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    Effects of Audit Quality on Earnings Management and Cost of...
    research summary posted October 3, 2013 by Jennifer M Mueller-Phillips  , tagged 11.0 Audit Quality and Quality Control, 11.10 Impact of Quality Reviewers, 15.0 International Matters
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    Title:
    Effects of Audit Quality on Earnings Management and Cost of Equity Capital: Evidence from China
    Practical Implications:

    This study analyzes the effect of high audit quality for two types of Chinese firms, State Owned Enterprises (SOEs) and Non-State Owned Enterprises (NSOEs). It provides evidence that high audit quality may reduce cost of equity capital and earnings management more for NSOEs than for SOEs. The results of this study are useful for participants in Chinese and other emerging capital markets as well as auditors in these markets.


    For more information on this study, please contact Gerald Lobo.
     

    Citation:

    Chen, H., J. Chen, G. Lobo, and Y. Wang. 2011. Effects of Audit Quality on Earnings Management and Cost of Equity Capital: Evidence from China. Contemporary Accounting Review 28 (3): 892-925.

    Keywords:
    Audit quality, cost of equity capital, earnings management, state-owned enterprises
    Purpose of the Study:

    Growth in the Chinese economy over the past 30 years has led to the generation of a significant Chinese capital market and a burgeoning auditing profession. While numerous prior studies have examined the effect of audit quality on market participants, there has been little research on how audit quality is important in emerging economies such as China. Institutional, cultural and legal differences make Chinese firms and capital markets markedly different than those in the United States and an important new frontier for researchers.
    This study investigates the difference in the value of audit quality for Chinese state owned enterprises (SOEs) and non-state owned enterprises (NSOEs). The authors select this setting because it allows them to investigate the effects of audit quality across two types of firms with different ownership structure and agency problems. These firms also differ in managerial incentives and opportunities in the financial reporting process. The authors make and test the following hypotheses:

    Hypothesis 1: The effect of audit quality on earnings management is weaker for SOEs than for NSOEs

    Hypothesis 2: The effect of audit quality on cost of equity capital is weaker for SOEs than for NSOEs
     

    Design/Method/ Approach:

    The authors use data on publicly-traded companies in China from 2001-2004. They measure audit quality as the propensity of auditors to issue a modified opinion given that the firm being audited is qualitatively similar to a control sample. They then correlate this measure of audit quality with measures for earnings management (signed discretionary accruals) and cost of equity capital for SOEs and NSOEs and compare the two groups.

    Findings:
    • The authors find that there is a significantly lower level of earnings management for NSOEs audited by Top 8 auditors as compared to NSOEs audited by lower tier auditors. This result is not found for SOEs.
    • The authors find cost of equity capital is significantly lower for NSOEs audited by top 8 auditors as compared to NSOEs audited by lower tier auditors. This result is not found for SOEs.
    • Finally, the authors find that, for NSOEs, both cost of equity capital and earnings management decrease more after hiring a top 8 auditor compared to hiring a lower tier auditor.

    Taken together, these findings are indicative of higher audit quality leading to a greater reduction in earnings management and cost of equity capital for NSOEs than for SOEs. However, the authors note that these firms have many potential monitoring and corporate governance mechanisms that could have a similar effect on earnings management and the cost of equity capital. They cannot rule out the possibility that these results are driven by some additional aspect of corporate governance.

    Category:
    Audit Quality & Quality Control, International Matters
    Sub-category:
    Impact of Quality Reviewers