5 Client Importance, Institutional Improvements, and Audit Quality in China-- An Office and Individu

THE ACCOUNTING REVIEW American Accounting Association V ol.85,No.1DOI:10.2308/accr.2010.85.1.127 2010pp.127–158Client Importance,InstitutionalImprovements,and Audit Quality inChina:An Office and IndividualAuditor Level AnalysisShimin ChenChina Europe International Business SchoolSunny Y.J.SunDonghui WuThe Hong Kong Polytechnic UniversityABSTRACT:This study examines how the legal and regulatory changes in China affectthe relationship between client economic importance and audit quality.At the individualauditor level,wefind that the propensity to issue modified audit opinions(MAOs)isnegatively correlated with client importance from1995to2000.However,from2001to2004,when the institutional environment became more investor-friendly,the propensityto issue MAOs is positively associated with client importance.Thesefindings are cor-roborated by an analysis of regulatory sanctions.Although client importance measuredat the office level is also negatively related to the propensity for MAOs from1995to2000without controlling for the auditor-level client importance,this result is sensitiveto model specification and sample composition.Our results suggest that(1)institutionalimprovements prompt auditors to prioritize the costs of compromising quality over theeconomic benefits gained from important clients;and(2)the impact of client impor-tance on audit decisions appears to be different at the individual auditor and officelevels.Keywords:client importance;audit quality;litigation;audit-reporting decision.Data Availability:The data are publicly available from the sources identified in thepaper.We thank Charles Chen,Zhihong Chen,Jere Francis,Ferdinand A.Gul,Sidney Leung,Nancy Su,Xijia Su,and participants of a research seminar at the City University of Hong Kong for their helpful comments on earlier drafts of this paper.We are especially grateful to Dan Dhaliwal and Steven Kachelmeier(the editors)and two anonymous referees for their constructive feedback.We also thank Tao Li and Pauline Wong for their able research assistance. Professor Chen acknowledgesfinancial support from China Europe International Business School.Professors Sun and Wu are grateful to The Hong Kong Polytechnic University for research funding(research grant no.G-YG26). Editor’s note:Accepted by Steven Kachelmeier,with thanks to Dan Dhaliwal for serving as editor on a previous version.Submitted:February2008Accepted:April2009Published Online:January2010127128Chen,Sun,and WuThe Accounting Review January 2010American Accounting Association I.INTRODUCTIONIn this study,we examine the relationships among client economic importance,institu-tional improvements,and audit quality in China at the audit office and individual auditorlevels.At issue is whether the impact of client economic importance on audit qualitydepends on the institutional environment and the level of analysis.It has long been sus-pected that the financial interests auditors have in their clients can adversely affect theirindependence (Mautz and Sharaf 1961;AICPA 1978).The Enron scandal,together withthe collapse of Arthur Andersen,has pushed the auditor independence issue even furtherto the forefront.Nonetheless,the empirical evidence has been less than consistent (e.g.,Frankel et al.2002;Ashbaugh et al.2003;Chung and Kallapur 2003).Previous studies,predominantly based on developed markets with better investor protection,normally at-tribute the lack of evidence of the impact of client importance to auditor concerns aboutlitigation and/or reputation (e.g.,Reynolds and Francis 2000).We directly test this conjec-ture in the Chinese stock market.As the institutional environment for investor protectionis generally perceived to be weaker in China than in more mature markets,we should bemore likely to observe the theorized negative impact of client dependence on auditor quality(DeAngelo 1981).More importantly,the substantial institutional improvements in Chinaduring our sample period provide us with a natural ‘‘laboratory’’in which to examinewhether auditor attitudes toward economically important clients change when Chinese in-stitutions become more investor friendly.Extant studies on client importance have been conducted either at the audit firm oroffice levels.Consistent with the argument that the audit office is a more appropriate levelof analysis than the audit firm (Francis et al.1999;Reynolds and Francis 2000),DeFondand Francis (2005)suggest that the level of analysis be pushed down