The Effects of IFRS Adoption on Audit Fees for Listed Companies in China

Transcription

1 I The Effects of IFRS Adoption on Audit Fees for Listed Companies in China Hsiao-Lun Lin National Chiao-Ton University HsinChu, Taiwan Ai-Ru Yen Northeastern Illinois University Chicago, IL, U.S.A.

2 The Effects of IFRS Adoption on Audit Fees for Listed Companies in China ABSTRACT In this study, we provide evidence of the effects of IFRS adoption on audit fees from China. A significant increase in audit fees for listed companies in China is observed in the initial years of IFRS adoption. We further document that accounting firms affiliated with Big 4 or other international CPA firms charge significantly higher incremental audit fees than domestic accounting firms after the IFRS adoption. This result suggests that IFRS-related expertise is an important determinant of audit premiums during the new accounting standards transition period. We also find that state-owned enterprises pay lower incremental audit fees after the IFRS adoption, consistent with the conjecture that those companies have lower demand for financial reporting quality and tend to hire small auditors. Our findings complement the existing evidence from other countries regarding the effects of IFRS on the audit fees. Our findings also provide insights into the potential advantage of being affiliated with international accounting firms. Given that China is one of the largest capital markets in the world, the results from our study can serve as a reference for future IFRS adopters. Keywords: IFRS, Audit fees, Transition 2

3 1. Introduction More than 100 countries around the world have already adopted International Financial Reporting Standards (IFRS) or are in the process of doing so (Barth, 2008; Daske et al., 2008). The adoption of IFRS has caused unprecedented impacts on the global capital market. In November 2005, the China Accounting Standards Committee signed a joint statement with the International Accounting Standard Board in respect with the status of substantial convergence between Chinese accounting standards and IFRS. As mentioned in the Joint Statement of the Secretary-General of China Accounting Standards Committee and the Chairman of the International Accounting Standard Board, China stated that convergence with IFRS is one of the fundamental goals of their standard setting program. In February 2006, the Ministry of Finance of China formally announced the issuance of the amended Accounting Standards for Business Enterprises (including one basic standard and 38 specific standards) that took effect for the 2007 financial reports of listed companies in China. The new standards, with a few exceptions, are substantially in line with IFRS. Unlisted companies are also encouraged to use the new accounting standards. The Ministry of Finance further mandated the implementation of the new standards for all state-owned enterprises by the end of The requirement of using the IFRS-equivalent accounting standards is expected to extend to all enterprises in China in the near future. Prior to the IFRS adoption, Chinese accounting standards are similar to U.S. GAAP, which provide a list of detailed rules that must be followed when preparing financial statements. Compared with U.S. GAAP, IFRS are generally principle-based accounting standards and only a simple set of principles are set out to ensure good reporting. It often requires more time for accountants to assess proper accounting treatments on corporate transactions due to lack of specific rules under principle-based accounting standards. More professional accounting judgments are also needed. The adoption of IFRS therefore increases 1

4 the complexity of financial reporting environment in China. The opportunity for management misreporting will be increased if financial statements preparers or auditors do not have sufficient expertise in IFRS. The introduction of a single set of global accounting standards has received much attention from both academics and practitioners. As Ball (2009) indicates, auditor status, independence, training, and compensation are all important factors affecting the quality of financial reporting after the convergence of local accounting standards in different jurisdictions with IFRS. Other practical studies also point out that the IFRS adoption will increase auditing cost (Marden and Brackney, 2009) and the litigation risk of accountants (Love and Eickemeyer, 2009). Despite the significant impacts of IFRS adoption on audit markets, most existing literature on IFRS focus on examining the economic consequences of adopting new principles and the corresponding market reactions. Only a small number of studies have provided evidence regarding the effects of IFRS adoption on audit fees in different countries (DeGeorge et al., 2008; Griffin et al., 2008; Schadewitz and Vieru, 2009). In this study, we investigate the effects of IFRS adoption on the China audit market. We conduct our analysis by examining the effects of IFRS adoption on audit fees for more than 1,500 companies that issue A-shares in Shanghai and Shenzhen stock exchanges during 2005 to Our empirical results show that audit fees for listed companies in China significantly increased in the initial years of IFRS adoption. The significant increase in audit fees supports the conjecture that accounting firms have to spend more costs and efforts on auditing IFRS-based financial statements for listed companies in China during the transition 1 In China, a company can be listed on different stock exchanges and issue different classes of stock. For instance, it is allowed that a company issue both A-shares and B-shares in Shanghai and Shenzhen stock markets. A-shares are equity securities that trade in Chinese Yuan, and B-shares are equity securities that trade in U.S. dollars (Shanghai) and Hong-Kong dollars (Shenzhen). The company can also issue H-shares in the Hong-Kong stock market. In our primary test, we focus on the effects of IFRS on A-shares audit fees. We consider the effects of B-shares and H-shares on our results in sensitivity analyses. 2

