Top

Review of Accounting Studies

Published in:

08-07-2020 | Non-Conference Submission

The impact of revealing auditor partner quality: evidence from a long panel

Authors: C. S. Agnes Cheng, Kun Wang, Yanping Xu, Ning Zhang

Published in: Review of Accounting Studies | Issue 4/2020

Activate our intelligent search to find suitable subject content or patents.

search-config

AI-assisted search

Off

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.

previous article Using video to disclose forward-looking information: the effect of nonverbal cues on investors’ judgments

next article Does it pay to ‘Be Like Mike’? Aspiratonal peer firms and relative performance evaluation

Dont have a licence yet? Then find out more about our products and how to get one now:

Springer Professional "Wirtschaft+Technik"

Online-Abonnement

Mit Springer Professional "Wirtschaft+Technik" erhalten Sie Zugriff auf:

über 102.000 Bücher
über 537 Zeitschriften

aus folgenden Fachgebieten:

Automobil + Motoren
Bauwesen + Immobilien
Business IT + Informatik
Elektrotechnik + Elektronik
Energie + Nachhaltigkeit
Finance + Banking
Management + Führung
Marketing + Vertrieb
Maschinenbau + Werkstoffe
Versicherung + Risiko

Jetzt Wissensvorsprung sichern!

inform now

Springer Professional "Wirtschaft"

Online-Abonnement

Mit Springer Professional "Wirtschaft" erhalten Sie Zugriff auf:

über 67.000 Bücher
über 340 Zeitschriften

aus folgenden Fachgebieten:

Bauwesen + Immobilien
Business IT + Informatik
Finance + Banking
Management + Führung
Marketing + Vertrieb
Versicherung + Risiko

Jetzt Wissensvorsprung sichern!

inform now

Available only for authorised users

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.

Abodia, D., Lin, C., & Petacchi, R. (2015). Capital market consequences of audit partner quality. The Accounting Review, 90(6), 2143–2176.CrossRef

Baker, M., Stein, J. C., & Wurgler, J. (2003). When does the market matter? Stock prices and the investment of equity-dependent firms. The Quarterly Journal of Economics, 118(3), 969–1005.CrossRef

Benabou, R., & Laroque, G. (1992). Using privileged information to manipulate markets: Insiders, gurus, and credibility. The Quarterly Journal of Economics, 107(3), 921–958.CrossRef

Bonner, S. E., Palmrose, Z. V., & Young, S. M. (1998). Fraud type and auditor litigation: An analysis of SEC accounting and auditing enforcement releases. The Accounting Review, 73(4), 503–532.

Chakravarthy, J., deHaan, E., & Rajgopal, S. (2014). Reputation repair after a serious restatement. The Accounting Review, 89(4), 1329–1363.CrossRef

Chang, X., Dasgupta, S., & Hilary, G. (2009). The effect of auditor quality on financing decisions. The Accounting Review, 84(4), 1085–1117.CrossRef

Chen, P. C. (2016). Banks’ acquisition of private information about financial misreporting. The Accounting Review, 91(3), 835–857.CrossRef

Chen, X., Cheng, Q., & Lo, A. K. (2013). Accounting restatements and external financing choices. Contemporary Accounting Research, 30(2), 750–779.CrossRef

Chen, S., Sun, S. Y. J., & Wu, D. (2010). Client importance, institutional improvements, and audit quality in China: An office and individual auditor level analysis. The Accounting Review, 85(1), 127–158.CrossRef

Cheung, Y., L., Jing, T. Lu, P. R. Rau, A. Stouraitis. 2009. Tunneling and propping up An analysis of related party transactions by Chinese listed companies: Pacific-Basin Finance Journal 17(3): 372–393.

Costello, A. M., & Wittenberg-Moerman, R. (2011). The impact of financial reporting quality on debt contracting: Evidence from internal control weakness reports. Journal of Accounting Research, 49(1), 97–136.CrossRef

DeFond, M., & Zhang, J. (2014). A review of archival auditing research. Journal of Accounting & Economics, 58(2–3), 275–326.CrossRef

deHaan, E. (2017). The financial crisis and corporate credit ratings. The Accounting Review, 92(4), 161–189.CrossRef

Diamond, D. W. (1991). Monitoring and reputation choice between bank loans and directly placed debt. Journal of Political Economy, 99, 689–721.CrossRef

Doxey, M. M., J. G. Lawson, T. J. Lopez, and Q. Swanquist. 2018. Do investors care who did the audit? Early evidence of the informativeness of form AP. Working paper.

