Similar MPR requirements are also in vogue in Australia, China, Taiwan, and many other jurisdictions.3The conse-quence of mandatory auditor rotation atfirm or partner level on audit quali
Trang 1Mandatory audit partner rotation, audit market concentration, and audit
Sati P Bandyopadhyaya,1, Changling Chena,⁎ , Yingmin Yub,2
a
School of Accounting and Finance, University of Waterloo, 200 University Avenue West, Waterloo, Ontario N2L 3G1, Canada
b School of Accountancy, Central University of Finance and Economics, 39 College South Road, Haidian District, Beijing 100081, China
a b s t r a c t
a r t i c l e i n f o
Available online xxxx
JEL classification:
M41
M42
Keywords:
Mandatory audit partner rotation
Audit market concentration
Audit quality
This research examines the audit quality consequences of China's mandatory audit partner rotation (MPR) reg-ulation, which became effective in 2004 The rule requiresfirms to rotate signing audit partners of audit reports everyfive years We find that audit quality improves in the three years immediately following a client firm's MPR during the 2004–2011 period for a sample of 273 Chinese publicly listed firms Specifically, we find that the im-provement is most pronounced in those Chinese provinces with both low levels of audit market concentration and low levels of legal development However, MPR does not improve audit quality in jurisdictions where legal conventions are more developed and/or where audit markets are highly concentrated with a handful of large auditfirms dominating the market
© 2013 Elsevier Ltd All rights reserved
1 Introduction
In this study we examine the effects of mandatory audit partner
ro-tation (MPR) on audit quality Specifically, we look at the effects of MPR
under varying audit market concentration (AMC) conditions in the
Chi-nese audit market, where, starting in 2004, regulators required client
firms to rotate audit partners every five years We find that MPR
im-proves audit quality in provinces with low levels of AMC but not in
provinces with high levels of AMC Our results suggest that the
effec-tiveness of MPR policy on audit quality depends on the structure of
the audit market Our research contributes to audit literature by relating
two long-standing issues, namely, the consequence of MPR on audit
quality, and the impact of AMC on audit quality Both these issues
have recently re-entered the public debate in the USA (Public
Company Accounting Oversight Board, 2011a) and the European
Commission (EU) (2011)
In the post-Enron era, several countries have mandated periodic
ro-tation of the lead audit engagement partner and the concurring
reviewing partner in order to improve audit independence and thus audit quality For example, the Sarbanes–Oxley Act (henceforthSOX,
2002) mandates US audit partners to rotate their audit clients every five years, and the European Union requires audit firms to replace audit partners in charge of their clients that are Public Interest Entities every seven years Similar MPR requirements are also in vogue in Australia, China, Taiwan, and many other jurisdictions.3The conse-quence of mandatory auditor rotation (atfirm or partner level) on audit quality depends on the tradeoff of improvement in audit indepen-dence versus loss in client-specific audit experience (Kinney & McDaniel, 1996; Knapp, 1991; Mautz & Sharaf, 1961).4On the one hand, a fresh look into the audit engagement by the rotated-in audit partner improves audit independence and thus the quality of the audit On the other hand, the rotated-in partner does not possess the client-specific expertise of the rotated-out partner, and this lack of ex-perience could reduce audit quality Thefinal effect of MPR on audit quality is an empirical issue determined by the tradeoff Empirical evi-dence on the relation between MPR and audit quality is mixed Studies based on the Taiwanese audit market indicate either no effect or a neg-ative effect of MPR on audit quality (Chen, Lin, & Lin, 2008; Chi & Huang,
Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx
☆ We thank the editor Philip Reckers and two anonymous referees for their insightful
comments We also thank Xi Wu, Junsheng Zhang, and other workshop participants at
the Central University of Finance and Economics This study is supported by the research
grants from the “Project 211” Fund of the Central University of Finance and Economics,
China and grants from the “2011 Synergetic Innovation” Key Project on “Development of
Public Accounting Profession” of the Central University of Finance and Economics, China.
We also gratefully acknowledge the financial support from the Research Fellowship
Program at the School of Accounting and Finance of the University of Waterloo.
⁎ Corresponding author Tel.: +1 519 888 4567x35731; fax: +1 519 888 7562.
E-mail addresses: bandy@uwaterloo.ca (S.P Bandyopadhyay), clchen@uwaterloo.ca
(C Chen), yuym168@gmail.com (Y Yu).
1
Tel.: +1 519 888 4567x32533; fax: +1 519 888 7562.
2 Tel.: +86 10 62156441; fax: +86 10 62288114.
3 Other countries adopting MPR include Singapore, Japan, United Kingdom, France, Spain, the Netherlands, and Germany (General Accounting Office 2003, Appendix V; Chi
et al., 2009 ).
4 These authors use the generic “auditor” term in their papers and do not specify
wheth-er their arguments apply to audit firm or audit partner level These arguments apply
equal-ly well to both firm and partner level ( Chen et al., 2008 ) DeAngelo (1981) defines audit quality as the joint probability that an auditor detects a breach of accounting standards and the probability that the auditor reports the breach MPR will likely decrease the prob-ability of detecting a breach because of lost audit knowledge but increase the probprob-ability of reporting the breach.
0882-6110/$ – see front matter © 2013 Elsevier Ltd All rights reserved.
http://dx.doi.org/10.1016/j.adiac.2013.12.001
Contents lists available atScienceDirect Advances in Accounting, incorporating Advances in
International Accounting
j o u r n a l h o m e p a g e : w w w e l s e v i e r c o m / l o c a t e / a d i a c
Trang 22005; Chi, Huang, Liao, & Hong, 2009) In contrast, research based on the
Australian audit market (Carey & Simnett, 2006) provides some
evi-dence that MPR tends to enhance audit quality Experimental evievi-dence
(Dopuch, King, & Schwartz, 2001; Tan, 1995) also suggests that MPR
im-proves audit quality Note that while the identity of audit partners is
public information in Taiwan and Australia, and thus the effect of MPR
on audit quality can be evaluated directly, this is not the case in many
jurisdictions, including the USA
Recently, theEuropean Commission (EU) (2011)has expressed the
view that the practice of MPR does not improve audit independence
(and hence audit quality) The argument is that MPR does not remove
the familiarity threat that might cloud audit judgment and reduce
pro-fessional audit skepticism of a new (rotated-in) audit partner, who
would not have incentives to take decisions that might cause the audit
firm to lose a long-standing client firm Hence, new (replaced) audit
partners“likely feel obliged to live with the decisions and agreements
made by the former (rotated-out audit) partner; he/she may have little
flexibility to reopen them” (European Commission (EU), 2011, page 17)
On the basis of these arguments,European Commission (EU) (2011)
proposes mandatory auditfirm rotation (MFR) to replace MPR
Consis-tent with the view of theEuropean Commission (EU) (2011), the US
Public Company Accounting Oversight Board (henceforth PCAOB)
is-sued a concept release in August 2011 (PCAOB, 2011a) that also
sug-gests MFR for USfirms
The accounting community, however, has generally opposed the
proposal to replace MPR with MFR For example, a summary of
re-sponses to the MFR study by the General Accounting Office (GAO,
2004, Question 73) shows that about two-thirds of the respondents
ap-pear to believe that relative to potentially more costly MFR, MPR suf
fi-ciently achieves the intended benefits of taking a fresh look at the
audit engagement by the rotated-in partner In their response letter to
the PCAOB (PCAOB, 2011b), the International Federation of Accountants
(henceforth IFAC) argues that“these changes [MPR] are still relatively
new, and have not been in place sufficiently long enough to objectively
assess their impact.” This IFAC response implies the need for further
ex-amination of the consequences of MPR
In summary, while many in the professional accounting and audit
community believe that MPR enhances audit quality, international
reg-ulators do not seem to share that view Moreover, as discussed above,
academic research provides mixed evidence on the impact of MPR on
audit quality
Responding to the call of IFAC for further research on the effects of
MPR, we examine the relation between MPR and audit quality in the
Chinese audit market to provide some insight into this contentious
de-bate Also, in contrast to extant research, we consider the impact of
re-gional variation in AMC, whose role has recently been highlighted in
the foregoing MPR versus MFR deliberations For example, the Center
for Audit Quality (henceforth CAQ) argues in its written statement
(PCAOB, 2011c) toPCAOB's (2011a)concept release that many small
auditfirms will find the costs of periodic tendering, documentation
and staffing associated with MFR too onerous and will be forced to
“abandon their public practice and focus instead on private company
audits” (PCAOB, 2011c, page 12) This suggests that abandonment of
MPR for MFR could lead to a higher level of concentration of the Big 4
auditfirms in many public audit markets that are already considered
highly concentrated by policymakers
For example,European Commission (EU) (2011)has expressed
con-cerns that a potential demise of any of the existing Big 4 auditfirms in
highly concentrated audit markets might de-stabilize thefinancial
sys-tem There is also concern that“concentration among a few firms
en-abled the largest accountingfirms to exercise greater influence over
the audit standard setting process and regulatory requirements.”