5 period. It is also consistent with the conjecture that higher audit premium is charged by accounting firms to compensate the increasing litigation risk under IFRS. In addition, we find that accounting firms affiliated with Big 4 or other international CPA firms (e.g. BOD, Harwath, Baker Tilly International) charge significantly higher audit fees than domestic CPA firms after the IFRS adoption. Among the joint ventures, audit fees charged by Big 4 member firms in China increased the most substantially. These results are consistent with our expectation that accounting firms with experience and expertise in auditing financial statements in accordance with IFRS are expected to provide better audit service and hence charge higher audit fees. On the other hand, we also find that the incremental audit fees paid by state-owned enterprises do not increase as much as those paid by non-state-owned enterprises after the adoption of IFRS. The low demand for signaling good financial reporting quality for state-owned enterprises as documented by previous studies does not change despite a new set of accounting standards is mandated and better financial reporting quality is expected by market participants. Our results are robust to several sensitivity tests. We examine the effects of IFRS adoption on audit fees for companies that issue both A-shares and H-shares in the same year to confirm that the increase in audit fees is not due to a universal trend effect. We find that there is no change in audit fees for H-shares and there is an increase in audit fees for A-shares after the adoption of IFRS. Thus, we conclude that the increase in audit fees for A-share stocks is less likely due to the trend effect. We also consider potential impacts of the dualaudit rule for B-shares and H-shares on A-share audit fees. After excluding companies that also issue B-shares and/or H-shares from our main sample, the results remain unchanged. Finally, we exclude companies filed for IPO during to control for the positive association between IPO filings and audit fees. A significant and positive association between audit fees and the IFRS adoption remains. 3

6 Our study contributes to the literature as follows. First, many emerging markets, such as India, Korea, Singapore, Malaysia and Taiwan, are in the process of adopting IFRS and it is our understanding that the effects of IFRS adoption on audit fees in emerging capital market have not been widely studied. 2 China is one of the largest emerging capital markets in the world and it has significant influence on the world economy in recent years. We expect that evidence from China will complement the existing international studies regarding the effects of international accounting standards adoption. Authorities and practitioners from other emerging capital markets can also learn the experience from China when making IFRSrelated policy. Second, we empirically demonstrate that IFRS-related auditing expertise is an important determinant of the audit fees when IFRS equivalent accounting standards are adopted in China. China decided to adopt IFRS in 2006 and began the implementation in Compared to other countries, the one-year transition period for new accounting principles adoption is very short. 3 Given such a short transition period, both listed companies and accounting firms in China have very limited of time to prepare for the change and the need for IFRS-related resources becomes urgent. By affiliating with international accounting firms, more IFRS-related resources become accessible to accounting firms in China. As a result, better audit service can be provided and higher audit premium can be charged. This finding also provides insight into the potential advantage of being affiliated with international accounting firms during the global convergence with IFRS. Finally, our finding contributes to the literature on the effects of institutional environment on audit fees. Previous literature suggests that state-owned enterprises lack of demand for larger auditors and pay lower audit fees. We show that while the adoption of IFRS has a significantly positive impact on audit fees, the incremental audit fees for state-owned enterprises are less than non-state-owned 2 For example, India has announced a plan to adopt IFRS for listed companies phased in Taiwan has adopted a plan to adopt IFRS in two phases starting ( ) 3 For instance, in 2002 the EU decided the implementation of IFRS for public listed firms from This decision gave both public listed companies and accounting firms at least two years to prepare for the change. 4

7 enterprises after the introduction of IFRS. This finding suggests that state-owned enterprises may not be well-motivated to signal good financial reporting quality by hiring reputable auditors, despite the changes in accounting standards have increased the overall litigation risk. Given that a high percentage of listed firms are state-owned in China, investors should pay attention to the effect of institutional characteristics on the financial reporting quality. The regulatory authorities should also devote their efforts to harmonizing incentives and institutional factors. The remainder of this paper is organized as follows. Section 2 reviews the previous literature and develops the hypotheses. Section 3 provides the research design. Data selection and descriptive statistics of variables are presented in section 4. Empirical results are reported in section 5. Section 6 concludes the study. 2. Literature Review and Hypothesis Development Most existing literature on IFRS focus on analyzing economic consequences of new principles adoption, the market reaction, or changes in earnings quality after converging local accounting standards in different jurisdictions with IFRS. For instance, Daske et al. (2008) indicate that the adoption of IFRS enhanced the market liquidity. Armstrong et al. (2010) examine European stock market reaction to 16 events associated with the adoption of IFRS. They document an incrementally positive reaction for European firms with low pre-adoption information quality and higher pre-adoption information asymmetry. Their finding suggests the market perceives that the adoption of IFRS improves the information transparency and earnings quality. Barth et al. (2008) find that firms applying International Accounting Standards (IAS) from 21 countries generally evidence less earnings management, more 5

