7th Global Conference on Business & Economics
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The Market Implications of Audit Quality
and Auditor Switch: Evidence from China
Z. Jun Lin
Hong Kong Baptist University, Hong Kong
Ming Liu
The University of Macau, Macau
Zhemin Wang
University Wisconsin-Parkside, USA
Z.Jun Lin, a professor of accounting at Department of Accountancy & Law, Hong Kong Baptist
University, Hong Kong. Ming Liu, an assistant professor at Department of Accounting and
Information Management, The University of Macau, Macau, and Zhemin Wang, a professor of
accounting, School of Business & Technology, University of Wisconsin-Parkside, the USA
Corresponding Address:
Zhijun Lin, Ph.D, CPA, CMA
Professor and Head
Department of Accountancy & Law
Hong Kong Baptist University
Kowloon Tong, Kowloon
Hong Kong
Tel: (852) 3411-7537
Fax: (852) 3411-5581
Email: Linzj@hkbu.edu.hk
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Ming Liu, Ph.D.
Assistant Professor
Department of Accounting and Information
Management
The University of Macau
Av. Padre Tomas Pereira, Taipa
Macau
Tel: (853) 397-4162
Fax: (853) 2883-8320
Email: mliu@umac.mo
7th Global Conference on Business & Economics
ISBN : 978-0-9742114-9-7
The Market Implications of Audit Quality
and Auditor Switch: Evidence from China
ABSTRACT
Independent auditing enhances the credibility of corporate financial reports and assist
investors to make rational decisions in the capital market. Nonetheless, the utility of auditing
function depends upon audit quality which is determined by the independence and expertise of
auditors. Hence, auditor choice and switch will not only affect audit quality but also influence the
decisions made by investors and other market participants. The purpose of this paper is to
investigate how investors respond to audit quality and auditor switch in the Chinese context. The
empirical results show that the audit quality and switching to a larger auditor have a positive
(negative) impact on the earnings response coefficients (ERCs) for firms with positive (negative)
abnormal earnings. On the contrary, switching to a smaller auditor has a negative (positive)
impact on ERCs for firms with positive (negative) abnormal earnings. The results suggest that
large auditors (Top 10) in China are perceived more effective in curbing income-increasing
earnings management, leading to higher (lower) ERCs for clients with positive (negative)
abnormal earnings. Firms’ switching to a larger auditor may signal good earnings quality,
investors therefore appreciate their stock prices more when the firms have positive abnormal
earnings and depreciate their stock prices less for their negative abnormal earnings. Vice versa,
switching to a smaller auditor may signal lower earnings quality and would result in opposite
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market responses. The evidence, in general, suggests that audit information is valued by the
market in China and large auditors have been able to product-differentiate themselves in the
Chinese stock market.
Keywords:
Audit Quality, Auditor Switch, Earnings Response Coefficients, Chinese Auditing, Market
Implications of Auditor Switch
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The Market Implications of Audit Quality
and Auditor Switch: Evidence from China
1 Introduction
The quality of corporate financial disclosure has become an important policy issue
following notorious corporate scandals such as Enron and WorldCom cases in recent
years. Enhancing disclosure quality increases transparency and facilitates investors to
better assess firms’ performance. Audits conducted by independent professionals serve a
very important role in improving corporate financial reporting and information credibility
(Datar et al. 1991; Balsam et al. 2003; Ferguson et al. 2004). Furthermore, the quality of
audits affects the utility of auditing function (Chaney and Philipich 2002). Many studies
confirmed that audit quality is relevant to the investment decisions made by investors and
other participants in the capital markets (Carcello et al. 2002; Anderson et al. 2004;
Bedard and Johnstone 2004; Beck and Wu 2006).
The purpose of this study is to investigate how investors respond to audit quality and
auditor switch in the Chinese context. The independent auditing function re-appeared in
China resulting from mushrooming Sino-foreign joint ventures in the mid 1980s. Due to
involvement of non-state-owned interests in the joint ventures, demand emerged for the
independent audits performed by professional auditors in the country (Xiao et al 2000;
DeFond et al. 2000; Lin et al. 2003). The shift of ownership rights from the state to
private and institutional investors in pace with increasing diversification in the economy
has further promoted the monitoring role of independent audits in China. In particular, the
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rapid development of shareholding (stock) companies in China led to a sharp increase in
the demand for external audits. The China Securities Regulatory Commission (CSRC)
requires that all listed firms have their annual financial statements audited by certified
public accountants (CPAs) in China (Lin and Chen 2004).1 Apparently the independent
auditing function has been employed by the government as an important mechanism in
transforming the Chinese economy from the one directed by the “visible hand” of
centralized planning to the one guided by the “invisible hand” of market forces.
