E vs. G: Environmental Policy and Earnings Management in China

Abstract

We investigate the conflict between environmental and governance issues by examining the implementation of the automatic air pollutant monitoring system in China. We find evidence that firms engage in downward earnings management to evade regulatory scrutiny. Compared to non-polluting firms, polluting firms increase their use of negative discretionary accruals and reduce the informativeness of earnings following the policy change. Firms that are larger, more profitable, located near monitoring stations, and situated in less market-oriented regions exhibit heightened earnings management. This behavior is moderated by stronger customer-supplier relationships and lower market competition. Our paper highlights the unintended consequences of environmental policies.