the economic consequences of voluntary auditing
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The Economic Consequence of
Voluntary Auditing
IN-MU HAW*
DAQING QI**
WOODY WU***
A number of Chinese firms voluntarily acquire auditing services for
their interim reports, even though the auditing of interim reports is man-datory only for a subset of firms in circumstances that are specified by
the state regulators. This unique institutional setting in the Chinese mar-
ket provides a natural experimental setting to directly investigate why
listed firms voluntarily have their financial reports audited, and whether
investors place more value on voluntarily audited earnings than on
unaudited earnings. Based on a sample of 2,458 semi-annual interim
reports released by listed Chinese firms from 1996 to 1999, we find that
the choice of voluntary auditing is positively associated with the per-
centage of tradable shares, profitability, and company size. We also find
that the earnings response coefficients of audited firms are higher thanthose of unaudited firms, especially when the auditing is voluntary. Our
findings are consistent with theoretical propositions that managers vol-
untarily purchase external auditing to enhance the credibility of
accounting numbers. This study contributes to the literature, especially
on the economic value of voluntary auditing.
Keywords: Voluntary auditing, earnings response coefficients, motivation,
China
1. Introduction
In recent years, investors and policymakers have become increasingly aware
of the importance of Chinas capital markets. As the largest and fastest-growing
emerging market, China has made significant progress in developing a viable
*Texas Christian University**Cheung Kong Graduate School of Business***Chinese University of Hong KongWe thank Paul Brockman, Edward Douthett, Lee-Seok Hwang, W. S. Kim, Steve Lim, Chul W.
Park, and Bill Wempe for their helpful comments; Ma Yue and Yu Xin for their assistance. The work
that is described in this paper was substantially supported by grant from the Research Grants Councilof the Hong Kong Special Administrative Region (Project No. CUHK4288/01H) and the NeeleySummer Research Award Program at Texas Christian University. The first author acknowledges that
i ifi t ti f k l t d h h i it d H K B ti t U i it
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capital market and more rigorous financial reporting and auditing regulations.
DeFond, Wong, and Li (1999) find that the quality and independence of Chinese
auditing firms have significantly improved in recent years, partly because of theimplementation of rigorous new auditing standards.
Listed Chinese firms have been required to issue interim (semi-annual)
reports since 1994. While the auditing of interim reports is not required in China
except for firms in circumstances specified by the state regulators (i.e., when
there have been two consecutive annual losses, when stock rights are offered,
and when declaring interim dividends), anecdotal evidence suggests that many
listed firms voluntarily have their interim reports audited. This phenomenon does
not exist in Western countries, where the auditing of interim reports is not
required and empirically infrequent. The unique institutional setting in China pro-
vides an opportunity for a direct empirical assessment of both the motivating fac-tors for having voluntary audits and the effect of voluntary audits on the
credibility and informativeness of the interim reports.
Prior studies postulate that one major reason for firms to hire an outside
monitoring mechanism is to help control the conflict of interests between man-
agers and stakeholders by allowing outsiders to verify the validity of financial
statements (see, among others, Jensen & Meckling [1976]; Watts & Zimmer-
man [1986]). Chow (1982) empirically analyzes U.S. firms incentives to hire
an external auditing service for their annual reports in 1926, when auditing
was not required by law. He shows that leverage, accounting-based debt cove-
nants, and firm size increase the probability that the firm voluntarily acquires
external auditing. Ettredge, Simon, Smith, and Stone (1994) and Manry, Tiras,
and Wheatley (2003) examine why some companies purchase timely reviews
of quarterly financial statements while others do not. Their findings suggest
that companies with higher agency costs are more likely to acquire timely
reviews.
