Institutional Environment and the Quality of Big 4 Auditors

Bin Ke Nanyang Technological University

Clive Lennox Nanyang Technological University

Qingquan Xin Chongqing University

Motivational question

• Do Big 4 accounting firms provide the same audit quality around the world?– Do Big 4 deliver the same quality in China?

• Potential economic forces governing Big 4’s quality– Ability– Incentives (litigation risk, reputation, quasi-rent)

• Focus of this study is the incentives of Big 4

Is the idea interesting?

• I think so because Big 4 auditors play a direct role in determining the quality of financial reporting

• There is a debate on whether Big 4 can deliver the same high quality audit in weak investor protection countries as in strong investor protection countries

Is the idea interesting?

• Relevance to China and HK: – H shares’ financial reports are allowed

to be audited by domestic auditors after December 15, 2010

How to test the idea?

• What is the ideal experiment?• The most obvious approach is to

compare the audit quality of Big 4 across different countries

• Common limitations of cross country studies– Accounting standards – Auditing standards– Other cross-country differences

Prior research

• Compare Big4 vs. non-Big4 across countries– This approach does not directly examine the

effect of institutional environment on Big 4– Unclear whether the cross-country differences

are effectively controlled for because the effects of country factors could be different for Big4 and non-Big4

– Any differences in results between Big4 vs. non-Big4 could be due to systematic differences of the clients audited by Big4 and non-Big4

Our approach

• Publicly traded firms listed on mainland China and audited by a domestic Big4 over 1995-2009– Pure A shares– AH firms– AB firms

Our specific research question

• Do domestic Big4 accounting firms provide the same audit quality in China for– Pure A shares, – AB firms, and – AH firms?

Mainland ChinaBig 4

of Pure A Firm

MainlandChina

Mainland ChinaBig 4

of AH Firm

HK Big 4

of AH firm

HongKong

MainlandChina

?

Mainland ChinaBig 4

of AB Firm

HK Big 4

of AB firm

HongKong

MainlandChina

?

?

Incentives of HK Big4: AH firms versus AB firms

H report of AH firm

B report ofAB firm

HK

HKSE √ X

HKSFC √ X/?

HKICPA √ √/?

HK court √ √/?

Market √ √/?

Mainland

CSRC √/? √

market X X

Mainland China Big4Of

AB Firms

Mainland ChinaBig4Of

AH Firms

Mainland ChinaBig4Of

Pure A Firms

HongKong

MainlandChina

?

Advantages of our approach

• We directly examine the effect of institutional environment on Big 4’s behavior

• We can effectively isolate the country effects because we compare the audit quality of Big4 in the same country

• We do not compare Big4 vs. non-Big4 and thus our results cannot be due to systematic differences of the clients audited by Big4 and non-Big4

Pure A share firms (firm years)

Domestic auditor

Big 4=1 Big4=0

Cell5 N=377 Cell6 N=12,649

AH share firms (firm years)

Domestic and HK auditors are the same for 256 firm years

Domestic auditor=375

Big 4=1 (cell13) Big4=0 (cell24)

HK auditor is big4=1 (cell12) Cell1 N=258 Cell2 N=68

HK auditor is big4=0 (cell34) Cell3 N=1 Cell4 N=48

AB firms (firm years)

Domestic (i.e., A share) auditor=1205

Auditor of B share report Big 4=1 (cell135) 253 Big4=0 (cell246) 937

B share auditor is big4=1 (cell12)

Cell1 N= 201 Cell2 N= 363

B share auditor is big4=0 (cell34)

Cell3 N= 1 Cell4 N= 362

No B share auditor Cell 5 N=51 Cell 6 N=212

Research design

• Y = α0 + α1 HK_MONITOR + α2

MULTIPLE_OFFICES + CONTROL VARIABLES + u– Dependent variable=

• Audit opinion• Earnings management (accruals and loss)• Audit fees (mainland)

Audit opinion model: key variables

OPINION = 1 if not clean opinion and zero if clean opinion in year t.

HK_MONITOR = Dummy variable, 1 if the firm is an AH firm and its HK auditor is a big4 and zero otherwise；

MULTIPLE_OFFICES = Dummy variable, 1 if the firm is audited by more than one office, and zero otherwise.

Audit opinion model: control variables

SIZE = Natural log of total assets in year t；

LEV = The ratio of the client’s total liabilities to total assets at the end of current fiscal year t；

CURRENT = The ratio of the client’s current assets to current liabilities.RETURN = Annual market adjusted abnormal return over the fiscal year t；

BETA = the firm’s beta estimated using a market model over the fiscal year

VOL =the variance of the residual from the market model over the

fiscal year;

INVESTMENT =cash, cash equivalents, and short- and long-term investment

securities deflated by total assets at fiscal year-end;

ARINV = accounts receivable and inventory divided by total assets in year t； 

ROE = net income over year-end total owners’ equity for year t；

LOSS = 1 if the firm reports a loss for the current year, and 0 otherwise;

SOE = Dummy variable, 1 if the audit firm is stated owned enterprise, and 0 otherwise.

Audit opinion model

Signed abnormal accrual model: dependent variable

Signed abnormal accrual model: control variables

Signed abnormal accrual model

Loss model

Loss model

Audit fee model

Audit fee model

Endogeneity of HK_MONITOR

• Cross-listing bonding hypothesis would suggest that AH firms are better and thus the self selection would bias against our predictions

• assess the severity of endogeneity:– SHORT is 1 if the distance between the fiscal year end and the HK IPO date for all AH firm years is less than 5 years (or 8) and zero otherwise

Endogeneity of HK_MONITOR

Descriptive stat for all regression variables

Descriptive stat for all regression variables