the economic consequences of voluntary auditing

8/2/2019 The Economic Consequences of Voluntary Auditing

1/32

The Economic Consequence of

Voluntary Auditing

IN-MU HAW*

DAQING QI**

WOODY WU***

A number of Chinese firms voluntarily acquire auditing services for

their interim reports, even though the auditing of interim reports is man-datory only for a subset of firms in circumstances that are specified by

the state regulators. This unique institutional setting in the Chinese mar-

ket provides a natural experimental setting to directly investigate why

listed firms voluntarily have their financial reports audited, and whether

investors place more value on voluntarily audited earnings than on

unaudited earnings. Based on a sample of 2,458 semi-annual interim

reports released by listed Chinese firms from 1996 to 1999, we find that

the choice of voluntary auditing is positively associated with the per-

centage of tradable shares, profitability, and company size. We also find

that the earnings response coefficients of audited firms are higher thanthose of unaudited firms, especially when the auditing is voluntary. Our

findings are consistent with theoretical propositions that managers vol-

untarily purchase external auditing to enhance the credibility of

accounting numbers. This study contributes to the literature, especially

on the economic value of voluntary auditing.

Keywords: Voluntary auditing, earnings response coefficients, motivation,

China

1. Introduction

In recent years, investors and policymakers have become increasingly aware

of the importance of Chinas capital markets. As the largest and fastest-growing

emerging market, China has made significant progress in developing a viable

*Texas Christian University**Cheung Kong Graduate School of Business***Chinese University of Hong KongWe thank Paul Brockman, Edward Douthett, Lee-Seok Hwang, W. S. Kim, Steve Lim, Chul W.

Park, and Bill Wempe for their helpful comments; Ma Yue and Yu Xin for their assistance. The work

that is described in this paper was substantially supported by grant from the Research Grants Councilof the Hong Kong Special Administrative Region (Project No. CUHK4288/01H) and the NeeleySummer Research Award Program at Texas Christian University. The first author acknowledges that

i ifi t ti f k l t d h h i it d H K B ti t U i it


2/32

capital market and more rigorous financial reporting and auditing regulations.

DeFond, Wong, and Li (1999) find that the quality and independence of Chinese

auditing firms have significantly improved in recent years, partly because of theimplementation of rigorous new auditing standards.

Listed Chinese firms have been required to issue interim (semi-annual)

reports since 1994. While the auditing of interim reports is not required in China

except for firms in circumstances specified by the state regulators (i.e., when

there have been two consecutive annual losses, when stock rights are offered,

and when declaring interim dividends), anecdotal evidence suggests that many

listed firms voluntarily have their interim reports audited. This phenomenon does

not exist in Western countries, where the auditing of interim reports is not

required and empirically infrequent. The unique institutional setting in China pro-

vides an opportunity for a direct empirical assessment of both the motivating fac-tors for having voluntary audits and the effect of voluntary audits on the

credibility and informativeness of the interim reports.

Prior studies postulate that one major reason for firms to hire an outside

monitoring mechanism is to help control the conflict of interests between man-

agers and stakeholders by allowing outsiders to verify the validity of financial

statements (see, among others, Jensen & Meckling [1976]; Watts & Zimmer-

man [1986]). Chow (1982) empirically analyzes U.S. firms incentives to hire

an external auditing service for their annual reports in 1926, when auditing

was not required by law. He shows that leverage, accounting-based debt cove-

nants, and firm size increase the probability that the firm voluntarily acquires

external auditing. Ettredge, Simon, Smith, and Stone (1994) and Manry, Tiras,

and Wheatley (2003) examine why some companies purchase timely reviews

of quarterly financial statements while others do not. Their findings suggest

that companies with higher agency costs are more likely to acquire timely

reviews.

Prior studies further argue that the certification of information by inde-

pendent auditors improves its credibility, and conveys the image that its quality

is high, thus increasing the value of the firm (e.g., Akerlof [1970]; Holthausen &

Verrecchia [1988]; Beaver [1998]). Teoh and Wong (1993) report that the earn-ings response coefficients of firms audited by the Big Eight are higher than those

of firms that are not audited by them, suggesting that the quality of auditing

affects the credibility of the accounting numbers reported. Blackwell, Noland,

and Winters (1998) show that auditor association leads to reduced interest rates

on revolving bank loans to private firms.

However, no empirical research has directly examined whether or not audit-

ing, especially voluntary auditing, enhances the informativeness of the earnings

report (Watts & Zimmerman [1983]; Healy & Palepu [2001]). Our study is moti-

vated by the limited amount of direct empirical research on the economic value

of auditing services (Kinney [1987]). This issue is especially important in emerg-ing markets such as China, where publicly available, firm-specific information is

scarce corporate governance systems are not very effective the enforcement of

64 JOURNAL OF ACCOUNTING, AUDITING & FINANCE


3/32

the regulation has lagged behind other countries, and earnings management is

pervasive.1 In an environment in which the quality of earnings is suspect due to

these earnings management practices, coupled with evidence of increased auditquality in recent years (DeFond, Wong, & Li [1999]), we argue that the volun-

tary auditing of interim reports is an effective means at the disposal of Chinese

managers for firms to make a public commitment that they are disclosing credi-

ble information.

In this study, we first examine the determinants of the voluntary auditing of

interim reports by listed Chinese firms. Because Chinese firms are not required

to purchase interim audit services (unless they are subject to the regulated cir-

cumstances outlined above), their demand for auditor assurance is likely to be

driven by the expected net benefits of the audit services purchased. We thus

examine the economic value of voluntary auditing by hypothesizing that volun-tary audits enhance the informativeness of interim reports. We test whether the

earnings response coefficients (ERCs) for voluntarily audited firms are greater

than those for unaudited firms.

Our sample consists of 2,458 interim reports released by listed Chinese firms

from 1996 to 1999. We find that the choice of voluntary auditing is positively

associated with the percentage of tradable shares and profitability, reflecting Chinas

unique institutional environment. We also report that larger firms, nonInitial Public

Offering (IPO) firms, and firms with only A-shares (shares available to Chinese citi-

zens) are more inclined to choose voluntary audits. For the economic value of audit

services, we find that the ERCs for voluntarily audited firms are significantly higher

than those for unaudited firms, which suggests that voluntary auditing increases the

credibility and informativeness of interim reports.

For comparative purpose, we examine the effect of mandated interim audits

and report that the ERCs of voluntarily audited firms are greater than those of

mandatorily audited firms. This suggests that investors perceive voluntary audits

to be more informative than audits required by the regulators. We should be cau-

tious of such an interpretation, however, as the effect of mandatory audits may

be attributable to the firm-specific economic circumstances underlying mandated

audits (namely, having two consecutive losses, offering rights, and making divi-dend payments). Overall, our findings suggest that, amid the prevailing concerns

over earnings management in China, the voluntary auditing of the interim report

appears to be an effective means for Chinese managers to make a commitment

to disclose accurate information. Our results are robust after controlling for audi-

tor quality, audit opinions, loss firms, and other ERC determinants.

1. The following example illustrates a typical case of earnings management in China. The par-ent company of Shanghai Video and Audio Electronics Company sold a piece of land to the listedcompany for 69.26 million yuan in June 1997. In November 1997, the listed company sold the land

back to the holding company at 219.26 million yuan. Further, the holding company agreed to buyanother subsidiary of the listed company for 94.135 million yuan on December 22, 1997, resulting ina nonoperating profit of 79.6 million yuan. This subsidiary incurred operating losses for the first nine

th (Sh h i S it N M h 25 1998)

65THE ECONOMIC CONSEQUENCE OF VOLUNTARY AUDITING


4/32

This study contributes to the literature on voluntary auditing. Our first research

question on the determinants of voluntary audits extends the prior studies of

Ettredge et al. (1994) and Manry, Tiras, and Wheatley (2003) on timely reviewsof quarterly reports by examining audited financial statements. It also extends

the research of Chow (1982) on the sample of annual audits in 1926 by examining

recent voluntary audits in an emerging market, where corporate governance systems

are less effective than in the Western hemisphere.2 Our second research question is

a direct examination of the effect of voluntary auditing on the informativeness of

accounting information, which has not hitherto been addressed in the literature. It

extends the research of Blackwell, Noland, and Winters (1998) on the value of

using an auditing service in terms of interest rates charged to private firms by

examining the market consequences of voluntarily audited reports. While theory

suggests that auditing enhances the informativeness of financial data, prior researchprovides little empirical evidence for this important matter. We provide evidence

that is consistent with managers making a commitment to quality reports and

investors having the ability to place more value on the audited numbers.