8 timely loss recognition, and more value relevance of accounting information. 4 On the other hand, Daske (2006) investigates the cost of capital for German firms during the period from 1993 to He finds that the adoption of IAS or IFRS does not help to reduce the cost of capital. IFRS are generally principle-based accounting standards. Due to lack of clear accounting treatments to follow, Marden and Brackney (2009) suggest that accountants must spend more time and efforts on analyzing business transactions under IFRS in order to make the most appropriate judgments and to ensure adequate compliance. Accounting firms must also allow auditors to receive more professional education with respect to IFRS. In other words, in response to the implementation of new standards, accounting firms are expected to make more investment in resources that enhance audit quality. The incremental costs thus will be reflected in the increased audit fees. On the other hand, the principle-based accounting standards make accountants judgments vulnerable to challenge. The litigation risk facing accountants will be higher when their clients mismanage their business (Love and Eickemeyer, 2009). As Hey et al. (2006) suggest, one of the factors affecting audit fees is the litigation risk. To compensate the increased litigation risk, it is expected that higher audit premium will be charged by accounting firms. A small number of studies empirically examine the impact of IFRS on audit fees. Griffin et al. (2008) analyze the association between overseas and New Zealand governance regulatory reforms, and audit and non-audit fees over 2002 to Following U.S. Sarbanes-Oxley Act of 2002, a series of corporate governance regulatory reform has taken place in New Zealand. In the meantime, public listed companies are allowed to voluntarily adopt IFRS since Griffin et al. (2008) find that audit fees increase in New Zealand over 4 IAS were issued by the International Accounting Standards Committee (IASC). The International Accounting Standards Board was formed in 2001 to replace the IASC. Current IFRS are developed and approved by IASB. 6

9 2002 to For companies voluntarily adopt IFRS, their audit fees increased both in the year prior to the IFRS adoption and in the first three years post to the IFRS adoption. Schadewitz and Vieru (2009) discuss the impact of 2005 IFRS adoption on audit fees and non-audit fees for 73 listed companies in Finland. They use the magnitude of IFRS adjustments on income before tax, net income, equity and total liabilities as the proxy of complexity of IFRS transition. Their results indicate a positive association between the complexity proxy and audit fees which suggest that higher audits fees were charged to compensate the increasing complexity of IFRS transition. DeGeorge et al. (2008) analyze the effects of IFRS adoption on audit fees for 438 listed Australian companies. They also find an increase in audit fees in the post-adoption period. Furthermore, they document that the increase is more substantial for smaller companies which contradicts the claims that smaller firms are less likely to be affected by the transition to IFRS. The level of audit premium charged by CPA firms partly depends on the level of litigation risk and the level of audit cost. In China, auditors become more aware of litigation risk after audit firms are separated from government control in For example, Yang et al. (2001) find that after the disaffiliation reform in 1998, the number and percentage of nonstandard opinions has increased dramatically. Their results indicate that the disaffiliated CPA firms face a higher degree of market risk and act more independently. Additionally, Wu (2007) and Chen et al. (2009) document that eight Chinese audit firms had their licenses to audit listed companies terminated or suspended in 2001 by China Securities Regulatory Commission. The Supreme People s Court of the People s Republic of China further issued rules regarding tort liability of auditors in Both the stricter regulatory scrutiny and greater civil and criminal liability in recent years increase auditor litigation costs. In the meantime, the transition of accounting standards has increased the level of audit complexity as several major revisions have been made on Chinese accounting standards and 7

10 many new line items on financial statements are introduced. For instance, firms are required to classify their investments into trading, available-for-sale and held-to-maturity securities under the new accounting standards. Development costs are capitalized as an asset instead of expensed. LIFO inventory cost flow assumption is no longer applicable. Accounting rules regarding income tax and investment property also have been revised substantially. Moreover, there is a wider application of fair value accounting, which requires more subjective estimates and valuation from financial reports preparers. Given the substantial changes in accounting rules in a short transition period, misreporting becomes more likely and hence the overall auditor litigation risk becomes higher. Additionally, the mandatory re-classification and revaluation also increase the degree of audit complexity. More costs and efforts must be spent on auditing IFRS-based financial reports as the audit complexity becomes higher. As a result, we posit that CPA firms will charge higher audit premium to compensate the increased litigation risk and audit cost after the adoption of IFRS in China. We test our conjecture in hypothesis 1 as follows. H1: Other things being equal, there is an increase in audit fees for listed firms in China after the IFRS adoption. Audit quality is another factor that affects auditor pricing decision. Previous literature suggests that accounting firms charge different levels of audit fees based on the level of audit quality provided (Palmrose, 1986; Francis and Simon, 1986; Gul, 1999). A higher level of audit fees is charged when better audit quality is provided. In China, only accounting firms with license of auditing securities and futures are allowed to audit listed companies. Because of merger or license suspension, licensed accounting firms are different year from year. On average, there are about 70 accounting firms licensed for auditing listed companies in each year. These accounting firms include member firms of Big 4 international CPA firms, and accounting firms affiliated with other international CPA firms (for example GT and BOD). 8

11 Appendix A provides a list of Chinese domestic accounting firms that affiliated with international accounting firms. 5 Because many countries have adopted IFRS prior to 2007, the majority of those international accounting firms have experience and expertise in auditing financial statements in accordance with IFRS. It is expected that their expertise and experience can assist their member firms in China in familiarizing the provisions of IFRS promptly and establishing a set of standardized audit procedures within a short period of time. We expect that the audit quality provided by those member firms can be enhanced through the knowledge-sharing among their global alliances during the transition period. Based on the expectation that members of international accounting firms are capable of providing better quality service than other domestic audit firms, we expect higher incremental audit fees will be charged by member firms during the transition of accounting standards. Our second hypothesis is stated as follows. H2: Other things being equal, members of international accounting firms in China charge higher incremental audit fees than other domestic accounting firms after the adoption of IFRS. On the flip side, it is likely for listed companies that are less concerned about financial reporting quality to shop around and find auditors that are willing to charge lower incremental audit fees after the IFRS adoption. Wang et al. (2008) examine how the institutional features of the Chinese political economy affect the firm s auditor choice decision. They find that Chinese local and central state-owned enterprises are more likely to hire small local auditors. The reasons for state-owned companies to hire small auditors, as argued by Wang et al. (2008), include (1) their preferential access to capital result in low 5 In China, foreign companies are required to form joint ventures with domestic companies in order to enter the market. To enhance the audit quality, the China Securities Regulatory Commission has actively encouraged domestic accounting firms to be affiliated with international accounting firms. Several joint ventures with Big 4 international accounting firms had formed since early 90s. 9