Auditors, by performing their audits in accordance with the Generally Accepted
Auditing Standards (GAAS), will attest the fairness of corporate financial reports and
detect and report material deviations from the Generally Accepted Accounting Principles
(GAAP) to the stakeholders. Firms can thus employ reputable auditors to assure
shareholders and potential investors of the credibility of accounting information and
hence mitigate the agency problems underlying the contractual relations between firms’
management and their owners/shareholders (DeFond 1992; Ashbaugh & Warfield 2003;
Fan and Wong 2005). Independent audits can reduce agency costs by assuring the quality
of financial statements, thereby allowing more precise and efficient contracting
arrangements between the principals (shareholders) and the agents (management) of
business firms (Watts and Zimmerman 1986; Imhoff 2003; Bedard and Johnstone 2004).
1
Initially only CPA registered with the Chinese government were permitted to conduct financial audits in
China while the libarisation of auditing market to allow market entrance of foreign CPAs was introduced in
2000s. Initially foreign auditing firms (mainly Big 5/Big 4) were required to form joint-ventures with
Chinese CPA firms in order to offer audit services in China.
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The primary purpose of corporate financial reporting is to provide useful accounting
information to assist investors to make rational investment decisions in the capital market
(FASB 1978). Considerable empirical evidence supports a contemporaneous correlation
between accounting earnings and stock price changes (Holthausen and Verrecchia 1988;
Degeorge et al. 1999; Abarbanell and Lehavy 2003). However, earnings explain only a
small portion of the variation in market returns at earnings announcement date (Easton
and Pae 2004). This has led to a search for models to incorporate “non-earnings”
information in market based studies on value relevance of accounting information. Audit
quality and auditor switch were found to be important information in explaining the
movement of market returns in the developed markets (Dopuch et al. 1986; Teoh 1992;
Becker et al. 1998; Pittman and Fortin 2004; Felix et al. 2005). We extend this line of
research into China, where the market is perceived to be of low efficiency and investors
are relatively inexperienced. In particular, the Chinese stock market is far from perfect,
characterized by less rigorous enforcement of financial reporting requirements compared
with that in the developed economies. Thus the credibility of financial statements was
perceived low, and auditors were perceived to be lack of independence and
professionalism in China (DeFond et al. 2000; Lin 2004). Furthermore, many small
investors have very limited knowledge and experience in using financial information.
Because of the uniqueness of the capital market and the auditing environment in China, it
is of an interest to study investor’s response to audit quality and auditor switch in such an
emerging market.
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Several factors motivate this study. First, different from the developed economies, the
Chinese accounting and auditing professions are not only regulated but also directly
administered by government agencies (Chen et al. 2000; Lin and Chen 2004). It is
therefore interesting to examine whether independent audits are value added in a market
where stringent government control often prevails over the market mechanisms. Second,
some prior studies on the developed countries indicate that the audit quality or auditor
switch should have “information content,” i.e., firms’ management may fulfill the
purposes of earnings management or ‘opinion shopping’ through auditor choice or switch.
Although the “opinion shopping” may not be substantialized in the developed countries
such as the USA, whether it can be realized in less developed countries is certainly a
meaningful issue to be examined empirically. Third, investors’ responses to audit quality
and auditor switch in China may be different from that in the developed markets because
the earnings management by Chinese firms is of distinctive nature, e.g., incentives for
earnings management in China are dominantly in the direction of increasing the reported
earnings. Empirical evidence on this issue should enrich the literature on the association
of different patterns of audit quality and auditor switch with the investor’s responses to
firms’ earnings management in the Chinese market. Finally, the Chinese Institute of
Certified Public Accountants (CICPA) has recently begun to rank auditors in China in
order to improve the transparency and quality of Chinese auditing practices, which
presents an opportunity for identifying the demand for, and the utility of, high-quality
auditors in the Chinese context.
