Management ownership structure, audit quality and impairment of assets--evidence from China

Management ownership structure, audit quality and impairment of assets--evidence from China

MANAGEMENT OWNERSHIP STRUCTURE, AUDIT QUALITY AND IMPAIRMENT OF ASSETS - EVIDENCE FROM CHINA by Wong Wai Yee, Pauline A thesis submitted in partial fulfillment of the requirements for the Degree of Doctor of Philosophy School of Accounting and Finance The Hong Kong Polytechnic University December 2007 UMI Number: 3313064 INFORMATION TO USERS The quality of this reproduction is dependent upon the quality of the copy submitted. Broken or indistinct print, colored or poor quality illustrations and photographs, print bleed-through, substandard margins, and improper alignment can adversely affect reproduction. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if unauthorized copyright material had to be removed, a note will indicate the deletion. ® UMI UMI Microform 3313064 Copyright 2008 by ProQuest LLC. All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. ProQuest LLC 789 E. Eisenhower Parkway PO Box 1346 Ann Arbor, Ml 48106-1346 CERTIFICATE OF ORIGINALITY I hereby declare that this thesis is my own work and that, to the best of my knowledge and belief, it reproduces no material previously published or written, nor material that has been accepted for the award of any other degree or diploma, except where due acknowledgement has been made in the text. (Signed) WONG Wai Yee. Pauline (Name of student) Abstract Management Ownership Structure, Audit Quality and Impairment of Assets — Evidence from China by Wong Wai Yee, Pauline Doctor of Philosophy Following the release of 1998 Accounting Standards, Chinese regulatory authority further implemented another set of regulations in 2001 governing the write-down of impaired assets and requiring an assessment of recoverable amount on four additional categories of assets. Since the recoverable value is difficult to obtain objectively, management can discretionally assess the magnitude of write-down to affect the bottom-line profit. Using a sample of 5,399 firm-year observations in China from 1998 to 2004,1 examine whether the percentage of asset write-down by state-controlled firms differs from non-state-controlled firms in China, conditional on more conservative financial reporting rules. Moreover, I investigate whether local auditors, who are more likely subject to political influence from local governments, will support managerial decisions on asset write-down. My empirical findings support that the companies controlled by state would be less sensitive to economic losses, as compared to companies dominated by holders of non-state shares. In addition, I also find that local auditors support managerial decisions on asset write-down. Chinese regulators realize that companies may use provision for asset write-down and its reversal to build up big-bath and to smooth reported income. Therefore, the 2006 Accounting Standards forbid the reversal of recognized asset impairment provision on long-term investments, fixed assets, construction in progress, and intangible assets, effective from 2007. I examine whether incentives including controlling ownership by state and audit quality of small domestic auditors located in the region of their clients will affect reversal of recognized provision for asset write-down during the transition period. My empirical findings show that state controlled companies tend to have weak incentive in reporting asset impairment reversal, conditional on positive stock returns or positive cash flows. Companies controlled by state tend to reverse more impairment provisions, as compared to companies dominated by holders of non-state shares. Furthermore, ocal small auditors are more likely to agree with the aggressive accounting treatment on impairment reversal of their clients. ACKNOWLEDGEMENTS My ultimate appreciation must go to my supervisors, Dr. Jiang Li, Professor Phyllis L. L. Mo, and Dr. Donghui Wu, for their thorough guidance on my dissertation. I would not be able to reach this stage without their talents, patience and continuous encouragement. I appreciate the financial support provided by the School of Accounting and Finance of the Hong Kong Polytechnic University, which makes it possible for me to complete my studies. I cannot thank them all in this limited space, but I would like to express my gratitude to the following academic professionals, Professor Ferdinand Gul, Professor Jeong Bong Kim, Professor