(GAO, 2003) Audit quality could also be compromised through moral
hazard issues if large auditfirms believe they are “too few to fail”
(GAO, 2003) The lack of choice in audit markets dominated by Big 4
auditfirms is another concern Client firms might not want to be audited
by the same auditfirm that audits its competitors (European Commission (EU), 2011)
Regardless of such comments, which reflect serious policy concerns about the consequences of heightened AMC, recent research oftenfinds
a positive relation between AMC and audit quality (Francis, Michas, & Seavey, 2013; Kallapur, Sandaraguruswamy, & Zang, 2010) In our paper we examine whether MPR can improve audit quality in low AMC jurisdictions where extant research tends to report lower audit quality than that in high AMC jurisdictions It might be noted that, to date, audit research has either examined the relation between audit quality and MPR without controlling for AMC (e.g.Carey & Simnett, 2006; Chi et al., 2009) or the relation between AMC and audit quality without controlling for MPR (Kallapur et al., 2010) The unequal pace
of audit market development across Chinese provinces makes it an ideal setting for our analysis For example, our Chinese MPR sample ex-hibits a wide range of variation in AMC at the provincial level During the 2004 to 2011 sample period, the provincial Herfindahl index based on audit fees and client locations varies between a minimum of 0.071 and a maximum of 0.982, with thefirst quartile of 0.125, a median
of 0.155, and the third quartile of 0.217.5
We identify 273 unique Chinese publicly listed client companies countrywide that are subject to the MPR rule and compare their audit quality both pre- and post-MPR.6We require our sample companies ro-tate out their signing audit partners when they have met the maximum five-year tenure requirement We also impose the condition that audit partner rotation not be accompanied by auditfirm rotation in the periods before and after MPR to avoid a potentially confounding effect of auditfirm rotation on audit quality Following prior research (e.g.Chen et al., 2008; Francis et al., 2013), we use abnormal (discretion-ary) accruals as our measure of audit quality
Wefind that on average MPR has a positive effect on audit quality in the post-rotation years, especially in the second and third years after MPR When we partition our sample by the provincial AMC levels, we find that the incremental benefit of MPR on audit quality is observed only in low, but not high, AMC provinces in China We then extend
Firth, Rui, and Wu (2012a)to examine whether the interaction of the level of legal development with AMC has an effect on how MPR en-hances audit quality.Firth, Rui, and Wu (2012a)show that MPR has a positive effect on audit quality in China only in regions with low levels
of legal development Wefind that the beneficial effect of MPR is ob-served in those provinces that not only have low levels of legal develop-ment but also low levels of AMC Our results are robust to alternative audit quality measures such as the discretionary working capital ac-cruals (Carey & Simnett, 2006), different AMC measures, and various pre-MPR periods (one year before MPR and a three-year period before MPR), after controlling for auditfirm tenure, client company size, cash flows, industry growth, age, state ownership, and leverage
Our paper contributes to the literature by bringing together two dif-ferent streams of extant audit research One stream examines the effects
of MPR on audit quality, but the results are indeterminate The other stream of literature examines the effect of AMC on audit quality in papers such asKallapur et al (2010)andFrancis et al (2013) We contribute to the literature by investigating the effects of MPR on audit quality under different AMC conditions and different levels of legal development We show that MPR is able to enhance audit quality in Chinese provinces where both of these features are relatively underdeveloped However,
5
Kallapur et al (2010) report US MSA (metropolitan statistical area) Herfindahl
index-es of 0.230, 0.252, and 0.293 rindex-espectively for thefirst quartile, median, and the third quar-tile distributions in the 2000–2006 period However, these authors study the relation between AMC and audit quality but not in the MPR setting.
6 Relative to a cross-sectional comparison between MPR clientfirms and a control sam-ple (e.g voluntary audit partner rotation or no-rotation samsam-ple, as in Chi et al., 2009 ) our pre- versus post-MPR comparison for MPR firms has the advantage of highlighting the consequence of MPR by eliminating the potentially confounding effects of covariates
relat-ed to client firms' characteristics.
Trang 3the improvement in audit quality does not seem to be large enough to
catch up with the high levels of audit quality enjoyed by clientfirms in
provinces with high AMC and a high level of legal development Our
find-ings suggest that the effect of MPR on audit quality needs to be examined
on a case-by-case basis and cannot be subject to generalized conclusions
for different audit market structures For example, the contradictory MPR
results in Taiwan versus Australia might arise from not considering
inter-nal variations in audit market conditions in these countries
Our results have some potential policy implications As previously
mentioned, while regulators are concerned about the potential adverse
effects of high AMC, audit quality is also demonstrated to be high in
these jurisdictions Our study shows that MPR is a policy tool that
could potentially improve audit quality in low AMC areas and thus
avoid the attendant policy problems of high AMC However, given that
our samplefirms (273) constitute less than 20% of Chinese publicly
listed companies, the generalizability of our results needs to be treated
with caution
The remainder of the paper is organized as follows InSection 2,
we describe the institutional background and summarize the
litera-ture We develop our hypotheses inSection 3 InSection 4, we
dis-cuss the sample selection procedure, variable measurement, and
research methods.Section 5 summarizes our results Section 6
concludes
2 Institutional background and literature review
Since the 1990s, Chinese accounting and auditing regulators,
in-cluding the Chinese Institute of Certified Public Accountants
(CICPA), the Ministry of Finance (MOF), and the China Securities
Regulatory Commission (henceforth CSRC), have undertaken a
num-ber of steps to enhance audit independence In 1996, these national
regulators required all Chinese auditfirms that had previously had
government affiliations to break off their government ties (Gul,
Fung, & Jaggi, 2009) Regulators also adopted a new set of auditing
standards in 1995, which ultimately resulted in their convergence
with the International Standards on Auditing (ISA) promulgated by
the IFAC (Firth et al., 2012a; Lin & Chan, 2000; Xiao, Zhang, & Xie,
2000)
Moreover, in the wake of a series of accounting scandals that took
place in the late 1990s and early 2000s, which resulted in the
bankrupt-cy of Yinguangxia Company and other listed companies, the auditing
li-cense of the then largest audit firm in China, Zhongtianqin
(Yinguangxia's auditors),7was suspended The Chinese government
then implemented a series of measures to restore public confidence in
thefinancial reporting process (Chen, Sun, & Wu, 2010) In October
2003, the CSRC and MOF jointly issued a mandatory audit partner
rota-tion rule (Chinese Securities Regulatory Commission (CSRC Regulation)
& China Ministry of Finance (MOF), 2003No 13) to improve audit
inde-pendence and thus audit quality Under this rule, which became
effec-tive January 1, 2004, all Chinese-listed companies are required to
rotate out their audit partners who have signed the company's audit
re-ports forfive consecutive years.8As in Taiwan, Chinese audit reports
have two signatories: a lead audit partner responsible forfieldwork
and a reviewing partner who must be at least a deputy executive of the auditfirm.9These two signing auditors are required to assume the same legal liability unless proved to the contrary (Firth et al., 2012a).10
To be consistent with prior literature, we refer to signing auditors as audit partners
The usefulness of mandatory auditor rotation (at thefirm or partner level) has been a matter of debate both in thefinancial press and in the academic auditing literature for a number of years Apart from a few jurisdictions, like Italy and Brazil, that have mandatory auditfirm rotation, individual audit partner rotation has become a require-ment in several jurisdictions including Australia (Carey & Simnett,
2006), Taiwan (Chi et al., 2009), China (Firth et al., 2012a), USA (SOX, 2002), Singapore, United Kingdom, France, Spain, Netherlands, Japan, and Germany (GAO, 2003, Appendix V) It is also currently being considered in Canada The adoption of MPR rules in these audit markets reflects regulators' concerns that lengthy audit partner ten-ure reduces audit quality on account of its adverse effect on audit independence
