in the analyst’s employers’ share of the trading in the covered stock shortly after the release of the forecast. Agrawal and Chen (2008) show that more favorable recommendations (relative to the consensus recommendation) are associated with a larger share of the securities firm’s revenue obtained from investment banking and brokerage business.7 The claim that analysts

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face incentives to be optimistic implicitly relies on the assumption that managers provide private information to analysts who issue biased forecasts and recommendation. Given that analysts have preferential access to information provided by management in China, we argue that analysts’ incentive to curry favor with management attenuates their monitoring function in enhancing financial reporting quality of those firms under their coverage, suggesting that there is a negative association between analyst following and financial reporting quality reflected by the higher propensity of MAO.

H1b: Analyst coverage reduces the financial reporting quality of Chinese listed firms as reflected by the higher propensity to receive MAOs.

Taking into consideration of the institutional or ownership characteristics of Chinese listed firms, we suggest that the monitoring effects of analyst tend to be more pronounced in NSOEs. Because SOEs have easy access to equity and credit markets due to political reason (e.g. Chen, Lobo and Wang, 2011), they generally have weaker incentives to reduce information asymmetry and are under less pressure from analysts to provide high-quality accounting information. Compared with the SOEs that receive preferential treatment from the government, NSOEs have to rely on the capital market for external financing. In order to lower the cost of raising capital, NSOEs have to provide high quality financial statements. Furthermore, when NSOEs are approached by financial analysts, they are incentivized to respond to analyst enquiries or any other clarifications sought from analysts, which results in the enhanced quality of accounting information. Hypothesis 2 thus follows:

H2: The effect of analyst coverage in reducing the incidence of MAOs is more pronounced in

recommendations to attract investment banking business, other studies report contradictory results. For example, based on a sample of 16,625 U.S. debt and equity offerings Ljungqvist et al. (2006) find little evidence that analysts employed by investment banks bias their research to earn investment banking deals. In a similar vein,

Jacob et al. (2008) document that more accurate earnings forecasts are issued by analysts employed by firms that offer investment banking.

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NSOEs.

Extant literature shows that earnings-based regulation induces earnings management to meet the regulatory requirements (DeFond and Jiambalvo, 1994; Burgstahler and Dichev,

1997; Liu and Lu, 2007).8 For example, Jiang and Wang (2008) show that Chinese listed

firms experiencing consecutive losses (ST firms) use earnings management to avoid compulsory delisting, as the ratio of small-profit to small-loss firms have increased significantly since 1998. These practices are likely to result in a higher probability of receiving MAOs.9 However, prior studies suggest that analysts are effective in detecting

serious financial reporting irregularities (i.e. fraud). For example, examining the alleged corporate frauds in U.S. between 1996 and 2004, Dyke, Morse and Zingales, (2010) conclude that analysts played a central role in detecting corporate frauds, in that auditors and analysts collectively account for 24% of whistleblowers. Although analysts do not receive monetary compensation from disclosing fraudulent behavior of the firms they cover, they do benefit from improved reputation and better career prospects (Hong, Kubik and ùsoloman, 2003) due to their obvious diligence. Building on the premise that analysts are able to use their experience and industry-specific expertise to identify financial reporting problems that arise from earnings management, we expect to find support for the following hypothesis:

H3: The effect of analyst coverage in reducing the incidence of MAOs is more pronounced for firms under more intense scrutiny (i.e. ST firms facing potential delisting risk)

8_{Anecdotal evidence shows that Chinese firms use financial packaging in the pre-IPO period to inflate earnings} (Aharony, Lee and Wong, 2000) and manage earnings with non-operating items to meet regulatory requirement for seasonal offering (Chen and Yuan, 2004).

9_{Previous literature (e.g., Chen and Yuan, 2004; Liu and Lu, 2007) suggests that Chinese listed firms manage} earnings to qualify for seasonal offerings (issuing additional shares to existing shareholders). According to CSRC, publicly listed firms are only allowed to make seasonal offerings if they have not received Modified Audit Opinions (MAO) for 3 consecutive years before the seasonal offering. Therefore, such regulation may deter firms interested in seasonal offerings from engaging in earnings management (which leads to high propensity of MAO), suggesting a negative association between seasonal offerings and Chinese listed firms receiving MAO. However, firms may use real earnings management (i.e. transaction with related party) to meet the regulatory requirement of seasonal offerings.

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3. Research design