Bin Srinidi, Professor T.J. Wong, Dr. Shimin Chen, Dr. Peter Cheng, Dr. Agnes Lo, Dr. Raymond Wong, Dr. Xiaodong Xu and other academic colleagues and professionals for their advices on my thesis. Thanks are due to Kevin Ding, Joseph Mak, Roger Lui, Shauna Shi, Byron Song and Kevin Zhu for their technical wizardry in working with regression techniques and other software issues. Big thanks to the Asia Pacific Conference on International Accounting Issues for awarding the "Vernon Zimmerman Best Paper Award" on an earlier version of this thesis. It is a priceless support. I also wish to thank the participants of the 18 th Asia Pacific Conference on International Accounting Issues, and the 2007 AAA Western Region Annual Conference for their comments. Thanks to my Godmother, Wendy, and the godparents of my sister, Irene and Peter, who buoyed me through countless nice meals. Special thanks to the Reverend Father Franco Bellati, the Reverend Father Robert J. Cook, the Reverend Father Francesco Cumbo, the Reverend Father Gabriel Y.T. Liu, the Reverend Father Joseph K.H. Mak, the Reverend Father Paul M.J. Vallat, and the Reverend Father Edward F.M. Yu, and sisters and brothers at the St. Stephen's Parish and the St. Thomas the Apostle Church in Hong Kong, who had helped co-ordinate the Requiem Mass and funeral of my mother in July this year. I am especially grateful to my friends and their extended families in Boston, MA., Malaysia, Singapore, Toronto, ONT., La Crosse, WL, and the mainland China and Taiwan. They always remember me in their prayers. I am blessed having them in my life. A special word of thanks to Professor K.H. Chan, Professor C.K. Wong, and Dr. Michael C.H. Kwok, who play perfect role as mentors of my sister and me. I would especially like to thank my little sister, Venus, for her love, encouragement, tireless support and patience. This dissertation is dedicated to my late parents, Maria and Joseph. They had always encouraged me to pursue studies and had sacrificed many to make my education possible. I thank God for everything. "I give my parents back to you, O Lord, who first gave them to me; And as You did not lose them in the giving, so I do not lose them in the return." Management Ownership Structure, Audit Quality and Impairment of Assets - Evidence from China Certificate of Originality Abstract Acknowledgements Table of Contents i List of Figure vi List of Tables vi Chapter 1 Introduction 1.1 Motivation for the Research 1 1.1.1 The Role of Accounting Standards in Conservative Financial Reporting 1 1.1.2 The Role of Accounting Standards in Conservative Financial Reporting in China 1 1.1.3 Significance of State Ownership 4 1.1.4 Significance of State Ownership in China 5 1.1.5 Significance of Audit Quality 6 1.1.6 Significance of Audit Quality in China 7 1.2 Objectives of the Thesis 9 1.3 Contributions of the Thesis 10 1.4 Organization of the Thesis 11 Chapter 2 State Ownership, Audit Quality and Earnings Management in China 2.1 Ownership Structure of Listed Companies in China 13 2.2 Audit Quality in China 15 I 2.3 Profitability Requirement for Listed Companies 21 2.3.1 Maintenance of Listing Status 21 2.3.2 Regulations on Rights Issues 23 2.4 Earnings Management Incentives 29 2.5 Accounting Regulations on Asset Impairments 34 2.5.1 Accounting Standards in Developed Economies 34 2.5.2 Accounting Standards in China 34 2.5.2.1 Accounting Standards before 1998 34 2.5.2.2 1998 Accounting Standards 35 2.5.2.3 2001 Accounting Standards 38 2.5.2.4 2006 Accounting Standards 39 Chapter 3 Literature Review Chapter Summary 42 3.1 Literature Review on Asset Impairments 43 3.1.1 Literature Review on Asset Impairments in Developed Economies 43 3.1.2 Literature Review on Asset Impairments in China 44 3.2 Literature Review on State Ownership 45 3.2.1 Literature Review on State Ownership in Developed Economies 45 3.2.2 Literature Review on State Ownership in Asian Countries 46 3.2.3 Literature Review on State Ownership in China 47 3.3 Literature Review on Audit Quality 48 3.3.1 Proxies for Audit Quality 48 3.3.1.1 Audit Firm Size 48 3.3.1.1.1 Big Eight/Six/Five/Four Audit Firms 49 3.3.1.1.2 Clients Sales 51 3.3.1.1.3 Clients Assets 51 3.3.1.1.4 Number of Clients 52 3.3.1.1.5 Audit Fees 52 3.3.1.2 Auditor Brand Name Reputation 5 3 3.3.1.3 Industry Specialization 54 3.3.1.4 Audit Tenure and Audit Firm/Partner Rotation 5 5 n [...]