Researchers have argued both in favor of and against mandatory ro-tation at the auditfirm level.11Some of these arguments apply to man-datory rotation at the audit partner level as well, because individual partners have incentives to maintain their relationships with a client
in order to retain the client (Chen et al., 2008, page 420) The argument
in favor of mandatory rotation is that a long association with an audit client clouds the auditor's judgment and leads to impairment of audit independence (Mautz & Sharaf, 1961) A new audit partner who rotates
in to periodically replace an incumbent audit partner is expected to take
a“fresh look” into different aspects of the engagement and improve audit quality.Healey and Kim (2003)argue that mandatory rotation will restore“badly shaken investor confidence in the financial account-ing system.” In an experimental study,Dopuch et al (2001)provide ev-idence that MPR increases auditor independence In another experimental study,Tan (1995, page 115)concludes that“staff rotation and review awareness can improve the quality of the audit decision pro-cess.”Raghunathan, Lewis, and Evans (1994)provide some evidence consistent with greater frequency of US Security Exchange Committee (SEC) actions against longer tenure auditfirms, suggesting a potential beneficial role of MPR practice
An important argument against mandatory rotation is that it will de-prive the client of thefirm-specific knowledge acquired by the incum-bent auditor through a steep learning curve over a period of time (Knapp, 1991) This knowledge is not available to the replaced (rotat-ed-in) auditor This view is largely supported in the extant US-based studies which, with few exceptions (e.g.Davis, Soo, & Trompeter, 2009; Deis & Giroux, 1992)find that audit quality is poor in the early
7
Chen et al (2010) , Appendix 1 ) provides a list of scandals in the Chinese stock market
in the early 2000s.
8 Chen et al (2008) raise the concern that MPR may be superficial if a partner rotates
back to the client after a very short “cooling-off” period They find that more than half of
the partners in their Taiwanese sample, who rotated off in 2003 or 2004, rotated back after
one year Note that there is no minimum cooling-off period for a rotation-off audit partner
in Taiwan In contrast, Chinese regulations require a minimum two-year “cooling-off”
pe-riod In our sample, 53 client companies are found to have re-appointed the same audit
partners to their prior audit clients in Year 8, the year right after the required two-year
cooling-off period We conduct sensitivity tests by eliminating these client companies
and our results hold Firth, Rui, and Wu (2012b) findings are consistent with reduced audit
quality associated with “rotated back” partners.
9
In the review process, a review partner examines audit plan, audit risk (inherent risk and control risk), audit evidence (e.g audit sampling), auditing adjustments, and audit re-port draft This is consistent with ISA regulations, under which engagement control review partners are required to review the risk of material misstatement (inherent risk and con-trol risk) and audit sampling among others In our sample, we are unable to identify which
of the two signing auditors is the lead or reviewing partner The authors' interviews with practitioners in China reveal that the order of two signatures is random for many auditing firms We find that our results are not sensitive to whether we center our MPR analyses on audit tenure of the first versus the second signing auditor In our sample, 108 of the 273 client companies of our sample rotated out their first signing audit partners, 83 rotated out the second signing audit partners, and 82 rotated out both partners.
10 Chinese Independent Auditing Standards, adopted in 1995, are highly convergent with the ISA of the IFAC ( Firth et al., 2012a; Lin & Chan, 2000; Xiao et al., 2000 ) According
to the Chinese auditing standards, reviewing partners must hold the position of at least deputy executive in an audit firm In the review process, a review partner shall examine the audit plan, audit risk (inherent risk and control risk), audit evidence (from audit sam-pling), auditing adjustments, and audit report draft By ISA, the engagement control re-view partner shall also rere-view the risk of material misstatement (inherent risk and control risk) and audit sampling among others The Chinese review audit partners' tasks, hence, share similarities with ISA's engagement quality control on audit review 11
In our paper, mandatory rotation refers to mandatory audit partner rotation, unless in-dicated otherwise.
Trang 4years of an auditfirm's tenure with a specific client.12This is consistent
with the notion that audit quality improves as an audit partner acquires
client-specific knowledge over time As a corollary, it could be argued
that the loss of client-specific expertise when an incumbent audit
part-ner is rotated out under MPR could hurt audit quality However, none of
the foregoing US-based papers provide direct evidence on the
conse-quences of MPR on measures of audit quality because they mostly
study auditfirm tenure but not individual audit partner tenure
Direct empirical tests of the consequences of MPR on audit quality
are mostly based on the audit and financial data obtained from
Taiwan and Australia where13, unlike in the US, identities of the audit
partners who perform the audit are disclosed In China, as in these
coun-tries, the names of the two audit partners engaged in auditing a client
are public information
Carey and Simnett (2006)examine the association between audit
quality and long audit partner tenure using data from Australia for a
pe-riod when audit partner rotation was not mandatory Theyfind that
audit quality declines with audit partner tenure when audit quality is
measured as (1) the propensity to issue a going concern opinion for
dis-tressedfirms, or (2) the probability of exceeding earnings benchmarks
Also using Australian data,Hamilton, Ruddock, Stokes, and Taylor
(2005)find less income-increasing discretionary accruals following
MPR In contrast, using Taiwanese audit partner data,Chen et al
(2008)find that audit quality increases with audit partner tenure and
auditfirm tenure, thus concluding that MPR (and also MFR) is likely
to impair audit quality Similarly,Chi et al (2009)conclude that MPR
does not help audit quality in Taiwan These authorsfind that the level
of discretionary accruals of client companies in the year of MPR is no
lower than the pre-rotation year level
The above mentioned mixed results show that the effect of MPR on
audit quality in Taiwan versus Australia is different, probably due to the
specific audit market in which the relationship is examined In our
study, wefirst examine the average effect of MPR on audit quality
using Chinese audit data over all Chinese provinces This analysis
pro-vides fresh insights into the benefits or otherwise of MPR in a different
audit market We then analyze how this relation changes with the
pro-vincial variation in AMC, which is an audit market characteristic not
studied in previous Australian/Taiwanese research It is important to
note that AMC has an independent effect on audit quality (e.g.Francis
et al., 2013; Kallapur et al., 2010) and might confound empirical tests
of the relation between MPR and audit quality if its effect not controlled
for Furthermore, international regulators are concerned about the
ad-verse effects on audit quality of dominance of a handful of auditfirms
in international audit markets
China exhibits wide variation in provincial AMC For example, the
Herfindahl index based on audit fees and client locations is around
0.07 in the populous Guangdong province through our sample period,
whereas thefigure is around 0.55 for the equally populous Zhejiang
province over the same period In the entire country, 64 auditfirms
audited 1570 listed clients in China (Chinese Institute of Certified
Public Accountants (CICPA), 2007Bulletin No 15), averaging at less than 25 clients per auditfirm The dominance of Big 4 audit firms is much less evident in China (auditing 17% of all listed Chinese companies during 1999–2007 period) relative to many other jurisdictions (Francis
et al., 2013) including the USA (61%), Australia (71%), and Taiwan (74%) Chinese regulators are wary of its audit markets being dominated by Big
4 auditfirms and is keen to encourage the growth of domestic firms to compete with large international auditfirms that were allowed to oper-ate directly in China after the country's accession to the World Trade Or-ganization (henceforth WTO) in the post-2001 period (Chan & Wu,
2011).14Variations in AMC across different Chinese provinces provide
us with the opportunity to examine whether the beneficial effects of MPR on audit quality, if any, vary with AMC levels
