Incentives for and Consequences of Initial Voluntary Asset Write-Downs in the Emerging Chinese Market

Abstract

Understanding the incentives for and consequences of accounting method choices is important to various constituents of accounting. In 1998, a Chinese accounting regulation allowed listed companies to voluntarily write-down assets through their income statements. The regulation was amended in 1999 to require all companies to write-down assets, with a retroactive adjustment of pre-1998 asset impairment to the beginning equity. These events allow us to unambiguously identify a test sample that voluntarily wrote down assets in 1998, and a control sample that suffered from asset impairment but chose not to write-down. This research setting is free from many problems that have been identified in the asset write-down literature. Overall, we find that the voluntary asset write-downs have a positive valuation effect. While recognizing the possibility of alternative explanations, we believe our results, taken together, are more consistent than others, with the voluntary write-downs being a signal of the potential for performance improvement. We provide evidence consistent with this signaling explanation. This study adds additional evidence to the accounting choice literature by taking advantage of a unique research opportunity in China and adopting a broad approach to examining both the incentives for and consequence of voluntary asset write-downs.

How do firms react to the prohibition of long-lived asset impairment reversals? Evidence from China

“…Wang (2007) studies Chinese listed firms' long-lived asset impairment write-down recognition and reversal data during 2001-2004, concluding that write-downs and their subsequent reversal result from earnings management incentives, not economic factors. In contrast, Chen et al (2004) examine initial asset impairment recognition for a sample of Chinese firms disclosing writedowns in 1998 and 1999. They argue that the observed positive capital market effects associated with the write-downs suggest that the write-downs convey positive signs about future performance, although they do not rule out opportunistic explanations.…”

A research on impairment of assets in listed firms with negative earnings in China

“…Zucca and Campbell (1992) find the same evidence but they deem that more firms write off assets to take a big bath. Chen et al (2004) reveal that the firms with CEO changes or big losses are more likely to write down assets and tend to write down assets by a larger amount. They also document an ex post association between the voluntary asset write-down and subsequent improvement of performance in terms of the return on assets but not in terms of cash flows.…”

“…However, Francis et al (1996) reveal that the effect of earnings smoothing and the big bath on the impairment of assets and the proportion is not significant. McNichols et al (1988), Linden (1990), Grover (1992, Zucca and Campbell (1992), Riedl (2004) and Chen et al (2004) provide evidence that firms' earnings management is an important factor which influences the impairment of assets more than the other factors mentioned above. However, the relevant evidence is inconsistent.…”

An Empirical Study on the Relationship between Accounting Conservatism and Asset Impairment Recognition: Evidence from Companies in Taiwan

“…However, Rees et al (1996) find that asset impairment recognition was caused by genuine changes in the economic environment and it reflect poor operating conditions rather than speculative behavior. Chen et al (2004) investigate the behaviors of voluntary disclosure asset impairment in the Chinese companies during the period 1998-1999, and find that a reduction in assets' book value communicated positive information to investors, allowing them to see that future performance would be improved. Using the economic asymmetric model, Yan & Ding (2008) investigate whether the motivation for the recognition of impairment losses under different economic conditions (growth vs. recession) by categorizing motivations according to management incentives (e.g., taking a big bath, earnings smoothing, changes in high-level managers, debt contracting) and real economic factors (e.g., sales growth rate, earnings growth rate).…”

“…Previous studies explore recognized impairment loss or gains on impairment reversal may result from earnings management motivation, in that managers regard recognized impairment losses as an important tool for the manipulation of profit or loss (Zucca & Campbell, 1992). Some have argued that gains on impairment reversal is subject to the influence of the earnings motivations of the managers (Chen et al, 2007); however, other studies have suggested that recognized impairment loss is based on the actual economic conditions of the company (Chen et al, 2004).…”