Prior studies further argue that the certification of information by inde-
pendent auditors improves its credibility, and conveys the image that its quality
is high, thus increasing the value of the firm (e.g., Akerlof [1970]; Holthausen &
Verrecchia [1988]; Beaver [1998]). Teoh and Wong (1993) report that the earn-ings response coefficients of firms audited by the Big Eight are higher than those
of firms that are not audited by them, suggesting that the quality of auditing
affects the credibility of the accounting numbers reported. Blackwell, Noland,
and Winters (1998) show that auditor association leads to reduced interest rates
on revolving bank loans to private firms.
However, no empirical research has directly examined whether or not audit-
ing, especially voluntary auditing, enhances the informativeness of the earnings
report (Watts & Zimmerman [1983]; Healy & Palepu [2001]). Our study is moti-
vated by the limited amount of direct empirical research on the economic value
of auditing services (Kinney [1987]). This issue is especially important in emerg-ing markets such as China, where publicly available, firm-specific information is
scarce corporate governance systems are not very effective the enforcement of
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the regulation has lagged behind other countries, and earnings management is
pervasive.1 In an environment in which the quality of earnings is suspect due to
these earnings management practices, coupled with evidence of increased auditquality in recent years (DeFond, Wong, & Li [1999]), we argue that the volun-
tary auditing of interim reports is an effective means at the disposal of Chinese
managers for firms to make a public commitment that they are disclosing credi-
ble information.
In this study, we first examine the determinants of the voluntary auditing of
interim reports by listed Chinese firms. Because Chinese firms are not required
to purchase interim audit services (unless they are subject to the regulated cir-
cumstances outlined above), their demand for auditor assurance is likely to be
driven by the expected net benefits of the audit services purchased. We thus
examine the economic value of voluntary auditing by hypothesizing that volun-tary audits enhance the informativeness of interim reports. We test whether the
earnings response coefficients (ERCs) for voluntarily audited firms are greater
than those for unaudited firms.
Our sample consists of 2,458 interim reports released by listed Chinese firms
from 1996 to 1999. We find that the choice of voluntary auditing is positively
associated with the percentage of tradable shares and profitability, reflecting Chinas
unique institutional environment. We also report that larger firms, nonInitial Public
Offering (IPO) firms, and firms with only A-shares (shares available to Chinese citi-
zens) are more inclined to choose voluntary audits. For the economic value of audit
services, we find that the ERCs for voluntarily audited firms are significantly higher
than those for unaudited firms, which suggests that voluntary auditing increases the
credibility and informativeness of interim reports.
For comparative purpose, we examine the effect of mandated interim audits
and report that the ERCs of voluntarily audited firms are greater than those of
mandatorily audited firms. This suggests that investors perceive voluntary audits
to be more informative than audits required by the regulators. We should be cau-
tious of such an interpretation, however, as the effect of mandatory audits may
be attributable to the firm-specific economic circumstances underlying mandated
audits (namely, having two consecutive losses, offering rights, and making divi-dend payments). Overall, our findings suggest that, amid the prevailing concerns
over earnings management in China, the voluntary auditing of the interim report
appears to be an effective means for Chinese managers to make a commitment
to disclose accurate information. Our results are robust after controlling for audi-
tor quality, audit opinions, loss firms, and other ERC determinants.
1. The following example illustrates a typical case of earnings management in China. The par-ent company of Shanghai Video and Audio Electronics Company sold a piece of land to the listedcompany for 69.26 million yuan in June 1997. In November 1997, the listed company sold the land
back to the holding company at 219.26 million yuan. Further, the holding company agreed to buyanother subsidiary of the listed company for 94.135 million yuan on December 22, 1997, resulting ina nonoperating profit of 79.6 million yuan. This subsidiary incurred operating losses for the first nine
th (Sh h i S it N M h 25 1998)
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This study contributes to the literature on voluntary auditing. Our first research
question on the determinants of voluntary audits extends the prior studies of
Ettredge et al. (1994) and Manry, Tiras, and Wheatley (2003) on timely reviewsof quarterly reports by examining audited financial statements. It also extends
the research of Chow (1982) on the sample of annual audits in 1926 by examining
recent voluntary audits in an emerging market, where corporate governance systems
are less effective than in the Western hemisphere.2 Our second research question is
a direct examination of the effect of voluntary auditing on the informativeness of
accounting information, which has not hitherto been addressed in the literature. It
extends the research of Blackwell, Noland, and Winters (1998) on the value of
using an auditing service in terms of interest rates charged to private firms by
examining the market consequences of voluntarily audited reports. While theory
suggests that auditing enhances the informativeness of financial data, prior researchprovides little empirical evidence for this important matter. We provide evidence
that is consistent with managers making a commitment to quality reports and
investors having the ability to place more value on the audited numbers.