Finally, we examine if the relation between MPR and audit quality is affected by the level of legal development of the province in which the audit client is located, especially when viewed in conjunction with the AMC level of the province Chinese provinces do not have a uniform level of legal development, and they exhibit large differences in this re-spect.Fan, Wang, and Zhu (2004)measure the provincial level of legal development in terms of the number of lawyers as a percentage of the population, the efficiency of the local courts, and the protection of prop-erty rights.Wang, Wong, and Xia (2008)show that there are great geo-graphical disparities in legal development in China in terms of protection of property rights and efficiency of law courts among other legal elements.Firth et al (2012a)examine the audit quality conse-quence of MPR in China in strong versus weak legal environments using theWang et al (2008)criteria These authorsfind that client panies subject to MPR exhibit better audit quality than non-MPR com-panies in 2004, the first year that MPR was adopted in China However, this positive audit quality effect is restricted to client compa-nies located in Chinese provinces suffering from low levels of legal de-velopment; the positive audit quality effect of MPR does not apply to more legally developed provinces
However,Firth et al (2012a)do not examine, as we do, the change
in audit quality pre- and post-MPR for both the mandatory rotation year and up to two years subsequently More importantly, they do not examine the audit quality effect of MPR conditional on varying provin-cial AMC levels In contrast, in our paper we examine how MPR affects audit quality for different provinces that exhibit different levels of legal development and AMC
3 Hypotheses development
As stated earlier, the effect of MPR on audit quality is the result of
a tradeoff between having an independent and fresh look at the en-gagement by a new (rotated-in) audit partner versus losing the audit expertise of the departing (rotated-out) auditor Note that audit independence is defined in the literature as the joint probability that a given auditor will both (a)“discover a breach in the client's accounting system, and (b) report the breach” (DeAngelo, 1981) The rotated-in partner will probably have less hesitation in reporting a breach,
if a breach is discovered, than the outgoing partner, because he or she would not have had enough time to build up a relationship with the client This is likely to enhance audit independence and thus audit quality However, the effects of MPR on the probability of discovering a breach is not very clear On the one hand, the new partner, by taking a
“fresh look” (Mautz & Sharaf, 1961), mightfind it easier to uncover a
12 Gul, Jaggi, and Krishnan (2007) demonstrate greater earnings management in the
ear-ly years of an auditfirm's tenure Arel, Brody, and Pany (2005) show that audit failures are
common in the initial years of an auditfirm's audit engagement Geiger and Raghunandan
(2002) measure audit failure as the inability of the auditor to issue a modified audit
opin-ion before its client goes bankrupt and find more instances of audit failures in the early
years of the audit firm's tenure Carcello and Nagy (2004) come to similar conclusions
about the timing of financial statement frauds Stanley and DeZoort (2007) also find that
audit failures tend to take place in the early years of an audit firm's tenure Several studies
find a positive relation between financial reporting quality and audit firm tenure (e.g.
Johnson et al., 2002; Mansi, Maxwell, & Miller, 2004; Myers et al., 2003 ) This suggests that
financial statement quality improves with audit firm tenure, which is in contrast to the
non-linear relation between earnings management and audit firm tenure demonstrated
by Davis et al (2009) , whofind that audit quality of firms with short (two to three years)
or very long (13–15 years or more) tenure tends to be low Ghosh and Moon (2005) find a
positive relation between earnings response coefficients and audit firm tenure.
13
Recently, PCAOB has proposed that US auditfirms disclose the name of the audit
part-ner in charge of a client's audit ( Rapoport, 2013 ).
14 The motivation for Chinese regulators to encourage the growth of domestic audit firms is to improve the supply of quality audit services to meet the increased demand resulting from the transformation of state-owned enterprises (SOE) into public-listed companies ( Chan & Wu, 2011 ) Note that before SOEs were privatized, they were audited
by the National Audit Office of the People's Republic of China, not independent audit firms.
In addition, the demand for large domestic audit firms arose from sovereignty consider-ations, rather than audit market considerconsider-ations, especially after the Chinese accession to WTO In other words, the Chinese government felt it was more desirable to have large local audit firms dominate the Chinese audit market than large foreign Big 4 audit firms.
Trang 5breach, compared to the outgoing partner On the other hand, the new
partner probably will not possess thefirm-specific expertise enjoyed
by the outgoing partner, thereby making it harder for him or her to
de-tect a breach, if one exists The outcome of the tradeoff of the“fresh
look” versus reduction of client-specific expertise on the probability of
discovering a breach is an empirical issue.15Thus, because it is
deter-mined by the joint probability of discovering a breach and disclosing a
breach, overall improvement of audit quality due to MPR is hard to
predict
Extant evidence on the effect of MPR on audit quality, which relies
on empirical research using Australian (Carey & Simnett, 2006;
Hamilton et al., 2005) and Taiwanese (Chen et al., 2008; Chi et al.,
2009) audit data, is mixed Experimental studies, on the other hand,
show positive effects of MPR on audit independence (Dopuch et al.,
2001) and audit quality (Tan, 1995) Given the theoretical and empirical
evidence, ourfirst hypothesis about average audit quality in Chinese
audit markets across all provinces is non-directional
H1 Average audit quality across Chinese provinces does not change
after mandatory audit partner rotation as compared to the
pre-rotation period
As stated earlier, AMC varies greatly across different provinces in
China In this paper we also examine the effect of MPR on audit quality
under varying AMC conditions at the provincial level To the best of our
knowledge, there has not been any theoretical analysis of this issue
However, the literature does provide a number of conflicting
predic-tions about the potential effects of AMC on audit quality For example,
in a theoretical paper,Chaney, Jeter, and Shaw (2003)argue that the
cost of losing a single client when an auditor tells the truth about a
breach is quite small under high competition (low AMC) because of
the low profit margins in these markets and a large client pool
These authors state that the low cost of“telling the truth” would
en-courage disclosure of a breach and improve audit quality in high
competition audit markets It is unclear, however, how MPR will
change this cost of telling the truth in highly competitive (low
AMC) audit markets
In contrast,DeAngelo (1981)argues that large auditfirms with a
large client base have strong incentives to remain independent because
of large quasi rents they earn from their clients Large quasi rents exist
because the potential reputation cost arising from an audit failure is
likely to be high for large auditfirms This implies that audit markets
that are dominated by a small number of large auditfirms (or high
AMC) will exhibit a high level of audit independence and therefore
high audit quality If this argument is true, MPR will likely not affect
audit quality in high AMC markets incrementally either, given that
audit quality is probably high to begin with.16
In addition,Watts and Zimmerman (1981)argue that larger audit
firms, which dominate concentrated audit markets, are better at
moni-toring their auditors in comparison with small auditfirms Since the cost
of audit failure is high for large auditfirms, resulting in costly decline in
reputation and probable shareholder lawsuits, these auditfirms
moni-tor their audit partners very closely Therefore, the incremental effect
of MPR, with its fresh look into the engagement by a rotated-in partner,
is likely to be minimal This implies that any enhancement to audit
qual-ity from MPR is more likely to be significant in less concentrated (highly
competitive) audit markets where auditfirm, on average, are likely to
be smaller, and the level of monitoring of audit partners by the audit
firm is probably less intense
The forgoing discussions indicate that the predicted effects of MPR
on audit quality under differing AMC conditions are uncertain Empirical
evidence tends to show that audit quality is better in high AMC US city markets (Kallapur et al., 2010) and international country-level markets (Francis et al., 2013) Despite this, some influential commentators hold a different view For example, Honorable Richard Breeden (seePCAOB,
