Skip to main content
SpringerLink
Log in

A Political–economic Analysis of Auditor Reporting and Auditor Switches

  • Original Article
  • Published:
Review of Accounting Studies Aims and scope Submit manuscript

Abstract

This study examines whether auditor opinions are affected by political and economic influences from governments. We use auditor locality (local versus non-local) to capture such influences from local governments in China. Based on data from China’s stock markets for the period 1996–2002, we find that local auditors, who have greater economic dependence on local clients and are subject to more political influence from local governments than non-local auditors, are inclined to report favorably on local government-owned companies to mitigate probable economic losses. Moreover, companies with qualified opinions are more likely to switch from a non-local auditor to a local auditor than companies with unqualified opinions. Contrary to some prior studies, we find that in China’s political environment, local government-owned companies that switched from a non-local auditor to a local auditor after receiving a qualified opinion can succeed in opinion shopping.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Fig. 1

Similar content being viewed by others

Notes

  1. Privatization and capital market development are key aspects of economic reforms adopted by many transitional economies, including China and its neighbors like Russia and Vietnam. A common feature of corporate share ownership structure in transitional economies is the dominance of insider ownership and government control, particularly in strategic industries like defense, minerals, and precious stone extraction (Krivogorsky, 2000; Wright & Nguyen, 2000). Concentrated corporate ownership and a long history of heavy government influence on business activities reduce the demand for independent auditing in these economies (Sucher & Bychkova, 2001).

  2. State shares are held by the state, with the local government being the controlling owner in most of the listed companies. State shares are non-tradable, but are transferable to government related institutions. Legal person shares are held by state-owned institutions, including securities firms, trust and investment companies, mutual funds, and state-owned enterprises that have at least one non-state owner, and can only be traded in blocks in a designated market. Tradable A shares and B shares are held and traded mostly by individuals in stock exchanges. On average, these tradable shares comprise of about one third of all the shares of Chinese listed companies.

  3. Managers can manipulate earnings by modifying how they interpret accounting standards, or by timing or structuring transactions (Healy & Wahlen, 1999). Nelson, Elliott and Tarpley (2002, 2003) define earnings management as broadly including earnings management that is (1) consistent with GAAP, (2) difficult to distinguish from GAAP, and (3) clearly not GAAP. They explain that while auditors are most likely to require the client to make an adjustment in situation (3), they are less likely to do so in the other two situations. However, in any case, auditors are only likely to require adjustment of earnings management attempts that they identify as material. Failure to make a required adjustment could result in qualified opinions. In this paper, we are mainly concerned with earnings management that will lead to qualified reports.

  4. In China, it is very difficult for individual shareholders to pursue lawsuits against the controlling government owners. For example, recently two groups of residents in Shanghai took legal actions against the government for corrupt dealings in the allocation of land to a property developer. Not only did the residents lose the cases, the lawyer who represented the residents was also sentenced to 3 years in jail (SCMP, 2003).

  5. We do not expect audit fees to be a significant factor affecting auditor switches in China. The Chinese Institute of Certified Public Accountants and the Pricing Bureau set a minimum limit on the audit fee which is based on a percentage of a client’s total assets (Beijing Pricing Bureau, 2001; Li & Jin, 2003). With the exception of the Big Five (Four) audit firms, most audit firms in China do not charge significantly above the limit due to competition. In addition, with the rapidly increasing workload due to new regulations, audit firms are unlikely to use “low-balling” strategies to entice companies to switch auditors. For example, in this study, for companies that switched auditors in 2001, 85 companies voluntarily disclosed their audit fees for 2000 and 2001. We find that these switching companies paid comparatively higher fees in 2001, by an average of RMB83,800 (approximately US$ 10,000) per engagement, or by 0.014% of total assets. Similarly, for companies that switched auditors in 2002, 56 companies disclosed their audit fees for both 2001 and 2002. The mean audit fee paid by these switching companies in 2002 is also higher than that paid in 2001 by RMB49,142 (approximately US$ 5,920) per engagement, or by 0.003% of total assets. While the Big Five firms do charge more than others, there were only a few switches away from the Big Five firms in our study period. As explained in our sensitivity analysis later, including or excluding the Big Five auditors does not change any of the conclusions of our analysis.

