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

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

of the r e q u i r e m e n t s for the Degree of

Doctor of Philosophy

School of Accounting a n d F i n a n c e

T h e H o n g K o n g Polytechnic University

December 2007

UMI Number: 3313064

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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 18th 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

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

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

3.3.1.5 Audit Contract Type 56 3.3.1.6 Modified Audit Opinions 57 3.3.1.7 Non-Audit Service 57 3.3.1.8 Audit Failures 58 3.3.1.9 Political Influence from Audit Clients 59

3.3.2 Previous Research on Audit Quality in China 59

Chapter 4 Are State Ownership and Auditor Locality Determinants

of Asset Write-Down?

Chapter Summary 63 4.1 Introduction 65 4.2 Hypotheses Development 70

4.2.1 Economic Factors 70

4.2.1.1 Stock Returns 70 4.2.1.2 Cash Flows from Operations 73

4.2.2 Incentives Factors 74

4.2.2.1 State Controlled Firms 74 4.2.2.2 Audit Quality 76 4.2.3 Regulator y Factors 81

4.2.3.1 Delisting Avoiders 82 4.2.3.2 Rights Offering Qualifiers 83

4.2.3.3 Big Bath Takers 85 4.3 Research Methodology 88

4.3.1 Sample Selection 88

4.3.2 Empirical Models 90

4.3.2.1 Basu (1997) Model 91 4.3.2.2 Ball and Shivakumar (2005) Model 100

4.3.3 Descriptive Statistics 102

4.4 Empirical Results 103 4.4.1 Basu (1997) Model 103

4.4.2 Ball and Shivakumar (2005) Model 107

4.5 Robustness Tests 110 4.5.1 Alternative Definition of Controlling Ownership 110

4.5.2 Alternative Definition of Local Auditors 111

4.6 Chapter Conclusion 112

Chapter 5 Do Firms Use Impairment Reversals to Meet Earnings

Targets?

Chapter Summary 115 5.1 Introduction 117 5.2 Hypotheses Development 123

5.2.1 Economic Factors 123

5.2.1.1 Stock Returns 123 5.2.1.2 Cash Flows from Operations 124

5.2.2 Incentives Factors 125

5.2.2.1 State Controlled Firms 125 5.2.2.2 Audit Quality 127 5.2.3 Regulator y Factors 132

5.2.3.1 Delisting Avoiders 132 5.2.3.2 Rights Offering Qualifiers 133

5.2.3.3 Big Bath Takers 134 5.3 Research Methodology 137

5.3.1 Sample Selection 138

5.3.2 Empirical Models 139

5.3.2.1 Basu (1997) Model 140 5.3.2.2 Ball and Shivakumar (2005) Model 150

5.3.3 Descriptive Statistics 153

5.4 Empirical Results 154 5.4.1 Basu (1997) Model 154

5.4.2 Ball and Shivakumar (2005) Model 157

5.5 Robustness Tests 159 5.5.1 The Tobit Specifications 159

5.5.2 Alternative Definition of Controlling Ownership 160

5.5.3 Alternative Definition of Local Auditors 161

5.6 Chapter Conclusion 161

Chapter 6 Conclusion and Discussion

6.1 Summary of the Results 164

LIST OF FIGURE

Figure 1-1 Audit Market in China 170

LIST OF TABLES

Table 1-1 Average Annual Percentage Growth of Real GDP 171

Table 2-1 Stock Market in China 172

Table 2-2 Licensed CPA Firms to Audit Listed Companies in China as at 175

Table 2-7 Accounting Treatment on Asset Impairment 182

Table 4-1 Descriptive Information on Sample Selection 183

Table 4-2 Descriptive Statistics on Variables Used in the Basu Model 185

Table 4-3 Descriptive Statistics on Variables Used in the Ball and 187

Shivakumar Model

Table 4-4 Regression Results on Asset Write-down (Basu Model) For 189

Years from 1998 to 2004

Table 4-5 Regression Results on Asset Write-down (Ball and 191

Shivakumar Model) For Years from 1998 to 2004

Table 4-6 Regression Results on Asset Write-down (Basu Model) - 193

Alternative Definition of Controlling Ownership

For Years from 1998 to 2004

Table 4-7 Regression Results on Asset Write-down (Ball and 195

Shivakumar Model) - Alternative Definition of Controlling

Ownership

For Years from 1998 to 2004

Table 4-8 Regression Results on Asset Write-down (Basu Model) - 197

Alternative Definition of Top-10 Auditors (ranked by the

number of audit clients)