Our findings provide implications for international investors and auditors.

China is further opening its capital market to the international community as a

member of the World Trade Organization. Recently, the Chinese Securities Reg-

ulatory Commission (CSRC) granted licenses to foreign investment banks such

as Morgan Stanley, Goldman Sachs, and Citibank to participate directly in

Chinas A-share market, which up to this time has been reserved exclusively for

Chinese investors.3 Our findings suggest that international investors need to be

aware of the effectiveness of voluntary audit services and the informativeness of

audited numbers. International auditors should pay more attention to the determi-

nants of the voluntary audit demand for interim reports and the economic value

attached by investors to audited interim reports. Our results imply that auditing

has begun to play a more effective role in the Chinese market.

The remainder of the paper proceeds as follows. Section 2 provides the insti-

tutional background. Section 3 discusses the hypotheses and research design.

Section 4 describes the sample. Section 5 reports empirical findings, followed by

concluding remarks in Section 6.

2. Institutional Background

2.1 Regulatory Infrastructure in China

The Ministry of Finance promulgated a new accounting framework (the

Accounting Standard for Business Enterprises) in 1993, which marked a significant

2. Begley and Fischer (1998) suggest the need of research based on the recent period sample asthere have been significant changes in audit markets and the litigation environment because of theintensified litigation risks faced by management and auditors since the 1980s.

3 Fi i l Ti J 8 2003



5/32


6/32

mandates the auditing of interim reports of listed firms that have reported losses

in two consecutive years (called special treatment firms), will apply to offer

stock rights in the second half of the fiscal year, or will distribute interim stockor cash dividends.7

The audits of these interim reports must follow the same independent audit-

ing standards and procedures as annual reports, and the auditors reports must be

issued and attached to the interim reports and made public. The auditor has to

state whether the interim report is prepared in accordance with Chinese GAAP

and issue an opinion on it. Independent Auditing Standard No. 7 on Auditor

Opinions specifies the same conditions as those in the United States for each of

the four types of opinions: unqualified, qualified, a disclaimer, and an adverse

opinion.8 An examination of our sample indicates that auditors issue a qualified

opinion if there is evidence of a departure from GAAP, a limitation to the scopeof the audit, or a violation of the consistency principle. Explanatory paragraphs

are also attached to unqualified opinions when there is substantial doubt about

the going concern, significant related party transactions have occurred, important

events have occurred subsequent to the postbalance sheet date, and material

uncertainties are evident, such as contingencies and litigation. Appendix A illus-

trates three types of auditors reports for interim reports. In sum, the procedure

and scope for auditing the interim report is the same as those for auditing the an-

nual report at the end of the year.

While an interim audit requires as comprehensive an evaluation as a

year-end audit does, it differs from an interim review in terms of the degree of

assurance, certification, precision, and credibility. It also differs in terms of the

auditors legal obligation. A review is less comprehensive than an audit and gen-

erally does not include a detailed evaluation of the companys internal control

structure, the collection of corroborative evidence, or tests of details of account

balances and transactions. Instead, it relies mainly on limited inquires and analyt-

ical procedures. As a consequence, there is no assurance that the auditor of a

review will be aware of all the significant matters affecting interim reports that

would be uncovered by an audit. Moreover, while information about the exis-

tence, nature, and findings of an interim review is communicated to managementor the board of directors, it is seldom provided to the public.

7. In addition, when necessary, the CSRC can make case-by-case decisions on whether the in-terim report of a firm needs to be audited.

8. However, there is an exception as Chinese auditors are required to issue qualified opinions ifthe consistency principle is violated. In the United States, the lack of a consistent application of theGAAP constitutes one of the circumstances for an unqualified opinion with an explanatory paragraph

to be issued. Article 17 of the Standard also allows Chinese auditors to attach an explanatory note totheir unqualified opinion. See DeFond, Wong, and Li (1999) and Xiang (1998) for details about thedevelopment of professional auditing and reporting in China. All auditing standards and regulations

il bl t i /F iR lt



7/32

3. Hypotheses and Research Design

3.1 Why Do Chinese Firms Voluntarily Purchase Audits forTheir Interim Reports?

This section discusses why some Chinese firms are motivated to have their

interim reports voluntarily audited. Prior studies based on mature markets argue

that a firms demand for monitoring is associated with the level of its agency

costs (Jensen & Meckling [1976]; Watts & Zimmerman [1986], among others).

Companies that voluntarily purchase an interim audit choose to have an external

auditor formally certify their internal control structures and financial statements.

They contract for a higher level of outside monitoring if the benefits are

expected to exceed the incremental costs, where the benefits of interim audits

primarily result from improvement in the credibility of interim reports. We con-

sider various supply-and-demand factors, including variables specific to the Chi-

nese market, to examine the determinants of voluntary interim audits.

Unlike in the United States, listed Chinese firms have a significant portion

of nontradable shares, providing either the state or legal entities, mostly SOEs,

with controlling ownership. Recent studies report that such ownership structures

adversely affect these firms financial performance and information environment,

resulting in high information asymmetries and low levels of informativeness in

accounting earnings (e.g., Claessens, Djankov, Fan, & Lang [2002]; Fan & Wong

[2002]). As the controlling shareholders may not report high-quality accounting

information, and may even manipulate earnings (e.g., Haw, Hu, Hwang, & Wu

[2004]), they have the incentive to avoid external monitoring, which further

exacerbates the problem of low corporate transparency (Ball, Robin, & Wu

[2003]).

Under the government-controlled economy of China, managers of listed

SOE firms are frequently appointed by the government, and strive not only to

promote financial performance but also to meet nonfinancial strategic goals set

by the government (such as producing and delivering strategic products to the

state). The managers of listed firms with a heavy state and legal-entity ownership

are strongly motivated to act in the best interest of the state and legal persons,and have less incentive to maximize the firms value of tradable shares for public

shareholders. In contrast, firms with a high proportion of tradable shares are bet-

ter motivated to act in the best interest of public shareholders, and therefore they

are more likely to acquire interim audit as an outside monitoring mechanism for

their interim reports (Ball, Kothari, & Robin [2000]). In such a context, volun-

tary auditing can effectively communicate a firms commitment to report high-

quality information to investors, reducing the level of information asymmetry

between the management and shareholders of tradable shares. Thus, our first hy-

pothesis is (in alternative form) as follows:

H1: Managers of firms with a high percentage of tradable shares are more

likely to purchase voluntary interim audits



8/32

We consider profitability to be an important factor in the demand for volun-

tary audits in China as the current regulatory requirements are based on reported

earnings. For example, a rights issue is the only primary source for listed Chi-nese companies to raise additional capital after the IPO. To make a rights offer,

a listed firm must obtain approval from the CSRC. One of the main considera-

tions of the CSRC is whether the company exceeds certain minimum profitability

requirements. In January 1996, the CSRC began to require that the reported

return on equity (ROE) be greater than 10 percent in each of the most recent

three years.9 Prior studies have found that a large number of listed Chinese firms

manipulate earnings to meet such regulatory requirements for rights offerings

(Chen & Yuan [2004]; Haw, Qi, Wu, & Wu [2005]). They have provided evi-

dence that a significant portion of applicants meeting the ROE benchmark do not

receive approval from the CSRC for a rights offering because of suspect earningsmanagement. Haw et al. (2005) find that the ERCs of Chinese firms with a

greater degree of earnings manipulation are lower than those of firms with less

earnings manipulation.

In Chinas emerging market, where pervasive earnings management makes

earnings less reliable, firms with a genuinely good economic performance may

have strong incentives to have their interim reports voluntarily audited as their

good earnings are likely to be suspected of earnings management. In a market

where financial intermediaries do not act effectively and the corporate gover-

nance system is weak, voluntary external audits can credibly communicate firms

commitment to disclose accurate information to investors and regulators, separat-

ing them from firms suspected of overstating their earnings and increasing the

probability of their future rights offerings. Moreover, while a third-party audit

certifies the quality of the earnings, it is costly for firms that have manipu-

lated their earnings to mimic this quality. Thus, our second hypothesis is (in al-

ternative form) as follows:

H2: Managers of firms that report high profits are more likely to purchase

voluntary interim audits.

Our analysis includes other variables used in prior studies such as companysize (SIZE), the proportion of assets held in receivables (REC), financial leverage

(LEV), and the issuance of new securities (NEWSTOCK) (Chow [1982]; Ettredge

et al. [1994]; Manry, Tiras, & Wheatley [2003]). We do not, however, consider

the percentage of common stock owned by managers and directors in our analy-

sis. Unlike in the United States, managers and directors of listed Chinese firms

hold none or only insignificant amounts of shares in their company. We do, how-

ever, control for auditor switching, because the incremental cost of auditing is

9. On March 17, 1999, the CSRC modified the annual ROE requirement to be greater than6 percent for each of the most recent three years, and the average ROE for the three years to be

t th 10 t



9/32

greater if the company changes an audit firm (Johnson & Lys [1990]; DeFond

[1992]; Ettredge et al. [1994]).

