Earnings Management, Valuation Reallocation, and the Role of Audits: Resolving the Value Relevance Puzzle in China

HRMARS - This study investigates a puzzling phenomenon in China's A-share market: the declining value relevance of accounting information amidst improving formal accounting standards. Challenging the conventional "erosion hypothesis," we document a complex market response to earnings management. While a baseline positive association with firm valuation might suggest a signaling role, more rigorous analysis addressing endogeneity calls this interpretation into question. Instead, we find that the primary market reaction is a sophisticated "valuation reallocation." Investors strategically respond to earnings management by discounting the value relevance of manipulable accruals while increasing their reliance on the more verifiable book value. This reallocation reinterprets the aggregate decline in value relevance not as an abandonment of accounting information, but as a shift in its usage (Collins et al., 1997; Lev Francis, 2004), attenuating the negative impact of earnings management on the value relevance of accruals. Our findings, robust to endogeneity concerns and alternative specifications, offer a more nuanced understanding of how markets process accounting information in imperfect institutional environments.