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Several recent North American corporate scandals have brought attention to the potential for accounting manipulations associated with related party transactions (RPTs), which have lead to a decline in perceived earnings quality. We examine the value relevance of disclosed RPTs in Chinese corporations. We focus on two types of RPTs: sales of goods and sales of assets. From 1997 to 2000, we find that the reported earnings of firms selling goods or assets to related parties exhibit a lower valuation coefficient than those of firms in China without such transactions. This result is not observed during 2001–2003 after a new fair value measurement rule for RPTs came into effect. Our evidence suggests that the new RPT regulation in China is perceived to be effective at reducing the potential misuse of RPTs for earnings management purposes. Since RPTs have been the subject of numerous scandals in North America, our evidence from the Chinese stock markets suggests that new RPT accounting standards could prove an efficient solution to this issue.

This paper investigates whether disclosures about related party transactions made by listed firms are value relevant. Recent scandals in the United States, such as Adelphia and the Riga family's corporate group, and Hollinger and Conrad Black's corporate group, have brought related party transactions under the spotlight. Related party transactions have also received attention in China, as China has adopted two related party transaction standards over the last ten years, making the examination of pre-post standard effects possible. Many Chinese listed companies are spin-offs of state-owned companies. Some companies are members of business consortia. Other related parties exist as a result of mergers and acquisitions or other capital investment activities. One view of the world is that related party transactions can be used within these corporate groups as a way to optimize internal resource allocation, reduce transaction costs, and improve return-on-assets. On the other hand, these transactions, if used opportunistically by management or other stakeholders, can produce misleading operating results and adversely affect minority shareholders' wealth. Many articles in the Chinese financial press express concerns about the widespread use of related party transactions (e.g., Huang, 2003 and Cao, 2003). For example, they are worried about controlling shareholders using listed firms as financing vehicles and then reallocating listed firms' capitals to other ventures. Another worry is that management may be inflating earnings to gain rights issue approval through wash sales with related parties. Management may also be seeking benefits through buying and selling at unreasonable prices, or through the exchange of assets with different qualities, etc. Responding to public concerns about the reporting of related party transactions, the Ministry of Finance of China (MOF), which is China's accounting standard setter, has first required listed firms to disclose related party relations and related party transactions to protect individual investors' rights in 1997. However, though Chinese listed companies were required to disclose their related party transactions, the MOF believed that some firms still engaged in these inter-company transactions to manipulate earnings and to mislead investors. By the end of 2001, the MOF promulgated another regulation that put restrictions on the accounting for related party transactions: Provisional Regulation on the Accounting for Sales of Assets and Other Transactions between Related Parties (labeled as “2001 RPT Measurement Regulation”). The new regulation states that if the price of a related party transaction is above its fair value, the price differential cannot be recognized as current earnings. In this study, we investigate whether disclosed related party transactions under the new regulation in 2001 provide value relevant information to investors. We posit that if the new regulation is effective and related party transactions cannot be used opportunistically to manage earnings, there is little reason for investors to discount firms involved in related party transactions. Between 1997 and 2000, the MOF argued that related party transactions continued to be used to manipulate earnings. Hence, if investors are aware of the existence of the potential for earnings manipulation through these related party transactions, they would have reacted by lowering their valuation of firms that engage in related party transactions in the 1997 to 2000 period. First, we empirically examine whether disclosures of related party transactions provide value relevant information to investors in a regime where a fair value measurement standard does not exist. Second, we examine whether a fair value measurement requirement for related party transaction, following the adoption of the new regulation by MOF, changes investors’ perceptions on the reliability of related party transactions information. Our test is based on a comparison of investor’s valuation parameters for accounting fundamentals in valuing the firm, by comparing value relevance of related party transactions in China under both regulation regimes. We predict that the earnings parameter of firms that have related party sales transactions (including sales of goods and sales of assets) is significantly lower than that of firms without such transactions before the adoption of the “2001 RPT Measurement Regulation”. Provided that the “2001 RPT Measurement Regulation” reduces the potential for earnings management, we predict that the valuation parameter of firms with related party transactions after this regulation is not significantly different from the valuation parameters of firms without related party transactions. If the regulation has successfully curtailed the use of related party transactions to manage earnings, then investors no longer need to discount the earnings of firms engaging in these transactions. We collect data for 52 manufacturing firms that are part of the “Top 100 Chinese listed firms”, as compiled in the “2002 Rankings” of New Youth Fortune, a Chinese financial magazine, and for which financial statements and stock market information are available. The accounting data cover the period 1997 to 2003. We divide our 297 firm-year observations into two test periods: 1997 to 2000 and 2001 to 2003. The partition point is the year 2001 when the “2001 RPT Measurement Regulation” has been issued. We perform regression analyses on sub-samples from these two test periods. Our results show that earnings of firms that have related party sales transactions (sales of goods and other assets) are less value relevant compared to the earnings of firms that do not engage in such transactions during the period of 1997-2000. However, there is no significant difference in the earnings valuation for the two groups in the second test period. These results suggest that the “2001 RPT Measurement Regulation” is perceived effective by investors at controlling opportunistic earnings management behavior by managers. In general, our results are robust to several sensitivity analyses. This study contributes to the accounting literature in two ways. First, it expands value relevance tests from traditional financial statement numbers to related party transactions, which include information disclosed in the financial statement notes. We provide evidence that related party transactions information is used by investors to assess the reliability of reported accounting numbers for valuation purposes. Second, the research also contributes to the earnings management literature. We provide evidence that is consistent with the scenario that earnings management through related party sales is perceived as an opportunistic behavior in the Chinese stock markets. Our empirical evidence also provides implications for Chinese accounting standard setter and other standard setters worldwide, who are concerned with related party transaction reporting, and their impact on firm value. For example, the events of Enron, Hollinger, and Adelphia suggest that we should also pay more attention to related party transactions in the North American stock markets. Our evidence suggests that increased disclosure requirements as well as a fair value measurement standard for related party transactions, as adopted in China, could prove useful. The remainder of this paper is organized as follows. Section 2 introduces the related party transaction accounting standards adopted in China. The hypotheses are developed in Section 3. Section 4 describes the sampling process and the research model. Section 5 presents the results. Additional tests are summarized in Section 6. We conclude this study in Section 7 with closing remarks for future research.