For Years from 1998 to 2004

Table 4-9 Regression Results on Asset Write-down (Ball and 199

Shivakumar Model) - Alternative Definition of Top-10

Auditors (ranked by the number of audit clients)

For Years from 1998 to 2004

Table 5-1 Descriptive Information on Sample Selection 201

Table 5-2 Descriptive Statistics on Variables Used in the Basu Model 203

Table 5-3 Descriptive Statistics on Variables Used in the Ball and 205

Shivakumar Model

Table 5-4 Tobit Regression Results on Reversal of Recognized Asset 207

Impairment Provision (Basu Model) For Years from 2001 to

2005

Table 5-5 Tobit Regression Results on Reversal of Recognized Asset 210

Impairment Provision (Ball and Shivakumar Model) For Years

from 2001 to 2005

Table 5-6 OLS Regression Results on Reversal of Recognized Asset 213

Impairment Provision (Basu Model) For Years from 2001 to

2005

Table 5-7 OLS Regression Results on Reversal of Recognized Asset 216

Impairment Provision (Ball and Shivakumar Model) For Years

from 2001 to 2005

Table 5-8 Tobit Regression Results on Reversal of Recognized Asset 219

Impairment Provision (Basu Model) - Alternative Definition of

Controlling Ownership

For Years from 2001 to 2005

Table 5-9 Tobit Regression Results on Reversal of Recognized Asset 222

Impairment Provision (Ball and Shivakumar Model)

-Alternative Definition of Controlling Ownership

For Years from 2001 to 2005

Table 5-10 Tobit Regression Results on Reversal of Recognized Asset 225

Impairment Provision (Basu Model) - Alternative Definition of

Top-10 Auditors (ranked by the number of audit clients)

For Years from 2001 to 2005

Table 5-11 Tobit Regression Results on Reversal of Recognized Asset 228

Impairment Provision (Ball and Shivakumar Model)

-Alternative Definition of Top-10 Auditors (ranked by the

number of audit clients)

For Years from 2001 to 2005

CHAPTER 1

INTRODUCTION

1.1 MOTIVATION FOR THE RESEARCH

1.1.1 The Role of Accounting Standards in Conservative Financial Reporting

Recent studies emphasize that accounting standards only partially influence

accounting properties, and it is the preparers' incentives that determine the quality

of accounting information (Ball et al., 2003; Ball and Shivakumar, 2005) In fact,

institutional features of a country influence the ownership and governance of

enterprises, which shape the preparers' incentives to report accounting information

Market forces and government's involvement play important roles in determining

the institutional features In other words, the demand for 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

The National Bureau of Statistics announced that Gross Domestic Products

(GDP) of China for 2006 grew by 10.7 percent to reach R M B 20.94 trillion,

equivalent to US$2.68 trillion and the Chinese economy, which overtook Britain in

2005 to become the world's fourth biggest, is moving closer to that of Germany,

which is estimated to have grown by 2.2 percent last year to US$2.86 trillion {China

Daily, 26 January 2007) Table 1-1 summarizes the average annual percentage

growth rate of real GDP in China and other developed countries The International

Monetary Fund (IMF) releases annual report on GDP and the GDP growth rates for

developed economies and emerging markets round the world As reported in the

IMF 2007 report, the average 10-year growth rates for 1989 to 1998 and for 1999 to

2008 (projected) for China is 9.6 percent and 9.4 percent respectively, as compared

to 3.2 percent and 4.4 percent for the world average, and 3.0 percent and 2.8 percent

for the United States In order to continue the growth and to attract foreign

investment, Chinese enterprises have to develop modern governance system and to

provide confidence to investors

(Insert Table 1-1 about here)

To improve the quality of accounting information in order to attract more

investors in local enterprises, Chinese authorities issue accounting regulations and

accounting standards with reference to international standards By introducing

asset write-down regulations in 1998 and 2001, the Chinese government aims at

enhancing the usefulness of the information reported on financial statements

However, the decision of writing down the value of assets and the magnitude of

write-down allow management of listed companies to exercise discretion in

determining the recoverable value of relevant assets and provides a good chance for

management to opportunistically manage the reported earnings Li (2001) shows

that, when the policy of asset write-down is compulsory, listed companies with loss

aversion, rights issues, and threshold motivations tend to increase (or, not to

decrease) the current earnings by lower asset write-down Since asset write-down

will affect the reported profits and thus the listing status, the Accounting System for