Our findings provide implications for international investors and auditors.
China is further opening its capital market to the international community as a
member of the World Trade Organization. Recently, the Chinese Securities Reg-
ulatory Commission (CSRC) granted licenses to foreign investment banks such
as Morgan Stanley, Goldman Sachs, and Citibank to participate directly in
Chinas A-share market, which up to this time has been reserved exclusively for
Chinese investors.3 Our findings suggest that international investors need to be
aware of the effectiveness of voluntary audit services and the informativeness of
audited numbers. International auditors should pay more attention to the determi-
nants of the voluntary audit demand for interim reports and the economic value
attached by investors to audited interim reports. Our results imply that auditing
has begun to play a more effective role in the Chinese market.
The remainder of the paper proceeds as follows. Section 2 provides the insti-
tutional background. Section 3 discusses the hypotheses and research design.
Section 4 describes the sample. Section 5 reports empirical findings, followed by
concluding remarks in Section 6.
2. Institutional Background
2.1 Regulatory Infrastructure in China
The Ministry of Finance promulgated a new accounting framework (the
Accounting Standard for Business Enterprises) in 1993, which marked a significant
2. Begley and Fischer (1998) suggest the need of research based on the recent period sample asthere have been significant changes in audit markets and the litigation environment because of theintensified litigation risks faced by management and auditors since the 1980s.
3 Fi i l Ti J 8 2003
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mandates the auditing of interim reports of listed firms that have reported losses
in two consecutive years (called special treatment firms), will apply to offer
stock rights in the second half of the fiscal year, or will distribute interim stockor cash dividends.7
The audits of these interim reports must follow the same independent audit-
ing standards and procedures as annual reports, and the auditors reports must be
issued and attached to the interim reports and made public. The auditor has to
state whether the interim report is prepared in accordance with Chinese GAAP
and issue an opinion on it. Independent Auditing Standard No. 7 on Auditor
Opinions specifies the same conditions as those in the United States for each of
the four types of opinions: unqualified, qualified, a disclaimer, and an adverse
opinion.8 An examination of our sample indicates that auditors issue a qualified
opinion if there is evidence of a departure from GAAP, a limitation to the scopeof the audit, or a violation of the consistency principle. Explanatory paragraphs
are also attached to unqualified opinions when there is substantial doubt about
the going concern, significant related party transactions have occurred, important
events have occurred subsequent to the postbalance sheet date, and material
uncertainties are evident, such as contingencies and litigation. Appendix A illus-
trates three types of auditors reports for interim reports. In sum, the procedure
and scope for auditing the interim report is the same as those for auditing the an-
nual report at the end of the year.
While an interim audit requires as comprehensive an evaluation as a
year-end audit does, it differs from an interim review in terms of the degree of
assurance, certification, precision, and credibility. It also differs in terms of the
auditors legal obligation. A review is less comprehensive than an audit and gen-
erally does not include a detailed evaluation of the companys internal control
structure, the collection of corroborative evidence, or tests of details of account
balances and transactions. Instead, it relies mainly on limited inquires and analyt-
ical procedures. As a consequence, there is no assurance that the auditor of a
review will be aware of all the significant matters affecting interim reports that
would be uncovered by an audit. Moreover, while information about the exis-
tence, nature, and findings of an interim review is communicated to managementor the board of directors, it is seldom provided to the public.