We include three additional control variables based on the findings of priorstudies on Chinese markets. They are as follows: (1) whether firms have issued

shares that are available to foreign investors (in addition to A-shares for Chinese

investors), because their reporting and auditing environments are different

(DeFond, Wong, & Li [1999]);10 (2) whether firms are IPOs (i.e., whether they

have gone public in the last year), because Chinese IPO firms tend to manage

earnings around the IPO year, and thus have less incentive to acquire voluntary

interim audits (Aharony, Lee, & Wong [2000]); and (3) whether firms hire qual-

ity auditors, because joint venture auditors and large local Chinese auditors are

more independent and more frequently issue modified opinions (DeFond, Wong, &

Li [1999]).11 We test our hypotheses by estimating the coefficients in the followinglogit regression (with subscripts firm i and time tomitted):

where:

Voluntary audit dummy a dummy variable that equals 1 for a voluntary in-

terim audit, and 0 for an unaudited interim report.

ROE net income divided by stockholders equity.TRADESHR the percentage of tradable shares.

SIZE the natural logarithm of the sum of market value of

equity and book value of short-term and long-term

debt (Chow [1982]).

REC receivables divided by total assets.

LEV long-term debt divided by total assets.

NEWSTOCK the proceeds received from new equity security issu-

ance scaled by total assets (mainly attributable to

previous rights offerings).

IPO dummy a dummy variable that equals 1 for an IPO during

the last year, and 0 otherwise.

10. Listed firms with shares available to foreign investors have to prepare financial statementsunder international accounting standards. Shares available to overseas investors include B-shareslisted on the Shanghai and Shenzhen Stock Exchanges, H-shares listed on the Hong Kong StockExchange, and shares listed on other foreign stock exchanges. From 2001, B-shares are allowed fortrading among domestic investors.

11. DeFond, Wong, and Li (1999) report that the frequency of modified opinions (the surrogate

for independence) has increased ninefold subsequent to the adoption of the new auditing standards in1996. They also report a large decline in market share by the independent auditors, interpreting thedecline as flight from quality in the Chinese audit market, consistent with the argument that Chi-

id dit th t lik l t i difi d dit i i



10/32

Foreign share dummy a dummy variable that equals 1 for firms that have

issued shares available to foreign investors, and 0

for firms with only A-shares.Quality auditor dummy a dummy variable that equals 1 if a firms auditor is

among the top-five local Chinese auditors or joint ven-

tures affiliated to international auditors, and 0 otherwise.

Auditor switch dummy a dummy variable that equals 1 if a firm switches its

auditor during the year before the interim audit, and

0 otherwise.

All continuous variables are measured based on the current interim period and

defined similarly as prior studies. Hypothesis 1 predicts that b2 will be positive,

and Hypothesis 2 predicts that b1 will be positive. Prior research predicts that b3,b5, and b6 will be positive, and b4 will be negative.

3.2 Impact of Auditing on the Informativeness of Interim Earnings

This section develops the hypothesis and research design to test whether

auditing, especially voluntary auditing, enhances the quality of interim earnings.

Theoretically, investors responses to an earnings surprise are related to the per-

ceived precision of the earnings report. Prior studies suggest that the ERCs vary

with the quality of the earnings (e.g., Holthausen & Verrecchia [1988]). Auditors

certify that financial statements have been prepared in conformance with theGAAP, which assures investors of their reliability. Because audited earnings are

perceived to be more credible than nonaudited earnings and hence to reflect true

economic value accurately, we expect them to have a greater effect on investors

valuation of the firm, thus implying a higher ERC.

As voluntary interim auditing is a costly but deliberate choice by managers,

they can be expected to exercise discretion by comparing the costs of the auditing

services with the anticipated increase in the value of the firm arising from inves-

tors perceptions of the enhanced quality of an audited report. Consistent with the

argument that certification can improve the credibility of information and com-

municate the high quality of the securities, we posit that voluntary auditing lends

credibility to interim earnings, and affects investors perception of their quality,

and therefore increases the magnitude of investors responses to a given earnings

surprise (e.g., Beaver [1998]; Holthausen & Verrecchia [1988]). Teoh and Wong

(1993) report that the ERC is higher for earnings audited by audit firms perceived

to be of higher quality. Whereas these studies examine the effect of high-quality

auditors vs. low-quality auditors on the ERCs, our study directly compares the

informativeness of audited reports with that of unaudited numbers. However, both

studies focus on the credibility of reported accounting numbers. Given pervasive

earnings management practices in China, we predict that voluntary auditing com-

municates the commitment of management to report accurate financial data to

investors. Thus, our third hypothesis is (in alternative form) as follows:



11/32

H3: Firms that have interim reports voluntarily audited have higher ERCs

than firms that have unaudited interim reports.

Because the earnings announcement date is the first date that the earnings

(as well as audit information) are publicly available, we develop the following

cross-sectional regression model with the three-day window surrounding the

announcement date (with subscripts firm i and time t omitted):12

where:

CAR market-adjusted abnormal returns accumulated over

the three trading days (1, 0, 1), where 0 is the in-

terim earnings announcement date, adjusted for divi-

dends and stock rights.

DE unexpected semi-annual earnings, defined as the dif-

ference between reported earnings in the first half

of years t and t 1, deflated by market value at thebeginning of the three-day event window in year t.

Voluntary audit dummy a dummy variable that equals 1 if the interim report

is voluntarily audited, and 0 otherwise.

Mandatory audit

dummy

a dummy variable that equals 1 if the interim report

is mandatorily audited, and 0 otherwise.

Modified opinion

dummy

a dummy variable that equals 0 if the audit opinion

is clean, and 1 otherwise.13

Firm size dummy a dummy variable that equals 1 if the market value of

the firm at the end of June of year t is above the sam-

ple median, and 0 otherwise.

Market-to-book dummy a dummy variable that equals 1 if the market value

of the common equity divided by the book value of

common equity at the end of June of year t is above

the sample median, and 0 otherwise.

12. The Chinese regulations do not allow listed firms to release preliminary earnings to thepublic before filing financial reports to the CSRC and the stock exchanges. While filing reports tothe stock exchanges and the CSRC precedes the public announcement, the latter is the first time thatearnings (as well as audit opinions) are made available to the public.

13. Auditors in China can emphasize events such as significant uncertainties, contingencies,and related party transactions in the explanatory note attached to unqualified opinions. Because thenote usually carries a negative view from the auditor, we group audit opinions other than clean opin-i difi d i i (D F d W & Li [1999] H P k Qi & W [2003])



12/32

Beta dummy a dummy variable that equals 1 if the market beta

of the firm at the end of June of year t is above the

sample median and 0 otherwise.Quality auditor dummy a dummy variable that equals 1 if a firms auditor is

among the top-five local Chinese auditors or joint

ventures affiliated to international auditors, and 0

otherwise.

Loss dummy a dummy variable that equals 1 if the semi-annual

earnings is negative, and 0 otherwise.

e error term.

Since earnings forecasts for listed Chinese A-share firms are not available,

we use the seasonal random walk model as a proxy for the market expectation ofinterim earnings prior to the announcement. In the model, b1 is the ERC for

unaudited earnings and is expected to be positive. Our primary interest is in b2,

the coefficient on the interaction between earnings news and a voluntary audit. If

it is positive and significant, the ERC of voluntary audits will be greater than

that of unaudited reports, implying that the voluntary audits enhance the credibil-

ity of the interim reports.

We include the effect of mandatory auditing in eq. (2) for comparison. In

contrast to voluntary audits, whether mandatory interim audits enhance the credi-

bility of interim reports may depend on the firm-specific economic circumstances

underlying mandated audits. While auditing in general enhances the quality of in-terim earnings, the enhanced effect for mandated audits may be offset by inves-

tors perceptions that these firms have stronger ex ante incentives for earnings

manipulation, especially in the case of special treatment firms (those that report

two consecutive annual losses and thus face the risk of being delisted), because

they have strong incentives to manage their earnings upward. A significantly

positive b3 would suggest that the ERC of mandated audits is greater than that

of unaudited reports. Although we do not make directional predictions on

whether the ERCs are different between voluntarily and mandatorily audited

firms, we will provide empirical results for comparative purpose.