Shareholding Companies of 1998 ("1998 Accounting Standards") and the

Accounting System for Business Enterprises of 2001 ("2001 Accounting Standards")

provide opportunities to management of listed companies to manage earnings To

reduce firm's earnings management behaviors, Chinese regulators attempt to tighten

accounting standards On February 15, 2006, the Ministry of Finance (MOF)

issued a new set of Accounting Standards for Business Enterprises ("2006

Accounting Standards") which will become mandatory for all listed companies in

China on January 1, 2007 The 2006 Accounting Standards disallow any reversals

of impairment provision on fixed assets and intangible assets, effective from 2007

In addition, the 2006 Accounting Standards further requires listed companies to

justify any reversal during the transition period of 2005 and 2006

1.1.3 Significance of State Ownership

Financial crisis and the Great Depression after the World War I brought an

increase in demand for greater social control over markets (Perotti, 2004)

However, the inefficiency of state-owned enterprises (SOEs) led to debates on the

government ownership for decades Perotti (2004) documents two arguments,

public commitment problem and private commitment problem, used for justifying

state ownership in the presence of market failures Public commitment problem

arises from the inability of the government to commit to regulatory policies, which

reduces private investment Private commitment problem is arising from the

inability of government to control important decisions by private owners (Hart et al.,

1997; Shleifer and Vishny, 1994) Sappington and Stiglitz (1987) suggest that

government may want to retain direct control to avoid costly contract renegotiation

processes with private parties

Perotti (2004) also reports the inefficiency of SOEs, including a lack of

managerial and employee incentives to efficiency, problems of competence or

corruption by state authorities, and the use of SOEs for political purposes

Megginson and Netter (2001) and Gong et al (2006) argue that private ownership is

more appropriate than public ownership as it is easier to have a well-defined and

stable corporate goal The results of prior literature on comparing the performance

of private enterprises and SOEs are mixed Megginson and Netter (2001)

conclude that empirical work on this area faces the problem of selection bias, which

is arising from the factors affecting the enterprises to be state-owned or privately

owned and influencing the performance of the enterprise Therefore, the

significance of state ownership remains an interesting area of research

1.1.4 Significance of State Ownership in China

Economic reforms have transformed China from a centrally planned

economy and have brought out restructuring of ownership structure in enterprises

from contractual leasing, collectively-owned Township-Village Enterprises to

investor-owned public enterprises (Zhang, 2001) Enterprises controlled by

ministries or government agencies were transformed to become shareholding

companies In July 1992, the State Council issued the Regulations on

Transforming the Management Mechanism of State-Owned Industrial Enterprises

and introduced the shareholding system The establishment of the Shanghai Stock

Exchange (SHSE) in 1990 and the Shenzhen Stock Exchange (SZSE) in 1991

provided a platform for enterprises to list their shares

Although shares of SOEs are allowed to be traded on the exchanges, the

state retains the ultimate control of the companies and reforming to market-oriented

economy according to the idea of "Socialism with Chinese characteristics"

Furthermore, the ministries and local governments transfer productive assets and

expertise from non-listed SOEs to establish a listed enterprise In order to achieve

their social targets and to recover the cost of assets transferred, the state has to

retain control of the listed companies

1.1.5 Significance of Audit Quality

Prior studies suggested that high quality auditors act as one of the effective

deterrents to earnings management by detecting and revealing misreporting by

management (Becker et al., 1998) and Big Six audit clients used more conservative

accounting methods (Chung et al., 2003; Basu et al., 2002) High quality auditors

help reducing information asymmetry between the owners and managers of a

company (Jensen and Meckling, 1976; Watts and Zimmerman, 1986) DeFond

and Jiambalvo (1993) present that when there is auditor-client disagreement, the

recommended 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 market is still dominated by small-scaled domestic CPA

firms and is not fully opened to international accounting firms Chan et al (2006)

find that local auditors have greater economic dependence on local clients and tend

to issue clean auditor opinions to companies owned by local government

International large audit firms enjoy a substantial share of audit market Liu and

Zhou (2007) report that senior officials of Chinese government believe Big 5 audit

firms provide much higher quality auditing service than local firms and therefore

allocate some market shares exclusively to international well-recognized audit firms