7. In addition, when necessary, the CSRC can make case-by-case decisions on whether the in-terim report of a firm needs to be audited.
8. However, there is an exception as Chinese auditors are required to issue qualified opinions ifthe consistency principle is violated. In the United States, the lack of a consistent application of theGAAP constitutes one of the circumstances for an unqualified opinion with an explanatory paragraph
to be issued. Article 17 of the Standard also allows Chinese auditors to attach an explanatory note totheir unqualified opinion. See DeFond, Wong, and Li (1999) and Xiang (1998) for details about thedevelopment of professional auditing and reporting in China. All auditing standards and regulations
il bl t i /F iR lt
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3. Hypotheses and Research Design
3.1 Why Do Chinese Firms Voluntarily Purchase Audits forTheir Interim Reports?
This section discusses why some Chinese firms are motivated to have their
interim reports voluntarily audited. Prior studies based on mature markets argue
that a firms demand for monitoring is associated with the level of its agency
costs (Jensen & Meckling [1976]; Watts & Zimmerman [1986], among others).
Companies that voluntarily purchase an interim audit choose to have an external
auditor formally certify their internal control structures and financial statements.
They contract for a higher level of outside monitoring if the benefits are
expected to exceed the incremental costs, where the benefits of interim audits
primarily result from improvement in the credibility of interim reports. We con-
sider various supply-and-demand factors, including variables specific to the Chi-
nese market, to examine the determinants of voluntary interim audits.
Unlike in the United States, listed Chinese firms have a significant portion
of nontradable shares, providing either the state or legal entities, mostly SOEs,
with controlling ownership. Recent studies report that such ownership structures
adversely affect these firms financial performance and information environment,
resulting in high information asymmetries and low levels of informativeness in
accounting earnings (e.g., Claessens, Djankov, Fan, & Lang [2002]; Fan & Wong
[2002]). As the controlling shareholders may not report high-quality accounting
information, and may even manipulate earnings (e.g., Haw, Hu, Hwang, & Wu
[2004]), they have the incentive to avoid external monitoring, which further
exacerbates the problem of low corporate transparency (Ball, Robin, & Wu
[2003]).
Under the government-controlled economy of China, managers of listed
SOE firms are frequently appointed by the government, and strive not only to
promote financial performance but also to meet nonfinancial strategic goals set
by the government (such as producing and delivering strategic products to the
state). The managers of listed firms with a heavy state and legal-entity ownership
are strongly motivated to act in the best interest of the state and legal persons,and have less incentive to maximize the firms value of tradable shares for public
shareholders. In contrast, firms with a high proportion of tradable shares are bet-
ter motivated to act in the best interest of public shareholders, and therefore they
are more likely to acquire interim audit as an outside monitoring mechanism for
their interim reports (Ball, Kothari, & Robin [2000]). In such a context, volun-
tary auditing can effectively communicate a firms commitment to report high-
quality information to investors, reducing the level of information asymmetry
between the management and shareholders of tradable shares. Thus, our first hy-
pothesis is (in alternative form) as follows:
H1: Managers of firms with a high percentage of tradable shares are more
likely to purchase voluntary interim audits
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We consider profitability to be an important factor in the demand for volun-
tary audits in China as the current regulatory requirements are based on reported
earnings. For example, a rights issue is the only primary source for listed Chi-nese companies to raise additional capital after the IPO. To make a rights offer,
a listed firm must obtain approval from the CSRC. One of the main considera-
tions of the CSRC is whether the company exceeds certain minimum profitability
requirements. In January 1996, the CSRC began to require that the reported
return on equity (ROE) be greater than 10 percent in each of the most recent
three years.9 Prior studies have found that a large number of listed Chinese firms
manipulate earnings to meet such regulatory requirements for rights offerings
(Chen & Yuan [2004]; Haw, Qi, Wu, & Wu [2005]). They have provided evi-
dence that a significant portion of applicants meeting the ROE benchmark do not
receive approval from the CSRC for a rights offering because of suspect earningsmanagement. Haw et al. (2005) find that the ERCs of Chinese firms with a
greater degree of earnings manipulation are lower than those of firms with less
earnings manipulation.
