Abstract
We examine whether the revelation of individual audit partner reputation affects client firms’ external financing choice. Specifically, we investigate whether a firm switches its financing choices once its auditor partner is perceived to be a low-quality partner, captured by whether one of the audit partner’s other clients is sanctioned for financial misreporting. We identify firms audited by a low-quality partner as the treatment firms and designate firms audited by other audit partners from the same audit office as the control firms. Using a long panel of data with audit partner identity, we find that, on average, the treatment firm switches from equity financing to credit financing after the discovery of individual audit partner quality. In addition, reduced equity financing is primarily concentrated among firms that choose to keep low-quality partners. By building an implicit link between the non-sanctioned firm and the sanctioned firm through a common audit partner, we show that investors can infer the quality of external audits using the auditor-level information, thus empirically supporting to the new PCAOB rule that requires disclosure of the partner-level information.
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Notes
Information about other audit firms participating in the audit must also be filed for all public company audits issued on or after June 30, 2017. See the full text at https://pcaobus.org/News/Releases/Pages/SEC-approves-transparency-Form-AP-051016.aspx.
From time to time, Chinese regulators examine the outcomes of audit engagements and audit failures are publicly announced to the public by government sanctions. Similarly, in the United States, the Government Accountability Office (GAO, formerly named the General Accounting Office) has conducted two waves of investigations and identified a list of financial restatements that occurred from 1997 to 2001 and from 2002 to 2006, respectively.
It is also available on the website of the China Institute of Certified Public Accountants (CICPA) at www.cicpa.org.cn.
The Chinese auditors are required to sign their audit reports in accordance with China’s Independent Auditing Standard (CIAS) No.7, Audit Report, issued in 1995 (Chen et al. 2010). The CIAS requires that at least two auditors sign an audit report. Typically, two engagement auditors sign each audit report, with the review partner mainly performing review work and the engagement partner mainly conducting fieldwork. Both signing auditors have the same legal liability and are equally responsible for the reports signed (Lennox et al. 2014). Therefore, in the main results, we define the treatment firms if any of review and engagement partners is an LQP.
We need the data for external financing three years pre-sanction announcement and post-sanction announcement. In addition, the data for statements of cash flows begins in 1998 in China. As a result, our final sample covers from 1998 to 2015, while the sanction sample covers from 2001 to 2012.
For example, on December 21, 2004, Hefei Fengle Seed Co., Ltd., was sanctioned by CSRC for financial reporting fraud between 1997 and 2002. Three major issues are involved in this case: (1) failure to disclose significant security investment outflows and inflows between 1997 and 2001, (2) inflated revenues between 1997 and 2001 and inflated assets on the balance sheet between 1992 and 2002, and (3) misleading information about the use of raised funds. This information is publicly disclosed at http://www.csrc.gov.cn/pub/zjhpublic/G00306212/200804/t20080418_14421.htm
The uptick in 2012 is partially due to China’s steps in recent years to improve financial reporting for the public firms and align with global accounting standards. The increased number of sanctions is the result of the CSRC’s initiatives to improve stock market transparency and strengthen the regulations of capital market professionals. See the full text of the CSRC 2012 annual report (English version) at http://www.csrc.gov.cn/pub/csrc_en/about/annual/201307/P020130716403852654782.pdf. In untabulated tests, results and inferences are similar if we remove sanction events in 2012.
For each LQP-revelation event, we identify treatment firms as those that have been audited by the low-quality partners in the year before the revelation event. This design is predicated on the assumption that, if a firm has recently been audited by an LQP before the revelation, investors perceive high information risks on the firm’s financial statements. In untabulated tests, we alternatively identify firms as the treatment firms when they have been audited by LQP in the recent three years. Results and inferences are qualitatively similar. In particular, when we estimate external equity financing in the baseline test, the coefficient on Treat*Post in equation (1) is statistically significant at the 5% level.
For example, if a firm has two triggering events in 2006 and 2009, respectively (i.e., the firm is audited by two distinct LQPs, the first in 2006 and the other in 2009), the years after 2006 but before 2009 are the post-event years with respect to the first event, but they constitute the pre-event years with respect to the second event. As such, the years in between are confounded by the two triggering events. If this is the case, we only keep the triggering event in 2006.
In addition to the difference in financial reporting, the financial industry is a highly regulated industry in China. As such, external financing for financial firms are likely to be subject to additional requirements by the regulatory bodies. Nevertheless, our results are similar if we include financial firms in the sample.
It is likely that a firm may issue equity and repurchase shares in the same fiscal year. To the extent that we capture the mix of new financing, we use the gross amount of equity issuance, instead of the net amount.
We use net income rather than income before extraordinary items because, in China, firms do not report extraordinary items as a line item.
In theory, we would need the marginal tax rate, following Graham (1996). U.S.-based studies (e.g., Chang et al. 2009; Chen et al. 2013) employ data estimated by Professor John Graham at https://faculty.fuqua.duke.edu/~jgraham/taxform.html. To the extent that this data is not available for international firms, we approximate the marginal tax rate with the average tax rate.
The relative use of each type is defined as the amount of this type scaled by the total amount of external financing. We only keep observations with nonzero total external financing.
We also assess the statistical difference between the coefficient on Treat*Before (t = −1) and the coefficient on Treat*Post (t = 0). We expect that the coefficient on Treat*Post (t = 0) is more negative than the coefficient on Treat*Before (t = −1), as treat firms that have an information problem due to quality of audit partner have reduced equity financing. The difference between the coefficient on Treat*Before (t = −1) and the coefficient on Treat*Post (t = 0) is 0.044 and is marginally statistically significant at the 10% level (p value = 0.10).
