The Information Content of
Earnings Components:Evidence from the Chinese Stock Market
GONGMENG CHEN ∗,MICHAEL FIRTH ∗∗and
DANIEL NING GAO †
∗
Antai School of Economics and Management,Shanghai Jiaotong University,Shanghai,China,∗∗Department of Finance and Insurance,Lingnan University,Tuen Mun,New Territories,Hong
Kong and †School of Management,Xia ´n Jiaotong University,Xia ´n,China (Received:January 2010;accepted:May 2011)
A BSTRACT China’s listed firms report substantial non-operating revenues and expenses.We argue that these non-core earnings should have different properties and different valuation implications than operating or core earnings.Furthermore,the different types of firm ownership may have differential impact
s on the information content of earnings components.Based on data from 1996to 2008,we find that core earnings are more persistent than non-core earnings.Because of this,core earnings have a greater association with contemporaneous stock returns.However,the stock market does not fully incorporate all the information in earnings;we find that core earnings are undervalued and non-core earnings are overvalued.This effect is much reduced for privately controlled listed firms.We develop an investment trading strategy to exploit these market inefficiencies.documented evidence
1.Introduction
The purpose of this paper is to examine the properties of accounting numbers of listed firms in China,an economic superpower that warrants further study and understanding from a financial capital markets perspective.Using a large data-set,we investigate the interplay between accounting earnings and stock prices.In doing so,we take account of China’s unique institutional features including the effects of different types of control ownership.
Correspondence Address:Daniel Ning Gao,School of Management,Xia
´n Jiaotong University,Xia ´n,China.Tel.:+8675583948067;Email:gtagao@gtadata
European Accounting Review
Vol.20,No.4,669–692,2011
0963-8180Print /1468-4497Online /11/040669–24#2011European Accounting Association /10.1080/09638180.2011.599929Published by Routledge Journals,Taylor &Francis Ltd on behalf of the EAA.
670G.Chen et al.
The relations between accounting earnings and stock market values have been the focus of intense research for the past40years and more.Among the issues that have been examined are earnings persistence and the value relevance and market pricing of earnings,often with mixed results(Burgstahler et al.,2002; McVay,2006;Fan et al.,2010).Moreover,Ball et al.(2000),Leuz et al. (2003)and others have shown that the properties of accounting information vary across national jurisdictions because countries’legal and infrastructural fra-meworks differ.This is especially true when comparing emerging markets and transitional economies with developed countries.
Our specific focus is on the relations among the components of earnings,future earnings and stock prices,and whether the ownership of thefirm has an impact on these relations.The components of earnings we explore are operating income or core earnings(CORE)and non-core earnings(NCE).Thes
e components of earn-ings have to be explicitly reported in China and,as we discuss later,they have very different properties.We argue that these two components of earnings will have different implications for stock prices and the prediction of future earnings. We test our arguments using data from1996to2006.
Our study is thefirst to investigate comprehensively the information content of the different components of earnings in China.In particular,we study the persist-ence,value relevance,and market pricing of core earnings and non-core earnings. Our study adds to prior research on the information content of Chinesefirms’financial statements.Bao and Chow(1999)and Chen et al.(2002)show that accounting information is value relevant in China.Haw et al.(2001)show that reported earnings are more persistent and have stronger predictive ability than do operating cashflows.There is also evidence of earnings management in China(Chen and Yuan,2004;Haw et al.,2005;Firth et al.,2007).Tang and Firth(2011)provide evidence of both earnings management and tax management in China.However,to date,there are no studies of the accounting properties of the components of earnings and this is something we seek to remedy in this paper. Like most transitional economies,China had to make decisions on the owner-ship of state-owned enterprises after the economic reforms began.The Chinese government decided to retain substantial ownership stakes in most of the listed companies it
spun-off from state-owned enterprises.In addition,the government encouraged private entrepreneurs to develop businesses and list them on the stock market.In some cases,an entrepreneur has taken over a former state-owned enterprise,reorganised it and subsequently listed it.Thus,listedfirms have differ-ent types of major shareholder and different business objectives.These differ-ences in objectives can lead to differences in accounting quality and the information content of earnings and so we control for the type of ownership of afirm.The study extends our understanding offirms in developing economies in general,and Chinesefirms in particular.
Based on earnings announcements from1996to2008,wefind that core earn-ings are more persistent and more value relevant than non-core earnings.This effect is more pronounced for privately owned listedfirms and we attribute
The Information Content of Earnings Components671 this to their focus on operational efficiency and profitability.In contrast,state-controlledfirms have multiple objectives,which result in less stable operations, greater related party transactions and more variable earnings.For state-controlled firms,the stock market does not fully price the information in the different com-ponents of earnings.This is because the stock market is more suspicious of the quality of the accounting information provided by state-controlledfirms than the accounting information provided by private-controlledfirms.Thus,the repo
rted accounting information is not reflected,or not fully reflected,in market prices.We show that a portfolio that is long on stocks that have large increases in core earnings and low increases in non-core earnings,has positive risk-adjusted stock returns.Similarly,wefind that a portfolio that is short on stocks that have large increases in non-core earnings and low increases in core earnings,has superior risk-adjusted stock returns.Our evidence implies that the stock market under-reacts to core earnings and over-reacts to non-core earn-ings.This irrational pricing of stocks may be due to investors’lack of understand-ing of the properties of the distinct components of earnings.
The paper proceeds as follows.In Section2,we discuss enterprise reforms in China,ownership structure,and the disclosure of earnings and components of earnings.Section3describes prior research on core and non-core earnings. Section4introduces the sample and Section5describes the models and discusses the results.Section6concludes.