On January 12, 2001, the China Securities Regulatory Commission (CSRC) and the

MOF jointly released the "Administrative Measures on Temporary License for

Overseas Certified Public Accountants' Firm When Executing Audit Business on

Financial Listed Companies" 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 (IPOs) and seasonal equity offerings, the No

16 Rules required all A-share companies to hire licensed local audit firms to render

audit services according to the accounting regulations in China, and to hire

international audit firms to provide supplementary audit services according to

international accounting standards1

However, as compared to developed markets, the litigation risk for auditors

1 This regulation is abandoned after the Enron incidence (Liu and Zhou, 2006)

On February 28, 2002, the CSRC released the 'Wo 10 Notice on Related Questions Regarding Supplementary Audit on A-Share Companies" ("No 10 Notice") and

restricted the scope of firms to (1) those offering more than 300,000,000 shares; or (2) those specifically required by relevant ministries or the CSRC In addition, the

No 10 Notice also allowed licensed local audit firms to provide supplementary

audit services

is low in China2 When Big Five audit firms can secure a substantial portion of

market share in China, the risk of losing quasi-rent is much reduced Therefore, it

is interesting to examine if Big Five is providing higher quality services than local

audit firms in China

1.2 OBJECTIVES OF THE THESIS

The primary objective of this 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 Limited (Stock Code: 600083) reported a fraudulent profit of over RMB100 million in 1996, instead of the actual loss of RMB53.8 million, to apply for listing The 1997 annual report of the company showed a loss of RMB203 million A minority shareholder of the company took a civil action and applied to court to sue the directors and the intermediaries, including auditors, for fraudulent financial information in the prospectus However, the court ruled that securities investments were risky decisions and any loss arising from such risky investments did not necessarily relate to the fraudulent disclosure of information by the company (Wang, 2000) On January 15, 2002, the

Supreme Court of the People's Republic of China released the "Notice of the Supreme People's Court on the Relevant Issues Concerning the Acceptance of Civil Tort Dispute Cases Caused by the False Statements in the Securities Markets'^ and

set out four prerequisite requirements for the public to sue the company and the related parties This further reduced the litigation risk of the auditors

adopt different policies on impairment provision Moreover, with the accession to

WTO, Chinese regulators encourage local auditors to improve audit quality and

independence in order to compete with international audit firms Hence, I further

investigate whether audit firms with operations in the same provincial region with

their clients will follow the clients' decision on asset impairment

Second, in order to prevent listed companies in China from opportunistically

managing earnings by over- or under-provision for asset impairment, the 2006

Accounting Standards forbid any reversals of impairment provision on fixed assets

and intangible assets, effective from 2007 The Chinese regulatory authority

further requires listed companies to justify any reversal during the transition 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 settings provide unique research opportunities to examine the

incentives of choices in accounting methods Second, this chapter shows the

impacts of ownership structures on earnings management, as the Chinese

government is not only the majority shareholder, but also the regulator, of

companies listed in China On the one hand, regulators on listed companies and

auditors have to safeguard the smooth operation and to maintain high quality of the

capital market On the other hand, the majority shareholder has to retain the listing

status and secure the existence of large scaled enterprise and employment level

Third, my study provides further evidence that locality of audit firms and their

clients have impact on the impairment decision To build a credible independent

auditing profession and to compete with international audit firms after the accession

to WTO, Chinese regulatory bodies should evaluate the effectiveness of the policies

relating to improving auditors' quality and independence Fourth, my results

further show that companies controlled by state have less incentives to recognize

asset impairments albeit the availability of conservative rules Policy makers

should design regulations on mitigating the influence of state and improving the

quality of financial reporting

1.4 ORGANIZATION OF THE THESIS

Chapter 2 discusses the accounting regulations and profitability requirement

for listed companies in China Chapter 3 reviews previous literature on asset

write-down, state ownership and audit quality in developed markets and in China

Chapter 4 examines whether the magnitude of asset write-down by state-controlled

firms differs from non-state-controlled firms in China, conditional on more

conservative financial reporting rules and whether local auditors will be supportive

of managerial decisions on asset-downs Chapter 5 repeats the examination by

focusing on reversal of asset impairment Chapter 6 concludes the thesis by

discussing the implications and further research opportunities of this area

CHAPTER 2

STATE OWNERSHIP, AUDIT QUALITY AND

EARNINGS MANAGEMENT IN CHINA

2.1 OWNERSHIP STRUCTURE OF LISTED COMPANIES IN CHINA

Currently, China's listed companies are classified into A-shares, B-shares,

H-shares, N-shares and L-shares according to the holders' residency A-shares are

listed on the Shanghai or the Shenzhen Stock Exchanges and are held by domestic

shareholders and are denominated in Renminbi (RMB)3 B-shares are also listed

on the two exchanges in China but to foreign shareholders, and are denominated in