12 demand for reputable auditors to serve as a signal of their quality, (2) the government bailout they will receive in case of financial distress, (3) small auditors have local knowledge advantage, and (4) possible collusion with government officials. While the size of CPA firm is often used as a proxy for audit quality in literature, the findings in Wang et al. (2008) suggest that Chinese state-owned firms have lower demand for reputable auditors to serve as a signal of their quality. In their additional analysis, Wang et al. (2008) show that small local auditors generally charge a price discount, which is also supported by Lin and Lin (2009). Based on previous literature, we hypothesize that state-owned enterprises will hire auditors that charge lower incremental audit fees after the IFRS adoption, and thus, their incremental audit fees will be less than non-state-owned enterprises after the IFRS adoption. We state our third hypothesis as follows. H3: Other things being equal, state-owned enterprises pay lower incremental audit fees than non-stated-owned enterprises after the adoption of IFRS. 3. Research Method To test the effects of IFRS adoption on audit fees in China, we develop an OLS crosssectional regression as follows. LNFE it F( ADOPTit, INTEXPit, INTEXPit * ADOPTit, SOEit, SOEit * ADOPTit, LNTAit, ARINV it, LEVit, LOSS it, OPIN it, AUDSIZE it, INITIAL it, EXCHit, REGION1 it, REGION 2it, REGION 3it, REGION 4it, IND1 it, IND2it, IND3it, IND4it ) (1), where for company i in year t, LNFE is the natural log of audit fees, ADOPT is an indicator variable which equals 1 after IFRS is implemented and 0 otherwise, INTEXP is an indicator 10

13 variable which equals 1 when the audit firm is affiliated with an international CPA firm (see Appendix A) and 0 otherwise, SOE is an indicator variable which equals 1 when the company is state-owned and 0 otherwise, LNTA is the natural log of total assets, ARINV is the total amounts of accounts receivable and inventory divided by total assets, LEV is total liabilities divided by total assets, LOSS is an indicator variable which equals 1 when the company has loss in year t and 0 otherwise, OPIN is an indicator variable which equals 1 when unqualified opinion is issued and 0 otherwise, AUDSIZE is an indicator variable which equals 1 when the audit firm is a Big 10 accounting firms in China and 0 otherwise, 6 INITIAL is an indicator variable which equals 1 if it is the initial audit of the company by the audit firm and 0 otherwise, EXCH is an indicator variable which equals 1 when the company is listed on the Shanghai Stock Exchange and 0 when it is listed on the Shenzhen Stock Exchange, REGION1 equals 1 when the company is located in Shanghai, Beijing, Tianjin, Zhejiang, and Guangdong and 0 otherwise, REGION2 equals 1 when the company is located in Jiangsu, Fujian, Shandong, and Liaoning and 0 otherwise, REGION3 equals 1 when the company is located in Heilongjiang, Xinjiang, Jilin, Hainan, Hubei, and Hebei and 0 otherwise, REGION4 equals 1 when the company is located in Henan, Shanxi, Anhui, and Ningxia and 0 otherwise, IND1 equals 1 when the company is in utilities industry and 0 otherwise, IND2 equals 1 when the company is in real estate industry and 0 otherwise, IND3 equals 1 when the company is in manufacturing industry and 0 otherwise, IND4 equals 1 when the company is in commercial industry and 0 otherwise. 6 Due to the low market share of Big 4 in China, most literature use Big 10 to control for the size of audit firm when examining the Chinese audit market (e.g. DeFond et al., 2000; Wang et al. 2008). We select Big 10 accounting firms in China based on total audited assets. Accounting firms with top 10 largest total audited assets for at least 3 years during our sample period are selected as Big 10. Based on this criteria, Big 10 include Pricewaterhouse Coopers Zhongtian CPAs, Deloitte and Touche Hujiang CPAs, KPMG Huazhen CPAs, Ernst & Young Huaming CPAs, Shu Lun Pan CPAs, RSM China CPA, Beijing Jingdo CPAs, Ascenda CPAs, Shinewing CPAs, and Zhejiang Pan-China CPAs. 11

