【Comment】Public companies artificially reducing profits are no different from financial fraud

熊锦秋

Recently, a listed company in China’s A-share market in the general-purpose equipment sector issued an announcement. The company and relevant parties received a “Preliminary Notice of Administrative Penalty” from the Shandong Securities Regulatory Bureau. The matter involves alleged fictitious reduction of profits. The author believes that fictitious reduction of profits is also a type of false record-keeping. In this regard, the listed company should attach great importance to it.

After investigation, the company is suspected of violating the law in the following way: in 2024, without any real business involving accepting repairs, technical services, and so on, the company recognized total selling expenses and administrative expenses of RMB 8.4627 million, which resulted in the company’s 2024 annual report showing fictitious reduction of profits of RMB 8.4627 million—accounting for 10.37% of the total profit disclosed externally for the period. Based on this, the Shenzhen Stock Exchange will apply other risk warnings to the company’s stock.

In practice, financial fraud by listed companies mainly takes the form of artificially inflating profits. Although fictitious reduction of profits appears to run counter to a company’s initial intention to pursue performance growth, in reality it is another form of financial manipulation. Some companies reduce current-period profits by artificially inflating expenses, booking impairment provisions in advance, and so on. This may be to “build momentum” for future performance. When subsequent operations come under pressure, they can release profits through reversing expenses, reversing impairment provisions, and similar actions, thereby artificially achieving “steady growth” in performance. Some companies reduce the taxable income for the current period by artificially inflating cost and expense items, which can lower the tax burden in the short term. Some companies have performance-gaming (earnings target) clauses; by lowering current-period profits, they can reduce the base for subsequent performance evaluations and ease management’s performance pressure, among other effects.

No matter what the underlying motivations may be, fictitiously reducing profits violates the principle of fair presentation of accounting information, meaning financial statements cannot truly reflect the company’s operating results. It is essentially no different from fraud that artificially inflates profits. If a listed company fictitiously reduces a certain amount of net profit in one year, and then fictitiously inflates an equivalent amount of net profit in the following year, then the amount of false profit record-keeping in these two years would be the sum of the two—effectively doubling directly.

The authenticity of financial data is the lifeline of the capital market. Listed companies must treat financial authenticity as an uncrossable bottom line, strictly comply with accounting standards and the relevant requirements for information disclosure, and ensure that financial data are true, accurate, and complete. To this end, listed companies should establish and improve internal oversight mechanisms, strengthen the independence of the finance department, define the standards and procedures for accounting treatments such as expense recognition and impairment provision booking, cost accounting, and so on, and prevent improper intervention by management through regulatory constraints backed by systems. Company directors and executives should also earnestly fulfill their duties of loyalty and diligence, enhance awareness of financial compliance and risk prevention, and focus their efforts on operating the core business and improving core competitiveness—delivering real operating performance to investors.

For regulatory authorities, they should continuously strengthen oversight of conduct such as fictitious reduction of profits by listed companies, and build an all-round, multi-layered, and three-dimensional regulatory framework:

First, strengthen normalized and targeted oversight. Regulatory authorities can build financial data monitoring models for listed companies to dynamically monitor and give real-time alerts to potential profit-adjustment signals, such as abnormal growth in expenses, large fluctuations in the impairment provision ratio, and severe divergence between operating cash flows and profits. For companies whose anomalies are identified through monitoring, exchanges should promptly issue inquiry letters, requiring companies to explain the reasons in detail and provide sufficient supporting materials. For companies whose explanations are unreasonable or whose evidence is insufficient, regulators should continue to follow up and conduct verification, so as to prevent problems before they grow and catch issues early.

Second, increase the intensity of law-enforcement and penalties. For confirmed financial fraud involving fictitious reduction of profits and other misconduct, not only should listed companies be subject to administrative penalties according to law, but also the directly responsible persons in charge and other directly responsible personnel should be punished strictly. Regulatory measures such as fines and market entry bans should be applied comprehensively so that those responsible bear the consequences they should bear. At the same time, establish a joint punishment mechanism for fraudulent conduct, incorporate information related to financial fraud into the social credit system, and ensure that entities engaging in fraud cannot take even a step in the capital market—or across society as a whole.

Third, improve accounting standards and information disclosure rules. In light of new situations and new problems in the capital market, enterprises’ accounting standards should be continuously revised and improved to further specify the specific standards for accounting treatments such as expense recognition, impairment provision booking, and cross-period profit-and-loss adjustments, thereby reducing the institutional room for enterprises to adjust profits. In addition, refine information disclosure requirements and urge listed companies to provide detailed disclosures on matters such as large expenses and impairment provision bookings, including calculation bases, confirmation procedures, and future impacts, to enhance the transparency of financial information so that investors can clearly understand the logic behind the company’s accounting treatment.

Fourth, strengthen investor education and protection of rights. Carry out investor-focused educational activities to guide investors to pay attention to the authenticity, sustainability, and cash-flow matching of profits. By analyzing key indicators such as gross margin, net profit margin, and net cash flow from operating activities, investors can accurately identify signs of profit adjustment. Meanwhile, improve mechanisms for investors to safeguard their rights and interests, support investors in protecting their lawful rights and interests through collective lawsuits, derivative lawsuits, and other means, and pursue civil compensation responsibilities of relevant parties in accordance with the law.

This column article represents only the personal views of the author.