further to an individualpartner level for a better understanding of auditor behavior.As the engagement auditor isrequired to sign the audit report in China,we are able to conduct our analysis at theindividual auditor level and compare it to the analysis at the office level.Based on a sample of 8,917firm-year observations from 1995to 2004,we find thatclient importance as measured at the individual auditor level impaired audit quality in Chinafor the period from 1995to 2000(the pre-2001period)when the institutions for investorprotection were relatively weak.Specifically,after controlling for other factors that affectmodified audit opinions (MAOs),we find that the probability of issuing MAOs was signif-icantly lower for clients that were more important to individual auditors.However,after2001(the post-2001period),when the laws and regulations surrounding audit failuresbecame harsher,the probability of receiving an MAO became higher for clients that weremore important to individual auditors.Controlling for the individual auditor level impact,we find that the client importance measured at the office level is not significant in explainingthe propensity of auditors to issue MAOs before or after 2001.Although the office-levelmeasure is also significantly negatively related to MAO issuance in the model withoutcontrolling for the auditor-level measure before 2001,this result is mainly caused by aportion of observations in which the client importance to the office is similar to that to theindividual auditors.Subject to the caveat of the possible multicollinearity problem causedby the correlation between the two measures,the effect of client importance appears to bestronger at the auditor level than at the office level.Our findings are robust to potential econometric and measurement issues.We alsocorroborate our main findings by analyzing the consequences of issuing inappropriate auditreports.We show that for the fiscal years during the pre-2001period,the probability ofaudit failure cases sanctioned by the Chinese regulator was positively related to clientimportance at the individual auditor level.This implies that individual auditors are moreClient Importance,Institutional Improvements,and Audit Quality in China 129The Accounting Review January 2010American Accounting Associationlikely to compromise their objectivity in auditing their key clients.However,the probabilityof sanctioned audit failures involving economically important clients decreases significantlyduring the post-2001period.Again,we find no such evidence at the office level.Overall,our findings suggest that auditors in China are more likely to compromiseaudit quality for economically important clients when the institutions for investor protectionare weak.Nevertheless,the institutional improvements in China help to mitigate that com-promise to the extent that auditors’concerns about litigation risks and regulatory sanctionsdominate their economic incentives.Previous studies conjecture that such concerns affectthe relation between client importance and audit quality,suggesting that the analysis ofclient importance at the individual auditor level would be the most pertinent.We contributeto the literature by providing evidence in line with this conjecture.In addition,our studycontributes to a growing body of literature on the impact of institutions on auditing practicesacross countries (Fan and Wong 2005;Choi and Wong 2007;Francis and Wang 2008).There are serious methodological limitations when using cross-country data,such as smallsample sizes,endogeneity,and omitted variables (Miller 2004;Gul 2006).By providingtime-series evidence of the impact of institutional changes on auditor behavior in a singlecountry,our research complements cross-country studies.Section II presents background information and discusses our research questions.Theresearch methods and empirical results follow in Section III.We check the robustness ofour findings in Section IV ,and conduct additional analyses in Section V .Finally,we sum-marize and discuss our findings in Section VI.II.BACKGROUND AND HYPOTHESIS DEVELOPMENTExtant LiteratureBecause of significant client-specific start-up costs,incumbent auditors have cost ad-vantages over competitors and earn quasi rents (i.e.,audit fees in excess of audit costs)insubsequent audits.Hence,incumbent auditors are not expected to be perfectly independentof their clients,as the latter can impose real costs on the former by terminating the bilateralrelationship (DeAngelo 1981).Ceteris paribus ,the larger the client in an auditor’s portfolio,the stronger should be the incentive that the auditor has to retain that client and thus possiblycompromise audit quality.The empirical evidence is,however,mixed.Studies based on investor perception pro-vide more supportive evidence.Both Krishnan et al.