2012, page 5), an ex-chairman of the SEC, has stated that the present value of future revenues from a few large audit engagements of any Big N auditfirm, assuming “continued incumbency,” could exceed sev-eral billion dollars, which“helps to explain why the issue of auditors try-ing to please the largest clients continues to arise.” This view is consistent with audit quality being low in highly concentrated markets, where MPR might have a beneficial effect
Since the relation between MPR and audit quality under different audit market conditions is ambiguous, our second hypothesis, also non-directional, is as follows:
H2 The improvement in audit quality after mandatory audit partner rotation in provinces with low audit market concentration
is not different from that in provinces with high audit market concentration
Finally, we examine the effect of market concentration in interaction with legal development on the change in post-MPR audit quality As stated earlier,Firth et al (2012a)find that the level of legal develop-ment in Chinese provinces affects the relation between MPR and audit quality using the provincial legal environment index ofWang et al (2008).17Arguably, market discipline and more effective monitoring
in the high AMC and high legal development provinces allow audit firms to maintain a high level of audit quality regardless of MPR The code of auditor ethics and legal environment likely provide an effective monitoring mechanism for maintaining audit independence in jurisdic-tions with high levels of AMC and a strong legal enforcement frame-work Thus, incremental benefits from MPR, if any, might be less significant in provinces with high AMC and a strong legal environment relative to provinces of low AMC and low legal development However,
we do not have a directional hypothesis on this interaction effect be-cause it is also possible that audit quality in low AMC and low legal de-velopment provinces does not improve after MPR due to potentially weak market discipline and government regulation Our third hypothe-sis also has no directional predictions:
H3 The improvement in audit quality after MPR in provinces with low audit market concentration and low legal development is not different from that in provinces with high audit market concentration and high legal development
4 Sample selection and research design 4.1 Sample selection
We obtain our audit andfinancial data from a database compiled by Sinofin Technology Limited Co and China Center for Economic Research (CCER) of Beijing University The names of the signing auditors and auditfirm data of Chinese publicly listed companies are available in the CCER database starting from 2000 We manually collect 1999 audit data from publicly available CICPA archives to compile data over a five-year period from 1999 to 2003, as illustrated inAppendix 1, for identifying clientsfirms' MPR in 2004, the first year of adoption of the MPR rule.18
Our sample covers the 1999–2011 period We require signing audi-tors' identity data for consecutive six-year rolling windows starting from 1999 in order to identify mandatory audit partner changes starting
in 2004, thefirst year of MPR Any effect of MPR on audit quality
15 In any case, we control for audit expertise effects by including incoming partner's
in-dustry experience in our empirical tests.
16
“Theory suggests that auditor independence and audit quality are inextricably linked,
with auditor independence being an integral component of audit quality.” ( GAO, 2003 ).
17
We provide details on the legal environment index measure in Section 5 18
Our sample does not include those companies that adopted the MPR rule early in
2003 All Chinese-listed companies are required to have a fiscal year end of December 31.
Trang 6could take longer than one year because rotated-in audit partners
might require some time to familiarize themselves with the new
client's business Therefore, we compare clientfirms' audit quality
in the pre-MPR period versus the MPR year, and two subsequent
years as well, in order to examine longer-term effects of MPR, if
any Our last MPR year is 2009 because 2011 is the last year of our
sample period
Appendix 1describes the method we follow to classify an audit
part-ner change as mandatory rotation We refer to thefirst year that we
start counting audit partner tenure as Year 1, the last year prior to
MPR as Year 5, the MPR year with new rotated-in audit partner as
Year 6, and the two subsequent years as Years 7 and 8, respectively
We classify an audit partner change as a mandatory rotation if the
pre-vious incumbent audit partner“A” had audited a client from Years 1 to 5
but was replaced by audit partner“B” in Year 6 In our main tests, we
compare audit quality of Year 5 versus Years 6, 7, and 8 For example,
for client companies subject to MPR in 2004 (Year 6), we use 2003
data to evaluate Year 5 audit quality, and 2006 and 2007 data to
evalu-ate Years 7 and 8, respectively
As shown inTable 1, we begin with the CCER sample of 13,287
firm–year observations for the 2004–2011 period After eliminating
observations with missing audit partner names in Year 6 and the
five preceding years, we obtain 7094 firm–year observations,
representing an average of 887 client companies per year Out of
this sample, we select 455 unique client companies who rotate
their audit partners after they finish their five-year tenure for
thefirst time during 2004–2009 We remove another 169 client
companies that change auditfirms during the Year 1 to Year 6
peri-od.19We then exclude 7 companies which rotated only one audit partner when both partners should have been replaced after the mandated maximumfive-year tenure, as well as 6 companies with missing accrual data during Years 5–6 We are left with 273 remain-ing unique client companies (or 1092firm–year observations) after completing these data screening procedures
As described above, our sample selection procedure requires client companies to have the same auditfirms in the five-year period (Years
1 to 5) preceding the identified mandatory rotation year (Year 6) In ad-dition, in the two-year period subsequent to the MPR year, if there is an auditfirm change in Year 7, we eliminate the corresponding Year 7 and Year 8 observations Alternatively, if there is no auditfirm change in Year 7 but there is one change in Year 8, we keep the Year 7 observation and eliminate only the Year 8 observation In this way, we attempt to re-move any confounding effect of auditfirm change in our empirical anal-yses; we also try to restrict loss of power of tests arising from small sample size by not requiring the inclusion of all three post-MPR years (Years 6, 7, and 8) in the sample selection procedure.20Ourfinal sample has 887firm–year observations, including 273 respectively for each of Year 5 and Year 6, 197 for Year 7, and 144 for Year 8 (see Panel B of
Table 1)
Note that we identify Year 6 as thefirst year of a client company's first-time mandatory audit partner rotation after the adoption of the MPR rule As in Australia and Taiwan, Chinese audit reports have two signing audit partners, namely, a lead engagement partner and a reviewing partner The rule allows a one-year postponement for one
of the two signing auditors if both signing auditors reach their five-year tenure at the same time (Chinese Securities Regulatory Commission (CSRC Regulation) & China Ministry of Finance (MOF),
2003No 13) For example, consider a client with two signing audit part-ners, one of them having audited the client forfive years, but the other for only four years According to the mandatory rotation rule, thefirst auditor is required to rotate out in Year 6, but the second auditor is allowed to audit the client for one more year Therefore, for this case, the second mandatory rotation happens in Year 7 We identify the first year of the client firm's MPR as Year 6; we treat the second MPR year as Year 7 It is also possible that audit partner changes in Years 7 and 8 that take place before the expiry of the MPR imposed maximum five-year tenure are voluntary In order to address any confounding ef-fects arising from multiple audit partner rotations in post-MPR years,
we eliminate those observations that are associated with audit partner changes (71 voluntary and 47 mandatory) in Years 7 and 8 in our sensi-tivity checks Our results hold
4.2 Audit quality measures Following the literature, we use an earnings quality measure,
name-ly, discretionary (abnormal) accruals, as a proxy of audit quality Prior research shows a positive relation between measures of high quality audit (such as auditfirm size or industry expertise) and high quality fi-nancial reporting (Balsam, Krishnan, & Yang, 2003; Ghosh & Moon, 2005; Johnson, Khurana, & Reynolds, 2002; Krishnan, 2003; Myers, Myers, & Omer, 2003) The underlying argument is that high quality au-ditors are capable of detecting questionable accounting practices and misrepresentations as reflected in discretionary accruals If managers are unwilling to address the auditor's concerns about their discretion
infinancial reporting, high quality auditors are more likely than other
Table 1
Sample selection and composition.