Our model includes other standard ERC determinants. Previous studies

report that the ERC differs systematically in size, growth, risk, and earnings per-

sistence (e.g., Holthausen & Verrecchia [1988]; Collins & Kothari [1989]; Easton

& Zmijewski [1989]). We control for firm-specific characteristics, such as firm

size, growth, risk, auditor quality, and loss by including their interaction vari-

ables. We measure the first three control variables following Teoh and Wong

(1993) and DeFond and Park (2001).14 To control for the effect of modified

14. Earnings persistence is not included as a control variable because the time series of interim

earnings is too short for listed Chinese firms. Collins and Kothari (1989) suggest that the book-to-market ratio is affected by both growth opportunities and persistence, and thus provides a normaliza-tion for persistence as well. Also not included is the number of analysts because of the unavailability

f th d t i Chi W i di t t l i bl f ll i D F d d P k (2001)



13/32


14/32

least one listed client increases slightly from 85 in 1996 to 88 in 1999, the num-

ber of public clients rises from 568 to 943, reflecting the substantial growth of

the Chinese stock market during this period. Government-affiliated auditors dom-

inate the market during our sample period, consisting of 85 percent of the audit-

ing firms and accounting for 82 percent of the clients.16 The top-ten local

Chinese auditors (ranked according to the number of listed firms audited) are

mostly government affiliated, and collectively account for about one-third of the

auditing market for listed firms. Appendix B reports both the identity and rank-

ing of joint ventures and the top-ten 10 local Chinese auditors, showing that the

identity of the top-five Chinese auditors is relatively stable during our sample pe-

riod. Table 2, Panel B, classifies the interim audits in our sample based on the

audit type, auditor affiliation, auditor size, and auditor opinion. Consistent with

the findings of DeFond, Wong, and Li (1999) for annual audits, joint venture

TABLE 1

Attributes of Sample Firms: Auditing Status, Audit Type, Auditor Opinion,and Reasons for Mandated Audits

Full 1996 1997 1998 1999

No. % No. % No. % No. % No. %

Auditing status:

Unaudited 1,782 72.5 284 86.4 407 72.3 513 70.0 578 69.4

Audited 676 27.5 45 13.7 156 27.7 220 30.0 255 30.6

No. of obs. 2,458 100.0 329 100.0 563 100.0 733 100.0 833 100.0

Type of audit:

Voluntary 161 23.8 18 40.0 38 24.4 56 25.5 49 19.2

Mandatory 515 76.2 27 60.0 118 75.6 164 74.5 206 80.8No. of audits 676 100.0 45 100.0 156 100.0 220 100.0 255 100.0

Auditor opinion:

Unqualified 600 89.1 44 97.8 152 97.4 193 87.7 211 82.7

Modified 76 10.9 1 2.2 4 2.6 27 12.3 44 17.3

No. of opinions 676 100.0 45 100.0 156 100.0 220 100.0 255 100.0

Reasons for

mandated audit:

Dividend 97 18.8 2 7.4 18 15.2 41 25.1 36 17.0

ST 97 18.8 0 0.0 12 10.2 26 15.8 59 29.0

Rights Offer 321 62.4 25 92.6 88 74.6 97 59.1 111 54.0

No. of mandated 515 100.0 27 100.0 118 100.0 164 100.0 206 100.0

Note: Modified opinions include opinions other than clean opinions, such as qualified, adverse, dis-

claimer, or unqualified opinion with an explanatory note. In China, auditors frequently emphasize events

such as significant uncertainty, contingency, and related party transactions in the note, which usually reflects

a negative view from the auditor.

ST are special treatment firms due to reported losses in two consecutive years.

16. All university- and government-affiliated CPA firms became independent legal entities byth d f 1998 (S iti Ti J 5 1999)



15/32

TABLE2

Descr

iptive

Info

rma

tion

on

Au

dit

or

Affiliation

,A

ud

itor

Siz

e,

Num

bero

fCli

en

ts,

an

dA

udit

or

Op

inio

n

PanelA

:Distributionofauditorsandannua

lauditsfortheentireChineselisted

firmsbyauditoraffiliation,

auditorsize,

andyear

Numberofauditfirmsbyyear

Numberoflistedclientsbyyear

1996

1997

1998

1999

1996

1997

1998

1999

All

aud

itors

Jointventureauditors

7

7

7

7

36

39

50

59

Localauditors:University

6

6

6

6

78

87

101

1

06

Govern

ment

72

74

74

75

454

607

703

7

78

Total

85

87

87

88

568

733

854

9

43

Loca

lau

dit

ors

Topten:University

2

2

2

2

53

56

63

64

Govern

ment

8

8

8

8

156

179

203

2

32

Nonto

pten:University

4

4

4

4

25

31

38

42

Govern

ment

64

66

66

67

298

428

500

5

46

PanelB

:Distribution(%)ofauditedinterim

auditsinoursamplebyauditoraf

filiation,

auditorsize,

audittype,an

dauditoropinion

Auditor

affiliationandauditorsize

Numberofauditsb

yaudittype

Numberofauditsbyauditoropinion

Voluntary(%)

Mandatory(%)

Unqualified(%)

Modified(%

)

Affiliati

on

Jointventure

5(1%)

19(3%)

17(3%)

7(1%)

University

22(3%)

54(8%)

6

2(9%)

14(2%)

Govern

ment

134(20%)

442(65%)

521(77%)

55(8%)

Total

161(24%)

515(76%)

600(89%)

76(11%)

Top

ten

loca

lau

dit

ors

Topten

47(7%)

137(21%)

171(26%)

13(2%)

Nonto

pten

109(17%)

359(55%)

412(63%)

56(9%)

Total

156(24%)

496(76%)

583(89%)

69(11%)


16/32

and university-affiliated auditors issue more modified opinions in 29 percent and

18 percent of their respective total interim audits, which is significantly higher

than the 9.6 percent (55 divided by a sum of 521 and 55) of government-affili-ated auditors.17 The type of auditing undertaken (voluntary vs. mandatory) is not

significantly related to the type of auditor affiliation or auditor size.

5. Empirical Results

5.1 Reasons Why Chinese Firms Voluntarily Purchase Audits for

Their Interim Reports

This section provides descriptive statistics and results from the logit regression

to identify motivating factors for voluntary interim auditing in eq. (1). We excludemandatorily audited firms because they are mandated by regulations, not voluntar-

ily initiated by managers. Table 3, Panel A, reports that on average, companies

purchasing voluntary audits are significantly larger in size (SIZE) and more profita-

ble (ROE) than unaudited companies. The percentage of tradable shares

(TRADESHR) and the proportion of assets tied up in receivables (REC) do not dif-

fer significantly between the two subsamples. The long-term debt divided by total

assets (LEV) and the proceeds from new equity issues (NEWSTOCK) are not signif-

icantly different between the two groups. Among the control variables, the propor-

tion of IPO firms is significantly lower for the audited firms, consistent with the

argument that IPO firms may have engaged more frequently in earnings manage-

ment (Aharony, Lee, & Wong [2000]) and thus may have less incentive to acquire

a voluntary audit. On the other hand, the proportions of firms that have issued

shares available to foreign investors, used quality auditors, and switched auditors

are not different between the two subgroups. Spearman correlations (not reported)

for the explanatory variables indicate that the correlations are generally moderate.

Table 3, Panel B, reports the coefficients and test statistics from the logistic

regression in eq. (1). The Chi-square statistic indicates that the logistic model is

highly significant, suggesting that it has a good overall explanatory power. The

likelihood of acquiring an interim audit is significantly associated with the per-centage of tradable shares (TRADESHR), profitability (ROE), and firm size

(SIZE). Unlike the univariate statistics in Panel A, the coefficient for the propor-

tion of tradable shares, b2, is positive and significant at the 5 percent level. The

result is consistent with Hypothesis 1. The coefficient for SIZE, b3, is positive

and significant at the 1 percent level, consistent with prior studies performed in

17. However, auditor size (the top ten or top five) is not significantly related to the type of theauditor opinions on interim reports issued by local Chinese auditors in our sample. While this differsfrom the results reported by DeFond, Wong, and Li (1999) for annual audits, our result is not directly

comparable because we use only a subset of the interim reports that are audited and none of our vol-untarily audited firms receives a modified opinion. Furthermore, DeFond, Wong, and Li (1999) rankChinese auditors based on the value of firms they audit, while we rank them based on the number ofli t d fi th dit



17/32

TABLE3

MotivatingFactorsforV

oluntaryInterim

Audits

PanelA:Univariatestatisticsforlogisticregressionvariables

Unaudited

(N

1,7

82)

