Does Transfer Pricing Disclosure Communicate Useful Information? Evidence from China

Related-party transactions (RPTs) are common business transactions among group-affiliated companies. On the one hand, these transactions can help the group to have better resources allocations and reduce transaction costs. On the other hand, RPTs are also used as a tool to manipulate earnings, to transfer profits to major shareholders, management, or other group companies. In serious fraud cases like that of Enron, RPTs have been executed for deceptive or fraudulent purposes. The contrasting views and paucity of empirical evidence with respect to the relevance of RPTs (and related disclosures) in conveying useful information to investors motivate the proposed study. While many prior studies examine the usefulness of accounting figures in interpreting financial information, evidence on the usefulness of RPTs is sparse.The unique institutional environment in China enables us to conduct this research project. As a result of the economic reform during the past decades, the profitable units of state-owned enterprises (SOEs) are separated from the original enterprises and then listed on the stock exchange (Green 2003; Chow 2007). In most of the cases, the original SOEs retain significant ownership in the listed firms and also retain the unprofitable units of the business as well as engage in social activities (e.g., hospitals and schools) (Ding et al. 2007; Lo et al. 2010b). Therefore, many Chinese listed firms have significant RPTs with their unlisted parent enterprises and other related companies (Jian and Wong 2010), where the impacts of these RPTs on interpreting firms’ performance still await investigation.Furthermore, the mandatory disclosure requirement of the pricing policy used for RPTs in China provides us a rich setting to evaluate the usefulness of not only the amounts of RPTs executed but also the substance (i.e., the disclosure details) involved in the RPTs. Revealing the role of the pricing methods should enhance our understanding of how the possible manipulative techniques engaged via RPTs are perceived by investors.We plan to develop a model that helps explain the information contents of RPTs. In particular, we aim to (1) empirically investigate the value relevance of RPTs that help address the superiority of RPT over conventional incomes in evaluating firms’ performance. Besides, we will (2) examine the incremental information content of the disclosed transfer pricing method of RPTs. The findings of this study will be important for researchers, accounting practitioners, and regulators and will enable them to better understand the information contents of transactions with group-affiliated companies. The research findings on examining the disclosure details will also help the standard-setting bodies to devise or revise effective disclosure requirements in improving the market efficiencies.