Panel A: Sample selection
China Center for Economic Research (CCER) Database No of Obs.
Total number of firm–year observations during 2004–2011 13,287
Less: Number of firm–year observations that had missing
signing audit partners' names in the current year
(2004–2011) and the five preceding years (1999 audit partner
and audit firm data were hand-collected)
(6193)
Preliminary sample:
Number of firm–year observations (2004–2011) 7094
Mandatory partner rotation sample selection:
Number of companies that had auditor rotations after a five-year
tenure for the first time at Year 6 (2004–2009)
455 Less: Number of companies with audit firm change in Year 6 or
the five preceding years
(169) Less: Number of companies that should rotate both partners but
only rotate one after mandated tenure (one-year extension
allowed when both audit partners' tenure reached five years
in the same year)
(7)
Less: Number of companies that have missing abnormal accruals
in Year 6 and Year 5
(6)
Number of firm–year observations in the period 2004–2011
(279 times 4 years, namely, Year 5, Year 6, Year 7, and Year 8)
1092 Less: Observations with audit firm change in Years 7 or 8 (202)
Less: Observations with missing abnormal accrual values in
Years 7 or 8
(2) Less: Observations with missing values in control variables (1)
Remaining number of firm–year observations (273 for Year 5,
273 for Year 6, 197 for Year 7, and 144 for Year 8):
887
Panel B: Distribution of mandatory rotation years:
19
We eliminate client companies with audit firm changes to isolate the effect of manda-tory audit partner rotation Companies can change their audit firms for many reasons For example, Johnson and Lys (1990) show that audit firm changes are related to client char-acteristics and audit firm cost structures Schwartz and Menon (1985) report that client firms with poor performance may switch their audit firms on account of disputes regard-ing audit opinions, reportregard-ing issues, management changes, and audit fees.
20
We thank our anonymous reviewer for this suggestion.
Trang 7auditors to issue qualified audit reports (seeDeAngelo, 1981).Myers
et al (2003), page 783) argue that“high quality audits mitigate
more extreme management reporting decisions, and suggest that
accruals can be used to identify these extreme reporting decisions.”
Empirical studies with Chinese data provide evidence that
discre-tionary accruals measures are capable of capturing earnings
manip-ulation behavior in China (Ting, Yen, & Huang, 2009; Yu, Du, & Sun,
2006)
Consistent with prior research on MPR and audit quality (Chen et al.,
2008; Chi et al., 2009), we measure discretionary accruals using the
modified Jones model (Dechow, Sloan, & Sweeney, 1995) matched by
performance (Kothari, Leone, & Wasley, 2005) For simplicity,firm
sub-script is omitted in Eq.(1)and later equations
TotalAccuralst=Assetst−1¼ α0þ α1ð1=Assetst−1Þ þ β1ðΔSt−ΔARtÞ=Assetst−1
β2ðPPEt−1=Assetst−1Þ þ β3ROAt−1þ εt ð1Þ
where total accruals (TotalAccruals) equal net income before
extraordi-nary items minus operating cashflows, ΔS is change in sales, ΔAR is
change in account receivables, PPE is net property, plant and equipment,
ROA is return on assets, and t is the year subscript All variables are
scaled by lagged assets (Assetst − 1)
We estimate Eq.(1)using the full CCER sample with non-missing
values of the regression variables by industry–year We require at
least 15 valid observations for each industry–year regression
The industry category follows the 13-industry codes announced
by CSRC The mean coefficients of industry–year regressions are
used to estimate thefitted values of non-discretionary accruals
Discretionary accrual (DA) is computed as the total accruals minus
thefitted values FollowingCarey and Simnett (2006), we also use
discretionary working capital accruals (DWCA) in our sensitivity
test
Extant literature uses a number of different measures of audit
qual-ity, for example, absolute values (unsigned) of discretionary accruals,
signed values, or positive/negative values of discretionary accruals In
this paper, we focus on the signed value of discretionary accruals for
two reasons Thefirst reason follows from the results ofHribar and
Nichols (2007)indicating thatfirm characteristics such as operating
volatility are related to the error variance in discretionary accruals
These authors argue that this correlation could weaken the statistical
power of detecting low quality earnings using the unsigned (or
abso-lute values of) discretionary accruals measure BesidesHribar and
Nichols (2007),Carey and Simnett (2006)andFrancis et al (2013)
also focus on the signed discretionary accruals in their analysis
of audit quality The second reason is regulatory; Chinese-listed
companies have disincentives to recognizing extreme
income-decreasing accruals arising from CSRC-imposed regulations for
eligi-bility for rights offerings The most rigid regulation is the minimum
ROE requirement.21This regulation is widely applicable because
al-most all listedfirms tend to seek permission to undertake rights
of-ferings (Chen & Yuan, 2004)
4.3 Research models
We estimate the following equation to compare the audit quality of Year 5, the last year prior to MPR, versus the three post-mandatory rota-tion Years: 6, 7, and 8
DA¼ α0þ α1POSTþ β1IBIG4þ β2CIBIG10þ β3FTþ β4SIZEþ β5CFO
þβ6GROWþ β7AGEþ β8SOEþ β9LEVþ β10TTYPEþ β11EXP
where DA is discretionary accruals POST is an indicator variable that equals one for Years 6, 7, and 8 and zero for Year 5
The constant term (α0) represents audit quality of Year 5, after con-trolling for covariates A negative coefficient (α1) on the POST variable is consistent with audit quality improvement in the post-rotation period relative to the benchmark last pre-rotation year (Year 5), after control-ling for covariates A positive coefficient of POST indicates lower audit quality after MPR
Following prior research (Carey & Simnett, 2006; Chen et al., 2008; Chi et al., 2009; DeFond, Raghunandan, & Subramanyam, 2002), we in-clude several control variables in Eq.(2) Auditfirm size variables IBIG4 and CBIG10 equal one respectively for Big 4 international audit firms and Top 10 Chinese audit firms22and zero otherwise FT is audit firm tenure measured as the number of years that a client firm is audited
by the same auditfirm.23SIZE is client company size computed as the natural logarithm of total assets Auditfirm size and audit firm tenure control for the audit quality effects of audits by large auditfirms and
by auditfirms with a long tenure with its incumbent client We include cashflow variable CFO (operating cash flows scaled by lagged assets) be-cause prior research shows that it is negatively associated with accruals (Chi et al., 2009) GROW is growth in sales, measured as the total sales of the current year scaled by the industry total sales of the last year AGE is the number of years that the clientfirm is listed in a Chinese stock ex-change, which controls for the propensity of relatively younger compa-nies in high-growth industries to recognize extreme accruals
In addition, we include the SOE variable, which equals one, for state-owned enterprises, and zero otherwise.Chen, Chen, Lobo, and Wang (2011)argue that SOE companies have less incentive to manage earn-ings relative to non-SOE companies because the differences in the na-ture of the ownership, agency relations, and bankruptcy risks However, we do not predict the sign of the SOE variable.Aharony, Lee, and Wong (2000)argue that while SOE managers do not have the same incentives as US managers to manage earnings since they do not own any shares of thefirm, they might still earn high prestige and other non-pecuniary benefits from reporting higher earnings by under-taking earnings management activities We also include a leverage var-iable (LEV) to capture the effects of risk associated with high levels of debt (Carey & Simnett, 2006) LEV equals total liability scaled by total assets TTYPE is an indicator variable for special treatment stocks to cap-ture earnings incentives arising from potential delisting risks.24We do
21 The requirement for rights offerings was changed a number of times, reflecting the
CSRC's efforts to protect shareholders against management expropriation For example,
rights offerings required two consecutive years of profits after December 1993, and a
three-year average ROE not below 10% after September 1994 The rules changed in
Janu-ary 1996, which required that for each of previous three years prior to a rights offering, the
incumbent firms' three-year average ROE must not fall below 10% This rule was changed
again in March 1999, which required the maintenance of a minimum ROE level of not
be-low 6% for each of previous three years before rights offerings After May 2006, these firms
needed to maintain a minimum three-year weighted average ROE of 6% For regulations
on rights offerings, see the CSRC's regulation released on May 8, 2006, available on the