Hong Kong dollars or US dollars.4 H-shares, N-shares and L-shares are Chinese

enterprises listing on the Hong Kong Exchange, New York Stock Exchange and

London Stock Exchange respectively A-shares, B-shares and the overseas-listed

-2

The Qualified Foreign Institutional Investors (QFIIs) Act enacted on December 1,

2002 allowed foreign investors to participate in A-share market, through designated accounts of foreign institutions approved by the CSRC The first batch of institutions approved as QFIIs were Citigroup, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, UBS, Morgan Stanley and Nomura Securities They were allowed to invest in shares denominated in RMB listed on SHSE and SZSE, A-shares, treasuries listed on the two exchanges, convertible bonds, corporate bonds, and other financial instruments approved by the CSRC The first QFII investment took place in July 2003 (Hong Kong Exchange, 2004)

4 Starting from June 2001 onwards, the restriction on B-shares to be traded by foreign investors using foreign currencies was uplifted

shares have the same ownership right

The ownership of A-shares is mainly divided into three different categories:

state shares, legal person shares, and tradable shares (1) State shares are issued to

the central government, local governments or wholly owned government enterprises,

including state asset management agencies (2) Legal person shares are further

divided into two categories - state-owned legal shares and ordinary legal shares

Ordinary legal shares are issued to domestic institutions such as securities

companies and non-bank financial institutions.5 (3) Tradable shares, which

amount to around 3 5 % of the total shares of the enterprises, are issued to the public

and employees and most of them are held in the hands of small individual investors

(Wang, 2004)

5 Before 2005, both state shares and legal person shares are not allowed to trade on the Shanghai and the Shenzhen Stock Exchanges, but can be transferred to domestic institutions within the same category, subject to CSRC's approval (Jiang, 2004; Cooper, 2003) State shares can only be transferred to another state shareholder and legal person shares are restricted to transfer to another legal person shareholder The transfer price is set at the net assets value per share plus a margin through negotiation and is also subject to the CSRC's approval (Wei and Xiao, 2005) The restriction is imposed in order to retain significant ownership and control of the enterprises and the industries by the state and to eliminate any chance of diluting the state control over listed companies without prior approval (Walter and Howie, 2001) Under the "Administrative Measures on the Share Segregation Reform of Listed Companies" and the "Guidelines on Practice and Operation of Share Segregation Reform of Listed Companies", the state and legal person shares are allowed to be traded after the proposal for disposal of these shares are approved by the state-owned assets regulatory authorities

(Insert Table 2-1 about here)

Non-tradable shareholders control the enterprises As shown from Panel C

of Table 2 - 1 , the portion of non-tradable shares was reduced from 71.9% in 1993 to

64.5% in 1995, and had been staying at a very steady level after that State shares

represent the largest portion within non-tradable shares In 1992, the total number

of state shares was 2.9 billion, representing 42.0% and 6 0 3 % of the total issued

number of shares and number of non-tradable shares respectively After the 15th

National Congress of the China Communist Party held in September 1997, more

state-owned enterprises were allowed to be listed on the exchanges The

additional number of shares raised during 1998 to 2001 was 327.5 billion, being

1.69 times of the total number of shares listed on the exchanges at the end of 1997

With the total non-tradable shares remaining at around 6 5 % of the total issued share

capital, the portion of state shares has been increasing from 31.5% in 1997 to 45.0%

in 2005 In other words, the controlling power of state shareholders over the

market is increasing

2.2 AUDIT QUALITY IN CHINA

The Certified Public Accounting (CPA) profession was established in China

in 1910s accompanied with the development of shareholding enterprises

International CPA firms started their practices in China and there were 3,356

registered CPAs in China in 1947 Revolution in 1949 brought auditing role in

China diminished In 1962, the economy was completely nationalized and the

majority of enterprises in China were owned and managed by the State or respective

industrial ministries SOEs operated strictly according to the State or ministerial

plans Hence, demand for independent audit by public accountants no longer

existed (Gensler and Yang, 1996) The economic reform in 1979 brought about

structural changes to the economy The 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 were in lack of

expertise and resources to provide services to their clients In order to monitor the

accounting profession, the M O F formed the Chinese Institute of Certified Public