In China, a listed firm is designated as a special treatment (ST) firm if it reports a net loss for two consecutive years.
To the extent that we need the assumption that the two-year-ahead realized EPS is greater than the one-year-ahead realized EPS (i.e., there is positive earnings growth), our sample size in this test is smaller.
Ideally, we would have used the more granular transaction-level data (e.g., the Dealscan-like databases provided by LPC) to calculate the cost of debt, as this data would incorporate more deal-level information, such as loan type, loan term, loan purposes, etc. However, the database that contains such detailed deal-level information is not available in China to researchers. We instead approximate the cost of debt using the approach adopted by U.S.-based studies before the availability of Dealscan, for example, Francis et al. (2005).
We take a dynamic approach when we identify LQPs. Specifically, we identify whether an audit partner is of low quality based on all public information as of time t. For example, if partner X has not been the auditor for any of the firms receiving regulatory sanctions as of 2008, we identify X as a high-quality auditor in years up to 2008, although X may be later identified as low quality in years after 2008. Under this approach, we, as researchers, work with the same information set as equity investors without introducing “look-ahead bias.”
We reason that this alternative explanation is unlikely to be the reason for our results. To the extent that we define LQP as the auditor partner who is involved in an audit failure at a sanctioned firm other than the treatment firm, it is almost impossible for the treatment firm’s manager to time the equity financing based on when the sanction is publicly announced. In fact, it is more likely that the manager of the treatment firm would have no information regarding the quality of the audit partner’s performance at another client firm. Nevertheless, we conduct the empirical test to rule out this possibility.
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Acknowledgments
We thank the editor and an anonymous reviewer for very helpful comments. We thank Michael Welker, Bohui Zhang, and seminar participants at Chinese University of Hong Kong (Shenzhen) for suggestions. Zhang and Cheng acknowledge financial supports from the Commerce ‘83 Fellowship at Queen’s University and Hong Kong Polytechnic University, respectively. Cheng and Wang acknowledge financial support from the Smith School of Business for their visits to Queen’s University. Kun Wang acknowledges financial support from the National Natural Science Foundation of China (Project 71372048). Yanping Xu acknowledges financial support from the National Natural Science Foundation of China (Project 71802092), the Enterprise Transformation Research Team Project of the Institute for Enterprise Development and School of Management, Jinan University, Guangdong Province and Jinan University Management School Funding Program, No. GY18002.
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Appendix: Variable Definitions
Appendix: Variable Definitions
External financing variables | |
Equity | Relative use of equity financing, defined as equity financing scaled by the total amount of external financing in the year. We set the value to zero for firm-years without equity financing. |
Bank | Relative use of bank loan financing, defined as bank loans scaled by the total amount of external financing in the year. We set the value to zero for firm-years without bank loan financing. |
Bond | Relative use of bond financing, defined as public bonds scaled by the total amount of external financing in the year. We set the value to zero for firm-years without bond financing. |
Other | Relative use of other types of financing (e.g., loans from related parties), defined as the ratio of other types of financing scaled by the total amount of external financing. We set the value to zero for firm-years without other types of financing. |
Cost of Equity | The industry-median adjusted square root of the inverse of the price-earnings-growth ratio. We calculate earnings growth as the two-year-ahead realized earnings per share (EPS) minus the one-year-ahead realized EPS, and price is the share price 90 days after the fiscal year-end. |
Cost of Debt | Interest expense scaled by the total interest-bearing debt outstanding. |
Key independent variables | |
Treat | An indicator that takes a value of one if the firm is audited by an LQP over the past three years and zero otherwise. We identify a partner as an LQP if the partner is involved in a regulatory sanction due to financial misreporting in another client firm. |
Post | An indicator variable that takes a value of one for the post period and zero otherwise. |
Before(t = −1) | An indicator variable that takes a value of one for the year before the sanction event and zero otherwise. |
Post(t = i) | An indicator variable that takes a value of one for the ith year after the sanction event and zero otherwise. |
Trea Still LQP | An indicator that takes a value of one if the treatment firm is still audited by the LQP in the post-period and zero otherwise. |
Treat Retain LQP | An indicator that takes a value of one if the treatment firm retains the incumbent LQP in the post-period and zero otherwise. |
Treat Another LQP | An indicator that takes a value of one if the treatment firm replaces the LQP with another LQP in the post-period and zero otherwise. |
Treat Dismiss LQP | An indicator that takes a value of one if the treatment firm replaces the LQP with a high-quality partner in the post-period and zero otherwise. |
Control variables | |
Size | The natural log of a firm’s total assets. |
Lev | Total liability scaled by total assets. |
ROA | Return on assets, net income scaled by total assets. |
PPE | Net property, plant, and equipment scaled by total assets. |
MB | End-of-year stock price times total shares outstanding scaled by total shareholders’ equity |
Loss | An indicator that takes a value of one if a firm reports negative net income and zero otherwise. |
Dividend | Dividend scaled by total assets. |
Return | The cumulative 12-month stock returns in the prior year |
Return Volatility | The standard deviation of monthly stock returns in the prior year |
Tax Rate | Income tax expense scaled by pre-tax income. |
Beta | The CAPM-beta estimated by regressing 36 monthly returns on a value-weighted market return. |
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Cheng, C.S.A., Wang, K., Xu, Y. et al. The impact of revealing auditor partner quality: evidence from a long panel. Rev Account Stud 25, 1475–1506 (2020). https://doi.org/10.1007/s11142-020-09537-w
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DOI: https://doi.org/10.1007/s11142-020-09537-w