Voluntaryaudit(N

161)

t-(Z-)

teststa

tisticsa

Firm

siz

eMean

3,483.9

4,640

.10

10.6

8***

million

yuan)Median

2,336.1

3,250

.8

3.7

8***

ROEMean

0.0

39

0

.069

44.3

3***

Median

0.0

38

0

.062

10.6

8***

TRADES

HRMean

0.3

46

0

.352

0.3

5

Median

0.3

19

0

.332

1.1

8

RECMe

an

0.0

82

0

.097

1.4

3

Median

0.0

36

0

.055

1.2

9

LEVMe

an

0.0

59

0

.054

0.4

6

Median

0.0

28

0

.022

0.8

3

NEWSTO

CKMean

0.0

06

0

.006

0.0

6

Median

0.0

00

0

.000

0.4

2

%

ofIPOfirms

32.3

0%

25

.00%

2.0

3**

%

offirmswithsharesavailabletoforeigninvestors

15.4

5%

11

.25%

1.5

9

%

offirmswithqualityauditors

25.6

5%

24

.38%

0.3

6

%

offirmswithauditorswitches

5.3

0%

3

.13%

1.4

7


18/32

TABLE

3(continued)

PanelB:Parameterestimatesfromlogisticregressionanalysis

Voluntar

yauditdummy

a

b1

ROEb

2

TRADESHR

b3

SIZE

b4

REC

b5

LEV

b6

NEWSTOCKg

1

IPO

dummy

g2

Foreignsharedummy

g3

Qualityauditordummy

g4

Auditorswitchdu

mmy

e

(1)

Intercept

ROE

TRADESHR

SIZE

REC

LEV

NEW-

STOCK

IPOdummy

Foreign

share

dummy

Quality

auditor

dummy

Auditor

switch

dummy

Chi-

Square

a

b1

b2

b3

b4

b5

b6

g1

g2

g3

g4

Predictio

ns

?

?

?

?

Coefficient

-statistics

10.9

81

9.337

1.288

0.367

0.3

69

0.3

48

5.4

07

0.527

0.587

0.111

0.639

66.9

7***

(4.05)***

(5.8

0)***

(1.9

1)**

(2.9

9)***

(0.5

3)

(0.3

2)

(1.3

7)

(2.5

6)**

(1.9

5)*

(0.5

4)

(1.3

2)

aTh

et-(WilcoxonZ-)testexamineswhethermeanandproportion(median)ofeachvariableforunauditedfirmsequalsthatofvoluntarilyaudited

irms.

?indicatesnopredictedsign.

*,**,and***suggeststatisticalsignificancelevelsatthe10percent,the5percent,andthe1percentlevels,one-tailedforpredictedsignsinPanelB,and

two-tailedin

PanelA,

respectively.N

1,933.

Note:Thevariablesaredefinedasfollow

s:

Voluntar

yauditdummy

adummyvariablethatequals1foravoluntaryinterimaudit,and0foranunauditedinterimreport.

ROE

netincomediv

idedbystockholdersequity.

TRADESHR

thepercentage

oftradableshares.

SIZE

thenaturallogarithmoffirmsize,whichisdefinedasthesumofmarketvalueofequityandbookvalueofshort-andlo

ng-

termdebt.

REC

receivablesdeflatedbytotalassets.

LEV

long-termdebtdividedbytotalassets.

NEWSTOCK

theproceedsreceivedfromnewequitysecurityissuancescaledbytotalassets.

IPOdummy

adummyvariablethatequals1foranIPOduring

thelastyear,and0otherwise.

Foreignsharedummy

adummyvariablethatequals1forfirmsthathaveissuedsharesavailabletoforeign

investors,and0otherwise.

Quality

auditordummy

adummyvariablethatequals1ifafirmsauditor

isamongthetop-fivelocalChineseauditorsorjointventuresaffiliatedto

internationalauditors,and0otherwise.

Auditor

switchdummy

adummyvariablethatequals1ifafirmswitches

itsauditorduringtheyearbeforetheinterimaudit,and0otherwise.


19/32

the United States (Chow [1982]; Ettredge et al. [1994]; Manry, Tiras, & Wheat-

ley [2003]). The coefficient for ROE, b1, is positively significant at the 1 percent

level, supporting Hypothesis 2 that the more profitable the firm, the more likelyit is to have its interim reports voluntarily audited. Similar to the findings of

Manry, Tiras, and Wheatley (2003), the coefficients for receivables (REC) and

leverage (LEV) are not significant at the conventional level, and neither is that of

the issuance of new equity shares (NEWSTOCK).18

Among the control variables, the coefficient on the IPO dummy is negative

and significant at the 5 percent level. The fact that IPO firms are less likely to

have their interim reports voluntarily audited is consistent with Aharony, Lee,

and Wong (2000), who find evidence that IPO firms manage earnings in the pe-

riod surrounding the IPO year. The coefficient for the firms with shares available

to foreign investors (Foreign share dummy) is also negative and significant atthe 10 percent level, suggesting that such firms are less likely to purchase an in-

terim audit voluntarily. One plausible explanation is that the annual financial

statements of these firms are audited by the Big Five international firms and are

therefore already perceived as credible by investors, diminishing the need for the

voluntary auditing of their interim reports. The coefficients on the auditor switch

dummy and the quality auditor dummy are not significant.19

In summary, consistent with our hypotheses, the results indicate that the vol-

untary audit choice of interim reports is positively associated with the proportion

of tradable shares and profitability, reflecting Chinas unique institutional envi-

ronment. We also find that larger firms, non-IPO firms, and firms with only A-

shares are more likely to acquire an interim audit.

5.2 Market Perception of the Quality of Audited Interim Reports

Table 4, Panel A, reports the descriptive statistics for selected market and fi-

nancial variables for the full sample. As shown in the top rows, the mean interim

earnings and market capitalization are 29.4 and 2,576.9 million yuan respec-

tively, and the mean (median) interim earnings change (DE) is 0.005 (0.00).

The yearly statistics in the middle rows indicate that the average market value of

18. Ettredge, Simon, Smith, and Stone (1994) show that the purchase of a timely review ispositively associated with company size, the issuance of new securities, and financial leverage, andnegatively associated with the percentage of common stock owned by managers and directors, andthe proportion of assets held in receivables (used as a proxy for the incremental cost). Manry, Tiras,and Wheatley (2003) find that only firm size and ownership variables are statistically significant aspredicted. Our results reflect Chinas unique market and regulatory environment in which long-termdebt is not a significant source of long-term financing for listed firms. For example, the averageyear-to-year changes of long-term debt are only 0.37 percent for the voluntarily audited firms and0.15 percent for the unaudited firms, respectively, and are not significantly different. Almost none ofthe listed Chinese firms issues corporate bonds because the preference for bond issuance is given tononlisted SOEs on the ground that listed firms are able to raise funds from shareholders through

rights issues. Long-term borrowing from banks is also infrequent.19. Results are similar when we include as quality auditors the sixth- to tenth-largest local Chi-nese auditors or use only joint ventures affiliated with international auditors, or when we measure

dit i b th i li t t t l t



20/32


21/32

listed firms has nearly doubled from 1996 (1,777 million yuan) to 1999 (3,263

million yuan). The bottom rows do not show significant differences in market or

financial performance measures between firms listed on the Shanghai and Shenz-hen Stock Exchanges.

Table 4, Panel B, provides descriptive statistics for selected variables by

their auditing status and the reasons for having mandatory audits. The top rows

suggest that voluntarily audited firms have significantly higher earnings and mar-

ket capitalization than unaudited firms, and perform better in DE and three-day

abnormal returns. Firms with voluntary audits are also larger in size and experi-

ence better earnings and market performance than firms with mandatory audits.

The bottom rows indicate that, among firms with mandatory audits, those plan-

ning to distribute dividends perform better in DE and market returns than the

special treatment firms and rights-offering firms.

5.2.1 Regression Results of Eq. (2)

Table 5, Panel A, provides descriptive statistics for the first three control

variables used in eq. (2). F-tests indicate that they vary with the status of the

audits undertaken, and the voluntarily audited firms are larger in size and have a

higher growth potential (in median) than the unaudited firms. This indicates the

need for their inclusion as control variables.

We first run the simple return-earnings regression testing the value relevance

of interim earnings (not tabulated). The earnings response coefficient for interimearnings is positive and statistically significant at the 1 percent confidence level

(with an adjusted R2 of 0.014). The result is consistent with those of prior studies

in mature markets, and with those reporting that investors respond significantly

to the announcement of annual earnings in the Chinese market.