  6. The number of audit firms licensed to audit listed companies was quite stable for the period 1996–1999 but has decreased significantly from 106 in 1999 to 78 in 2000 and 72 in 2002. The major reason for the decrease is the mergers of audit firms. In this study, we also excluded companies that switched to new entrant auditors. The new entrant auditor might have been an audit firm without a license to audit listed companies but was engaged to conduct the audit on behalf of the predecessor. When the non-licensed firm was granted its own license, it might keep the client and sign the audit report. Although the auditor identity is different, it is not really an auditor switch. If the new entrant auditor happens to be a local auditor, then this could potentially bias the findings in this study. However, there were only a few new entrant auditors subsequent to 1996 (five in 1998 and two in 2002) and most of them did not participate in the audit of listed companies until several years later. Specifically, for the five new entrant auditors in 1998, only one engaged in auditing the financial statements of listed companies in that year, whereas for the two new entrant auditors in 2002, none participated in the audit of listed companies in that year.

  7. The database was prepared by Shenzhen GTA Information Technology Company Limited based on the detailed information about the top ten shareholders disclosed in the annual reports of listed companies and other relevant publications such as company prospectuses for the period 1996–2002. To ensure the accuracy of the database, we have cross checked the data for a sample of 100 randomly selected companies against their annual reports, and if necessary, prospectuses and websites. We also confirmed the reliability of the data with partners of two CPA firms, who have audited listed companies in China.

  8. For example, the largest shareholder of Xinjiang International Industry (XII) Co. Ltd (stock code: 000159) is Xinjiang Foreign Trade (Group) Co. Ltd., which holds 53.43% of XII’s total stock. According to the background information on the controlling shareholder (i.e. Xinjiang Foreign Trade (Group) Co. Ltd.) disclosed in XII’s annual report, the ultimate owner of Xinjiang Foreign Trade (Group) Co. Ltd. is Xinjiang Tongbao Asset Management Co. Ltd., a wholly owned company of Xinjiang provincial government. Thus, XII Co. Ltd. is classified as a local government-owned company. On the other hand, the largest shareholder of Sinochem International Company Ltd (stock code: 600500) is China Chemical Import & Export Corporation which holds 64.4% of the total shares outstanding. As disclosed in the annual report of Sinochem, China Chemical Import & Export Corporation is a state-owned company established in 1950 and directly controlled by the State Council of the central government. Therefore, Sinochem International Company Limited is classified as a non-local government-owned company.

  9. Before 2000, virtually no audit firm in China had multiple offices in different provinces. The number of audit firms with multiple offices has increased subsequent to 2000. As at the end of 2002, of the 72 audit firms licensed to audit listed companies (including the Big Four), 17 firms have two offices and three firms have three offices (including the head office) located in different provinces in China. For those audit firms that have offices in different provinces, the 50% requirement for local auditor status is satisfied only if every office has local clients comprising over 50% of the office’s clientele, i.e. over 50% of the clients’ total assets come from clients in the same province where the office is located. This implies that the firm as a whole serves mainly local clients. This definition for multi-office local audit firms is rather conservative. In a few cases, a firm has one office serving mainly local clients and one office serving mainly non-local clients. Such firms were classified as non-local. Alternatively, we classify an audit firm with multiple offices as local if the combined local clients of the offices are more than 50% of the total clientele of the entire audit firm (regardless of the distribution in any one office). This classification measures the extent of local services for the firm as a whole. Our sensitivity test results indicate that the main results are insensitive to this alternative definition of local auditor for multi-office firms. Moreover, we also conducted a sensitivity test on the three regression models by excluding audit firms with multiple offices from the data. The results are substantially identical to our main analyses discussed later. The significance of all the main test variables remains unchanged.

  10. Our analysis on qualified companies that do not switch their auditors also indicates that local auditors are more likely (by 8%) than non-local auditors to issue a subsequent clean opinion to qualified local government-owned companies.

  11. One may argue that local auditors have special local information or expertise that allows them to attract better clients and do a better evaluation of local companies. Thus, they may issue more clean opinions than non-local auditors. However, our empirical evidence indicates that overall, local auditors do not have better clients. Furthermore, given our definition of local auditor, all the clients of a local auditor are located in the same province as the auditor. In other words, all the clients of a local auditor are local clients regardless of their ownership. Therefore, if local auditors have information advantage about the local business environment, this advantage should apply to all clients, not just the local government-owned clients. We attribute the differential treatment by local auditors to their local government-owned clients to the effect of political influence rather than information advantage.

