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This study, using data from the Chinese stock market, investigates the relationship between earnings management induced by profitability regulation and modified audit opinions (MAOs). We review recent developments in the accounting profession and in independent auditing to foster an understanding of the environment in which Chinese auditing operates. Based on annual reports published by listed companies from 1995 to 1997, we analyze the underlying reasons for MAOs. Our test results show a significant association between receiving MAOs and reporting profits marginally above the target levels specified in stock de-listing and rights offering regulations. Our findings are consistent with the notion that asymmetric profitability requirements exacerbate managers' propensity to engage in earnings management, which in turn is positively associated with receiving MAOs. Though based on Chinese data, our findings are of general interest because they address a fundamental issue of trade-offs between expected costs and expected benefits in deciding whether to avoid MAOs in a transitional economy.

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This paper reports the results of an empirical examination of the difference between earnings based on Chinese GAAP and those based on International Accounting Standards (IAS). Specifically, the study determines how current Chinese accounting standards are different from the IAS, whether these differences are systematically biased toward under- or overstated earnings, and which items from the financial statements contributed most to these differences. The findings suggest that reported accounting earnings based on current Chinese GAAP are significantly different from those based on IAS. On average, the reported earnings determined under the Chinese GAAP are 20–30 percent higher than earnings reported under IAS. After restatement, 15 percent of the B-share companies changed from a reported profit to a reported loss. The findings suggest that the differences between the two sets of earnings are caused by differences in accounting standards and financial rules, opportunistic applications of Chinese GAAP, and unusual market-wide events. An analysis of recently promulgated accounting standards indicates that the difference between the two sets of accounting earnings is likely to be significantly reduced from those reported for 1998 as a result.

This study investigates the valuation effect of modified audit opinions (MAOs) on the emerging Chinese stock market. Here, the term MAO refers to both qualified opinions and unqualified opinions with explanatory notes. The latter can be considered an alternative form of a qualified opinion in China. The institutional setting in China enables us to find compelling evidence in support of the monitoring role of independent auditing as an institution. First, we find a significantly negative association between MAOs and cumulative abnormal returns after controlling for effects of other concurrent announcements. Further, results from a by‐year analysis suggest that investors did not reach negative consensus about MAOs' valuation effect until the second year, exhibiting the learning process of a market without prior exposure to MAOs. Second, we do not observe significant differences between market reaction to non‐GAAP‐ and GAAP‐violation‐related MAOs. Third, no significant difference is found between market reaction to qualified opinions and market reaction to unqualified opinions with explanatory notes.

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