CITY UNIVERSITY OF HONG KONG 香港城市大學 An Empirical Study on Audit Quality of Chinese Companies: Regulatory Oversight and Audit Market Perspectives 從法律監管和審計市場視角研究中國企業審計質量 Submitted to Department of Accountancy 會計學系 in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy 哲學博士學位 By GUO Yingwen 郭穎文 May 2014 二零一四年五月
i Abstract China is one of the largest and most fast-growing economies in the world. Since the establishment of domestic stock exchanges in the 1990s, the Chinese capital market has experienced amazing growth. Moreover, in recent years, there have been an increasing number of Chinese companies listed overseas, mostly in the U.S. External auditors are considered as playing an important role in enhancing the credibility of financial statements of listed companies. Therefore, audit quality is important to the healthy development of capital markets. However, in recent years, a number of accounting fraud allegations have attracted public attention to the audit quality of Chinese companies. In this thesis, I investigate the audit quality of auditors of Chinese companies listed domestically and overseas, from the perspectives of regulatory oversight and the audit market (e.g., audit fees and audit market concentration). Given that the auditors of domestic-listed Chinese firms are exposed to the Chinese legal environment, whereas the auditors of U.S.-listed Chinese firms are exposed to the U.S. legal environment, I study the audit quality of domestic-listed firms and that of U.S.-listed Chinese firms separately. For the domestic-listed firms, I study how market concentration affect audit fees, auditor reporting conservatism and the audit fee quality relationships. While Prior studies mainly focus on the U.S. audit markets that are dominated by Big 4 international auditors, my study is based on the Chinese audit markets at provincial level which are concentrated by Non-Big 4 domestic auditors due to local protectionism or political
ii cronyism. The differences in audit market characteristics between U.S. and China make the study in China interesting. For the U.S.-listed Chinese companies, I investigate whether the lack of the Public Company Accounting Oversight Board (PCAOB) inspection leads to low audit quality provided by China-based auditors. Currently, Chinese authorities do not allow the PCAOB to inspect U.S.-related audit work in China; however, compared to U.S. auditors, Chinese auditors enjoy information advantages in the audits of China-based companies because of the geographical proximity to clients. It is an empirical question to examine the superior local knowledge or regulatory oversight is the dominating factor in affecting the quality differentiation between Chinese and U.S. auditors. The main findings of my study are as follows. For domestic-listed firms, I found that regional market concentration is positively related to audit fees and negatively related to audit quality. Next, I show that abnormal audit fees have a positive association with audit quality in less concentrated regional markets; however, this association is weaker in highly concentrated regional markets. The results suggest that abnormal audit fees capture extra audit efforts with consequent improvement in audit quality in competitive markets; as market concentration increases, monopoly auditors can extract abnormally high profits without additional effort; thus, abnormal audit fees in concentrated markets are more likely to capture the auditor-client economic bonding that may impair audit quality. For U.S.-listed Chinese firms, I tested the quality differentiation among Chinese Non-Big 4 auditors, U.S. Non-Big 4 auditors and the Chinese affiliates of international
iii Big 4 auditors (Chinese Big 4). I found that both Chinese Big 4 auditors and Chinese Non-Big 4 auditors provide audits of higher quality than do U.S. Non-Big 4 auditors, whereas there is no quality differentiation between Chinese Big 4 auditors and Chinese Non-Big 4 auditors. The results reflect that local knowledge advantage dominates regulatory oversight in affecting the audit quality of U.S.-listed Chinese companies.
vi Table of Contents Chapter 1... 1 Chapter 2... 8 2.1. Introduction... 8 2.2. Institutional Background... 14 2.3. Literature Review and Hypothesis Development... 16 2.3.1 Audit market concentration and audit fees... 16 2.3.2. Audit market concentration and audit quality... 18 2.3.3. Effects of audit market concentration on the audit price-quality relation... 20 2.4. Research Design... 24 2.4.1. Specification of the Audit Fee Model... 24 2.4.2. Specification of the Audit Opinion Model... 27 2.5. Data Collection and Empirical Results... 30 2.5.1. Sample Selection and Descriptive Statistics... 30 2.5.2. Main Tests of Hypotheses... 32 2.5.3. Sensitivity Tests... 36 2.6. Conclusions... 39 Chapter 3... 43 3.1. Introduction... 43 3.2. Institutional Background... 49 3.2.1. Accounting Frauds of U.S.-listed Chinese companies... 49 3.2.2. Audit Quality of U.S.-listed Chinese companies... 51 3.3. Literature Review and Hypothesis Development... 53 3.3.1. Regulatory Oversight and Local Knowledge... 53 3.3.2. Local Knowledge and Audit Firm Size... 57 3.3.3. Regulatory Oversight and Audit Firm Size... 60 3.4. Research Design... 62 3.4.1. Measurement of Audit Quality... 62 3.4.2. Empirical Models for Testing the Hypotheses... 63 3.5. Data Collection and Empirical Results... 65 3.5.1. Data Source and Sample Selection... 65
vii 3.5.2. Descriptive Statistics... 67 3.5.3. Multivariate Analysis... 70 3.6. Sensitivity Tests... 71 3.6.1. Alternative Measures of Audit Quality... 71 3.6.2. Correction for Self-selection Bias Arising from Listing Method: the PSM Approach... 73 3.6.3. Combination of Chinese Big 4 auditors and Chinese Non-Big 4 auditor... 75 3.6.4. Change in Audit Quality after Auditor Switch... 76 3.6.5. A Proxy of Local Knowledge: U.S. Non-Big 4 Auditors with Offices in China... 77 3.6.6. Audit Fee Analysis... 78 3.7. Conclusions... 79 Chapter 4... 82 Bibliography... 86 Appendix... 105 Appendix I: Definition of Variables in Chapter 2... 105 Appendix II: Definition of Variables in Chapter 3... 107