Institutional Environment and the Quality
of Big 4 Auditors
Bin Ke Nanyang Technological University
Clive Lennox Nanyang Technological University
Qingquan Xin Chongqing University
Motivational question
• Do Big 4 accounting firms provide the same
audit quality around the world?
– Do Big 4 deliver the same quality in China?
• Potential economic forces governing Big 4’s
quality
– Ability
– Incentives (litigation risk, reputation, quasi-rent)
• Focus of this study is the incentives of Big 4
Is the idea interesting?
• I think so because Big 4 auditors play a
direct role in determining the quality of
financial reporting
• There is a debate on whether Big 4 can
deliver the same high quality audit in
weak investor protection countries as in
strong investor protection countries
Is the idea interesting?
• Relevance to China and HK:
– H shares’ financial reports are allowed to
be audited by domestic auditors after
December 15, 2010
How to test the idea?
• What is the ideal experiment?
• The most obvious approach is to compare
the audit quality of Big 4 across different
countries
• Common limitations of cross country
studies
– Accounting standards
– Auditing standards
– Other cross-country differences
Prior research
• Compare Big4 vs. non-Big4 across countries
– This approach does not directly examine the effect
of institutional environment on Big 4
– Unclear whether the cross-country differences are
effectively controlled for because the effects of
country factors could be different for Big4 and
non-Big4
– Any differences in results between Big4 vs. nonBig4 could be due to systematic differences of the
clients audited by Big4 and non-Big4
Our approach
• Publicly traded firms listed on mainland
China and audited by a domestic Big4
over 1995-2009
– Pure A shares
– AH firms
– AB firms
Our specific research question
• Do domestic Big4 accounting firms
provide the same audit quality in China
for
– Pure A shares,
– AB firms, and
– AH firms?
Mainland China
Big 4
of
Pure A Firm
Mainland
China
HK
Big 4
of
AH firm
Hong
Kong
?
Mainland China
Big 4
of
AH Firm
Mainland
China
HK
Big 4
of
AB firm
?
Mainland China
Big 4
of
AB Firm
?
Hong
Kong
Mainland
China
Incentives of HK Big4:
AH firms versus AB firms
H report of
AH firm
B report of
AB firm
HKSE
√
X
HKSFC
√
X/?
HKICPA
√
√/?
HK court
√
√/?
Market
√
√/?
CSRC
√/?
√
market
X
X
HK
Mainland
Mainland China
Big4
Of
Pure A Firms
Mainland China
Big4
Of
AH Firms
Mainland China
Big4
Of
AB Firms
?
Hong
Kong
Mainland
China
Advantages of our approach
• We directly examine the effect of
institutional environment on Big 4’s
behavior
• We can effectively isolate the country
effects because we compare the audit
quality of Big4 in the same country
• We do not compare Big4 vs. non-Big4 and
thus our results cannot be due to
systematic differences of the clients
audited by Big4 and non-Big4
Pure A share firms (firm years)
Domestic auditor
Big 4=1
Big4=0
Cell5 N=377
Cell6 N=12,649
AH share firms (firm years)
Domestic auditor=375
Big 4=1 (cell13)
Big4=0 (cell24)
HK auditor is big4=1 (cell12) Cell1 N=258
Cell2 N=68
HK auditor is big4=0 (cell34) Cell3 N=1
Cell4 N=48
Domestic and HK
auditors are the
same for 256 firm
years
AB firms (firm years)
Domestic (i.e., A share) auditor=1205
Auditor of B share report
Big 4=1 (cell135) 253
Big4=0 (cell246) 937
B share auditor is big4=1
(cell12)
Cell1 N= 201
Cell2 N= 363
B share auditor is big4=0
(cell34)
Cell3 N= 1
Cell4 N= 362
No B share auditor
Cell 5 N=51
Cell 6 N=212
Research design
• Y = α0 + α1 HK_MONITOR + α2 MULTIPLE_OFFICES
+ CONTROL VARIABLES + u
– Dependent variable=
• Audit opinion
• Earnings management (accruals and loss)
• Audit fees (mainland)
Audit opinion model: key variables
OPINION
=
1 if not clean opinion and zero if clean opinion in year t.
HK_MONITOR
=
Dummy variable, 1 if the firm is an AH firm and its HK
auditor is a big4 and zero otherwise；
MULTIPLE_OFFICES
=
Dummy variable, 1 if the firm is audited by more than one
office, and zero otherwise.
Audit opinion model: control variables
SIZE
=
Natural log of total assets in year t；
LEV
=
The ratio of the client’s total liabilities to total assets at the end
of current fiscal year t；
CURRENT
RETURN
=
=
BETA
=
VOL
=
The ratio of the client’s current assets to current liabilities.
Annual market adjusted abnormal return over the fiscal year t；
the firm’s beta estimated using a market model over the fiscal
year
the variance of the residual from the market model over the
INVESTMENT
=
ARINV
=
securities deflated by total assets at fiscal year-end;
accounts receivable and inventory divided by total assets in year
t；
ROE
=
net income over year-end total owners’ equity for year t；
LOSS
=
1 if the firm reports a loss for the current year, and 0 otherwise;
SOE
=
Dummy variable, 1 if the audit firm is stated owned enterprise,
and 0 otherwise.
fiscal year;
cash, cash equivalents, and short- and long-term investment
Audit opinion model
Signed abnormal accrual model:
dependent variable
Signed abnormal accrual model:
control variables
Signed abnormal accrual model
Loss model
Loss model
Audit fee model
Audit fee model
Endogeneity of HK_MONITOR
• Cross-listing bonding hypothesis would
suggest that AH firms are better and thus
the self selection would bias against our
predictions
• assess the severity of endogeneity:
– SHORT is 1 if the distance between the fiscal year end
and the HK IPO date for all AH firm years is less than 5
years (or 8) and zero otherwise
Endogeneity of HK_MONITOR
Descriptive stat for all regression
variables
Descriptive stat for all regression
variables