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Through the analysis of relevant models applied in prior studies in the developed
countries and the unique market conditions in China, we developed a logit regression
model to test the market implication of audit quality and auditor switch in China with
respect to two major types of auditor switch (namely switching to a larger auditor and
switching to a smaller auditor). We posited that the two types of auditor switch should
have opposite signaling effects to the market. Our study findings show that, for firms
with positive abnormal earnings, the audit quality and switching to a larger (higher
quality) auditor have a positive impact on firms’ earnings response coefficients (ERCs) 2
while switching to a smaller (lower quality) auditor has a negative impact on ERCs. Vice
versa, for firms with negative abnormal earnings, both audit quality and switching to a
larger auditor have a negative impact on ERCs and switching to a smaller auditor has a
positive impact on ERCs. The empirical results suggest that high quality auditors in
China (proxied by Top 10) may be perceived of more effective in curbing incomeincreasing earnings management, leading to higher ERCs for clients with good news and
lower ERCs for clients with bad news. Firms’ switching to a larger auditor may signal
more conservative in firms’ financial reporting, investors therefore appreciate their stock
prices more for positive abnormal earnings and depreciate their stock prices less for
negative abnormal earnings of those firms. Vice versa, switching to a smaller auditor may
signal aggressiveness in firms’ financial reporting and hence result in market responses in
the opposite direction.
2
Earnings Response Coefficients (ERCs) measure the relation between accounting earnings and stock
returns. ERCs are commonly estimated as the slope coefficient in a regression of the abnormal stock returns
on a measure of earnings surprise (Collins and Kothari 1989; Cho and Jung 1991; Imhoff and Lobo 1992).
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The issue of audit quality is identified as an important factor for the development of
Chinese stock market, in which investor confidence has to be bolstered in order to
mobilize resources for the private business sectors. Our study findings should not only
provide empirical evidence on the market implications of audit quality and auditor switch
in the Chinese market but also facilitate investors and market regulators to better monitor
firms’ auditor choice or switch in order to enhance the quality of auditing function and
the credibility of corporate financial reporting to promote smooth operation of the stock
market in China. In addition, the results of this study should generate some implications
for international investors. As the CSRC recently granted licenses to Qualified Foreign
Institutional Investors (QFII) such as Morgan Stanley, Goldman Sachs, Citibank, and
HSBC to participate directly in China’s A-share market, the findings of this study suggest
that international investors need to be aware of the structural arrangement of financial
reporting of the listed firms and the utility of audit services in China.
The remainder of the paper is organized as follows. Section 2 introduces relevant prior
studies. Section 3 illustrates hypotheses development. Section 4 describes research
methodology and the data. Section 5 presents and discusses the empirical results of this
study. Finally Section 6 concludes the paper.
2 Literature Review
2.1 Development of auditing function and capital market in China
As mentioned earlier, the auditing function reappeared in China only in the mid 1980s
after more than 30 years of suspension under the planned economy with the public (the
state) ownership. Following the ‘open-door’ policy adopted by the Chinese government
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to launch ambitious economic reforms, large sum of foreign capitals flowed into China in
the form of joint-ventures in the mid 1980s. The needs for independent verification of the
capital contributions made by various partners and for independent audits of the financial
statements and tax returns surfaced. Thus the Chinese government has to restore the
independent auditing function carried out by public accountants while the CICPA, a
semi-government organization, was established in the late 1980s to administer the affairs
of Chinese CPAs (Lin & Chen 2004).
In pace with the progress of economic reforms, Chinese economy has undergone
significant restructuring aiming at reducing direct involvement and intervention of the
government in business administration. Non-state-owned economies were encouraged in
the country. The share-capital (stocks) companies reappeared in the economy in the late
1980s. With the establishment of Shanghai Stock Exchange (SHSE) and Shenzhen Stock
Exchange (SZSE) in 1990 and 1991 respectively, more and more originally state-owned
enterprises (SOEs) were converted into stock companies, resulted in a rapid development
of the capital market in China. At present the stock market in China has become one of
the fastest-growing capital markets in the world.
Proper operation of a stock market depends upon reliable information disclosure and
effective market regulation (Easton and Zmijewski 1989; Dechow and Skinner 2000;
Ghosh al. 2005). In China, the market regulator, the CSRC, requires all listed firms must
have their financial statements being audited by Chinese CPAs (Lin et al. 2003).