of-ficial webpage http://www.csrc.gov.cn
22 The top 10 Chinese audit firms are selected based on the ranking prepared by CICPA in
2009 Chen, Chen, Lobo, and Wang (2011) use Top 8 to categorize big audit firms in their study.
23 Audit data in CCER become available in 2000 Therefore, we count the number of years that an auditfirm serves a client (audit firm tenure) starting in 2000 For observations with MPR year in 2004, we manually check 1999 audit firm data to ensure that audit firms are the same in 1999.
24 ST/PT/ ∗ ST firms are firms that report consecutive losses and face substantial delisting risk According to the rules introduced by the CSRC in 1999, a firm is designated as a special treatment (ST) firm if it incurs losses for two consecutive years and a particular treatment (PT) firm if it continues to report a loss for another year A PT firm is delisted if it fails to become profitable in the following year PT stocks cannot be traded except on Fridays and are limited to a maximum 5% price increase over the last Friday's close (no downside limit) The PT designation has been discontinued by the CSRC in 2002 Since 2003, the CSRC introduced a new designation called “*ST”, which is similar to ST, to further advise the market of the risk that a company will be delisted if its loss continues the following year If a firm incurs losses for three consecutive years, it is de-listed.
Trang 8not have predictions for LEV and TTYPE Whilefinancially distressed
firms with high debt and delisting risk may be aggressive in accruals
recognition, thesefirms may have to reduce instances of earnings
man-agement because of potentially restrictive debt covenants for high
le-veragefirms and/or the tight levels of regulations on TTYPE companies
The EXP variable measures the two incumbent audit partners'
com-bined experience in auditing clients in the incumbent client's industry
An audit partner's industry experience is measured as the percentage
of his/her audited client companies' assets in the same industry Note
that the EXP score associated with the rotated-in partner(s)
compen-sates partially for the audit expertise that is lost with the departing
part-ner(s) As mentioned earlier, the effects of MPR on audit quality reflect a
tradeoff of enhanced audit independence versus loss of client-specific
audit expertise After controlling for EXP (and effects of covariates),
the indicator variable POST captures the change in post-MPR audit
qual-ity arising from potentially improved audit independence
The CLIENTP variable measures client power, which equals the
per-centage of a client's total assets as a perper-centage of its auditfirm's total
audited assets countrywide This variable and EXP are both highly
corre-lated with the SIZE variable, with correlation coefficients of around 0.50
(un-tabulated) In an attempt to reduce the potential effects of
multicollinearity, we use a two-stage approach Wefirst run two
regres-sions, namely EXP on SIZE, and CLIENTP on SIZE We derive the residuals
of each regression by taking the actual EXP (CLIENTP) value minus its
fitted value Then we use the residual values, which are orthogonal to
SIZE values, to estimate Eq.(2) We control for Industry (Industry)
and year (Year)fixed effects in all regressions.Appendix 2provides
de-tails on the measurement of all variables
To assess the effect of MPR on audit quality in each of the individual
post-MPR years, we revise Eq.(2)by replacing the POST variable with
three indicator variables Y6, Y7, and Y8, that equals one, respectively, for Years 6, 7, and 8, and zero for pre-rotation period (Year 5)
DA¼ α0þ α1Y6þ α2Y7þ α3Y8þ β1IBIG4þ β2CBIG10þ β3FT
þβ4SIZEþ β5CFOþ β6GROWþ β7AGEþ β8SOEþ β9LEV
þβ10TTYPEþ β11EXPþ β12CLIENTþ δYEAR þ γIndustry þ ε
ð3Þ
5 Data descriptive statistics and researchfindings 5.1 Data descriptive statistics
Table 2Panel A reports the descriptive statistics of the selected sam-ple The means of different indicator variables show that 5.4% of the sample observations are audited by Big 4 international auditfirms (IBIG4), and 15.7% by the Top 10 largest Chinese auditfirms (CBIG10); 66.1% reflect state ownership (SOE) of client firms; and finally, 15.9% were listed as special treatment stocks or particular transfer stocks (TTYPE) at some point by the CSRC in Year 5 and/or Year 6 The average firm tenure (FT) is approximately 6.5 years The average leverage ratio (LEV) is 54.0%, with a median of 54.4% The minimum and maximum values of discretionary accruals (DA), discretionary working capital ac-cruals (DWCA), and other variables do not exhibit obvious outliers.25
Table 2Panel B reports the Pearson correlation matrix of our variables
Table 2
Variable distributions and correlation matrix.
Panel A: variable distributions
Panel B: Pearson correlation matrix
See Appendix 2 for variable definitions Bold numbers in Panel B are correlations significant with p b 0.05 (including b0.01) EXP (CLIENTP) variable values in Panel B are the residuals from the first-stage regression EXP (CLIENTP) on SIZE (see Section 4.3 for the details of the two-stage method).
25 To address the effects of potentially influential observations, we winsorize variable values at the levels of 1% and 99% We also use r-student screening ( Belsley, Kuh, & Welsch,
1980 ) in all our regressions by eliminating observations with r-student absolute values greater than 4 in the regressions.