Table 5, Panel B, reports the regression results for eq. (2). The adjusted R2

is 0.028, consistent with the magnitude reported by most previous short-window

studies. The coefficient for unaudited earnings (b1) is 0.465, significant at the

1 percent level. More important, the ERCs are higher for the audited firms than

for the unaudited firms, as evidenced by the positive coefficients for the interac-

tion terms between the voluntary and mandatory audit dummies and earningsnews. The coefficient for voluntary audits (b2) is 1.196, significant at the 1 per-

cent level. The coefficient for mandatory audits (b3) is 0.450, significant at the

5 percent level. The results suggest that auditing enhances the credibility and

informativeness of interim earnings. Among the control variables, the coefficients

for the interaction terms with modified auditor opinions, firm size, and loss firms

are statistically significant at conventional levels.20

20. Following Basu (1997) and DeFond and Park (2001), we also control for good and badnews effects by partitioning earnings surprises into positive and negative items and interacting them

with variables of interest. The regression results (not tabulated) show that the ERCs are asymmetricbetween good news and bad news. The coefficient of the interaction term between voluntary (manda-tory) audit and good earnings news is 1.805 (0.485), significant at the 1 percent (10%) level, consis-t t ith th lt t d i T bl 5 P l B



22/32

TABLE5

RegressionofThre

e-DayMarket-AdjustedRe

turnsonEarningsChangesandAuditStatus

PanelA:

Univariatestatisticsforcontrolvariablesa

Unaudited

Voluntaryaudit

Mandatory

audit

Mean

Median

Mean

Median

Mean

Median

F-s

tatistics

w2-s

tatistics

Marketv

alue

3600.8

2443.6

4639.8

3250.6

3490.0

2645.4

5.5

8***

17.5

9***

Book/marketratio

0.17

0

0.1

98

0.1

86

0.1

72

0.2

15

0.1

59

80.6

1***

41.4

9***

Beta

0.93

9

0.9

60

0.9

77

0.9

50

0.9

71

0.9

39

2.9

7*

4.4

6*

PanelB:

Regressionanalysisb

CAR

a

b1

DE

b2

(Voluntaryauditdummy

DE)

b3

(Mandatoryauditdummy

DE)

g1

(ModifiedopiniondummyD

E)

g2

(Firmsizedummy

DE)

g3

(Market-to-bookdummy

DE)

g4

(Betadummy

DE)

g5

(Qualityauditordummy

DE)

g6

(Lossdummy

DE)

e

(2)

Auditstatusandearningssurprise

Controlvariables

Voluntary

auditdummy

Mandatory

auditdummy

Mo

dified

op

inion

du

mmy

Firmsize

dummy

Market-to-

bookdummy

Betadummy

Quality

auditor

dummy

Lossdummy

Intercept

DE

DE

DE

DE

DE

DE

DE

DE

DE

a

b1

b2

b3

g1

g2

g3

g4

g5

g6

Predictio

ns

?

?

Coefficient

0.0

04

0.4

65

1.1

96

0.4

50

0

.415

0.2

22

0.0

91

0.0

75

0.1

49

0.3

53

-statistics

(3.2

7)***

(4.5

2)***

(3.5

2)***

(2.2

9)**

(

1.9

5)*

(2.0

9)**

(1.4

5)

(1.2

9)

(0.6

5)

(3.5

4)***


23/32

PanelC:Statisticaldifferencebetweencoefficientsforvoluntaryauditandmandatoryaudit

F-statistictotestb2

=b3:3.7

8**

*,**,and***indicatestatisticalsignificancelevelsatthe10percent,the5p

ercent,and1percentlevels,respectiv

ely,one-tailedforpredictedsignsin

PanelB,

othersar

etwo-tailed,respectively.

N

2,4

58.

?indicatesnopredictionfordirection.

aThevariablesaredefinedasfollows:

Marketv

alueisthemarketvalueofcommone

quityatthedateofinterimearningsannouncementinmillionyuan.

Book/ma

rketratioisthebookvalueofcommo

nequitydividedbythemarketvalueofcommonequityattheendofJuneofyeart.

BetaisthemarketbetaofthefirmattheendofJuneofyeart.

bTheadjustedR2

is2.8

0percent.Thevariablesintheregressionaredefinedas

follows:

CAR

market-adjusted

abnormalreturnsaccumulatedoverthethreetradingdays(1,

0,1),where0istheinterim

earnings

announcementdate,adjustedfordividendsandstoc

krights.

DE

unexpectedsem

i-annualearnings,definedasthedifferencebetweenreportedearningsinthefirsthalvesofyearstandt

1,

deflatedbythe

marketvalueatthebeginningofthethree-dayeventwindow

inyeart.

Voluntar

yauditdummy

adummyvariablethatequals1iftheinterim

reportisvoluntarilyaudited,and0other

wise.

M

andatoryaudit

dummy

adummyvariablethatequals1iftheinterim

reportismandatorilyaudited,and0othe

rwise.

Modifiedopinion

dummy

adummyvariablethatequals0iftheauditopinion

isclean,and1otherwise.

Firmsizedummy

1ifthemarket

valueofthefirm

attheendofJune

ofyeartisabovethesamplemedian,and0otherwise.

Market-to-bookdummy

1ifthemarket

valueofthecommonequitydividedbythebookvalueofcommonequ

ityattheendofJuneofyeartisabove

thesamplemed

ian,and0otherwise.

Betadummy

1ifthemarket

betaofthefirm

attheendofJuneofyeartisabovethesamplemedia

n,and0otherwise.

Qualityauditordummy

adummyvariablethatequals1ifafirmsauditorisamongthetop-f

ivelocalChinese

auditorsorjointventuresaffiliated

to

internationalauditors,and0otherwise.

Lossdummy

1ifthesemi-an

nualearningsisnegative,and0oth

erwise.


24/32

Table 5, Panel C, tests the difference in market reaction to voluntary and

mandatory audits. The F statistic is 3.78 and significant at the 5 percent level,

indicating that the coefficient for voluntary audits (b2) is greater than that formandatory audits (b3). This suggests that investors perceive that voluntary audits

are more credible than mandatory audits in our interim sample. However, we

should be cautious of this interpretation, as the effect of mandatory audits might

merely reflect their unique economic circumstances (such as two consecutive

losses and rights offering). In sum, audits enhance the credibility of interim earn-

ings, and voluntary audits in particular convey a strong management commitment

to disclose accurate and reliable earnings reports to investors. Our finding also

provides insights in the quality of auditing in China (DeFond, Wong, and Li

[1999]).21

5.2.2 Regression Results for Specific Reasons of Mandatory Audits

This section examines whether investors respond differently to the release

of interim reports that are mandated for audit because of their economic circum-

stances, as specified by the CSRC (namely, special treatment due to two consec-

utive annual losses, applying for offering stock rights, or distributing interim

stock or cash dividends). As each of these reasons underlying mandated audits

may convey different information on the quality of a firms earnings and future

cash flows, we further partition mandated audits into three subgroups and allowseparate coefficients in regression. The interim dividend dummy equals 1 if divi-

dend distribution is the reason for a mandated audit, and 0 otherwise. Special

treatment and rights-offer dummies are defined analogously. We make no direc-

tional predictions for the coefficients on the interactions between these dummies

and earnings as their ERCs will depend on the trade-off between the enhanced

credibility resulting from audits and the ex ante perception by investors of their

earnings quality related to specific economic circumstances.

The regression results shown in Table 6 remain consistent with Hypothesis

3. The coefficient for the voluntary audit dummy, b2, remains positive and signif-

icant at the 1 percent level. Among mandated audits, only the ERC for rightsoffer dummy is significantly positive at the 10 percent level, and others are not

significant at conventional levels.

21. Teets and Wasley (1996) argue that cross-sectional ERCs based on pooling observationsacross firms and over time are likely to be biased because the cross-sectional model assumes theequality of the coefficient and equal variance of unexpected earnings across firms. They point out

that the bias depends on the cross-firm variability of earnings and the ERC in the sample. While wecontrol for firm-specific factors such as growth, size, and risk, it is possible that the ERCs of oursample are downward biased. Because the history of listed Chinese firms is relatively short, however,

t bl t l t th t ti l ff t f thi bi lt



25/32

TAB

LE6

Regr

essionofThree-DayMarket-AdjustedReturnsonEar

ningsChanges,AuditStatu

s,andMandatedAuditRe

asonsa

C

AR

a

b1

DE

b2

(Voluntaryauditdummy

DE)

b3

(Interimdividenddummy

DE)

b4

(Specialtreatmentdummy

DE)

b5

(Rightsofferdummy

DE)

g1

(Modifiedopiniondummy

DE)

g2

(Firmsizedummy

DE)

g3

(Market-to-bookdummy

DE)

(3)

g4

(Betadummy

DE)

g5

(Qualityauditordummy

DE)

g6

(Lossdummy

DE)

e

Specificmandatedau

ditsandearningssurprises

Contro

lvariables

Voluntary

audit

dummy

Interim

dividend

dummy

Special

treatment

dummy

Rights

offer

dummy

Modified

opinion

dummy

Firmsize

dummy

Market-

to-book

dummy

Beta

dummy

Quality

auditor

dummy

Loss

dummy

Intercept

DE

DE

DE

DE

DE

DE

DE

DE

DE

DE

DE

a

b1

b2

b3

b4

b5

g1

g2

g3

g4

g5

g6

edictions

?

