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    Aggregate Quasi Rents and Auditor Independence: Evidence...
    research summary posted July 30, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 11.0 Audit Quality and Quality Control, 11.05 Training and General Experience 
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    Title:
    Aggregate Quasi Rents and Auditor Independence: Evidence from Audit Firm Mergers in China.
    Practical Implications:

    The findings of this study have policy implications for regulators in China and other emerging economies with regard to administering the auditing profession and improving the corporate governance of public companies by fostering auditor independence. One policy implication of this finding is that simply increasing audit firm size fails to enhance auditor independence. The experience of mature markets suggests that, in addition to public regulatory enforcement, other mechanisms, such as private litigation against auditors and improved disclosures on audit services, are helpful in ensuring a well-functioning audit market.

    Citation:

    Chan, K. H., and Wu, D. 2011. Aggregate Quasi Rents and Auditor Independence: Evidence from Audit Firm Mergers in China. Contemporary Accounting Research 28 (1): 175-213.

    Keywords:
    consolidation & merger of corporations, auditor independence, aggregate quasi rents, audit quality
    Purpose of the Study:

    Prior research suggests that large audit firms have more aggregate quasi rents, which are defined as audit fees in excess of audit costs, to serve as collateral against opportunistic behavior on the part of auditors. Audit firm size affects not only auditor independence, but also auditor competence, which makes clear inferences on the relationship between audit firm size and independence difficult. The economic and regulatory changes in China’s audit market induced a large number of audit firm mergers in a short period of time, thus enabling the authors to investigate the impact of mergers on audit quality in a similar environment for an important economy. In the multi-license mergers, mergers occur between two (or more) accounting firms that are licensed to audit listed companies; in the single-license mergers, an accounting firm with such a license merges with non-licensed firms.

    Using data on audit firm mergers in China, the authors investigate the empirical relationship between audit firms’ aggregate quasi rents at stake and auditor independence in a setting that allows us to mitigate potential problems. However, they do have an immediate and significant impact on audit firm size and auditors’ aggregate quasi rents. Therefore, the changes in audit quality that occur immediately after mergers take place can be attributed mainly to changes in auditors’ independence rather than competence. The authors investigate the differences in independence between the pre-merger and immediate post-merger periods of the auditors in the same audit firms.

    Design/Method/ Approach:

    The authors collect data for audit firm mergers that took place between 1999 and 2006 from the CICPA and several leading financial newspapers. Client firm financial statement and stock market data are from the China Stock Market & Accounting Research database (CSMAR). The sample consists of 59 cases, including 21 multi-license mergers (MULTI hereafter) and 38 single-license mergers (SINGLE hereafter).

    Findings:

    The evidence indicates that an increase in audit firm size does not necessarily lead to an improvement in auditor independence. What matters is the size of the public clientele, where the quasi rents are more likely to serve as collateral against auditor malfeasance.

    • The level of independence, and thus audit quality, is determined by the auditor’s trade-offs between the costs and benefits of opportunistic behavior.
    • Audit firms involved in MULTI mergers are more likely to issue MAOs (modified auditor opinions) to their clients after the mergers.
    • This increased propensity to issue MAOs is significantly related to the change in audit firm size after the mergers.
    • There is no evidence to suggest any significant change in the issuance of MAOs among audit firms involved in SINGLE mergers.
    • The different effects of mergers on audit quality support the theory that auditor independence is a positive function of the aggregate quasi rents a stake.
    • The increase in MAOs is positively correlated with the change in the size of listed clientele that results from multi-license mergers.
    Category:
    Audit Quality & Quality Control, Independence & Ethics
    Sub-category:
    Sustainability ServicesTraining & General Experience