Easton, P. D. (2004). PE ratios, PEG ratios and estimating the implied expected rate of return on equity capital. The Accounting Review, 79(1), 73–95.CrossRef

Fan, G., X. Wang, and H. Zhu, 2011, NERI Index of Marketization for China’s Provinces: 2010 Report, Beijing, China, Economic Science Press (in Chinese).

Fang, J., Pittman, J., Zhang, Y., & Zhao, Y. (2017). Auditor choice and its implication for group-affiliated firms. Contemporary Accounting Research, 34(1), 39–82.CrossRef

Francis, J. R. (2011). A framework for understanding and researching audit quality. Auditing: A Journal of Practice & Theory, 30(2), 125–152.CrossRef

Francis, J., LaFond, R., Olsson, P., & Schipper, K. (2005). The market pricing of accruals quality. Journal of Accounting and Economics, 39(2), 295–327.CrossRef

Graham, J. R. (1996). Debt and the marginal tax rate. Journal of Financial Economics, 41(1), 41–73.CrossRef

Graham, J. R., Li, S., & Qiu, J. (2008). Corporate misreporting and bank loan contracting. Journal of Financial Economics, 89(1), 44–61.CrossRef

Gul, F. A., Wu, D., & Yang, Z. (2013). Do individual auditors affect audit quality? Evidence from archival data. The Accounting Review, 88(6), 1993–2023.CrossRef

Hail, L., & Leuz, C. (2006). International differences in the cost of equity capital: Do legal institutions and securities regulation matter? Journal of Accounting Research, 44(3), 485–531.CrossRef

Jian, M., & Wong, T. J. (2010). Propping through related party transactions. Review of Accounting Studies, 15(1), 70–105.CrossRef

Kedia, S., Khan, U., & Rajgopal, S. (2018). The SEC’s enforcement record against auditors. Journal of Law, Finance and Accounting, 3(2), 243–289.CrossRef

Lennox, C., & Pittman, J. A. (2010). Big five audits and accounting fraud. Contemporary Accounting Research, 27(1), 209–247.CrossRef

Lennox, C. S., Wu, X., & Zhang, T. (2014). Does mandatory rotation of audit partners improve audit quality? The Accounting Review, 89(5), 1775–1803.CrossRef

Leuz, C., and Verrecchia, R., 2004. Firms’ capital allocation choices, information quality, and the cost of capital. University of Pennsylvania working paper.

Li, L., Qi, B., Tian, G., & Zhang, G. (2017). The contagion effect of low-quality audits at the level of individual auditors. The Accounting Review, 92(1), 137–163.CrossRef

Moore, G., & Scott, W. R. (1989). Auditors’ legal liability, collusion with management, and investors’ loss. Contemporary Accounting Research, 5(2), 754–774.CrossRef

Myers, S. C. (1977). Determinants of corporate borrowing. Journal of Financial Economics, 5(2), 147–175.CrossRef

Ng, J., Tuna, I., & Verdi, R. (2013). Management forecast credibility and underreaction to news. Review of Accounting Studies, 18(4), 956–986.CrossRef

Vashishtha, R. (2014). The role of bank monitoring in borrowers’ discretionary disclosure: Evidence from covenant violation. Journal of Accounting and Economics, 57(2–3), 176–195.CrossRef

Wang, Y., Yu, L., & Zhao, Y. (2015). The association between audit-partner quality and engagement quality: Evidence from financial report misstatements. Auditing: A Journal of Practice & Theory, 34(3), 81–111.CrossRef

Title: The impact of revealing auditor partner quality: evidence from a long panel
Authors: C. S. Agnes Cheng
Kun Wang
Yanping Xu
Ning Zhang
Publication date: 08-07-2020
Publisher: Springer US
Published in: Review of Accounting Studies / Issue 4/2020
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-020-09537-w

Springer Professional

Abstract

Please log in to get access to your license.

Dont have a licence yet? Then find out more about our products and how to get one now:

Springer Professional "Wirtschaft+Technik"

Springer Professional "Wirtschaft"

Other articles of this Issue 4/2020

Do going concern opinions provide incremental information to predict corporate defaults?

Gender and beauty in the financial analyst profession: evidence from the United States and China

Economic persistence, earnings informativeness, and stock return regularities

Does it pay to ‘Be Like Mike’? Aspiratonal peer firms and relative performance evaluation

Tax-savvy executives

The effect of ASU 2014–08 on the use of discontinued operations to manage earnings