(2005)and Francis and Ke (2006)findlower earnings response coefficients for firms paying higher nonaudit fees,and Khuranaand Raman (2006)show that higher audit fees are associated with a higher cost of equity.Although these findings can be considered to reflect investors’concerns about the negativeimpact of client dependence,we cannot necessarily conclude that there is an actual adverseeffect.On the contrary,there is more evidence suggesting no negative impact of clientimportance on auditor quality,as measured by earnings management (Chung and Kallapur2003),earnings restatement (Kinney et al.2004),or modified audit opinions (Craswell etal.2002).1Reynolds and Francis (2000)and Gaver and Paterson (2007)find that U.S.Big5auditors are even more conservative in auditing clients that are more important to thelocal audit offices,which is consistent with the argument that audit failures involving largerclients are more likely to result in lawsuits,such that auditors exercise greater care inauditing such clients (Stice 1991;Lys and Watts 1994).1Although Frankel et al.(2002)show a positive relation between nonaudit service purchases and earnings man-agement,their findings and methods have been questioned in many follow-up studies (e.g.,Ashbaugh et al.2003;Chung and Kallapur 2003;Larcker and Richardson 2004).130Chen,Sun,and WuThe Accounting Review January 2010American Accounting Association More research is needed to untangle the relationship between client dependence andaudit quality.An unanswered question is whether the institutional environment for investorprotection is the reason for the failure to identify the negative impact of client dependencethat has been conjectured in the literature (Reynolds and Francis 2000;Craswell et al.2002;DeFond et al.2002).China provides an interesting setting for such a test.The Pre-2001Institutional Environment in ChinaAn important feature of China’s audit market is its fierce competition.Unlike developedeconomies in which the Big 4auditors audit the majority of listed companies,concentrationin the Chinese audit market for listed companies is rather low.In 2001,the concentra-tion ratio for the Top 4and Top 8auditors was 30.32percent and 44.70percent,respectively(Xia and Lin 2003),and the average market share of the Big 5(now the Big 4)auditorsin the statutory audit market between 1995and 2003was 26percent (Chen et al.2007).Inaddition,the number of listed companies in China is small relative to that of the CPA firmsqualified to audit them.At the end of 2006,there were 73audit firms qualified to auditapproximately 1,400listed companies,which means that one qualified firm had less than20listed clients on average.Such a buyer’s market is likely to afford clients more bargainingpower and impose pressure on auditors fighting for their slice of the cake (Chen et al.2007).Moreover,there is a lack of demand for quality auditing.To avoid drawing regulatoryattention,managers of Chinese-listed companies are averse to modified audit opinions.DeFond et al.(1999)show that Chinese audit firms with a greater propensity to issuemodified reports tended to lose market share during the 1994–1996period.Fierce com-petition,together with a lack of demand for high-quality audit services,means that theproblem of dependence on important client could be more obtrusive in China.Chen (2003)argues that there was no legal infrastructure in earlier years to supportcapital market development in China,as private securities litigation against accounting fraudand market manipulation was not significant until 2001.As a result,compared to those indeveloped markets such as the U.S.,the regulatory enforcement and litigation risk facedby Chinese auditors were relatively low in the 1990s.The penalties for auditor violationof the audit regulations remained mostly at the administrative level,taking the form ofpublic reprimands,warnings,fines,and suspension of licenses to practice.The numberof CPA firms brought to court for civil or criminal liability was negligible (Pistor and Xu2005).The legal framework for CPA civil liability was fundamentally problematic:the civillaw did not give consistent definitions of auditor liability,was ambiguous in its compen-sation procedures,and explicitly forbade class action litigation (Li and He 2000).Starting in 