References

  • Aharony, J., Lee, C. J. & Wong, T. J. (2000). Financial packaging of IPO firms in China. Journal of Accounting Research, 38, 103–126

    Google Scholar 

  • Beattie, V., & Fearnley, S. (1995). The importance of audit firm characteristics and the drivers of auditor change in UK listed companies. Accounting and Business Research, 25, 227–239

    Google Scholar 

  • Beijing Pricing Bureau (2001). Notice for amendment of service fees charged by CPA firms—Notice [2001] No. 335. (In Chinese)

  • Cahan, S.F. (1992). The effect of antitrust investigations on discretionary accruals: A refined test of the political cost hypothesis. The Accounting Review, 67, 77–96

    Google Scholar 

  • Cahan, S.F., Chavis, B.M. & Elemendorf, R. G. (1997). Earnings management of chemical firms in response to political costs from environmental legislation. Journal of Accounting, Auditing & Finance, 12(1), 37–65

    Google Scholar 

  • Chan, K. H. & Mo, P. L. L. (2002). The impact of firm characteristics on book-tax-conforming and book-tax-difference audit adjustments. The Journal of the American Taxation Association, 24, 18–34

    Google Scholar 

  • Chen, C. J. P., Su, X., & Zhao, R. (2000). An emerging market’s reaction to initial modified audit opinions: Evidence from the Shanghai Stock Exchange. Contemporary Accounting Research, 17, 429–455

    Article  Google Scholar 

  • Chen, C. J. P., Chen, S. & Su, X. (2001). Profitability regulation, earnings management and modified audit opinions: Evidence from China. Auditing: A Journal of Practice & Theory, 20, 9–30

    Google Scholar 

  • China Securities Regulatory Commission (CSRC) (2001a). Notice for the issues of additional shares by listed companies—notice [2001] no. 43. (In Chinese)

  • China Securities Regulatory Commission (CSRC). (2001b). Disclosure requirements of China securities market no. 14—Non-standard unqualified audit opinions and their related events. (In Chinese)

  • Chow, C. W. & Rice, S. J. (1982). Qualified audit opinions and auditor switching. The Accounting Review, 57, 326–335

    Google Scholar 

  • Citron, S. B. & Taffler, R. J. (1992). The Audit report under going concern uncertainties: An empirical analysis. Accounting and Business Research, 22, 337–345

    Google Scholar 

  • Craswell, A. T. (1988). The association between qualified opinions and auditor switches. Accounting and Business Research, 19, 23–31

    Google Scholar 

  • DeAngelo, L. (1981). Auditor size and audit quality. Journal of Accounting and Economics, 3, 183–199

    Google Scholar 

  • DeFond, M. L. (1992). The association between changes in client firm agency costs and auditor switching. Auditing: A Journal of Practice and Theory, 11, 16–31

    Google Scholar 

  • DeFond, M. L. & Jiambalvo J. (1993). Factors related to auditor–Client disagreements over income increasing accounting methods. Contemporary Accounting Research, 9, 415–431

    Google Scholar 

  • DeFond, M. L., Wong, T. J., & Li, S. (2000). The impact of improved auditor independence on audit market concentration in China. Journal of Accounting and Economics, 28, 269–305

    Google Scholar 

  • Dunn, K. A. & Mayhew, B. W. (2004). Audit firm industry specialization and client disclosure quality. Review of Accounting Studies, 9, 35–58

    Article  Google Scholar 

  • Francis, J. & Wilson, E. (1988). Auditor changes: A test of theories relating to agency costs and auditor differentiation. The Accounting Review, 63, 663–682

    Google Scholar 

  • Gujarati, D. (1999). Essentials of Econometrics, 2nd edition. New York: McGraw-Hill

    Google Scholar 

  • Hackenbrack, K. E. & Hogan, C. E. (2002). Market response to earnings surprises conditional on reasons for an auditor change. Contemporary Accounting Research, 19, 195–223