Trang 9DA and DWCA are positively correlated DA is negatively correlated with
HERF, LEGAL, CFO, and LEV
5.2 Results ofH1
Table 3reports the regression results of estimating Eqs.2 and 3 Note
that all our tests are two-tailed t-tests because our hypotheses are
non-directional Standard errors are clustered at individual clientfirm level
since discretionary accruals arefirm-specific.26Using signed
discretion-ary accruals (DA) as the dependent variable in Eq (2), we find
that the indicator variable, POST, has a negative coefficient of −0.012
(t-stat =−2.54) significant at less than 5% level This result is
consis-tent with the notion that audit quality in the post-MPR years is superior
to that in the last year prior to the start of MPR
We also estimate truncated regressions respectively for positive
DA and negative DA observations Wefind that a positive DA subsample
has less income-increasing abnormal accruals in the POST period
(α3=−0.059, t-stat = −1.97, p b 10), but a negative DA subsample
exhibits no significant change in audit quality in the post-MPR period
This is consistent with samplefirms not undertaking “big baths”
(poten-tial reasons forfirms recognizing negative accruals) in the post-MPR
pe-riod For Eq.3, while the coefficient on the first rotation year (Y6)
is insignificant, both Year 7 (Y7) and Year 8 (Y8) coefficients are
negative and significant (α2=−0.014, t-stat = −2.66; α3=−0.017,
t-stat =−2.63) at less than the 1% level Collectively, these results
indi-cate that client companies report less extreme income-increasing
abnor-mal accruals after MPR.27
The control variables inTable 3are generally consistent with our
predictions Specifically, our findings of positive coefficients on SIZE
and negative coefficient on CFO are consistent withChi et al (2009)
andFrancis et al (2013) Our positive coefficient on SOE is consistent with SOE companies having incentives to use income-increasing ac-cruals to boost bottom line net incomes (Aharony et al., 2000) We find some evidence of high audit quality associated with Big 4 interna-tionalfirms' audits We also find that high leverage clients report more income-decreasing accruals and that there is some evidence that TTYPE clients are more aggressive in recognizing income-increasing accruals
5.3 Results ofH2 and H3 Hypothesis H2examines whether the MPR's effect on audit qual-ity in provinces with less concentrated audit markets is different from that in other provinces To testH2, we compute the Herfindahl index for each client-province as the sum of squared auditfirm fee shares of all auditfirms in a province We estimate Eq.2for two sub-samples grouped by the observations that reflect clients located in provinces with higher than the median provincial Herfindahl index versus those with lower than the median provincial Herfindahl index.28
Table 4summarizes the regression estimates of Eq.(2)for clients lo-cated in provinces that exhibit Herfindahl indices less than the median level (low AMC) versus more than the median level (high AMC) The re-sults show that the POST variable is insignificant for the high AMC group but significant at less than the 5% level for the low AMC group using two-tailed tests (coefficient = −0.017, t-stat = −2.30) The control variables have similar coefficients across the two regressions SIZE and LEV are both significant at less than 1% level
We also examine the stand-alone effect of legal environment on the relation between MPR and audit quality (Firth et al., 2012a) The provin-cial legal environment index scores are taken fromWang et al (2008), Table A1) These authors report the levels of legal development index
Table 3
Audit Quality Pre versus Post-MPR.
Adj R 2
See Appendix 2 for variable definitions All regressions control for industry and year fixed effects Truncated regressions were used in the positive and negative abnormal accrual regressions *, **, *** significant respectively at 10%, 5%, and 1% levels with two-tailed tests.
26
We use the SAS programming codes provided by Noah Stoffman, Kelley School of
Business, Indiana University ( http://kelley.iu.edu/nstoffma/fe.html ) to run regressions
with clustered standard errors and fixed effects models While the degree of freedom is
much less after controlling for (client) firm effects in the fixed effects model, our results
(un-tabulated) hold.
27
The truncated regressions do not report the adjusted R-Squared When using OLS
re-gressions, the adjusted R-Squared is respectively 39.87% and 46.87% for the
income-increasing and income-decreasing accrual regressions.
28 We also estimate Eq (3) using the same sample decompositions by median of the me-dian of provincial Herfindahl index, and the meme-dian of legal development index Consis-tent with Eq (2) results reported in Table 4 , our results (un-tabulated) suggest audit quality improvement in the post-MPR period, especially in Years 7 and 8, for the low Herfindahl index and low legal development index groups, respectively.
Trang 10of 30 Chinese provinces' comprising of the following sub-indices,
name-ly, (1) the number of lawyers as a percentage of the provincial
popula-tion, (2) the efficiency of local courts (percentage of lawsuits
pursued by the courts), and (3) protection of property rights.29As
Table 4summarizes, POST is significantly negative (coefficient =
− 0.017, t-stat = − 2.47) only for the low legal development
provinces (i.e., those with legal indices less than median index
for the country) but not for the high legal development group The
re-sults, consistent withFirth et al (2012a), suggest that MPR is less
like-ly to improve audit quality in high AMC or high levels of legal
development audit markets, but is more effective in provinces low
levels of AMC or low levels of legal environment
In the foregoing regressions, we use the median split to estimate
separate regressions for high versus low AMC subsamples and also
high versus low legal development subsamples The reason for
estimat-ing separate regressions is that the relation between audit quality and
control variables (e.g IBIG4) likely varies with high versus low AMC
and legal development For example, inTable 4, the coefficients of
IBIG4 and CLIENTP are significant in the low AMC group but not in the
high AMC group Consequently, estimating one single regression
would force equality of coefficients on the control variables in this
re-gression that could potentially bias the coefficient of POST, the
post-MPR year indicator variable
To testhypothesis H3, we estimate the effect of MPR on audit quality
with provincial AMC in interaction with the provincial legal
develop-ment in empirical tests.Table 5presents the regression results of the
two groups with low AMC and low legal development (low–low) versus
those with high AMC and high legal development (high–high) based on
medians of these variables To save space, we only report the results of
Eq.(3)with the POST variable to capture the overall change in audit
quality after MPR The regression results are similar when we substitute
Y6, Y7 and Y8 indicator variables for POST in regression models (results
un-tabulated) For the low–low group, the POST variable is significantly
negative at less than 1% level (coefficient = −0.027, t-stat = −2.74)
The results from the high–high group show insignificant change in audit quality in the post-MPR period The results (un-tabulated) are also insignificant for the two middle groups, namely, the low AMC and high legal development and the high AMC and low legal development provinces
We also estimate a single regression with the full sample where POST interacts respectively with the AMC variable (LHERF) and the legal environment variable (LLEGAL) The regression includes a two-way interaction of LHERF∗ LLEGAL, and a three-way interaction
of POST∗ LHERF ∗ LLEGAL In order to simplify the interpretation of the coefficient signs, we reverse decile rank both the provincial Herfindahl indices and the provincial legal development indices For example, the variable LHERF is set to one for provincial Herfindahl indices that are included in the lowest decile of observa-tions Conversely, LHERF is set to zero for Herfindahl indices falling in the highest decile rank LHERF takes values between zero and one for the intervening Herfindahl indices.30We repeat this procedure for the legal development index variable, LLEGAL Decile ranking pro-vides more information in the variable measures relative to binary indicator measures
Consistent with our decile ranking approach, in the following dis-cussions, LL provinces are those that have the lowest AMC decile rank and the lowest legal development index decile rank as well For these provinces, both LHERF and LLEGAL take the value of one Similarly, the HH provinces reflect the highest AMC decile and highest legal development index decile, with LHERF and LLEGAL both taking the value of zero.31
Table 5shows that audit quality improves in the LL (LHERF = 1 and LLEGAL = 1) provinces in the post-MPR period, but not in the HH provinces (LHERF = 0 and LLEGAL = 0) Note that the change in the (pre- versus post-MPR) audit quality in LL provinces, after controlling for covariates, equals the sum of coefficients of POST + POST ∗ LHERF + POST∗ LLEGAL + POST ∗ LHERF ∗ LLEGAL Since the coefficient on POST
is insignificantly different from zero, and all the other foregoing
29 The index is obtained from the National Economic Research Institute (NERI) Index of
Marketization of China's provinces in 2000 to measure the quality of market-supporting
institutions at the provincial level The NERI Index project was sponsored by the National
Economic Research Institute and the China Reform Foundation and conducted by Fan,
Wang, and Zhu (2004)
30 Setting the lowest value to zero and the highest value to one is convenient for the in-terpretation of coefficients The intervening eight values are set to 1/9, 2/9, …, up to 8/9 consistent with the Proc Rank procedure under SAS.
31 Note that in Table 4 , we use median-based ranks to define low–low/high–high groups;
in Table 5 , we used decile-based ranks to define LL/HH groups.
Table 4
Audit quality pre versus post-MPR: conditioning on AMC or legal environment.
Adj R 2
See Appendix 2 for variable definitions Low and high AMC regressions are respectively for the two subsamples of below or above median audit market concentration levels measured by Herfindahl index (HERF) Low and high legal regressions are respectively for the two subsamples of below or above median legal environment index (LEGAL) All regressions control for industry and year fixed effects *, **, *** significant respectively at 10%, 5%, and 1% levels with two-tailed tests.