Accrual-based and real activity earnings management at the back door: Evidence from Chinese reverse mergers

• We examine earning management (EM) behaviors in Chinese reverse merge (RM) firms.
• Chinese RMs trade-off and conduct accrual-based and real activities manipulation.
• Chinese RMs transition to real activities management in years after reverse merger.
• Big 4 auditors constrain both accrual-based and real activities EM in Chinese RMs.
• Accrual-based EM predicts post-RM performance, but real activities EM does not.

We examine how Chinese reverse merger (RM) firms trade off and conduct income-increasing earnings management through accrual-based and real activities manipulation strategies. We find that Chinese RM firms engage in both real activities and accrual-based manipulation at higher levels than non-Chinese RM firms, regular US firms and other Chinese US-listed firms. Further analysis suggests that Chinese RM firms use real activities and accrual-based manipulation as substitutes and tend to transition to real activities management in the years after a reverse takeover. Big 4 auditors can effectively constrain both real activities and accrual-based earnings management in Chinese RM firms. We also find that accruals manipulation is more costly relative to real activities management in the short term because it predicts changes in post-acquisition operating performance in Chinese RM firms. Overall, the results provide practical implications to regulators, investors and auditors on the channels through which Chinese RM firms manipulate earnings and the economic consequence of those manipulations.