Financial audits are to enhance the credibility of corporate financial reports and to ensure
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the usefulness of corporate financial statements to market investors (Datar et al. 1991;
Felthain et al. 1991; Francis and Krishnan 1999). Nonetheless the utility of auditing
function depends upon the quality of audits, which is determined by the independence of
auditors and the effective enforcement of auditing standards (Ashbaugh and Warfield
2003; Ferguson et al. 2004; Hay and Davis 2004). However, the Chinese auditors were
lack of independence over a quite long period after the restoration of the auditing
function in China. This is because that most auditing firms in China were initially set up
by government agencies at different levels (such as the Bureaus of Public Finance,
Taxations, and other industrial administrations), or most Chinese auditing firms were
initially under the sponsorship of government agencies. The operations of auditing firms
were frequently intervened by their sponsoring bodies to fulfill specific policy needs of
the governments (Chen et al. 2001; Lin & Chen 2004). In addition, as most auditing firms
were affiliated to local governments, their size was generally small as their operations
were restricted to the specific jurisdictions.
Such affiliation of Chinese auditing firms to the governmental sponsors could not
produce objective and independent attestation of corporate financial statements, and it
was criticized strongly by various stakeholders (DeFond et al. 2000; Lin et al. 2003, Haw
et al. 2003). Thus the reform of CPA practices was introduced by the government, to
delink auditing firms from their sponsoring bodies (most are governmental departments
or agencies) since 1997. The reform was not completed nationwide until 1999 due to
strong resistance from various interested parties. Such a change helps to enhance the
independence of Chinese auditors and the quality of financial audits, resulting in a
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substantial increase in the number of unclean (non-standard) audit reports being issued in
audit engagement for the listed firms (Lin et al. 2003).
In order to ensure the quality of corporate financial disclosures and auditing practices,
the CSRC has set up relatively stringent market-entrance standards for Chinese CPAs
who provide auditing services to the listed firms in China. Additional qualification
examinations and licensing systems were imposed by the CSRC. Only a very small
number of Chinese CPA firms had obtained such licenses.3 In general, these qualified
auditing firms are relatively large in size compared to those without the license for
auditing the listed firms. Following China’s entrance to WTO in the early 2000s and the
growth of globalization of Chinese economy, the government has gradually opened the
domestic auditing market to foreign auditing firms. After several years of joint-ventures
with the Chinese CPA firms, Big 5/Big 4 international auditing firms have been permitted
to directly offer auditing and other attesting services to the Chinese listed companies
since 2004.
The development of stock market and auditing practices in China is in the right direction
and has made substantial progress in respect of reducing policy intervention by
sponsoring governmental bodies, improving auditor independence, and enhancing the
credibility of corporate financial reporting (DeFond et al. 2000; Haw et al. 2003).
However the quality of auditing function and its utility in China remain a critical issue
that has not been empirically examined. Hence, the association between audit quality and
3
Although there were more than 6000 auditing firms in Chine, only about 107 auditing firms were initially
qualified by CSRC. The number has reduced to 73 in 2006 owing to merging and suspension of some
auditing firms in China.
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the credibility of financial statements in the stock market as well as the market
implications of auditing quality and auditor switch in China should warrant serious
empirical studies.
2.2 Earnings Management and Audit Quality
Earnings management involves the selection of accounting procedures and estimates
that may induce a bias in reporting earnings numbers to achieve certain objectives
(Dechow 1994; Burgslahler and Dichev 1997; Dechow and Skinner 2000; Abarbanell and
Lehavy 2003). The literature on earnings management makes three general predictions
about the use of discretions relevant to a particular benchmark (Healy 1985; Bartov et al.
2002; Abarbanell and Lehavy 2003). First, if pre-managed earnings are high above a
relevant benchmark, firms will make income-decreasing choices. Next, if pre-managed
earnings are below a benchmark but reserves are available to meet the benchmark, firms
will draw from accounting reserves or manipulate the discretionary accounting accruals
to just beat the benchmark. Finally, if pre-managed earnings and available reserves are
insufficient to meet any benchmark, firms will adopt income-decreasing measures that
will pay back in the future. Healy and Wahlen (1999), Das and Zhang (2003), and
Dechow et al. (2003) all reported the evidence from the US market that firms might
undertake income-increasing or income-decreasing procedures to manipulate the reported
income.
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Prior studies document other incentives for earnings management. Watts and
Zimmerman (1990) contended that larger firms would make income-decreasing
accounting choices in an attempt to minimize political costs. Other empirical studies
(Cahan 1992; Han and Wang 1998; Jones 1991; Cahan et al. 1997; Monem 2003; Bartov
and Mohanram 2004) also documented that business managers would use incomereducing discretionary accruals to minimize the political costs. Litigation concerns
discourage firms to manage earnings upward because of the asymmetric loss function on
firms that exaggerate their earnings. Perry and Williams (1994) reported the evidence of
downward earnings management in the year prior to the management buyouts in the US.