1996,the Chinese government took steps to improve the institutional en-vironment of the stock market.These steps included the disaffiliation program,2the devel-opment of accounting and auditing standards,and legislative measures such as the SecuritiesLaw (effective on July 1,1999).The impact of these improvements was,however,not muchfelt until 2001,after the massive exposure of accounting frauds and audit failures causeda public outcry.Changes in the Institutional Environment around 2001The large-scale exposure of fraud was triggered by the scandal of ZhengBaiWen (StockCode:600898)in 2000,followed by two cases involving MonkeyKing (Stock Code:2Chinese CPA firms were originally part of or affiliated with governmental agencies.In 1997,the China Securities Regulatory Commission (CSRC)initiated a disaffiliation program that transformed these firms into partnership or limited liability companies.Client Importance,Institutional Improvements,and Audit Quality in China 131The Accounting Review January 2010American Accounting Association000535)and the star company Yorkpoint (Stock Code:000008),and ending with the Chi-nese ‘‘Enron,’’YinGuangXia (Stock Code:000557)in August 2001.All of these scandalsinvolved earnings manipulation or fraudulent financial reporting,but none of the companiesreceived any modified audit opinions from their auditors,including ZhongTianQin,theauditor of YinGuangXia,then the largest audit firm in China.These scandals contributedto a market crash later in 2001,which in turn led to a fight for compensation by affectedinvestors.Consistent with Coffee’s (2001)‘‘crash-then-law’’interpretation of legal developments,these events provided the impetus for the government to consider possible remedies.Inaddition to a substantially larger number of public enforcement actions taken by the reg-ulatory agencies during 2001,the Supreme Court issued a Notice on January 15,2002thatit would accept civil lawsuits against false statements in the securities market.Investorsresponded with a wave of lawsuits.In January 2003,the Supreme Court further promulgatedthe Private Securities Litigation Rules to expand the scope of securities litigation.TheAppendix contains a more detailed account of institutional changes in China during oursample period.Institutional Improvements and Client DependenceThe Supreme Court Notice represents a sea change in private securities litigation inChina (China Securities Journal 2007a).Consistent with the suggestion that liberalizingthe rules governing shareholder litigation is the single most important factor that motivatesmanagers and auditors to improve financial reporting quality (Ball 2001),we expect thechanges in the regulatory and legal environment in China to significantly affect auditorbehavior.The high competition and low litigation/sanction risk in the pre-2001periodsuggest that the market force constraining pressure from large clients was relatively weak,and we thus expect client importance to affect audit quality negatively during this period.However,because of the institutional improvements in 2001,the litigation and sanctionrisks faced by auditors have risen significantly.As a result,auditors’concern about potentiallosses from audit failures,particularly those involving large clients,can supersede the ec-onomic benefits of retaining problematic large clients.Consequently,for the post-2001period,we expect the negative impact of client importance on audit quality to diminish.3Level of AnalysisChinese auditors are required to sign on audit reports in accordance with China’s In-dependent Auditing Standard (CIAS)No.7,Audit Report ,issued in 1995.Two CPAs mustsign the audit report to clarify who was responsible for the audits performed.4In practice,Chinese CPAs are indeed accountable for audit reports in their names:regulatory sanctionsfor detected audit failures are imposed not only on CPA firms,but also on individual CPAsignatories.53As all Chinese-listed firms have December 31as their fiscal year-end,the annual audit work for most of the 2001reports would have been affected by the Notice issued in early 2002.We assume that auditors respond quickly to changes in the environment to maximize their own utility,and thus consider fiscal year 2001as the first year to be affected by the institutional improvements.In the Appendix,we further justify this choice by showing the immediate market response to the announcement of the Notice.4For partnership CPA firms,the signing auditors should be the engagement CPA plus the partner conducting the final review;for limited liability CPA firms,the signing auditors should be the engagement CPA plus the head of the firm or a deputy head authorized by the head.5For example,in the sanction notice involving HongGuang Company (Stock Code:600083)and its auditor,ShuDu CPA Firm,it is clearly stated that ‘‘as the signing CPAs for the audit reports of HongGuang Company,Wang Yingqin and Zhang Xiuhua are permanently banned from providing any security-related service’’().132Chen,Sun,and WuThe Accounting Review January 2010American Accounting Association Francis et al.