Accountants (CICPA) in November 1988 The CICPA then started its duties,

under the supervision of MOF, of setting standards for certified public accountants,

administering the national uniform examination for CPAs In 1995, the MOF

released the first set of Independent Auditing Standards, drafted by CICPA

according to the international auditing standards

During 1980s and early 1990s, local government agencies, universities and

research institutes transferred qualified personnel to work in the audit firms, and

controlled the business operations of the firms This affiliation of audit firms with

government agencies resulted in lack of independence (Chan et al., 2006)

Sponsoring local government agencies often demanded companies located within

their administrative territory to appoint their sponsored audit firms (Yang et al.,

2001) In return, auditors' judgments and audit opinions were often influenced by

local governments (Tang, 1999; Zhong, 1998) To prepare for accession to WTO

and to build a credible independent auditing profession, CICPA began the structural

reform of CPA firms in 1997 and 1998 by delinking the financial ties of CPA firms

with their sponsoring government units (Chan et al., 2006) By the end of 1999,

all CPA firms in China had delinked from their sponsoring organizations

However, delinking CPA firms from sponsoring government agencies may

not be an effective means to create an independent auditing profession First, by

retaining formerly government-affiliated auditors as their personnel, local CPA

firms can maintain "guanxi", i.e., close relationship, with local governments and

thus are able to benefit from this relationship to provide service to new clients and

to retain existing clients in the same region (Chan et al., 2006) As local

governments remain important in securing clientele for local audit firms, they

continue to exercise strong political influence over auditor independence Second,

audit firms in China are generally small in size and they are in lack of technical

expertise 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 To audit listed companies, licensed CPA firms were required

to employ at least 8 licensed CPAs In order to meet the requirements of licensed

employees, CPA firms started to merge with one another At the end of 1999,

Zhong Rui merged with Hua Xia and it was the first merging case on CPA firms

By the end of 1999, only 106 CPA firms were authorized to audit listed companies

(Chen, Su and Wang, 2005) Effective from July 2000, the M O F required all

licensed CPA firms to audit listed companies to employ at least 60 CPAs, including

20 licensed CPAs, and to generate annual revenue of at least R M B 15 million in the

previous year The number of CPA firms licensed to audit listed companies in

China reduced from 106 in 1999 to 70 in 2006 Owing to a lack of supply of

licensed CPA firms, audit clients are mostly located within the same provincial

region According to Chan et al (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, if the audit firm is engaged in the periodic reporting of a

listed company, the audit firm and related CPA's were prohibited from trading the

stock of such client during the period from which it is engaged in the assignment to

5 days after the announcement of the audit report

To improve the transparency of the annual accounts, all listed companies are

required to disclose the auditors' remuneration in their annual reports effective 2001

Starting from 2002, CICPA further discloses the ranking of the Top-100 audit firms

in China annually on their official website, on the basis of their total fee income and

the number of certified public accountants employed Table 2-4 summarizes the

Top-10 audit firms ranked by fee income for years 2002 to 2006 Table 2-5

documents the Top-10 audit firms ranked by the number of CPAs hired, for years

2002 to 2006

(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 reasons for receiving the

modified reports (DeFond, Wong and Li, 2000) DeFond, Wong and Li (2000)

conjecture that an auditor with greater independence is more resilient to client

pressure to issue a clean audit report when a modified report is appropriate and use

relative frequency with which auditors issue modified audit reports as surrogate for

independence They find that managers prefer clean audit opinions and lack

incentives to demand independent auditors, and an increase in independence among

larger auditors will cause managers to prefer smaller, less independent auditors

Yang et al (2001) find that the number of MAOs increased substantially after the

promulgation of the disaffiliation program of local audit firms from their sponsoring

government agencies in 1997, and conclude an improvement in audit independence

Table 2-6 summarizes the types of audit opinions issued for Chinese listed

companies from 1992 to 2005

(Insert Table 2-6 about here)