... course of auditors will lead to lower earnings as compared with the treatment of management Basu et al (2002) find that auditors' conservatism associates positively with levels of litigation against auditors Research on auditor behavior can help identifying factors to improve or maintain auditors' quality in different institutional settings 1.1.6 Significance of Audit Quality in China In China, audit. .. thesis is to investigate the impact of state ownership and auditors' locality on the magnitude of asset impairment and on the reversal of asset write-down First, with the introduction of the 2001 Accounting Standards, I attempt to examine whether different ownership structures of A-share listed companies in China will have different levels of earnings management and 2 In 1997, Chengdu Hong Guang Industrial... local auditors will be supportive of managerial decisions on asset-downs focusing on reversal of asset impairment Chapter 5 repeats the examination by Chapter 6 concludes the thesis by discussing the implications and further research opportunities of this area 12 CHAPTER 2 STATE OWNERSHIP, AUDIT QUALITY AND EARNINGS MANAGEMENT IN CHINA 2.1 OWNERSHIP STRUCTURE OF LISTED COMPANIES IN CHINA Currently, China' s... period of 2005 and 2006 The release of the 2006 Accounting Standards provides a unique opportunity to examine the effect of state ownership and auditors' locality on impairment reversal 1.3 CONTRIBUTIONS OF THE THESIS The results of this thesis contribute to the literature in several aspects First, this thesis contributes to understanding the characteristics of capital market in China The recent standard... (2006), the lack of mobility of audit firms reduces their ability to resist pressure from local clients (Insert Tables 2-2 and 2-3 about here) To make sure that auditors remain independent, article 39 of the "Securities Law" specifies that, within 6 months of engaging as auditors of a company offering stocks, the audit firm and its employees were prohibited from trading the stocks of such client Furthermore,... (Insert Tables 2-4 and 2-5 about here) Recent studies on audit quality in China use modified audit opinions (MAOs) to proxy for audit independence Modified audit opinions are rare in China before the enactment of the first set of Independent Auditing Standards in 1995 Managers in China have incentives to prefer clean audit opinions, as they have to explain directly to the CSRC the nature and the underlying... restructure of SOEs into joint stock companies and the inflows of foreign direct investment created a demand for independent external audits in China The first Chinese CPA firm, Ganzu CPA firm, was established on September 1, 1980 and thereafter, thousands of new CPA firms were set up throughout the country (Liu and Lin, 2000; Tang, 2000) However, the audit profession was newly developed and audit firms... and resources to provide service to listed companies The establishment of Shanghai and Shenzhen stock exchanges in 1990 and 1991 respectively further expanded the audit markets for CPAs in China Companies listed in these 2 stock exchanges increased from 53 in 1992 to 1,381 by the end of 2005 To qualify for auditing listed companies, CPAs and CPA firms have to obtain license from the CSRC and the MOF... on and required annual accounts of all listed companies in Finance and Insurance Industry be audited by one of the Big 5 audit firms and a local audit firm On December 30, 2001, CSRC issued the 'Wo 16 Rules on Compilation of Information Disclosure of Companies That Make Public Offering of Securities - Interim Rules on Supplementary Audit on A-Share Companies" ("No 16 Rules'") For Initial Public Offerings... financial reporting by the public and the government's participation in setting and enforcing rules and standards affect the ownership structure of enterprises and in turn their incentives of reporting 1.1.2 The Role of Accounting Standards in Conservative Financial Reporting in China 1 The National Bureau of Statistics announced that Gross Domestic Products (GDP) of China for 2006 grew by 10.7 percent . of student) Abstract Management Ownership Structure, Audit Quality and Impairment of Assets — Evidence from China by Wong Wai Yee, Pauline Doctor of Philosophy Following the release of. Organization of the Thesis 11 Chapter 2 State Ownership, Audit Quality and Earnings Management in China 2.1 Ownership Structure of Listed Companies in China 13 2.2 Audit Quality in China 15 I. Significance of State Ownership in China 5 1.1.5 Significance of Audit Quality 6 1.1.6 Significance of Audit Quality in China 7 1.2 Objectives of the Thesis 9 1.3 Contributions of the Thesis