(1999)suggest the use of city-level markets (i.e.,offices),rather thanfirms,as a unit of analysis in audit research.Consistent with this suggestion,Reynolds andFrancis (2000)and Craswell et al.(2002)argue that client importance is better analyzed atthe local office level because the economic impact of a larger client is more important toany particular local office than to the firm as a whole.Other studies following this approachinclude Chung and Kallapur (2003),Krishnan (2005),and Gaver and Paterson (2007).DeFond and Francis (2005)further suggest lowering the level of analysis to individualauditors to improve the power of the tests.However,information about individual engage-ment partners is not generally available except in a very small number of jurisdictions,ofwhich China is one.Although some researchers have investigated the relation betweenauditor tenure at the partner level and audit quality (Carey and Simnett 2006;Chen et al.2008),we are the first to examine how client importance affects audit quality at the indi-vidual auditor level and compare it with that at the office level over two periods of im-proving institutional environments for investor protection.III.RESEARCH METHOD AND EMPIRICAL RESULTSData Source and Sample SelectionOur sample period is from 1995to 2004,with the six years from 1995to 2000for thepre-2001period and the four years from 2001to 2004for the post-2001period.Modifiedaudit opinions (MAOs)were rare in China before 1995.In December 1995,the ChineseInstitute of Certified Public Accountants (CICPA)issued the first batch of CIASs,whichspecify the responsibility of auditors and the content and format of audit reports.As aresult,MAOs increased substantially in that year (DeFond et al.1999).Our data consist ofthree types:(1)financial statement and stock market information,which we obtained fromthe China Stock Market and Accounting Research Data Base (CSMAR);(2)audit opinionsand the identities of audit firms,audit offices,and signing auditors,which we manuallycollected from annual reports,supplemented by the auditor database complied by the CSRC(/);and (3)regulatory sanctions against auditors,which we ob-tained from the CSRC website.We begin to construct our sample with all the available firm-year observations fromthe A-share Financial Statement Database of CSMAR.We obtain 9,247observations for theperiod 1995to 2004,from which we delete 36observations with missing information aboutauditor identity and 294observations with insufficient weekly return data to estimate themarket model.6Our final sample contains 8,917firm-year observations from 1,368uniquefirms.Measurement of Audit Quality and Client ImportanceWe use an auditor’s propensity to issue a modified audit opinion (MAO)as a proxyfor audit quality.Craswell et al.(2002,255)state that ‘‘the presumption underlying thisline of inquiry is that,if fee dependence affects auditors’independent judgment,then au-ditors are less likely to issue qualified audit opinions.’’This assumption is also applicablein the Chinese context,as Chen et al.(2000)document a negative market reaction to MAOrecipients in China.According to the CSRC’s disclosure requirements,a firm’s managementshould explain the underlying reasons for an MAO in the annual report.Furthermore,the6We require at least 15weekly observations during a year for the market model estimation.Client Importance,Institutional Improvements,and Audit Quality in China 133The Accounting Review January 2010American Accounting Associationstock exchanges also consider the nature of audit opinions in their delisting decisions.7Therefore,MAOs can be costly to clients,and auditors may compromise by issuing a cleanopinion when an MAO is warranted.The CIAS specifies four types of audit opinions:unqualified,qualified,disclaimer,andadverse.It also stipulates that explanatory notes can be used with unqualified opinionswhere necessary.Although the CICPA interprets unqualified opinions with explanatorynotes in a manner similar to the ‘‘emphasis of a matter’’in the