In Chinas emerging market, where pervasive earnings management makes
earnings less reliable, firms with a genuinely good economic performance may
have strong incentives to have their interim reports voluntarily audited as their
good earnings are likely to be suspected of earnings management. In a market
where financial intermediaries do not act effectively and the corporate gover-
nance system is weak, voluntary external audits can credibly communicate firms
commitment to disclose accurate information to investors and regulators, separat-
ing them from firms suspected of overstating their earnings and increasing the
probability of their future rights offerings. Moreover, while a third-party audit
certifies the quality of the earnings, it is costly for firms that have manipu-
lated their earnings to mimic this quality. Thus, our second hypothesis is (in al-
ternative form) as follows:
H2: Managers of firms that report high profits are more likely to purchase
voluntary interim audits.
Our analysis includes other variables used in prior studies such as companysize (SIZE), the proportion of assets held in receivables (REC), financial leverage
(LEV), and the issuance of new securities (NEWSTOCK) (Chow [1982]; Ettredge
et al. [1994]; Manry, Tiras, & Wheatley [2003]). We do not, however, consider
the percentage of common stock owned by managers and directors in our analy-
sis. Unlike in the United States, managers and directors of listed Chinese firms
hold none or only insignificant amounts of shares in their company. We do, how-
ever, control for auditor switching, because the incremental cost of auditing is
9. On March 17, 1999, the CSRC modified the annual ROE requirement to be greater than6 percent for each of the most recent three years, and the average ROE for the three years to be
t th 10 t
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greater if the company changes an audit firm (Johnson & Lys [1990]; DeFond
[1992]; Ettredge et al. [1994]).
We include three additional control variables based on the findings of priorstudies on Chinese markets. They are as follows: (1) whether firms have issued
shares that are available to foreign investors (in addition to A-shares for Chinese
investors), because their reporting and auditing environments are different
(DeFond, Wong, & Li [1999]);10 (2) whether firms are IPOs (i.e., whether they
have gone public in the last year), because Chinese IPO firms tend to manage
earnings around the IPO year, and thus have less incentive to acquire voluntary
interim audits (Aharony, Lee, & Wong [2000]); and (3) whether firms hire qual-
ity auditors, because joint venture auditors and large local Chinese auditors are
more independent and more frequently issue modified opinions (DeFond, Wong, &
Li [1999]).11 We test our hypotheses by estimating the coefficients in the followinglogit regression (with subscripts firm i and time tomitted):
where:
Voluntary audit dummy a dummy variable that equals 1 for a voluntary in-
terim audit, and 0 for an unaudited interim report.
ROE net income divided by stockholders equity.TRADESHR the percentage of tradable shares.
SIZE the natural logarithm of the sum of market value of
equity and book value of short-term and long-term
debt (Chow [1982]).
REC receivables divided by total assets.
LEV long-term debt divided by total assets.
NEWSTOCK the proceeds received from new equity security issu-
ance scaled by total assets (mainly attributable to
previous rights offerings).
IPO dummy a dummy variable that equals 1 for an IPO during
the last year, and 0 otherwise.
10. Listed firms with shares available to foreign investors have to prepare financial statementsunder international accounting standards. Shares available to overseas investors include B-shareslisted on the Shanghai and Shenzhen Stock Exchanges, H-shares listed on the Hong Kong StockExchange, and shares listed on other foreign stock exchanges. From 2001, B-shares are allowed fortrading among domestic investors.