?

?

?

efficien

t

0.0

04

0.4

65

1.1

96

0.3

53

0.4

72

0.4

72

0

.436

0.2

22

0

.090

0.0

75

0.1

45

0

.353

tatistics

(3

.27)***

(4.5

2)***

(3.5

2)**

*

(0.8

3)

(1.4

2)

(1.7

8)*

(1

.29)

(2.0

7)**

(1

.45)

(1.2

9)

(0.6

3)

(3

.54)**

*

*,

**,

and***indicatestatisticalsignifican

celevelsat10percent,5percent,and

1percent,one-t

ailedforpredictedsig

ns,othersaretwo-t

ailed

,respectively.

2,4

58

.ThevariablesintheregressionaredefinedasthoseofTable5

,exceptforthefollow

ing:

terimdividenddummy

1ifdividenddistributionisthereasonformandated

au

dit

,and0otherwise.

ecialtre

atmentdummy

1ifspecialtreatment(twoconsecutiveannuallosses)isthereasonformandatedau

dit,

and0otherwise.

Rightsofferdummy

1ifrightsofferingisthereasonformandatedau

dit,

and0otherwise.


26/32

5.2.3 Sensitivity Analyses

Our hypotheses are still supported even after the following sensitivity analy-

ses. (1) We add intercept dummies for voluntary and mandatory audits to regres-

sion eq. (2). (2) We rerun the regression by adding year dummies. (3) We rerun

the regression, after excluding A-share firms that have also issued shares that are

available to overseas investors. (4) We delete loss firm-years from the sample,

because the ERC of loss firms is lower than that of profitable firms (Hayn

[1995]). (5) To reduce the undue influence of outliers, we winsorize (and alterna-

tively drop) each of continuous variables used in this study at the first and

ninety-ninth percentile. We also replicate the regression by partitioning our sam-

ple into the more recent two-year period (199899) and the earlier two-year pe-

riod (199697) because of the rapid changes in auditing and the marketenvironment in China. We find that our results are stronger in the more recent

period than in the earlier one. This implies that the credibility-enhancing effect

of auditing has become stronger over time, as the CSRC has tightened up finan-

cial reporting and auditing regulations.

6. Conclusion

Theory suggests that auditing enhances the credibility of financial data, but

prior research provides little empirical evidence on whether voluntary auditingincreases the economic value of the accounting numbers. In this paper, we use

the unique institutional setting provided by the Chinese stock market to investi-

gate why some listed firms voluntarily have their financial reports audited, and

whether voluntary auditing enhances their credibility. Our first research question

adds onto the prior studies of Chow (1982), Ettredge et al. (1994), and Manry,

Tiras, and Wheatley (2003). Our second research question is a direct examination

of the economic value of voluntary auditing for the informativeness of account-

ing information, which has not been addressed in the existing literature. Thus,

our study contributes to the literature on voluntary auditing.

Based on 2,458 interim reports from 1996 to 1999, we find that the choiceof voluntary auditing is positively associated with the percentage of tradable

shares, profitability, and company size. We also show that the ERCs of voluntar-

ily audited firms are greater than those of unaudited firms, suggesting that volun-

tary auditing enhances the credibility and informativeness of interim earnings.

They are also greater than the ERCs of mandated audits. However, we should be

cautious of this interpretation as the ERCs of mandated audits depend on firm-

specific economic circumstances, such as reporting two consecutive annual losses

and applying for stock rights issues. Our main results are robust even after

controlling for auditor quality, auditor opinions, loss firms, and other ERC

determinants.



27/32

Overall, our results are consistent with theoretical propositions that managers

voluntarily acquire auditing services to enhance the credibility of accounting

numbers (e.g., Akerlof [1970]; Beaver [1998]) and that certified informationreduces information risk when investors assess the future cash flows of firms

(e.g., Collins & Kothari [1989]). Given the prevalence of earnings management

in China, the voluntary purchase of auditing service has become an effective

means for listed firms to communicate credibly the higher quality of their interim

earnings. This differentiates them from firms that might have manipulated earn-

ings, hence enhancing the informativeness of their earnings.

The empirical regularities shown in this study provide useful insights to for-

eign investors and international auditors. As a member of the World Trade Orga-

nization, China is attracting more and more direct and financial investment from

the international community. Chinese regulators recently granted licenses toselected foreign investment banks to participate directly in Chinas A-share mar-

ket, which had hitherto been reserved exclusively for Chinese investors. Our

findings suggest that the users of financial statements of listed Chinese firms

should be aware of the managerial incentives in acquiring voluntary interim

audits and the informativeness of audited interim reports. International auditors

need to pay more attention to the determinants of the audit demand for interim

reports and the economic value attached by investors to the audited reports. Our

study sheds light on the effectiveness of the recent reporting and auditing regula-

tions in China, suggesting that auditing has begun to play a more effective role

in the Chinese market.

APPENDIX A

Examples of Interim Audit Reports in China

1. Unqualified Auditor Report (by Shenzhenshi CPAs on August 18, 1998)

We were appointed to audit the consolidated balance sheet of Shenzhen Hongkai

(Group) Co., Ltd (the Company) as of June 30, 1998, and the income statement and cash

flow statement for the period from January to June 1998. These financial statements arethe responsibility of the Companys management. Our responsibility is to express an opin-

ion on these financial statements based on our audit. We conducted our audit in accor-

dance with the Independent Audit Standards for Chinese CPAs. Our audit also includes an

examination, on a test basis, of the Companys accounting records and other audit proce-

dures which we consider appropriate.

In our opinion, the Companys financial statements have been prepared in accordance

with the requirements of Accounting Standards for Enterprises, Accounting System

for Joint Stock Companies, and the relevant laws and regulations, and present fairly, in

all material respects, the financial position of the Company as of June 30, 1998, and the

results of the operations and cash flows for the half-year then ended, and the accounting

policies have been consistently applied.



28/32

2. Unqualified Auditor Report with Explanatory Notes (by Shekou Xinda CPAs on

August 17, 1998)

We were appointed to audit the consolidated balance sheet of Shenzhen Energy

Investment Co., Ltd (the Company) as of June 30, 1998, and the income statement and

cash flow statement for the period from January to June 1998. These financial statements

are the responsibility of the Companys management. Our responsibility is to express an

opinion on these financial statements based on our audit. We conducted our audit in ac-

cordance with the Independent Audit Standards for Chinese CPAs. Our audit also includes

an examination, on a test basis, of the Companys accounting records and other audit pro-

cedures which we consider appropriate.

In our opinion, the Companys financial statements have been prepared in accordance

with the requirements of Accounting Standards for Enterprises, Accounting System

for Joint Stock Companies, and the relevant laws and regulations, and present fairly, inall material respects, the financial position of the Company as of June 30, 1998, and the

results of the operations and cash flows for the half-year then ended, and the accounting

policies have been consistently applied.

In addition, we noticed that:

1. As discussed in Note 4 to the financial statements, a subsidiary of the Com-

panyShenzhen Mawan Electricity Ltd.recorded an interest income of

RMB35.56 million yuan, which is yet to be confirmed.

2. As discussed in Note 41 to the financial statements, as of June 30, 1998, the contin-

gent loss of the Company amounts to RMB16.6 million yuan. (Renminbi [RMB] is

the official currency on the mainland of the Peoples Republic of China [PRC]).

3. Qualified Auditor Report (by Shenzhen Tongren CPAs in 1999)

We were appointed to audit the consolidated balance sheet of Shenzhen Huabao Co.,

Ltd (the Company) as of June 30, 1999, and the income statement and cash flow state-

ment for the period from January to June 1999. These financial statements are the respon-

sibility of the Companys management. Our responsibility is to express an opinion on

these financial statements based on our audit. We conducted our audit in accordance with

the Independent Audit Standards for Chinese CPAs. Our audit also includes an examina-

tion, on a test basis, of the Companys accounting records and other audit procedures

which we consider appropriate.