2.Accounting in China
Enterprise Reforms
China’s rapid transition from a centrally planned economy to one that embraces free market practices is well documented.One of the main planks of the reforms is the corporatisation of enterprises and the
subsequent listing of many of them on one of the country’s two stock exchanges.By2010,there were more than1700 listedfirms in China and,in terms of market capitalisation,China is now the second largest stock market in the world behind the USA.While the modern enterprise reforms have had many successes,improvement in operating perform-ances of listedfirms is not one of them.Chen et al.(2006)document a reduction in performance and profitability from before listing to after listing for Chinese IPOs.They attribute this poor performance to non-business objectives,ownership issues and poor corporate governance.
One of the impediments to the development of strong and vibrant capital markets is the underdevelopment of afinancial infrastructure that provides the mechanisms for efficient investing.The legal infrastructure,financial intermedi-aries and accounting practices were all sadly lacking in the early stages of the pri-vatisation process and China’s authorities are striving to address these problems. High qualityfinancial accounting and extensivefinancial disclosure are vital ingredients for the detailedfinancial analysis needed to valuefirms.Compared
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to the USA and other developed countries,China lacks a large coterie offinancial analysts and indepen
dent institutional investors who have the expertise and experience to analysefinancial statements.Most stock trading is conducted by small private stockholders1who have short-term investment horizons.2The short-term horizons of these investors imply they place less weight onfirm-specific information such as earnings and the components of earnings. Ownership
China’s listedfirms have unique ownership characteristics that impinge on their objectives and economic performance(Chen et al.,2009).Moreover,these differ-ences have the potential to affect the quality and usefulness of accounting reports. Eachfirm has a dominant stockholder who,on average,owns43%of the com-pany’s stock(Chen et al.,2009).In contrast,the second largest stockholder usually owns less than10%of thefirm’s shares.The state is the dominant stock-holder in most listedfirms with private investors the dominant owner in the remainder.The state’s ownership of shares can be separated into those adminis-tered by the state asset management bureaus(SAMBs)and those owned by state-owned enterprises(SOEs).SAMBs and SOEs have different objectives and incentives.The state designates SAMBs to administer its shareholdings in large businesses with national operations.The remainder of the state-controlled listedfirms has a SOE‘parent’or regional government as the major stockholder. The officials of SAMBs are civil servants and they require listedfirms under their control to fulfil social objectives,such as increasing employment,
as well as making profits.The relative importance of the different government objectives is likely to vary over time and this may lead to more variable core and non-core earnings,which makes them less informative.The maximisation of stock price and informative accounting reports may be of second-order importance for thesefirms.
SOE-controlled listedfirms often engage in related party transactions(RPTs), which involve transactions with the parent SOE or otherfirms with the same owner.These transactions are sometimes made at non-market prices,which either transfer wealth into the listedfirm(propping)or transfer resources out of thefirm(expropriation or tunnelling).RPTs may involve the purchase and sales of goods and services,which affect core earnings,or the sales of assets, which affect non-core earnings.The presence of RPTs at non-market prices may have an impact on the predictive ability of earnings and the association of earnings with market prices.
The private individual who controls a listedfirm often has private businesses and he or she may be tempted to transfer wealth from the partly owned listed firm to the wholly owned privatefirm.However,in the absence of RPTs,pri-vately controlled listedfirms are more likely to want to maximise stockholder wealth than are SAMB-and SOE-controlledfirms.On the one hand,this concern with stockholder wealth may encourage a private-controlledfirm to
The Information Content of Earnings Components673 have better qualityfinancial reports.On the other hand,the expropriation of minority stockholders via tunnelling activities may lead the privately controlled firm to have less transparent accounts to camouflage the expropriation,which make them less informative.
If government objectives and propping and tunnelling activities vary over time, this will make the core earnings and non-core earnings more difficult to predict and thus earnings will be less informative.Moreover,firms may use less transpar-ent accounting in a bid to hide or obfuscate the tunnelling activities.We have laid out arguments whyfirms may have more or less informative accounting and we show how this can arise in each type of owner-controlledfirm.A priori,it is not clear which effects dominate.In order to obtain some resolution of these argu-ments,we turn to empirical observation.In particular,we investigate whether the type of owner(SAMB,SOE and Private)has a material impact on earnings informativeness.Firms in other countries do not have the same ownerships types,and the incentives and opportunities for propping and tunnelling are different.China is an ideal setting to examine the impact of state and private ownership on earnings informativeness inside a single country.
Disclosure of Earnings
Under Chinese reporting standards,operating income is a separate line item in the income statement.Investment income and other non-operating income are shown after income from operations.The Appendix shows an income statement under Chinese GAAP.Subsidy income is subsidies from the state or government that reimburse losses that result from government policies.Subsidy income is small for mostfirms.Non-operating income consists mainly of items that are unusual or nonrecurring,or income that is peripheral to thefirm’s core business.We cat-egorise non-operating income and subsidy income as non-core earnings(NCE). In general,the two main categories of earnings,operating income and non-core earnings,are expected to have different implications forfirm valuation(Stark, 1997;Pope and Wang,2005).Income from operations represents recurring events and can be used to help predict future profits.Thus,financial analysts pay particular attention to operating income and unexpected changes in it are the focus of much analysis and discussion.3Operating income is seen as a permanent source of income,albeit with changes in its level.
Non-core earnings are principally made up of investment income and other non-core expenses and revenues.Investment income is made up of dividends received and gains and losses from sales of investments.While the dividend income may be somewhat stable,the realised gains and losses from the sale of investments are subject to managerial whim and are less predictable.In China, on average,r
ealised investment gains are greater than investment losses,and so investment income is usually positive.Investment income can be quite large in some Chinese listedfirms.One reason for the large investment income is thatfirms often take a considerable time before investing the proceeds from

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