kong - 2005 - an empirical study of audit quality in china

J AN EMPIRICAL STUDY OF AUDIT QUALITY IN CHINA FROM THE PERSPECTIVES OF REGULATORS AND THE ACCOUNTING PROFESSION by Wong Man Kong, Raymond 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 September 2005 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. UMI Number: 3205525 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 3205525 Copyright 2006 by ProQuest Information and Learning Company. All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. ProQuest Information and Learning Company 300 North Zeeb Road P.O. Box 1346 Ann Arbor, Ml 48106-1346 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 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. -/ , (si«ned) WONG Man Kon£ (Name of student) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Abstract An Empirical Study of Audit Quality in China From the Perspectives of Regulators and the Accounting Profession by Wong Man Kong, Raymond Doctor of Philosophy The effective functioning of securities markets depends on the quality of audits and the integrity of auditors. However, the recent tide of corporate scandals and audit failures has shocked the public, and both audit quality and auditor independence have been questioned. It is therefore in the interests of both auditors and regulators to understand the main causes of audit failure, and to investigate the factors that drive audit quality. While much of the focus in the accounting literature has been on audit quality in the U.S. and other developed countries, a comprehensive study of the audit quality in developing countries is of equal significance given the increasing importance of international investment. The increasingly vital role that is played by China in the world economy and its unique institutional setting provide a motivation for the examination of the specific factors that drive audit quality. In this thesis, I first evaluate audit quality directly through an examination of the cases of audit failure that have been discovered by the Chinese regulator, the China Securities Regulatory Commission (CSRC). I attempt to show the extent to which the regulator perceives auditors to be responsible for their failure to detect fraud. Then I use auditor independence as a measure of audit quality to investigate two specific factors that drive auditor independence from the perspective of the accounting profession. I hypothesize that regulatory sanctions serve as an incentive to improve auditor independence, and further posit that the organizational form of CPA firms affects the independence level of auditors. The empirical results indicate that audit failures that involve material misstatements by clients are more likely to lead to enforcement actions against auditors than disclosure fraud. Misstatement fraud that involves accounting earnings is more likely to lead to enforcement actions against auditors than misstatement fraud that involves balance sheet figures. The results reveal a strong association between Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. several types of fraud and audit failures from the regulator’s perspective. To examine the factors that drive auditor independence, I use the issuance of modified audit opinions as a proxy for auditor independence, and demonstrate that sanctioned auditors act more independently after being subject to regulatory sanctions and that CPA firms that are registered as partnership firms are more independent than firms that are registered as limited liability firms. This implies that formal regulatory sanctions and the organizational form of CPA firms are important drivers of auditor independence and audit quality in China. Overall, the results make several contributions to regulators, the accounting profession, and academia. First, the analyses on audit failures provide direct and useful information for the improvement of audit quality. In particular, regulators and the accounting profession can make use of my findings in their policy making. Regulators and policy makers may consider devising new accounting and auditing standards to govern substandard audits to detect specific types of fraud. The accounting profession may also consider providing technical training for staff to identify various prominent types of fraud. Second, the evidence of an improvement in auditor independence that is motivated by regulatory sanctions implies that formal sanctions serve as an effective deterrent to the unethical behavior of auditors. This result supports the view that more resources should be devoted to regulatory supervision to improve audit quality and auditor independence. Finally, the results on the organizational form of CPA firms contribute to the literature by empirically demonstrating the link between auditor independence and the organizational form of CPA firms. This finding is also useful for regulators and the accounting profession as they attempt to evaluate the optimal balance in implementing a limited liability regime without diminishing audit quality and auditor independence. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. ACKNOWLEDGEMENTS I wish to acknowledge the help of many people during my study. The first and foremost thanks go to my two supervisors, Professor Phyllis L. L. Mo and Professor Michael A. Firth. This dissertation would not have been possible without their supports and encouragements throughout my study. I owe my great deal to my chief supervisor, Professor Phyllis Mo, to her dedication in offering me direction and penetrating criticism, as well as guiding me through draft after draft over the past several years. My gracious thanks also go to my co-supervisor, Professor Michael Firth, who has been so generous with his time in providing valuable comments on my thesis and is a wonderful coach in guiding me throughout this dissertation. Their advice on both substance and style are palpable on every page of this dissertation. Thanks are also due to many faculty members at The Hong Kong Polytechnic University. I am greatly indebted to Professor Ferdinand Gul, Dr. Peter Cheng, Dr. Thomas Lau, Dr. Ben Bao, and Dr. Sandra Ho, for their insightful comments on various chapters of my thesis. I also thank many academic colleagues and professionals in Hong Kong, China, and the United States who provided valuable suggestions, comments, and insights on audit quality and auditors’ practices in China. Last but not least, I would like to thank my family members whose constant love and encouragement enable me to persist throughout my study. Especially, my wife, Agnes, is my source of inspiration and impetus for pursing my study and finishing this dissertation. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. An Empirical Study of Audit Quality in China From the Perspectives of Regulators and the Accounting Profession Certificate of Originality Abstract Acknowledgements Table of Contents i List of Tables iv Chapter 1 Introduction 1.1 Motivation for the Research 1 1.1.1 Importance of Audit Quality 1 1.1.2 Importance of Audit Quality in China 2 1.2 Objectives of the Thesis 5 1.3 Contributions of the Thesis 7 1.4 Organization of the Thesis 9 Chapter 2 Literature Review 2.1 Introduction 10 2.2 Various Measures of Audit Quality 11 2.2.1 A Direct Measure of Audit Quality 11 2.2.2 Auditor Size 12 2.2.3 Brand Name Reputation 14 2.2.4 Industry Specialization 15 2.2.5 Modified Audit Opinions 15 2.2.6 Auditor Economic Dependence on Clients 17 2.3 Previous Research on Audit Quality 18 2.3.1 Audit Quality in Developed Economies 18 2.3.2 Audit Quality in China 23 Chapter 3 Audit Quality from the Perspective of Regulators Chapter Summary 29 3.1 Introduction 30 3.2 China Securities Regulatory Commission (CSRC) Enforcement Actions 33 3.3 Hypotheses Development 35 3.3.1 Material Misstatement Fraud versus Disclosure Fraud 35 3.3.2 Revenue-related Fraud versus Assets-related Fraud 39 3.4 Research Methodology 42 3.4.1 Sample Selection 42 3.4.2 Empirical Models 43 i Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3.5 Empirical Results 46 3.5.1 Sanctions on CPA Firms and Audit Partners 46 3.5.2 Fraud Characteristics and Univariate Tests 47 3.5.3 Multivariate Tests 49 3.6 Chapter Conclusion 50 Chapter 4 Audit Quality from the Perspective of the Accounting Profession - Formal Sanctions as an Effective Incentive for Auditor Independence Chapter Summary 55 4.1 Introduction 56 4.2 Formal Sanctions on Auditors in China 60 4.2.1 Chinese Institute of Certified Public Accountants (CICPA) Disciplinary Actions 61 4.2.2 China Securities Regulatory Commission (CSRC) Enforcement Actions 62 4.3 Hypothesis Development 63 4.4 Research Methodology 67 4.4.1 Sample Collection 67 4.4.2 Empirical Model 69 4.5 Empirical Results 72 4.5.1 Stock Market Responses to Sanctioned Clients with Sanctioned Auditors 72 4.5.2 Consequences for Sanctioned CPA Firms and Audit Partners 75 4.5.3 Market Share of Auditors after Sanctions 76 4.5.4 Effectiveness of the Regulatory Sanctions 78 4.6 Chapter Conclusion 81 Chapter 5 Audit Quality from the Perspective of the Accounting Profession - An Empirical Examination of the Organizational Form of CPA Firms and Auditor Independence Chapter Summary 84 5.1 Introduction 85 5.2 Development of the Legal Forms of CPA Firms in China 90 5.3 Hypotheses Development 93 5.4 Research Methodology 100 5.4.1 Sample Description 100 5.4.2 Empirical Models 102 5.4.3 Control Variables 104 5.5 Empirical Results 107 5.5.1 Descriptive Statistics of the Sample Firms 107 5.5.2 Results for Testing the Association between the Legal Form of CPA Firms and Audit Opinions (Hypothesis H I) 107 5.5.2a Univariate Tests and Correlation Matrix 108 5.5.2b Multivariate Tests 109 5.5.3 Results for Testing the Association between Auditor Switch ii Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. and Audit Opinions (Hypothesis H2) 109 5.5.3a Univariate Tests and Correlation Matrix 109 5.5.3b Multivariate Tests 110 5.5.4 Results for Testing the Association between Incorporation of Partnerships and Audit Opinions (Hypothesis H3) 111 5.5.4a Univariate Tests and Correlation Matrix 111 5.5.4b Multivariate Tests 112 5.6 Robustness Tests 112 5.7 Chapter Conclusion 114 Chapter 6 Conclusion and Discussion 6.1 Summary of the Results 117 6.2 Implications 119 6.3 Limitations 121 6.4 Future Extensions of this Research 122 Tables 123 References 151 iii Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. LIST OF TABLES Table 1-1 Table 1-2 Table 2-1 Table 3-1 Table 3-2 Table 3-3 Table 3-4 Table 3-5 Table 3-6 Table 4-1 Table 4-2 Table 4-3 Table 4-4 Table 4-5 Table 4-6 Table 5-1 Table 5-2 Table 5-3 Table 5-4 Table 5-5 Average Annual Percentage Growth of Real GDP Development of the Chinese Stock Market Development of the Accounting Profession for the Audits of Listed Companies Sample Collection Procedure for the CSRC Enforcement Releases Descriptive Statistics of Enforcement Releases Analysis of the Punishments Enforced in the Enforcement Actions Detailed Description of Fraud Descriptive Statistics and Univariate Tests for Financial Statement Fraud and Auditor Sanctions Multivariate Analysis Results for Financial Statement Fraud and Auditor Sanctions Sample Descriptions for Testing the Effectiveness of Auditor Sanctions Market Reaction to Sanctioned Clients with Sanctioned Auditors versus Sanctioned Clients with Non-sanctioned