14 Our primary experimental variables are ADOPT, the interaction term between ADOPT and INTEXP, and the interaction term between ADOPT and SOE. We expect positive coefficients on ADOPT and ADOPT*INTEXP based on hypotheses 1 and 2. We expect a negative coefficient on the interaction term between ADOPT and SOE based on our hypothesis 3. We also include INTEXP and SOE to control for the higher audit fees charged by members of international CPA firms and the lower audit fees paid by listed state-owned enterprises before the IFRS adoption, respectively. LNTA is included to control for the size of audit client. The larger the size of audit client the higher the audit fees; thus, we expect a positive coefficient on LNTA. The ratio of accounts receivable and inventory on total assets is included as a proxy of audit complexity. Both bad debts estimate and inventory valuation increase the audit complexity. Furthermore, confirmation of receivables and inventory physical count are required by generally accepted auditing procedure. We expect that the more receivables and inventory, the higher the audit complexity and the higher the audit fees. Therefore, the coefficient on ARINV is expected to be positive. Following prior studies (Francis, 1984; Craswell et al., 1995), LEV and LOSS are included to measure operational risk of audit clients. The higher the operational risk, the higher level of audit fees may be charged. We expect both coefficients on LEV and LOSS are positive. The opinion issued by the auditor reflects the risk sharing between the auditor and the auditee (Simunic, 1980). A few studies from China suggest that some auditors in China issue unqualified with explanatory opinion to replace qualified opinion (see for example, Chen et al., 2000 and Chen et al., 2001). Hence, literature only classifies auditor opinion into two categories: unqualified opinion and other opinions. Following the literature, we classify modified opinion, qualified opinion, adverse opinion, and disclaimer of opinion as Qualified opinion, and OPIN equals 1 only when a standard unqualified opinion report is issued. We 12

15 expect that the coefficient on OPIN is negative because unqualified opinion indicates that the evaluated risk is low so that a lower level of audit fees will be charged. Craswell and Francis (1999) indicate that audit firms charge lower audit fees on initial audit engagements (low-balling strategy). Hence, we expect that the coefficient on INITIAL will be negative. In addition, most literature suggests that larger audit firms charge higher audit fees (Francis, 1984; Palmrose, 1986; Hay et al., 2006). To control for the effects of audit firm size on audit fees, we identify the Big 10 accounting firms in China based on their total assets and include AUDSIZE in the equation. The coefficient on AUDSIZE is expected to be positive. In China, a big gap between rich and poor exists, and significant regional differences in living standards are observed. Such regional differences may affect audit fees. In order to control the effect of regional differences on audit fees, we include four regional indicator variables (REGION1-4) as control variables (Liu et al., 2003; Han and Chan, 2007). Finally, industry classification (IND1-4) is included to capture the industry effect on audit fees. Different audit procedures and audit tests may be applied when auditing different industries. It is therefore possible for CPA firms to charge audit fees based on the industry they audit. 4. Data Our primary sample consists of listed companies that issue A-shares in Shanghai and Shenzhen stock exchanges during 2005 to Years 2005 and 2006 represent the pre- IFRS-adoption period and years 2007 and 2008 represent the post-ifrs-adoption period. Information regarding audit fees and audit opinion is collected from companies annual reports. All financial data is retrieved from Taiwan Economic Journal (TEJ) database. Information about domestic accounting firms and the joint ventures with international 13

16 accounting firms is obtained from the Chinese Institute of Certified Public Accountants Management Information System published by the Chinese Institute of Certified Public Accountants ( Table 1 summarizes the sample selection process. We apply the following filters in selecting samples. First, we exclude observations with missing data for the required financial variables after merging data from different sources. Second, samples without audit fee data are eliminated. Finally, we eliminate top and bottom 0.5 percent extreme values for variables LNTA, LEV, and ARINV. The final sample consists of 4,581 firm-year observations. As reported in Table 1, many sample observations are excluded due to lack of audit fees. This is partly because some companies that issue B-shares and/or H-shares in addition to A-shares only disclose a combined amount of audit fees for all shares. Since we focus on the changes in A-share audit fees after the IFRS adoption, observations that do not specify A-share audit fees are excluded. Table 2 provides the descriptive statistics of primary variables. More than 65% of companies are state-owned, indicating a high percentage of listed companies are controlled by the government. Most of our sample companies are audited by accounting firms that do not affiliate with international accounting firms. Only about 33 percent of sample observations are audited by members of international accounting firms. Moreover, only 5 percent of our observations are audited by Big 4 member firms. The audit market share of Big 4 in China is very different from in the U.S., where the market share of Big 4 is higher than 45% in The unqualified opinion report is issued most of the time. About 93 percent of observations receive standard unqualified opinion from their audit firms, suggesting that the average audit risk as assessed by auditors is not very high among our sample firms. Finally, as reported in Table 3, we do not find a high degree of correlation 14

17 among our variables based on the Pearson correlation coefficients, suggesting no severe multicollinearity problem Empirical Results (1) Main results Model (1) in table 4 reports the regression of audit fees on ADOPT and other control variables. The result indicates that the adoption of IFRS has significantly increased audit fees for listed companies in the IFRS-compliant period. The positive effect of IFRS adoption on audit fees remains significant after we include other experimental variables in models (2)-(6). The coefficients on ADOPT range from 4.8% to 10.5% and are all significant at the 1% level. The significantly positive coefficients on ADOPT are consistent with those found in previous literature. Model (2) in table 4 reports positive coefficients on INTEXP and ADOPT*INTEXP. The significance of these coefficients is not affected after we include other experimental variables (i.e. SOE and SOE*ADOPT) as reported in model (5). The significantly positive coefficients on INTEXP suggest that members of international accounting firms charge a higher level of audit fees than domestic CPA firms, independent of the mandated IFRS adoption. On the other hand, the significantly positive coefficients on ADOPT*INTEXP suggest that, in the initial years of IFRS adoption, international member firms charge higher incremental audit fees than domestic CPA firms. This finding supports our second hypothesis. We attribute the higher incremental charge in the IFRS-compliant period to the greater IFRS-related audit experience and expertise available from other member firms around the world. By affiliating 7 The variance inflation factors (VIF) as reported in Tables 4-6 also suggest that there is no multicollinearity problem in our regression models. 15