U.S.,this type of auditreport is often issued in place of a qualified opinion (Chen et al.2000;Haw et al.2003).The CSRC and the stock exchanges in China also treat this type of report in the same wayas other non-clean opinions in disclosure requirements or delisting decisions.To measurethe different types of MAOs according to their levels of severity,we code the audit opinionvariable OP from 0to 3to represent clean opinions,unqualified opinions with explanatorynotes,qualified opinions,and disclaimers/adverse opinions,respectively.We combine thedisclaimers and adverse opinions into one group because there are only four cases ofadverse opinions in our sample.In the multivariate analysis,we use an ordered logisticmodel rather than a dichotomous model,because the former more accurately measures theseverity of auditor opinions.8The ordered specification also has a higher pseudo R 2thanthe dichotomous model,but our main conclusions remain the same even if audit opinionsare measured dichotomously.9Table 1shows the distributions of our final sample and the audit opinions for each year.MAOs account for 13.7percent of the entire sample,and their relative frequency peaks in1999and declines thereafter.This decline in the post-2001period is mainly due to thefollowing reasons.First,the CSRC issued Listed Company Disclosure Rule No.14,Prob-lems under Non-Standard Audit Opinions ,in 2001(CSRC 2001b).This rule stipulates morestringent requirements for audit adjustments when violations of the GAAP or the regulationsare detected by auditors.Second,the CICPA revised the Audit Reports standard in 2003and restricted the use of unqualified opinions with explanatory notes to going-concern anduncertainty issues that do not affect the overall audit opinion.Under this standard,clientsare more likely to accept an audit adjustment if an audit opinion other than unqualified isexpected.Consistent with this reasoning,we observe less unqualified opinions with ex-planatory notes in 2003and 2004than in the preceding years.Third,with improved investorprotection in the post-2001period,management is also likely to take less risk with ac-counting manipulations,reducing instances of MAOs.Although the time-series variation inthe frequency of MAOs may affect the regression intercepts,we are primarily interestedin the slope effect,or how client importance affects the likelihood of MAOs under a givenaudit-reporting regime.As audit fees were not disclosed before 2001,we use the natural logarithm of a client’stotal assets as a surrogate to measure client economic importance.This is suitable because7In China,a firm that has incurred losses in the previous three years must report a profit with a clean audit opinion in the current year to avoid being delisted by the stock exchange.8Wu and Zhuang (2006)report a monotonic decrease in clients’current and one-year-ahead financial performance from clean opinions to disclaimers/adverse opinions.This indicates that Chinese auditors use different audit opinions to convey information to the market,and justifies the ordered nature of our dependent variable.Haw et al.(2003)also report earnings announcement evidence that is consistent with the severity of audit opinions.Further,regulators consider the appropriateness of audit report types.The CSRC sanctioned the Beijing JingDu CPAs for its audit of ZhongGuanCun in 2002because of an inappropriate use of explanatory notes for a more severe accounting problem in the company.9More details will be provided about alternative measures of audit opinion in the sensitivity analysis.134Chen,Sun,andWuTheAccountingReviewJanuary2010American Accounting Association TABLE 1Sample Distribution by Year and Type of Audit OpinionOpinion 1995199619971998199920002001200220032004Total(1)Clean 2523675896497128209691,0121,1301,1937,69386.6%88.2%86.1%81.7%79.8%82.2%86.8%86.8%91.9%89.6%86.3%(2)Unqualified but 428529310910789945769702with Explanatory Notes1.4% 6.7%7.6%11.7%12.2%10.7%8.0%8.1% 4.6% 5.2%7.9%(3)Qualified 3521413957574042234640112.0% 5.0% 6.0% 4.9% 6.4% 5.7%3.6% 3.6% 1.9% 3.5%4.5%(4)Disclaimer 001121313181819231170.0%0.0%0.1% 1.5% 1.5% 1.3% 1.6% 1.5% 1.5% 1.7% 1.3%(5)Adverse 001111000040.0%0.0%0.1%0.1%0.1%0.1%0.0%0.0%0.0%0.0%0.0%Total 2914166847948929981,1161,1661,2291,3318,917From all of the firm-year observations available in the A-share Financial Statement Database of CSMAR during the 1995–2004period,we delete:(1)36observations that do not reveal the signing auditor’s identity;and (2)294observations with insufficient weekly return data to estimate the market model.。