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Do Bond Investors Care About Engagement Auditors’ Negative Experiences? Evidence from China

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Abstract

Using data from China, where the identity of engagement auditors is disclosed, we find significant relationships between engagement auditors’ negative experiences and the costs of corporate bonds. Further tests differentiate field and review auditors’ experiences, and we find that both field and review auditors’ negative experiences are significantly related to higher costs of corporate bonds. In addition, we find that the above results are significant only when the engagement auditors are affiliated with non-Big10 audit firms. Using path analysis, we find that credit rating is a possible channel through which information on engagement auditors’ negative experiences can transfer to bond investors. Regarding non-price terms, we conclude that engagement auditors with negative experiences are associated with smaller bond sizes, shorter bond maturities, a higher likelihood of requiring collateral, and more restrictive covenants. Further analyses also show that the effects of engagement auditors’ negative experiences on the costs of corporate bonds are less pronounced for well-governed firms. To show that our results obtained from China’s corporate bond market are relevant to loan markets, we replicate the above tests using a Chinese sample, and the results from the loan market are consistent with those from the corporate bond market. Overall, our empirical results suggest that investors are indeed concerned with engagement auditors’ negative experiences.

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Notes

  1. In the previous literature, there are several naming methods for individuals who work in the audit profession, such as individual auditor, individual partner, signatory auditor, signatory partner, and audit partner. In this study, we further differentiate audit professionals based on their specific duties. Therefore, to avoid confusion, we name all auditors who sign audit reports as engagement auditors. Specifically, we name the engagement auditors who visit the field and conduct audit practices as field auditors and name those who review the audit documents as review auditors.

  2. We note that several papers have discussed the negative market reactions caused by the outbreak of negative events (Gul et al. 2016; Li et al. 2017). These papers generally focus on the “contagion effect,” which is the market’s immediate reaction. However, our paper observes these negative events as engagement auditors’ important professional experiences, which may greatly affect their following behaviors and customer recognition. The main interests of this paper are whether investors perceive engagement auditors’ past experiences and how do investors incorporate this information into the decision-making procedures.

  3. Public Company Accounting Oversight Board (PCAOB). 2015. Improving the transparency of audits: Rules to require disclosure of certain audit participants on a new PCAOB Form and related amendments to Auditing Standards, PCAOB Release No. 2015–008; PCAOB Rule making Docket Matter No. 29, December 15, 2015.

  4. In addition, we also conduct extended analyses based on listed firms’ costs of debts (approximate to the costs of bank loans). The findings are similar to that in the corporate bond market. The specific results are reported in Sect. 5.

  5. In untabulated results analysis, we find that engagement auditors’ experiences are not significantly related to bond issuers’ audit quality in China’s corporate bond market. We sincerely thank the referee for his or her suggestion on providing some empirical evidence on the relationship between engagement auditors’ experience and audit quality using Chinese data.

  6. Li et al. (2017) confirm that regulatory sanctions are imposed not only on the audit firm but also on the engagement auditors. Between 2001 and 2013, 118 auditors were sanctioned by the CSRC for issuing fraudulent auditing reports, only 62 of whom are still working in the audit market but have been imposed a fine. By verifying the regulatory sanctions, we find that the field auditor and review auditor are imposed the same penalties.

  7. In the firm’s bond prospectus, the firm must list three years of audited financial information and the latest financial information (CSRC, 2006, No. 2). Engagement auditors are responsible for ensuring the authenticity of financial information being presented in the bond prospectus.

  8. For the 13 bond prospectuses that are not available in CNINFO, we collected information from the websites of Finance Sina (finance.sina.com.cn) and CFI (www.cfi.cn).

  9. In our sample, there are 7 companies’ audit reports that were signed by three auditors. We specify less experienced auditors as field auditors and the most experienced auditors as review auditors. Our results do not change if we delete those observations.

  10. Although audit reports in China do not explicitly disclose the role assumed by the engagement auditor, in practice, junior auditors usually fulfill the engagement responsibility (Wang et al. 2015a, b).

  11. The CPC Central Committee of the State Council issued the “China Education Reform and Development Program and the Improvement of Views” on February 13, 1993, to strive to have a number of colleges that would reach high-level teaching and research at the beginning of the twenty-first century; the project was titled “211 Project”. The “985 Project” was implemented by Chinese government for the construction of a number of world-class universities selected from the “211 Project”. Only with strong scientific research and a well-known reputation can universities be selected as “211 Project” or “985 Project” universities.

  12. We sincerely acknowledge the referee’s suggestion on controlling for the firm- and office-level industry expertise. Unfortunately, the office-level data are currently not available to us, and we should admit this deficiency. However, Gul et al. (2013) indicate that branch offices conduct less than 5 percent of the audits in China, and most of their clients are small local firms. Hence, we predict that this factor would not have a great influence on our findings.

  13. Owing to the limited number of firms with multiple-year bonds issuances, to an extent, the effectiveness of fixed effects estimation and change analyses on the treatment of endogeneity issue is weakened. We should acknowledge this deficiency here.

  14. Based on the instruction of DeFond et al. (2005), the following describes how we dichotomize the each of the characteristics of corporate governance. Board Size is a variable that equals 1 if the appointing firm’s board size is less than the sample median, and 0 otherwise. Board Independence is a variable that equals 1 if the ratio of independent directors is more than the sample median, and 0 otherwise. Board Diligence is a variable that equals 1 if the number of board meeting is more than the sample median, and 0 otherwise. Board Committee is a variable that equals 1 if the appointing firm has four committees simultaneously including Audit, Salary and Performance Evaluation, Nominations, and Strategy Committee, and 0 otherwise. CEO Duality is a variable that equals 1 if the chairman and the general manager are different people in the appointing firm, and 0 otherwise. Annual Shareholders Meeting Attendance is a variable that equals 1 if the attendance rate of the annual shareholders meeting is more than the sample median, and 0 otherwise.

  15. We acknowledge that it may be more convincing if we alternatively use this weighted measurement of spread in the main text. However, using this method also leads to significant decreasing in sample size, i.e., 14.3% of observations are missing. Because the sample of corporate bonds is relative small, a further decrease in sample size may draw more concerns on this issue. Therefore, we use this measurement in the robustness check.

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Acknowledgement

We would like to thank Steven Dellaportas (the Editor), two anonymous expert reviewers, Jin-Chuan Duan, Lin Chen, Xiaohui Li, Lin Liao, Wanfa Lin for helpful comments and suggestions. We also appreciate comments and suggestions from participants of the Seminar on Finance, Insurance, and Statistics at Hunan University; the 2016 Conference of Accounting Society of China; the Second Seminar on Finance and Accounting at Xiangtan University; and the International Workshop on Interdisciplinary Research in Accounting at Southwestern University of Finance and Economics (Grant No. 20130161110045).

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Authors and Affiliations

  1. Business School of Hunan University, Changsha, 410079, China

    Guangming Gong & Liang Xiao

  2. School of Economics and Management, South China Normal University, Guangzhou, 510006, China

    Si Xu

  3. College of Finance and Statistics, Hunan University, Changsha, 410079, China

    Xun Gong

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  4. Xun Gong
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Correspondence to Si Xu.

Appendix

Appendix

See Table 10.

Table 10 Variable definition
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Gong, G., Xiao, L., Xu, S. et al. Do Bond Investors Care About Engagement Auditors’ Negative Experiences? Evidence from China. J Bus Ethics 158, 779–806 (2019). https://doi.org/10.1007/s10551-017-3737-6

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