18 with international accounting firms, auditors in China have access to IFRS-related resources and thus are capable of providing better audit service and charge higher audit fees. To see if Big 4 member firms charge different levels of audit premium than other international accounting member firms after the IFRS adoption, we further replace INTEXP by two dummy variables, IBIG4 and IOTHER, in equation (1) and rerun the test. IBIG4 is a dummy variable that equals 1 when the audit firm is a member of Big 4 international accounting firms and 0 otherwise. IOTHER is a dummy variable that equals 1 when the accounting firm is a member of other international accounting firms and 0 otherwise. The results are provided in models (3) and (6) of table 4. Consistent with prior studies, the significantly positive coefficient on IBIG4 suggests that Big 4 member firms charge a much higher level of audit fees than domestic accounting firms. Other international accounting firms also charge more audit fees than domestic accounting firms but not as much as Big 4 member firms do. Both Big 4 member firms and other international accounting firms charge incremental audit fees after the IFRS adoption. Yet, the increase in audit fees charged by Big 4 member firms is more significant. Compared to other international CPA firms, Big 4 CPA firms are larger in their size and have rich global resources and supports. It is therefore possible for them to charge more audit premium after the introduction of new accounting standards in China. 8 Models (4) and (5) in table 4 report negative coefficients on SOE and SOE *ADOPT. The negative coefficients on SOE indicate that state-owned enterprises pay less audit fees than non-state-owned enterprises, regardless of the adoption of IFRS. This finding is consistent 8 Because of economy of scale, it is also likely that Big 4 CPA member firms are able to allocate their incremental costs from IFRS learning to a wider base as compared to other CPA firms in China. As a result, they may charge lower incremental audit fees after the IFRS adoption. However, our results do not support this conjecture. Also, due to lack of data for audit costs, we are not able to verify if the incremental audit cost for Big 4 member firms is lower than other CPA firms after the adoption of IFRS. 16

19 with Lin and Lin (2009) and Wang et al. (2008), who document that state-owned enterprises pay lower audit fees than non-state-owned companies. The adoption of IFRS has an overall positive effect on audit fees for state-owned enterprises (i.e. consider the total of coefficients on ADOPT and ADOPT*SOE). Yet, the significantly negative coefficients on SOE*ADOPT suggest that the incremental audit fees paid by state-owned enterprises is significantly less than those paid by non-state-owned enterprises after the IFRS adoption. While audit fees are affected by audit quality, the lower incremental audit fees paid by state-owned enterprises after the IFRS adoption implies little improvement in the demand for better audit quality among listed state-owned companies. Poor financial reporting quality thus remains likely. Given that a high percentage of listed companies in China are state-owned, investors should be cautious when investing in those companies. The regulatory authorities should also devote their efforts to motivate good financial reporting practice under the new accounting standards. For our control variables, we find significant coefficients in the expected direction for all variables except ARINV. The negative coefficient on ARINV contradicts to the results from prior studies in the U.S.; yet, it is consistent with previous studies in China (Chen et al., 2007; Wang et al., 2008). The explanation on this anomaly has not been provided and further investigations will be needed in the future. (2) Sensitivity tests To see if above results are robust, we perform three additional tests. First, in recent years, audit fees have been increased year by year in the U.S. If audit fees in China follow the same trend, then it is likely that our experimental variable, ADOPT, simply captures the impact of yearly increases in audit fees, instead of the effects of IFRS adoption. To ensure our above findings are not due to this trend effect, we examine the changes in audit fees for companies that issue both A-shares in Shanghai and Shenzhen stock markets and H-shares in the Hong- 17

20 Kong stock market. Companies are required to prepare their financial statements based on IFRS when they issue H-shares. Thus, the adoption of IFRS should not have significant impacts on H-share audit fees. Furthermore, financial statements for A-shares and H-shares must be audited by different accounting firms. After the adoption of IFRS, financial statements issued for A-shares and H-shares will both be prepared and audited in accordance with IFRS. Therefore, for the same company, if the increase in audit fees for its A-shares is simply due to the trend effect, then audit fees for its H-shares should also be increased. Contrarily, if we find no change in audit fees for H-shares, then it is probable that the increase in audit fees for A-shares is because of the IFRS adoption. A total of 145 firm-year observations issue both A-shares and H-shares in the same year during 2005 to After excluding 13 observations in financing industry, 15 observations without disclosing audit fees, and 55 observations disclosing only a total audit fees for both A-shares and H-shares, the final sample includes only 62 firm-year observations. Based on this small sample, we test the effects of IFRS adoption on A-share audit fees and H-share audit fees respectively. We make a few adjustments on equation (1) in testing the effects. First, due to the small sample size, we exclude state-owned effects (SOE and SOE*ADOPT), industry indicators (IND1-4) and regional indicators (REGION1-4) from equation (1). Further, the exchange variable (EXCH) does not apply to the H-share market, and is therefore dropped when we examine the change in H-share audit fees after the IFRS adoption. Finally, since those who audit H-shares all have experience in auditing IFRS-based financial statements before the IFRS adoption, the variables INTEXP and the interaction term between INTEXP and ADOPT are not applicable to H-share market. To make the results from A-share market and H-share market comparable, we also remove those two variables from equation (1). Table 5 provides the results from cross-sectional regression models based on the above adjustments. As reported in column (1) of Table 5, A-share audit fees increased statistically 18

