Profitability regulation, earnings management, and modified audit opinions: Evidence from China

This study, using data from the Chinese stock market, investigates the rela tionship between earnings management induced by profitability regulation an d modified audit opinions (MAOs). We review recent developments in the acco unting profession and in independent auditing to foster an understanding of the environment in which Chinese auditing operates. Based on annual report s published by listed companies from 1995 to 1997, we analyze the underlyin g reasons for MAOs. Our test results show a significant association between receiving MAOs and reporting profits marginally above the target levels sp ecified in stock de-listing and rights offering regulations. Our findings a re consistent with the notion that asymmetric profitability requirements ex acerbate managers' propensity to engage in earnings management, which in tu rn is positively associated with receiving MAOs. Though based on Chinese da ta, our findings are of general interest because they address a fundamental issue of trade-offs between expected costs and expected benefits in decidi ng whether to avoid MAOs in a transitional economy.