11. DeFond, Wong, and Li (1999) report that the frequency of modified opinions (the surrogate
for independence) has increased ninefold subsequent to the adoption of the new auditing standards in1996. They also report a large decline in market share by the independent auditors, interpreting thedecline as flight from quality in the Chinese audit market, consistent with the argument that Chi-
id dit th t lik l t i difi d dit i i
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Foreign share dummy a dummy variable that equals 1 for firms that have
issued shares available to foreign investors, and 0
for firms with only A-shares.Quality auditor dummy a dummy variable that equals 1 if a firms auditor is
among the top-five local Chinese auditors or joint ven-
tures affiliated to international auditors, and 0 otherwise.
Auditor switch dummy a dummy variable that equals 1 if a firm switches its
auditor during the year before the interim audit, and
0 otherwise.
All continuous variables are measured based on the current interim period and
defined similarly as prior studies. Hypothesis 1 predicts that b2 will be positive,
and Hypothesis 2 predicts that b1 will be positive. Prior research predicts that b3,b5, and b6 will be positive, and b4 will be negative.
3.2 Impact of Auditing on the Informativeness of Interim Earnings
This section develops the hypothesis and research design to test whether
auditing, especially voluntary auditing, enhances the quality of interim earnings.
Theoretically, investors responses to an earnings surprise are related to the per-
ceived precision of the earnings report. Prior studies suggest that the ERCs vary
with the quality of the earnings (e.g., Holthausen & Verrecchia [1988]). Auditors
certify that financial statements have been prepared in conformance with theGAAP, which assures investors of their reliability. Because audited earnings are
perceived to be more credible than nonaudited earnings and hence to reflect true
economic value accurately, we expect them to have a greater effect on investors
valuation of the firm, thus implying a higher ERC.
As voluntary interim auditing is a costly but deliberate choice by managers,
they can be expected to exercise discretion by comparing the costs of the auditing
services with the anticipated increase in the value of the firm arising from inves-
tors perceptions of the enhanced quality of an audited report. Consistent with the
argument that certification can improve the credibility of information and com-
municate the high quality of the securities, we posit that voluntary auditing lends
credibility to interim earnings, and affects investors perception of their quality,
and therefore increases the magnitude of investors responses to a given earnings
surprise (e.g., Beaver [1998]; Holthausen & Verrecchia [1988]). Teoh and Wong
(1993) report that the ERC is higher for earnings audited by audit firms perceived
to be of higher quality. Whereas these studies examine the effect of high-quality
auditors vs. low-quality auditors on the ERCs, our study directly compares the
informativeness of audited reports with that of unaudited numbers. However, both
studies focus on the credibility of reported accounting numbers. Given pervasive
earnings management practices in China, we predict that voluntary auditing com-
municates the commitment of management to report accurate financial data to
investors. Thus, our third hypothesis is (in alternative form) as follows:
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H3: Firms that have interim reports voluntarily audited have higher ERCs
than firms that have unaudited interim reports.
Because the earnings announcement date is the first date that the earnings
(as well as audit information) are publicly available, we develop the following
cross-sectional regression model with the three-day window surrounding the
announcement date (with subscripts firm i and time t omitted):12
where:
CAR market-adjusted abnormal returns accumulated over
the three trading days (1, 0, 1), where 0 is the in-
terim earnings announcement date, adjusted for divi-
dends and stock rights.
DE unexpected semi-annual earnings, defined as the dif-
ference between reported earnings in the first half
of years t and t 1, deflated by market value at thebeginning of the three-day event window in year t.
Voluntary audit dummy a dummy variable that equals 1 if the interim report
is voluntarily audited, and 0 otherwise.
Mandatory audit
dummy
a dummy variable that equals 1 if the interim report
is mandatorily audited, and 0 otherwise.