    Article  Google Scholar 

  • Han, J. C. Y. & Wang, S. W. (1998). Political costs and earnings management of oil companies during the 1990 Persian Gulf crisis. The Accounting Review, 73, 103–117

    Google Scholar 

  • Healy, P. M. & Wahlen, J. M. (1999). A review of the earnings management literature and its implications for standard setting. Accounting Horizons, 13, 365–383

    Google Scholar 

  • Hofstede, G. (2001). Culture’s consequences: Comparing values, behaviors, institutions, and organizations across nations, 2nd edition. Thousand Oaks: Sage Publications Inc

    Google Scholar 

  • Hong Kong Economic Journal Monthly. (2003). Hong Kong Stock and Finance Important Statistics 2002. no. 311, 99–130

  • Johnson, W. B. & Lys, T. (1990). The market for audit services – Evidence from voluntary auditor changes. Journal of Accounting and Economics, 12, 281–308

    Article  Google Scholar 

  • Judge, G. G., Hill, R. C., Griffiths, W. E., Lutkepohl, W. E. & Lee, T. C. (1988). Introduction to the Theory and Practice of Econometrics, 2nd edition. New York: John Wiley & Sons, Inc

    Google Scholar 

  • Key, K. G. (1997). Political cost incentives for earnings management in the cable television industry. Journal of Accounting and Economics, 23, 309–337

    Article  Google Scholar 

  • Klassen, K. L. (1997). The impact of inside ownership concentration on the trade-off between financial and tax reporting. The Accounting Review, 72, 455–474

    Google Scholar 

  • Krishnan, J. (1994). Auditor switching and conservatism. The Accounting Review, 69, 200–215

    Google Scholar 

  • Krishnan, J. & Stephens, R. (1995). Evidence on opinion shopping from audit opinion conservatism. Journal of Accounting and Public Policy, 14, 179–201

    Article  Google Scholar 

  • Krishnan, J., Krishnan, J. & Stephens, R. (1996). The simultaneous relation between auditor switching and audit opinion: An empirical analysis. Accounting and Business Research, 26, 224–236

    Google Scholar 

  • Krivogorsky, V. (2000). Corporate ownership and Governance in Russia. The International Journal of Accounting, 35, 331–353

    Article  Google Scholar 

  • La Porta, R., Lopez-de Silanes, F., Shleifer, A. & Vishny, R. W. (1999). Corporate ownership around the world. Journal of Finance, 54, 471–517

    Article  Google Scholar 

  • Li, S. & Wu, X. (2003). Supplementary audit patterns and auditor independence: Evidence from China’s B Share Market. China Accounting and Finance Review, 5(3), 72–102

    Google Scholar 

  • Li, R. S. & Jin, R. F. (2003). Audit fees for listed companies in China. http://www.e521.com. (February 11)

  • Lys, T. & Watts, R. (1994). Lawsuits against auditors. Journal of Accounting Research, 32(suppl), 65–102

    Google Scholar 

  • Magee, R. P. & Tseng, M. (1990). Audit pricing and independence. The Accounting Review, 65, 315–336

    Google Scholar 

  • Ministry of Finance (MOF), PRC. (2000). Notice of the concerns about the administrative interferences on the practices of CPA firms—Notice [2000] no. 25 (In Chinese)

  • Ministry of Finance (MOF), PRC. (2002). Accounting Standards for Business Enterprises. Beijing, PRC: Economic Science Press (In Chinese)

  • Nelson, M. W., Elliott, J. A., & Tarpley, R. L. (2002). Evidence from auditors about managers’ and auditors’ earnings management decisions. The Accounting Review, 77, 175–202

    Google Scholar 

  • Nelson, M. W., Elliott, J. A. & Tarpley, R. L. (2003). How are earnings managed? Examples from auditors. Accounting Horizons, 17, 17–35

    Google Scholar 

  • Reynolds, J. K. & Francis, J. R. (2001). Does size matter? The influence of large clients on office-level auditor reporting decisions. Journal of Accounting and Economics, 30, 375–400

    Google Scholar 

  • Schwartz, K. B. & Menon, K. (1985). Auditor switches by failing firms. The Accounting Review, 60, 248–261

    Google Scholar 

  • Smith, D. B. (1986). Auditor ‘subject to’ opinions, disclaimers, and auditor changes. Auditing: A Journal of Practice & Theory, 6, 95–108