21 significant at the 10% level after the IFRS adoption. On the other hand, the coefficient on ADOPT is insignificant in the H-share market as reported in column (2) of Table 5. These results indicate that the increase in audit fees in the A-share market is most likely due to the IFRS adoption instead of the trend effect. However, we also acknowledge that the small sample size must be taken into account when making generalizations and inferences from the results. We next consider the possible effects of dual audit rule on audit fees. Companies listed on Chinese stock exchanges that issue B-shares or H-shares must publish audited financial statements that conform to IFRS in addition to financial statements that conform to Chinese accounting standards. 9 Compared with companies that issue A-shares only, companies that issue B-shares or H-shares in addition to A-shares have more experience in preparing financial statements in accordance with IFRS. This IFRS-related experience may affect the audit fees. To account for the effect of the differences in IFRS-related experience among A- share firms, we exclude companies that also issue B-shares and/or H-shares from our sample. A total of 4,297 firm-years are included for the test. The results after excluding the effects of dual-audit rule are reported in column (1) of table 6. Consistent with our earlier findings, for companies that only issue A-shares, there is a significant increase in audit fees in the IFRScompliant period, higher incremental audit fees are charged by members of international accounting firms, and state-owned enterprises pay significantly lower incremental audit fees after the IFRS adoption. Finally, we consider the effects of initial public offerings (IPO) on audit fees. Simunic and Stein (1996) suggest that the audit risk is higher when auditors audit IPO companies because there are more procedures to be compliant with. Since 2006, the Chinese government has encouraged companies listed overseas to issue A-shares in China stock markets. Many 9 This dual-audit rule is no longer required for B-shares and will not be required for H-shares from

22 IPO have been observed since then. Because most of the companies listed overseas are audited by Big 4 accountants, audit fees in the A-share market could have been increased just by including those companies. To exclude such effects, we eliminate A-share companies that filed for IPO during and re-estimate equation (1). Column (2) of table 6 presents the results. After excluding IPO observations, the coefficients on our experimental variables remain significant in the expected directions. 6. Conclusions Existing literature has documented the effects of IFRS adoption on audit fees in different countries around the world. One general conclusion is audit fees increased following the adoption of IFRS. We arrive at the same conclusion in this study. The evidence from China regarding the effects of IFRS adoption complements the existing international studies on the effects of IFRS on audit fees. It also sets up an example for other emerging markets that are in the process of adopting international accounting standards. Additionally, we argue that, with access to abundant IFRS-related resources and global professional supports, audit firms that affiliated with international CPA firms can provide better audit service and hence charge higher incremental audit fees after the IFRS adoption. The results support our conjecture and suggest the potential advantage of being affiliated with international CPA firms in the transition of accounting standards. We also show that listed state-owned companies pay lower incremental audit fees than non-state-owned companies. We suggest the regulatory authorities in China should devote their efforts in motivating sound financial reporting practice among state-owned enterprises. We also acknowledge the following research limitations. First, we have not empirically tested if better quality of service has been provided by CPA firms that are affiliated with 20

23 international CPA firms. Nor have we tested if there is a decline in audit quality for stateowned enterprises after the IFRS adoption. Related evidence will be interesting and can be examined in future studies. Moreover, due to the relative newness of IFRS adoption in China, we are only able to examine the changes in audit fees in the initial two years of IFRS adoption. Follow-up studies on the changes in audit fees in subsequent years will provide a more comprehensive understanding on the effects of IFRS adoption. While our study documents an increase in audit fees for listed companies in China after the introduction of IFRS, there are also benefits to those IFRS adopters. China s achievements in converging with and implementing international standards have been widely recognized. For instance, in November 2008, the European Securities Committees voted and decided that during the transition period from 2009 to 2011, the EU will allow Chinese securities issuers to adopt Chinese accounting standards when entering the European market. This decision will reduce the cost of preparing financial information and thus benefits Chinese securities issuers in EU. Despite the ongoing controversy about the costs and benefits of moving toward the globalization of accounting standards, we believe Chinese experience in adopting IFRS will provide insights to future IFRS adopters and is worth to be further explored. References Armstrong, C. S., M. E. Barth, A., and E. J. Riedl Market reaction to the adoption of IFRS in Europe. The Accounting Review, Vol. 85(1): Ball, R International Financial Reporting Standards (IFRS):Pros and Vons for investor. Accounting and Business Research, Forthcoming, Available at SSRN: Barth, M. E Global financial reporting: Implications for US academics. The Accounting Review, 83 (5) :