Hence, in the US and other western countries, even firms are generally motivated to
manipulate earnings upward, there are also bunch of incentives for them to manipulate
earnings downward.
Nonetheless, Chinese listed firms have very different ownership structure and incentive
systems and their motivations and behaviors of earnings management are also different
(Haw et al. 2005). As Chinese listed firms are usually controlled by the government or
parent SOEs, they face much fewer political costs compared with their US counterparts.
In China, the legal system is not highly independent, often influenced by the government;
and the law enforcement is weak. As the controlling shareholders are usually the
government agencies or parent SOEs, it is very difficult for Chinese investors to
effectively sue business managers and the controlling shareholders. The threat of
litigation is thus less likely to deter business managers from reporting earnings
optimistically. Business managers are motivated to manipulate earnings upward to fulfill
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certain political agenda such as getting promotion in their career advancement. In
addition, the bonus system also motivates business managers to overstate earnings.
Therefore, the Chinese listed firms have a much stronger intention to manage earnings
upward than to manage earnings downward.
Many studies confirm that the management’s earnings management behaviors impair
the credibility of financial statements and the usefulness of accounting numbers to
investors, because business managers could engage in opportunistic earnings
management that would seriously undermine the informativeness of the reported earnings
(Basu 1997; Schrand and Wong 2003; Anderson et al. 2004; Durtschi and Easton 2005;
Hribar et al. 2006; Hunton et al. 2006). This phenomenon is especially serious in China,
where business managers have strong incentives to opportunistically manipulate earnings
upward for the benefits of the controlling owners and themselves. Thus the stakeholders
(e.g., investors, creditors, market regulators and other interested parties) would introduce
certain mechanisms to curb the management’s earnings management. One of the
mechanisms is to adopt the independent auditing function, which should detect earnings
management behaviors and restrict the management’s ability in applying discretionary
accounting accruals to overstate or understate earnings (Johnson and Lys 1990; DeFond
and Subramanyam 1998; Bedard and Johnstone 2004; Fields et al. 2005).
Investors rely heavily on the audited financial statements and auditor opinions to make
investment decisions. If the audited financial statements and auditor opinions turn out to
be misleading, investors may sue the auditors. Auditors are thus encouraged to curb
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opportunistic management of accruals to make earnings credible and of high quality.
Several prior studies have found that the auditor’s ability to curb earnings management
was determined by audit quality: the higher quality of audits, the less degree of earnings
manipulation, and the higher credibility of corporate financial reports (Becker et al. 1998;
Chan and Wong 2002; Bedard and Johnstone 2004). Thus, the audit quality is one factor
that restricts the extent to which business managers can manipulate earnings (Kadous
2000; Balsam et al. 2003; Imhoff 2003).
However, audit quality is difficult to measure and many researchers applied a variety
of proxy in their studies. For example, DeAngelo (1981) and Lennox (1999) suggest that
the quality of audit firm is positively associated with firm size or the firm’s market share.
Large auditing firms have more resources and they have eager needs to protect their
reputations, so they will perform better audit services than the small auditors. However,
Johnson et al. (2002) adopt the tenure of auditor with their clients to reflect the quality of
audits as auditors who have served the clients for longer terms would know their clients’
internal control and accounting systems better and would be easier for the auditors to
curb earnings management behaviors and other irregularities in clients’ financial
reporting process. Nonetheless, Ghosh and Mood (2005) argued the tenure of auditors
may have a negative association with audit quality as the long-served auditors may
surrender their independence to keep close relationship with their clients. In addition,
other researchers applied the number of SEC investigations or sanctions as the indicator
of audit quality (Stice 1991; Dye 1993, Kadous 2000), or the frequency of issuing
unclean auditor opinions to reflect the quality of audits, i.e., higher quality auditors would,
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relatively, issue more unclean opinions than the lower quality auditors (Chow and Rice
1982, Craswell 1988; Francis and Krishnan 1999). Although so many different proxies
have been utilized, most researchers generally agree that the size or brand name of audit
firms is an appropriate indicator of audit quality (Lennox 1999; Reynolds and Francis
2000; DeFond et al. 2000; Chaney and Philipich
2002; Monem 2003). Thus large
auditors should curb earnings management more effectively.