As discussed in footnote 5.6 to the financial statements, the construction of the

Dongguan Waterpark, a property project invested and constructed by the Company,

stopped for a long time, and the book value of the project amounts to RMB253.5 million

yuan as of June 30, 1999. The Company is studying the alternatives about the project in

the future. There is no reliable evidence indicating whether there exists substantial write-

down in the value of the property.

In our opinion, except for the effects of such adjustments, the Companys financial

statements have been prepared in accordance with the requirements of Accounting

Standards for Enterprises, Accounting System for Joint Stock Companies, and the rel-

evant laws and regulations, and present fairly, in all material respects, the financial posi-tion of the Company as of June 30, 1998, and the results of the operations and cash flows

for the half year then ended and the accounting policies have been consistently applied



29/32

Ranking

Rankingbyyear

NumberofListedClients

1996a

1997

1998d

1999d

1996

1997

1998

1999

ointventuresb

1

Pricewaterhouse

Pricewaterhouse

Ande

rsen

BDO

7

7

13

12

2

BDO(17)

KPMG

Price

waterhouse

Andersen

7

7

9

11

3

Ernst&Young(4)

Andersen

BDO

Pricewaterhouse

6

7

8

8

4

KPMG(3)

BDO

KPM

G

KPMG

6

6

7

8

5

C&L

Ernst&Young

C&L

C&L

4

5

6

6

6

Andersen

C&L

Deloitte&Touche

Deloitte&Touc

he

4

5

5

6

7

Deloitte&Touche

Deloitte&Touche

Ernst&Young

Ernst&Young

2

2

2

4

Topten

localauditors

1

Shanghai(2)

Shanghai

Dahu

a

Dahua

37

37

41

41

2

Dahua(1)

Dahua

ShanghaiShangkuai

ShanghaiShangkuai

31

34

36

34

3

ShenzhenZhonghua

(5)

ShenzhenZhonghua

ShenzhenZhongtian

ShenzhenZhongtian

22

24

28

32

4

Lixin(7)

Lixin

ShenzhenZhongshen

ShenzhenZhongshen

22

22

27

30

5

Shenzhenshi(10)

Shenzhenshi

SichuanJunhe

SichuanJunhe

20

22

25

29

6

Sichuan(6)c

Sichuanc

Zhejiang

ZhejiangTianjia

n

18

21

23

28

7

Guangzhou(9)

Zhejiang

Lixin

ShenzhenTongr

en

16

20

22

28

8

Zhejiang(N/A)

ShenzhenZhongcheng

Huna

nKaiyuan

BeijingJingdu

16

19

22

26

9

Chengdu(N/A)c

Chengduc

Hube

iDaxin

HunanKaiyuan

15

18

21

25

0

ShekouZhonghua(8)

HubeiDaxin

ShenzhenTongren

Lixin

12

18

21

23

APPEN

DIXB

MarketShareofQualityAuditorsin

TermsofNumberofListed

Clients

Numbersinparenthesesarethe1996rankin

gsoftherespectiveauditorsinTab

le8ofDeFond,Wong,andLi(199

9).

AlljointventureswereaffiliatedwithBigS

ixinternationalauditors,exceptShekouXindaBDO,whichwasoneofthetop-tenauditorsinChinaduring

199395

inDeFond,Wong,andLi(1999).

Sichuan

CPAsandChengduCPAsweredis

solvedbytheMinistryofFinancein1998forsevereviolationsoflawsandregulationsinauditing.

Alluniv

ersityandgovernmentaffiliatedCP

Afirmsbecameindependentlegalentitiesbytheendof1998(SecuritiesTimes,January5,1999).Conseq

uently,

thefollo

wingCPAfirmsweretransformed

tonewentities:ShanghaiCPAstoShanghaiShangkuai,ShenzhenZhonghuatoShenzhenZhongtian,Shen

zhenshi

toShenzhenZhongshen,andShenzhenZho

ngchengtoShenzhenTongren.


30/32

REFERENCES

Aharony, J., C. J. Lee, and T. J. Wong. 2000. Financial Packaging of IPO Firms in TraditionalEconomy: The Case of B-shares and H-shares in China. Journal of Accounting Research 1(Spring): 103125.

Akerlof, G. A. 1970. The Market for Lemons: Quality Uncertainty and the Market Mechanism.Quarterly Journal of Economics, 488500.

Ball, R., S. P. Kothari, and A. Robin, A. 2000. The Effect of Institutional Factors on Properties onAccounting Earnings: International Evidence. Journal of Accounting and Economics 29: 152.

Ball, R., A. Robin, and J. S. Wu. 2003. Incentives Versus Standards: Properties of AccountingIncome in Four East Asian Countries. Journal of Accounting and Economics 36: 235270.

Basu, S. 1997. The Conservatism Principle and the Asymmetric Timeliness of Earnings. Journalof Accounting and Economics 24: 337.

Beaver, W. H. 1998. Financial Reporting: an Accounting Revolution. 2nd edition. Upper SaddleRiver, NJ: Prentice-Hall.

Begley, J., and E. Fischer. 1998. Is There Information in an Earnings Announcement Delay?Review of Accounting Studies 3: 347363.

Blackwell, D. W., T. R. Noland, and D. B. Winters. 1998. The Value of Auditor Assurance: Evi-dence from Loan Pricing. Journal of Accounting Research 36 (Spring): 5770.

Chen, C. J. P., X. Su, and R. Zhao. 2000. An Emerging Markets Reaction to Initial Modified AuditOpinions: Evidence from the Shanghai Stock Exchange. Contemporary Accounting Research(Fall): 429455.

Chen, K. C. W., and H. Q. Yuan. 2004. Earnings Management and Capital Resource Allocation:Evidence from Chinas Accounting-Based Regulation of Rights Issues. The Accounting

Review 79 (July): 645665.Choi, S. K., and D. C. Jeter. 1992. The Effect of Qualified Audit Opinion on Earnings Response

Coefficients. Journal of Accounting and Economics 2 & 3: 229247.Chow, C. W. 1982. The Demand for External Auditing: Size, Debt and Ownership Influences. The

Accounting Review (April): 272291.Claessens, S., S. Djankov, J. P. H. Fan, and Larry H. P. Lang. 2002. Disentangling the Incentive

and Entrenchment Effects of Large Shareholdings. Journal of Finance 57 (6): 27412771.Collins, D. W., and S. P. Kothari. 1989. An Analysis of Intertemporal and Cross-Sectional Determi-

nants of Earnings Response Coefficients. Journal of Accounting and Economics (July): 143181.

DeFond, M. L. 1992. The Association between Changes in Client Firm Agency Costs and AuditorSwitching. Auditing: A Journal of Practice and Theory 11 (Spring): 1631.

DeFond, M. L., and C. W. Park. 2001. The Reversal of Abnormal Accruals and the Market Valua-tion of Earnings Surprises. The Accounting Review (July): 375404.

DeFond, M. L., T. J. Wong, and S. Li. 1999. The Impact of Improved Auditor Independence onAudit Market Concentration in China. Journal of Accounting and Economics 28 (December):269305.

Dopuch, N., R. Holthausen, and R. Leftwich. 1986. Abnormal Stock Returns Associated with MediaDisclosures of Subject to Qualified Audit Opinions. Journal of Accounting and Economics(June): 93118.

Easton, P., and M. Zmijewski. 1989. Cross-Sectional Variation in the Stock Market Response toAccounting Earnings Announcements. Journal of Accounting and Economics 11: 117141.

Ettredge, M., D. Simon, D. Smith, and M. Stone. 1994. Why Do Companies Purchase Timely Quar-terly Reviews? Journal of Accounting and Economics 18: 131155.

Fan, J. P. H., and T. J. Wong. 2002. Corporate Ownership Structure and the Informativeness ofAccounting Earnings in East Asia. Journal of Accounting and Economics 33: 401425.

Haw, I. M., D. Qi, D. Wu, and Y. W. Wu. 2005. Market Consequences of Earnings Management inResponse to Security Regulations in China. Contemporary Accounting Research 22: 95140.

Haw, I. M., B. Hu, L. Hwang, and Y. W. Wu. 2004. Ultimate Ownership, Income Management,and Legal and Extra-Legal Institutions. Journal of Accounting Research 42: 423462.

Haw, I. M., K. Park, D. Qi, and Y. W. Wu. 2003. Audit Qualification and Timing of EarningsAnnouncements: Evidence from China. Auditing: A Journal of Practice and Theory 2: 121146



31/32


32/32

the economic consequences of voluntary auditing

Documents