24 Barth, M. E., W. R. Landsman, and M. Lang International accounting standards and accounting quality. Journal of Accounting Research, 46(3): Chan, K. H., K. Lin, and P. L. L. Mo A political-economic analysis of auditor reporting and auditor switches. Review of Accounting Studies, 11(March): Chen, C. J. P., X. Su, and R. Zhao An emerging market s reaction on initial modified audit opinion: Evidence from the Shanghai Stock Exchange. Contemporary Accounting Research, 17(3) : Chen, J. P., X. Su, and X. Wu Market competitiveness and Big5 pricing: Evidence from China s binary market. The International Journal of Accounting, 42:1-24 Chen, J. P., X. Su, and X. Wu Forced audit firm change, continued partner-client relationship, and financial reporting quality. Auditing: A Journal of Practice and Theory, 28 (2): Chen, C., S. Chen, and X. Su Profitability regulation, earnings management, and modified audit opinions: Evidence from China. Auditing: A Journal of Practice and Theory 20(2): Craswell, A. T., J. R. Francis, and S. L. Taylor Auditor brand name reputations and industry specializations. Journal of Accounting and Economics, 20(December): Daske, H Economic benefits of adopting IFRS or USGAAP-Has the expected cost of equity capital really decreased? Journal of Business Finance & Accounting, 33(3-4): Daske, H., L. Hail, C. Leuz, and R. Verdi Mandatory IFRS reporting around the world: Early evidence on the economic consequences. Journal of Accounting Research, 46(5): DeAngelo, L. E. 1981a. Auditor independence, lowballing and disclosure regulation. Journal of Accounting and Economic, 3(3): b. Auditor size and auditor quality. Journal of Accounting and Economic, 3(4):

25 DeFond, M. L., T. J. Wong, and S. Li The impact of improved auditor independence on audit market concentration in China. Journal of Accounting and Economics 28 (December): DeGeorge, E., C. Ferguson, and N. Spea The effects of IFRS adoption on audit fees: Evidence from the Australian experience. Working paper, University of Michigan. Francis, J The effect of audit firm size on audit prices-a study of the Australian market. Journal of Accounting and Economics, 6 (August): Francis, J. R., and E. Wilson Auditor change: A joint test of theories relating to agency costs and auditor differentiation. The Accounting Review, 63(October): Francis, J.R. and D. J. Stoke Audit prices, product differentiation, and scale economies: Further evidence. Journal of Accounting Research, 24(2): Griffin, P. A., D. H. Lont, and Y. Sun Governance regulatory changes, IFRS adoption, and New Zealand audit and non-audit fee: Empirical evidence. Accounting and Finance, Vol. 49 (4): , Gil, F. A Audit prices, product differentiation and economic equilibrium. Auditing: A Journal of Practice & Theory, 18(1): Han, H. and H. Chan The investigation on pricing for initial audit engagement for listed companies in China: evidence from changes in auditors. Accounting Research, September: (In Chinese) Hay, D.C., W. R. Knechel, and N. Wong Audit fee: A meta-analysis of the effect of supply and demand attributes. Contemporary Accounting Research, 23(Spring): Haw, I. M. G., K. Park, D. Qi, and W. Wu Audit qualification and timing of earnings announcements: Evidence from China. Auditing: A Journal of Practice & Theory, 22(2): Lin C. and S. Lin The effects of accounting firm size, brand, and competition on audit fees: Evidence from China. The International Journal of Accounting Studies, Vol. 49: (In Chinese) Lin, Z. J Auditor s responsibility and independence: Evidence from China. Research in Accounting Regulation 17:

26 Liu, B., J. Ye, and Y. Liao Empirical study on the determinants of audit fees for listed companies in China. Auditing Research, Vol.1: (In Chinese) Love, V. J. and J. H. Eickemeyer IFRS and accountants liability. The CPA Journal, 79(4): Low, L., P. Tan, and H. Koh The determination of audit fee: An analysis in the Singapore context. Journal of Business Finance and Accounting, 17 (Spring): Marden, R. E. and K. S.,Brackney Audit risk and IFRS. The CPA Journal, 79(6):32-36 Palmrose, Z. V Audit fee and audit size: Further evidence. Journal of Accounting Research, 24(Spring): An analysis of auditor litigation and audit service quality. The Accounting Review, 63 (1): Schadewitz, H and M. Vieru Impact of IFRS transition complexity on audit and nonaudit fee: Evidence from small and medium-sized listed companies in Finland. Working paper, Available at SSRN: Simunic, D.A The pricing of audit services: Theory and evidence. Journal of Accounting Research, 18(1): Auditing, consulting, and auditor independence. Journal of Accounting Research, 22(2): Simunic, D. A. and M. T. Stein The impact of litigation risk on audit pricing: A review of the economics and the evidence. Auditing: A Journal of Practice and Theory, 15(Supplement): Wang, Q., T. J. Wong, and L. Xia State ownership, the institutional environment, and auditor choice: Evidence from China. Journal of Accounting and Economics, 46(1): Wu X Regulatory propensity toward auditor liability in audit failures: An empirical analysis. Accounting Research, July: (In Chinese) 24