In pace with the development of the stock market and auditing practice in China, a
group of big auditors has also emerged. From the year of 2003, the CICPA publicizes the
ranking of audit firms in China according to their annual auditing revenues. As indicated
in the Appendix and Table 1, among all auditing firms in China, the average revenue of
the ten largest auditing firms (Top 10) is substantially higher than that of others (non-Top
10).4 Since the audit quality is positively related to auditor size, we expect that Top 10
auditing firms should provide higher-quality audits in China. In this study, we use Top 10
to proxy for the quality auditors in China.
[insert Table 1 here]
2.3 Audit Switch and Its Market Implications
4
The concentration of Chinese audit market is very low compared to most western countries owing to
original market segregation under the sponsoring system for auditing firms by government agencies at
different levels. In addition, the Big5/Big4 international auditing firms were allowed to independently
provide auditing services to Chinese listed firms only after 2004. Thus the large auditors in China during
our study period are either the domestic Chinese CPA firms or the joint-venture of Chinese CPA firms and
the Big 5/Big 4 international auditing firms, while their market shares remain in a relatively low level
compared to their counterparts in the western countries.
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Since high quality auditors are more able to curb earnings management, firms’
management should have a motivation of switching auditors in order to realize the gains
from the manipulation of accounting numbers (Krishnan 1994; Willenborg 1999; Kim et
al. 2003; Krishnan et al. 2005). Some prior studies report that management may choose or
switch to relatively lower quality (more pliable) auditors in order to be able to obtain
greater leeway in manipulating discretionary accruals to adjust the reported earnings
(Francis and Krishnan 1999; Hay and Davis 2004). In particular, when the incumbent
auditors would issue an unclean opinion, firms are more likely to initiate a search for new
auditors whose views are more in line with that of the management in the consequent
year, e.g., switch from high quality to low quality auditors, because receiving an unclean
auditor opinion would depress the price of a firm’s securities and impair its ability to
raise funds in the future (Klock 1994; Anderson et al. 2004; Bedard and Johnstone 2004).
Nonetheless, empirical results on whether firms can achieve “opinion shopping” through
auditor switch are mixed as some studies found no evidence of successful “opinion
shopping” after auditor switch in the US market (Craswell, 1988; Krishnan, 1994;
Schauer, 2002).
But other studies argue that there are differences in the industrial
knowledge and auditing resources between the incumbent auditors and their successors so
the management should be able to manipulate accounting numbers if switching from high
quality (large) auditors to low quality (small) auditors as the later may be less effective in
curbing earnings management behaviors (Willenborg 1999; Nelson et al. 2002; Kim and
Kross 2005). Therefore auditor choice or switch will affect audit quality and its utility,
which should have an effect on investors’ perception of the credibility of financial
statements. The lower quality of auditors, the lower credibility of financial statements
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and the less information content of the accounting numbers being reported (Watkins et al.
2004).
Auditor switch usually signals the increase of the possibility of earnings management in
financial reporting which may result in lower quality of earnings numbers (Nicholes and
Smith 1983; Becker et al. 1998; Nelson et al. 2002). As a result, investors may respond
correspondingly. For instance, Chaney and Philipich (2002) found that when clients
announced auditor switch, changing from Big5/Big 4 to non-Big 5/Big 4 auditors in
particular, the market would normally reacted with a decline of stock prices and market
returns because investors would anticipate a decline in the information content of the
reported earnings. Auditor switch after a qualified opinion being issued represents a bad
news, because the client may be perceived to shop for a clean opinion from a new auditor.
DeFond and Subramanyam (1998) and Kim et al. (2003) attribute this phenomenon to the
notion that a perceived decline in audit quality due to auditor switch impairs the
credibility of financial reporting, i.e., it may result in a lower level of assurance to
investors and a higher probability that the reported earnings and book values are
overstated.
