Auditor Disaffiliation Program in China and Auditor Independence

Abstract

SUMMARY: This study examines whether the disaffiliation program introduced by the Chinese government improved auditor independence and whether auditor quality affects this relationship. Auditor independence is measured in terms of the likelihood of receiving a qualified report and the level of earnings management (measured by noncore operating income). The results show that the likelihood of receiving qualified audit opinions for listed companies significantly increased, and noncore operating earnings significantly decreased, after auditors were disaffiliated. However, companies audited by auditors without any affiliation also showed an increase in the likelihood of receiving qualified opinions and a decrease in noncore operating earnings, possibly because of the increased surveillance by the regulatory bodies that accompanied the act of disaffiliation. The results also show that the association between the disaffiliation program and the likelihood of receiving qualified audit opinions is stronger for small auditors than for large auditors, possibly because of the initial lower audit quality of small auditors. Auditor size, however, did not significantly affect the association between the disaffiliation program and noncore operating earnings.

The Effect of Guanxi on Audit Quality in China

“…Hence, in China, going-concern opinions are usually contained in the four types of unclean opinion (unqualified opinions with explanatory notes, qualified opinions, disclaimed, and adverse opinions), rather than being given as an independent audit opinion. Most of the research in the literature on Chinese audit opinion makes this classification, i.e., divides audit opinion into five types: unqualified opinions without explanatory notes, unqualified opinions with explanatory notes, qualified opinions, disclaimed, and adverse opinions (e.g., Chen et al, 2000Chen et al, , 2001DeFond et al, 2000;Gul et al, 2009;Haw et al, 2003;Ting et al, 2008). One exception is Liao and Wang (2008), who focus on financially distressed firms and explicitly examine going-concern opinions.…”

Does auditor size matter? Evidence from small audit firms

“…We also compute the performance-adjusted discretionary accrual (PDA t ) similar to Cahan and Zhang (2006). We assign firms in each industry into deciles based on the prior year return on assets (ROA) and then obtain the performance-adjusted discretionary accrual by taking the DA t 7 In addition to studies where auditor reputation is represented by the use of Big 4 auditors, studies also investigate other auditor characteristics that may affect audit quality by constraining managers' deliberately discretionary behavior such as expertise, tenure, and independence (Craswell, Francis, & Taylor, 1995;Krishnan, 2003;Myers, Myers, & Omer, 2003;Lennox and Pittman, 2010;Gul et al, 2009;Reichelt & Wang, 2010). These studies do not control for client characteristics using a propensity score matched sample.…”

“…We also include the ratio of current assets to total assets because accounts receivable and inventory are viewed as high-risk assets and require more audit effort and more extensive audit procedures. To measure audit risk among different industries, we include a dummy variable that equals one when the industry is regarded as a high-risk industry (industries with SIC codes of 2833-2836, 3570-3577, 3600-3674, 5200-5961, 7370-7374) based on previous research (Ashbaugh et al, 2003;Gul, Sami, & Zhou, 2009). We also include year and industry fixed effects, where industries are identified using the Fama and French 48 industry classification.…”

Response to the Discussant Comments on the “Value-Relevance of Earnings and Book Value Over the Institutional Transition in China: The Suitability of Fair Value Accounting in this Emerging Market”

“…And it is reasonable to expect that the betterment of auditing and accounting environment will improve the quality of financial information. Although Sami and Zhou (2008) and Gul, Sami, and Zhou (2009) verified that the implementation of auditing standards in 1997 improved the quality of the information environment in the Chinese markets, we have to admit that the disaffiliation of accounting firms from their sponsoring bodies and the setup of IAS were not completed within two years (1997)(1998), as it says in the papers of Sami and Zhou (2008) and Gul et al (2009).…”