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Underwriter–Auditor Relationship and Pre-IPO Earnings Management: Evidence from China

Abstract

This study examines the influence of underwriter–auditor relationship (UAR) on pre-initial public offering (IPO) earnings management. Using a sample of Chinese to-be-listed firms, we find that a close UAR, as reflected in repeated collaborations between an underwriter and an audit firm in IPOs, is positively associated with pre-IPO earnings management. This association is more pronounced for firms with politically connected auditors/underwriters, firms with less reputable auditors/underwriters, firms located in provinces with weak legal environment, firms to-be-listed on boards with lax listing requirements, and firms whose auditors are with low industry specialization, and legal liability exposures. We provide further evidence that UAR is associated with greater likelihood of irregular activities in post-IPO period and poorer post-IPO financial performance. To the extent that we control for alternative explanations and potential endogeneity, our results suggest that the collusion incentive is likely to drive repeated collaborations between underwriters and auditors in the Chinese IPO market. Our findings provide interesting implications for auditors, investors, and regulators seeking to understand the Chinese IPO market.

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Notes

  1. 1.

    See news coverage at: http://finance.ifeng.com/ipo/xgyw/20110801/433-453.shtml, as an example.

  2. 2.

    Starting from 2006, firms that apply for IPOs were mandated to disclose their prospectuses on the CSRC website.

  3. 3.

    According to statistics taken from MoneyWeek, the average income for an underwriter in an IPO is over 48 million RMB, and the average income for an audit firm in an IPO is about 3 million RMB.

  4. 4.

    The conceptual framework of our study is similar to that applied in studies of the effect of auditor tenure on audit quality. Although “extended auditor–client relationships” theory predicts that long tenure jeopardizes an auditor’s independence and therefore has a negative effect on audit quality (International Federation of Accountants 2010; Mautz and Sharaf 1961), “new auditor learning costs” theory predicts that long tenure facilitates an auditor’s knowledge accumulation and therefore has a positive effect on audit quality (Geiger and Raghunandan 2002; Myers et al. 2003; Petty and Cuganesan 1996).

  5. 5.

    Of the 1368 underwritings in our sample period (2006–2012), only three were provided by more than one underwriter (i.e., syndicate), in which we measure the UAR based on the collaborations between the lead underwriters and audit firms. Our results are also robust to using raw number (UARaw) of collaborations between an underwriter and an audit firm.

  6. 6.

    Our results are robust to performance-matched discretionary accruals based on the model adopted by Kothari et al. (2005) (DA_PMADJ), non-operating income (Chen and Yuan 2004) or ROA-based measure used in Aharony et al. (2000) and Kao et al. (2009) (see “Further Analyses” section).

  7. 7.

    We thank the anonymous referee for suggesting us to explore more unique questions in the Chinese context.

  8. 8.

    From this perspective, our contribution shares the same merits as that of Armstrong and Vashishtha (2012), which show that jointly considering the incentive of both portfolio delta and portfolio vega of executive equity-based compensation substantially alters inferences reported in prior literature. Our findings highlight the importance of joint consideration of both underwriter and auditor in the IPO situation.

  9. 9.

    Available at: http://www.reuters.com/article/china-ipo-regulation-idUSL3N14D1IO20151227.

  10. 10.

    Nevertheless, we address the potential endogeneity concern associated with the choices of underwriters and auditors during a firm’s IPO process in additional analyses (see “Further Analyses” section).

  11. 11.

    CSRC No. 32, “Administrative Measures for the Initial Public Offering and Listing of Stocks” (CSRC 2006; http://en.ce.cn/Markets/news/201407/03/t20140703_3090239.shtml).

  12. 12.

    Alternatively, we measure audit firm political connection by an indicator variable that equals one if the audit firm used to belong to Chinese government prior to the disaffiliation program initiated around 1997–1998 and zero otherwise. Our conclusion remains unchanged.

  13. 13.

    Chen et al. (2011) measure auditor reputation (AUD’) as one if the audit firm is one of the largest eight (i.e., Big 4 and largest 4 Chinese firms). Chen et al. (2013) measure underwriter reputation (UW’) as one if the underwriter’s market share is among top 25 %. Our measure of AUD10 (UW5) is closely correlated with AUD’ (UW’), and in a robustness check our results (untabulated) are qualitatively similar when measuring auditor and underwriter reputation using alternative measures of AUD’ and UW’.

  14. 14.

    Fan et al. (2011) index covers a period till year 2009. In main analyses, we take the value of year 2009 index as index values of 2010–2012. Moreover, we use the average growth rate of the index in prior one-/two-/three-year period in a given province to predict the index in the corresponding province for year 2010–2012. Our results remain unchanged.

  15. 15.

    When we include the variable LEGAL in the Hypothesis 2c regressions to control for any within-subsample variations in the legal environment, our results remain qualitatively the same.

  16. 16.

    This could be caused as we measure earnings quality using the raw value of discretionary accruals, where a positive coefficient may indicate that independent board increases positive DA, decreases the magnitude of negative DA, or both. In further analyses (see the section of “Further Analyses”), we adopt +DA as an alternative measure of earnings quality and find insignificant coefficient for INDR (untabulated). In this regard, our finding on board independence does not contradict with prior evidence.

  17. 17.

    We thank the anonymous referee for raising this point.

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Acknowledgments

We are grateful for the valuable comments from Hongqi Yuan, Bin Lin, Feng Liu, Shizhong Huang, Xiongyuan Wang, and workshop participants at Zhongnan University of Economics and Law. Prof. Xingqiang Du acknowledges financial support from the National Natural Science Foundation of China (the approval number: NSFC-71572162). Dr. Xuejiao Liu acknowledges financial support from the National Natural Science Foundation of China (the approval number: NSFC-71402025).

Funding

The authors acknowledge financial support from the National Natural Science Foundation of China (the approval numbers: NSFC-71572162; NSFC- 71402025).

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Correspondence to Shaojuan Lai.

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The authors declare that they have no conflict of interest.

Appendix

Appendix

See Table 15.

Table 15 Variable definition

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Du, X., Li, X., Liu, X. et al. Underwriter–Auditor Relationship and Pre-IPO Earnings Management: Evidence from China. J Bus Ethics 152, 365–392 (2018). https://doi.org/10.1007/s10551-016-3278-4

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Keywords

  • Underwriter–auditor relationship (UAR)
  • Earnings management
  • The collusion incentive
  • Political connections
  • Underwriter (auditor) reputation
  • Legal environment