    Google Scholar 

  • South China Morning Post (SCMP). (2003). Property-dispute lawyer gets three years’ jail for leaking state secrets (October 29)

  • Stice, J. (1991). Using financial and market information to identify pre-engagement factors associated with lawsuits against auditors. The Accounting Review, 66, 516–533

    Google Scholar 

  • Sucher, P. & Bychkova, S. (2001). Auditor independence in economies in transition: A study of Russia. The European Accounting Review, 10, 817–841

    Google Scholar 

  • Tang, Y. W. (1999). Issues in the development of the accounting profession in China. China Accounting and Finance Review, 1, 21–36

    Google Scholar 

  • Teoh, S. H. (1992). Auditor independence, dismissal threats and the market reactions to auditor switches. Journal of Accounting Research, 30, 1–23

    Google Scholar 

  • Teoh, S. H. & Wong, T. J. (1993). Perceived auditor quality and the earnings response coefficient. The Accounting Review, 68, 346–366

    Google Scholar 

  • Vanstraelen, A. (2003). Going-concern opinions, auditor switching, and the self-fulfilling prophecy effect examined in the regulatory context of Belgium. Journal of Accounting, Auditing & Finance, 18, 231–256

    Google Scholar 

  • Watts, R.L. & Zimmerman, J. L. (1986). Positive Accounting Theory. Englewood Cliffs, NJ: Prentice Hall

    Google Scholar 

  • Wilkins, M. S. (1997). Technical default, auditors’ decisions and future financial distress. Accounting Horizons, 11(4), 40–48

    Google Scholar 

  • Woo, E. S. & Koh, H. C. (2001). Factors associated with auditor changes: A Singapore study. Accounting and Business Research, 31, 133–144

    Google Scholar 

  • Wright, P.C. & Nguyen, V. T. (2000). State-owned enterprises (SOEs) in Vietnam. The International Journal of Public Sector Management, 13, 169–177

    Article  Google Scholar 

  • Xu, H. Y. (1998). Qualified opinions and unqualified opinions with explanation: No significant differences in their nature. China Securities News (April 20) (In Chinese)

  • Yang, L., Tang, Q., Kilgore, A. & Hong, J. Y. (2001). Auditor–government associations and auditor independence in China. The British Accounting Review, 33, 175–189

    Article  Google Scholar 

  • Zhong, H. (1998). Analysis of the answers to survey questions by Chinese CPAs. CPA News, No. 1. (In Chinese)

Download references

Acknowledgements

We thank Mark DeFond, Michael Firth, Jere Francis, William Shafer and Dan Simunic for their reviews of the earlier versions of the paper. We are grateful to Maureen McNichols (the Editor), two anonymous referees, and participants at the Asian Pacific Conference on International Accounting Issues, Los Angeles, the Academy of International Business Meeting, Shanghai, and the Department of Accounting research workshop at National Taiwan University for their helpful comments and suggestions. Financial supports from Lingnan University (funding ref. RES200/BUS001-4) and The Hong Kong Polytechnic University (research grant no. A-PC 32) are gratefully acknowledged.

Author information

Authors and Affiliations

  1. Department of Accountancy, Lingnan University, Tuen Mun, Hong Kong

    K. Hung Chan & Kenny Z. Lin

  2. School of Accounting and Finance, The Hong Kong Polytechnic University, Hung Hom, Kowloon, Hong Kong

    Phyllis Lai-lan Mo

Authors
  1. K. Hung Chan
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Kenny Z. Lin
    View author publications

    You can also search for this author in PubMed Google Scholar

  3. Phyllis Lai-lan Mo
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Phyllis Lai-lan Mo.

Appendix A

Appendix A

Appendix Demographics of audit firms in China
Full size table

Rights and permissions

Reprints and permissions

About this article

Cite this article

Chan, K.H., Lin, K.Z. & Mo, P.Ll. A Political–economic Analysis of Auditor Reporting and Auditor Switches. Rev Acc Stud 11, 21–48 (2006). https://doi.org/10.1007/s11142-006-6394-z

Download citation

  • Issue Date:

  • DOI: https://doi.org/10.1007/s11142-006-6394-z

Keywords

JEL Classification

Search

Navigation