Auditors Consequences for Sanctioned CPA Firms and Audit Partners after Enforcement Action Univariate Tests for Sanctioned CPA Firms’ Market Share, Audit Partners’ Share of the Client Portfolio, and the Percentage of Modified Opinions Issued before and after the Enforcement Actions Descriptive Statistics of Auditor and Client Characteristics Multivariate Results for the Effectiveness of Auditor Sanctions Sample Descriptions for Testing the Association between the Legal Form of CPA Firms and Audit Opinions Descriptive Statistics of the Sample Firms Univariate Tests for the Association between the Legal Form of CPA Firms and Audit Opinions (full sample) Pearson (Spearman’s rho) Correlations for the Association between the Legal Form of CPA Firms and Audit Opinions (full sample) Multivariate Tests for the Association between the Legal Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 123 124 125 126 127 128 129 130 131 133 134 135 136 137 138 139 140 141 142 [...]... auditors are more effective than low -quality auditors in deterring eamings management cases when clients have an income-increasing incentive to manage eamings Their results show that Big more effective than non-Big 6 6 (non-Big 6 ) auditors are (Big 6 ) auditors in constraining aggressive eamings management when managers have the incentive to prefer income-increasing (income-decreasing) accrual choices Bartov... studies that examine audit quality in developed economies can be classified into two main streams: the demand for audits of a certain quality and the supply of audits of a certain quality As regards the demand for auditing services of a certain quality, Johnson and Lys (1990) show that the determinants of a change of auditor are related to changes in the operations and activities of client firms over... technologically specialized industries (Craswell et al 1995) than low -quality auditors As a consequence, high -quality auditing services are of particular importance in lending credibility to financial statements and increasing investor confidence Auditors specialize in the supply of various levels of quality (product differentiation), and clients demand different levels of audit quality because of the differential... functioning of the financial reporting systems, and helps safeguard the assets of investors (Fan and Wong 2005) It is therefore highly instructive for foreign and domestic investors and the government to learn more about the quality of financial statements and the mechanisms that are used to ensure quality in such a fast growing emerging economy Previous literature affirms the role of audit quality and auditor... permission independence in China in recent years [Insert Table 2-1 About Here] Recent studies that focus on audit quality and auditor independence in China provide empirical evidence that supports these observations For example, DeFond et al (2 0 0 0 ) investigate the impact of the adoption of new auditing standards on auditor independence Their results reveal a nine-fold increase in modified audit opinions... is presented in Chapter 3, and an investigation into audit quality from the perspective of the accounting profession is documented in Chapters 4 and 5 Specifically, Chapter 4 examines the effectiveness of formal sanctions as incentives for auditor independence, and Chapter 5 empirically investigates the impacts of the legal form of CPA firms on auditor independence and audit quality Finally, Chapter... attract substantial capital inflows to the economy, the quality of financial statements is an impediment to foreign investment in, and transactions with, Chinese firms The absence of an efficient legal environment and corporate governance regimes, which are characteristics of many transitional and developing economies, means that the quality of audit services plays an important role in ensuring the proper... establishment of the Chinese Institute of Certified Public Accountants (CICPA) in 1988, the disaffiliation program, in which CPA firms were severed from their sponsoring government agencies, in early 1997, and the gradual harmonization of domestic and international accounting and auditing standards (Lin and Chan 2000; Yang et al 2001) Table 2-1 provides a description of the Chinese accounting profession in terms... auditor independence in China (Chen et al 2001; Gul et al 2003), and provides some evidence of improved auditor independence following regulatory changes (DeFond et al 2000; Yang et al 2001) However, there is limited research that examines other factors that drive audit quality and auditor independence in China Given the importance of quality auditing services in the Chinese economy, this study hopes... setting up of a peer review 8 Reproduced with permission of the copyright owner Further reproduction prohibited without permission regime to self-reguiate the behavior of auditors in China 1.4 ORGANIZATION OF THE THESIS Chapter 2 provides a literature review of audit quality measures and presents the research to date on audit quality in developed countries and in China An investigation into audit quality . permission. LIST OF TABLES Table 1-1 Table 1-2 Table 2-1 Table 3-1 Table 3-2 Table 3-3 Table 3-4 Table 3-5 Table 3-6 Table 4-1 Table 4-2 Table 4-3 Table 4-4 Table 4-5 Table 4-6 Table 5-1 Table 5-2 Table. on the quality of audits and the integrity of auditors. However, the recent tide of corporate scandals and audit failures has shocked the public, and both audit quality and auditor independence. J AN EMPIRICAL STUDY OF AUDIT QUALITY IN CHINA FROM THE PERSPECTIVES OF REGULATORS AND THE ACCOUNTING PROFESSION by Wong Man Kong, Raymond A thesis submitted in partial fulfillment of the