Earnings quality is a concept that is not directly observable. The ultimate test of
earnings quality is the market’s responses to earnings. Some capital market-based
researchers have focused on the determination of the earnings response coefficients
(ERCs) to examine the market reactions to reported earnings or audit quality and auditor
switch (Klock 1994; Kothari 2001; Schauer 2002; Mansi et al. 2004; Kim and Cross
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2005). 5 ERCs are the relation between market returns and earnings changes and are
commonly estimated as the slope coefficients in a regression of the abnormal stock
returns on a measure of earnings surprises. It is therefore a measure of the extent to which
new earnings information (earnings surprise) is capitalized in the stock prices (Kasznik et
al. 2002; Ryan and Zarowin 2003; Rosner 2003). Holthausen and Verrecchia (1988)
documented a positive association between the magnitude of the stock price responses
and the quality (precision) of the accounting information, which is associated with the
quality of audits (Nelson et al. 2002; Mansi et al. 2004).
Teoh and Wong (1993) and Balsam et al. (2003) suggested that investors’ responses to an
earnings surprise depend on the perceived quality and credibility of the earnings reported.
Specifically, Teoh and Wong (1993) hypothesized that to the extent that investors
perceive Big 8 auditors as providing higher-quality audits, i.e., their clients would report
earnings of higher quality and credibility, the stock price reaction to the unexpected
earnings of Big 8 clients should be greater than that of others. Consistent with this
hypothesis, they found the ERCs of Big 8 clients were significantly higher than that of
non-Big 8 clients. Thus, by linking financial reporting results to the ERCs, several studies
provide evidence that the financial statements audited by large auditors (Big 8 or Big 6)
are of higher quality and utility (Becker et al. 1998; Reynolds and Francis 2000; Francis
and Krishnan 1999; Krishnan 2003). Hence, firms audited by large auditors are valued
more by investors and have higher ERCs (Teoh and Wong 1993; Krishnan 2003; Felix et
al. 2005; Beck and Wu 2006).
5
The earliest adoption of ERCs in research on the effects of audit quality was by Holthousen and
Verreschia 1988.
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However the results of market reaction to audit quality and auditor switch in respect of
ERC are mixed in the literature (Watkins et al. 2004), we believe such inconsistent
empirical findings may be due to non-differentiation of the type of auditor switch in
respect of the direction of abnormal earnings in the previous studies. In theory, auditor
switch can have two forms, i.e., switching from a large auditor to a small auditor (switch
downward, SD) or from a small auditor to a large auditor (switch upward, SU), and they
would have varied market implications. In the case of downward switch, the audit quality
may decline or the firms’ earnings management may be less likely detected by the
successor auditor, which may impair the credibility of the financial statements and
increase the noise component of the reported earnings. Hence, investors would react more
cautiously to the earnings information which should yield lower ERCs (Klock 1994;
Francis and Krithnan 1999; Hunton et al. 2006). However, when auditor switch is from a
small auditor to a large auditor, the audit quality should be enhanced as the successor
auditor will be more likely to detect and curb the management’s earnings management
behaviors and enhance the quality or the information content of the reported earnings.
Investors should react favorably to the upward switch of auditor so the ERCs should also
be higher in the case of upward switch of auditors. It is therefore more appropriate to
probe into the types of auditor switch to obtain more convincing results in the study of
investors’ responses to the reported earnings.
3 Hypothesis Development
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The dual characterization of auditors, as both an assurance provider and as an
information intermediary, suggests that audits provide value to the capital markets. Mansi
et al. (2004) contend that the assurance effect of audits is value-added to capital market
participants and investors will value the assurance role of auditors in addition to their
information role. The financial statements audited by high-quality auditors are perceived
to be more credible and hence better reflect true economic value. Considering the audit
quality to be commensurate with the size of auditor, we expect the large auditors (Top 10)
to provide high-quality audits in China. Furthermore, high-quality auditors have ‘deep
pockets’ and can therefore provide investors with greater assurance in the event of
securities litigation (Dye 1993, Schsuer 2002; Hay and Davis 2004).
Potential costs associated with audit failure (including a loss of reputation capital) are
likely to be higher for large auditors than for small auditors. For example, when the
allegation of audit failure arises, Large (Top 10) auditors are likely to face greater
publicity in the financial media, and thus they are likely to bear a greater reputation loss
than small (non-Top 10) auditors. Given the potential litigation risks, Top 10 are more
likely to be sued (and suffer larger damage) because of their perceived “deep pockets”; or,
litigation is likely to be more costly for large (Top 10) auditors in terms of the potential
impairment to their brand name reputation capital. Since large (Top 10) auditors have
more to lose in terms of the reputation capital and the size of damage penalty, litigation
risks can be expected to motivate large auditors to provide higher-quality audits.