Prior studies in China also use audit size to proxy for audit quality as larger

auditors are likely to be more independent (Dopuch and Simunic, 1980, DeFond et

al., 2000) Gul et al (2003) show that the market reaction to an increase in

earnings be stronger for firms that are audited by Top-10 auditors, and conclude that

investors value the importance of audit quality in China

2.3 PROFITABILITY REQUIREMENT FOR LISTED COMPANIES

2.3.1 Maintenance of Listing Status

The establishment of the Shanghai and the Shenzhen stock exchanges in

1990 and 1991 respectively provided platforms for companies to raise capital

Initially, the People's Bank of China supervised the local governments of Shanghai

and Shenzhen and other government bodies to monitor the capital market in China

The CSRC was established pursuant to the State Council Directive in July 1992 to

monitor and regulate the Chinese stock market In 1998, the CSRC set up the

Special Treatment (ST) and Particular Treatment (PT) system to improve the quality

of listed companies and to protect the rights of investors Companies continuously

suffering from loss will be labeled to remind investors the additional risks involved

when investing in their shares When a listed company suffered from loss for two

consecutive years, the shares will be labeled as "ST" CSRC will impose reporting

and trading restrictions on its shares.6 If the ST firm has a turnaround in the

following year, the label of " S T " will be uplifted However, if the ST company

continues to incur loss in the third year, its shares will be classified as "PT" and are

only allowed trading on Fridays.7 When the PT company suffers from further loss,

the shares will be suspended from trading and the company will be delisted from the

stock exchange By labeling the firms with " S T " or "PT", companies with poor

quality of management can be easily identified by investors

Local governments are unwilling to have companies under their provincial

6 Apart from providing an audited interim report to the CSRC, the daily fluctuation

of stock price of the " S T " company should not exceed 5% Since the daily stock price variation for normal listed companies is restricted at 10%, the reduction in price variation on " S T " firms has further reduced the attractiveness to investors on trading their shares

7 The share price of a PT company can continue to fall but is not allowed to go up over 5% for any trading day in order to avoid any manipulation from related parties

supervision be delisted Hence, speculators push the share prices upwards as they

expect the local governments to step in to bail the PT companies out (Wall Street

Journal, 2001) Before 2001, no firm has been de-listed (Fan, Wong and Zhang,

2007b) In order to convey right information to the public, the CSRC strengthened

the regulatory procedure and, with effect from January 1, 2002, abolished the

category of "PT" According to the new rules, all companies suffering loss for

three consecutive years are suspended from trading If the ST company, after

incurring loss for three consecutive years, continues to report loss in the following

quarter, the CSRC will label it with an asterisk before "ST" In case an "*ST"

company again reports loss in the quarter followed, it will be delisted from the

exchange (Hong Kong Commercial News, 2003)

2.3.2 Regulations on Rights Issues

Raising equities in China, including IPOs and re-issuance of securities,

requires CSRC's approval To protect the IPO market, the CSRC did not allow

listed companies to issue additional shares to the public through seasoned equity

sales prior to 2001 (Wang, Wei and Pruitt, 2006) Apart from IPO, rights issue is

the primary source available to raise additional capital, as listed companies in China

are unable to issue corporate bonds or to offer seasoned shares (Haw et al., 2005)

Only one listed company was allowed to issue bonds during the period from 1993 to

1997 (Haw et al., 1999)

Before 1993, there was no regulation specifying the rules for stock rights

offerings The Interim Provision on the Shenzhen Special Economic Zone

Joint-Equity Cooperative Enterprises released in February 1992 authorized the

local People's Bank of China to approve applications for rights offerings for

companies with stable profits records Because of the excessive demand for

securities from the public, rights offerings were fully subscribed by shareholders in

early 1990s (Chen and Yuan, 2004) The CSRC then issued the Interim Provision

on Rights Offerings by Listed Companies [CSRC #128 1993] CI993 Rights Issue

Guidelines"), the first set of regulations governing rights issue, in December 1993

The 1993 Rights Issue Guidelines delegated the local provincial and municipal

governments to assess the applications for rights offering, provided that the

enterprise reported profits for two consecutive years It was soon amended by the

Notice about Doing Well in the Assessment of Rights Offerings by Listed Companies

[CSRC #79 1994] CI994 Rights Issue Notice"), which was released in June 1994

The 1994 Rights Issue Notice continued to delegate the right of assessment to the