Earnings Management and Tunneling through Related Party Transactions: Evidence from Chinese Corporate Groups*

This paper attempts to provide large sample evidence of opportunistic related party transactions in China where economic institutions, legal system and corporate structures are conducive to such dealings. We found that firms belonging to a corporate group report abnormally high levels of related party sales when they have incentives to manage earnings to avoid being delisted, or prior to issuing new equity. Our stock return results also support the conjecture that the market perceives these sales transactions as opportunistic. When the firms have free cash flows, they divert resources back to the controlling shareholders through generous trade credits and other loans. Tobin’s Q and market-to-book equity results show that the market discounts these firms’ share prices, suggesting that the market views such related lending as tunneling.