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Prior research finds that auditors will curb the management’s earnings manipulation
and high-quality auditors are more effective in constraining the opportunistic reporting of
discretionary accruals (Becker et al. 1998; Francis and Krishnan 1999; Krishnan 2003).
Teoh & Wong (1993) and Balsam et al. (2003) found that higher audit quality is
associated with lower-level earnings management and higher-level ERCs. They argue
that an earnings surprise will result in a greater stock price reaction when investors
perceive the reported earnings to be more credible. Their research is conducted in
countries with both directions of earnings management incentives, namely, incomeincreasing and income-decreasing incentives.
As mentioned earlier, the Chinese listed firms have much stronger motivations to
manage earnings upward than to manage earnings downward. Therefore, earnings
management is conjectured dominantly in the direction of increasing the reported
earnings. Correspondingly, the auditors’ role in curbing earnings management is
predominantly in the direction of reducing the management-reported earnings in China.
Since lawsuits typically allege that earnings were overstated in China, we can assume that
large or high quality auditors (Top 10) will be more conservative than small or low
quality auditors (non-Top 10) in determining the reported earnings. As a result, large
(Top 10) auditors should have a greater intention to limit the management’s ability to
choose income-increasing accruals than small (non-Top 10) auditors.
Since Chinese investors, to certain extent, can see through the earnings management
activities (Haw et al. 2005), the ERCs of firms audited by large (Top 10) auditors will be
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different from those audited by small (non-Top 10) auditors. However, because auditors
are perceived mainly in curbing income-increasing earnings manipulation in China, we
posit that the impact of high-quality audits on the magnitude of ERCs will be sensitive to
the sign of the abnormal earnings, i.e., whether the unexpected earnings are positive or
negative.
For the same magnitude of positive unexpected earnings, the firms audited by large
auditor (Top 10) are perceived to be more conservative and report earnings less
optimistically. Responding to the firms’ conservatism, investors will appreciate their
stock prices more, thus, implying higher ERCs for the firms audited by large auditors
(Top 10). For the same magnitude of negative unexpected earnings, firms audited by
large auditors (Top 10) are perceived to be more conservative and report more
pessimistically. Similarly, responding to the firms’ conservatism in reporting earnings,
investors will depreciate their stock prices less, implying lower ERCs for the firms
audited by large auditors (Top 10). Nonetheless the effects of unexpected earnings on
ERCs of the firms audited by small or low quality (non-Top 10) auditors will be on the
opposite situation. To examine the effect of the audit quality on ERCs, we test
empirically the following hypothesis:
Hypothesis 1 (H1): ceteris paribus, for positive (negative) unexpected earnings, firms
audited by large (Top 10) auditors have higher (lower) ERCs than those audited by small
(non-Top 10) auditors.
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Information asymmetry leads to a demand for effective corporate governance and
financial reporting mechanisms, which can be used to enhance the credibility of financial
information. The choice of a high-quality auditor is one possible solution (Johnson and
Lys 1990; Klock 1994; Imhoff 2003; Lee et al. 2004). The audit quality can be used as a
signal of auditor’s value (information signaling) and assurance provided (assurance
signaling) to investors (Willenborg 1999; Kadous 2000; Watkins et al. 2004; Anderson et
al. 2004; Hay and Davis 2004). Similarly, auditor switch also signals the inside
information to investors and other market participants. When firms switch auditors, they
can switch to a higher-quality auditors or a lower-quality auditor. If the successor auditor
is of higher quality to the predecessor auditor, the signal is that the management may not
try to make aggressive income-increasing earnings manipulation. On the contrary, if the
successor auditor is of lower quality than the predecessor auditor, it may indicate that the
management wants to manipulate earnings aggressively by hiring a more pliable auditor.
We expect that, for switching to higher-quality auditors, the market will attach higher
ERCs to firms with good news (e.g., positive earnings surprises), and lower ERCs to
firms with bad news (e.g., negative earnings surprises); and for switching to lower-quality
auditors, the market will attach higher ERCs to firms with bad news and lower ERCs to
firms with good news. To examine the effect of auditor switch on ERCs, the following
hypotheses are set:
Hypothesis 2 (H2): ceteris paribus, for positive (negative) unexpected earnings, firms
switching to larger auditors have higher (lower) ERCs than other firms.
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Hypothesis 3 (H3): ceteris paribus, for positive (negative) unexpected earnings, firms
switching to smaller auditors have lower (higher) ERCs than other firms.
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