In this study, we provide an empirical examination of whether the disclosure of information about related party transactions contains value relevant information to investors in China. Our test explores the value relevance of related party transactions before and after the “2001 RPT Measurement Regulation”. Our evidence suggests that investors discount earnings when valuing firms that engage in related party sales transactions (including sales of goods and other assets) during the period of 1997 to 2000. In fact, for a firm engaging in both types of transactions, the valuation multiplier of their earnings would fall from 16.18 to 2.60. After the “2001 RPT Measurement Regulation” became effective, the earnings parameters of firms selling goods or assets to related parties are not significantly different from the parameters of firms without these transactions. This suggests that the regulation is perceived effective by investors at reducing opportunistic earnings management behavior by managers. Our results are robust to several sensitivity analyses. We provide evidence that both the existence and the magnitude of these transactions matter to investors. The significance of our interaction terms in the pre-“2001 RPT Measurement Regulation” implies that market participants find relevant information from the financial statement notes, but that they need to process and interpret this information when valuing firms. The adoption of the “2001 RPT Measurement Regulation” seems to have reduced the need for such analysis, as reported earnings appear to be used without qualification in valuation models. China's standard setter's goal of reducing potential earnings manipulation through related party transactions by the adoption of the regulation seems to have been a step forward in the right direction. Standard setters worldwide may find our evidence useful in their own analysis of related party transaction standards. Several recent North American corporate scandals have drawn attention to related party transactions. Even though much financial information is disclosed under North American standards, stock market reaction following the discovery of these scandals indicates the difficulties in interpreting this relatively obscure information. The emphasis of the existing North American standards has been to let investors know about the existence of related party transactions, a regulation similar to the regulation in effect in China between 1997 and 2000. Yet, it remains doubtful that investors have access to all relevant information to properly analyze the impact of these transactions on reported earnings. Given the recent globalization movements and complexities attached to international transfer prices, the task may become even more daunting. A direct fair value measurement standard as applied in China may restore investors' confidence and reduce general concerns. Society may be better served if reported earnings can be directly used, without further analysis. It should be noted that we do not cover all types of related party transactions in our study. We only focus on the sales of goods and on the sales of other assets. In practice, many Chinese listed firms also have other types of related party transactions, including the purchase of goods or assets, the lease of tangible assets, related party loan guarantees, agency, managerial contracts, etc. As a supplemental analysis, we also perform some tests on loan guarantees, which is without immediate direct income effects. The “2001 RPT Measurement Regulation” does not bring any modification to the accounting standards pertaining to loan guarantees. We explore their impact by adding the existence of guarantee risk as an independent variable, or as an interaction term with either of BV and EPS, to our original test model. The coefficients of these variables are not statistically significant at the 0.05 level in either test period. One possible reason is that investors do not have access to information about the probability that the loan guarantee will be exercised, and that they rely on the auditor's opinion that this is unlikely when valuing firms. Still the effects of many related party transactions (some are recognized and disclosed, some are not recognized but disclosed by listed companies) remain to be explored. Future research could extend this study by examining the usefulness of information about these other related party transactions. Subramanyam (1996) documents that the North American markets attach value to discretionary accruals. In further tests, the author suggests that this result is consistent with the explanation that managerial discretion improves the ability of earnings to reflect firm's fundamental value. In this paper, we do not attempt to distinguish opportunistic and efficient related party transactions. Further research in creating models to sort through these transactions would be beneficial to our understanding of large, unconsolidated but related corporate groups. We recognize our sample size is relatively small. While this small sample allows us to focus specifically on manufacturing firms to increase the power of our tests, one limitation is that it confines the generalizability of the results. The external validity of our results needs to be validated by future research that performs empirical tests across industries, and in mature stock markets. Altogether, the empirical evidence from these investigations would provide useful information for regulation by accounting standard setters. Since related party transactions exist worldwide, we also hope this paper can inspire research on related party transactions in mature stock markets.