Modified opinion
dummy
a dummy variable that equals 0 if the audit opinion
is clean, and 1 otherwise.13
Firm size dummy a dummy variable that equals 1 if the market value of
the firm at the end of June of year t is above the sam-
ple median, and 0 otherwise.
Market-to-book dummy a dummy variable that equals 1 if the market value
of the common equity divided by the book value of
common equity at the end of June of year t is above
the sample median, and 0 otherwise.
12. The Chinese regulations do not allow listed firms to release preliminary earnings to thepublic before filing financial reports to the CSRC and the stock exchanges. While filing reports tothe stock exchanges and the CSRC precedes the public announcement, the latter is the first time thatearnings (as well as audit opinions) are made available to the public.
13. Auditors in China can emphasize events such as significant uncertainties, contingencies,and related party transactions in the explanatory note attached to unqualified opinions. Because thenote usually carries a negative view from the auditor, we group audit opinions other than clean opin-i difi d i i (D F d W & Li [1999] H P k Qi & W [2003])
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Beta dummy a dummy variable that equals 1 if the market beta
of the firm at the end of June of year t is above the
sample median and 0 otherwise.Quality auditor dummy a dummy variable that equals 1 if a firms auditor is
among the top-five local Chinese auditors or joint
ventures affiliated to international auditors, and 0
otherwise.
Loss dummy a dummy variable that equals 1 if the semi-annual
earnings is negative, and 0 otherwise.
e error term.
Since earnings forecasts for listed Chinese A-share firms are not available,
we use the seasonal random walk model as a proxy for the market expectation ofinterim earnings prior to the announcement. In the model, b1 is the ERC for
unaudited earnings and is expected to be positive. Our primary interest is in b2,
the coefficient on the interaction between earnings news and a voluntary audit. If
it is positive and significant, the ERC of voluntary audits will be greater than
that of unaudited reports, implying that the voluntary audits enhance the credibil-
ity of the interim reports.
We include the effect of mandatory auditing in eq. (2) for comparison. In
contrast to voluntary audits, whether mandatory interim audits enhance the credi-
bility of interim reports may depend on the firm-specific economic circumstances
underlying mandated audits. While auditing in general enhances the quality of in-terim earnings, the enhanced effect for mandated audits may be offset by inves-
tors perceptions that these firms have stronger ex ante incentives for earnings
manipulation, especially in the case of special treatment firms (those that report
two consecutive annual losses and thus face the risk of being delisted), because
they have strong incentives to manage their earnings upward. A significantly
positive b3 would suggest that the ERC of mandated audits is greater than that
of unaudited reports. Although we do not make directional predictions on
whether the ERCs are different between voluntarily and mandatorily audited
firms, we will provide empirical results for comparative purpose.
Our model includes other standard ERC determinants. Previous studies
report that the ERC differs systematically in size, growth, risk, and earnings per-
sistence (e.g., Holthausen & Verrecchia [1988]; Collins & Kothari [1989]; Easton
& Zmijewski [1989]). We control for firm-specific characteristics, such as firm
size, growth, risk, auditor quality, and loss by including their interaction vari-
ables. We measure the first three control variables following Teoh and Wong
(1993) and DeFond and Park (2001).14 To control for the effect of modified
14. Earnings persistence is not included as a control variable because the time series of interim
earnings is too short for listed Chinese firms. Collins and Kothari (1989) suggest that the book-to-market ratio is affected by both growth opportunities and persistence, and thus provides a normaliza-tion for persistence as well. Also not included is the number of analysts because of the unavailability
f th d t i Chi W i di t t l i bl f ll i D F d d P k (2001)
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least one listed client increases slightly from 85 in 1996 to 88 in 1999, the num-
ber of public clients rises from 568 to 943, reflecting the substantial growth of
the Chinese stock market during this period. Government-affiliated auditors dom-
inate the market during our sample period, consisting of 85 percent of the audit-
ing firms and accounting for 82 percent of the clients.16 The top-ten local
Chinese auditors (ranked according to the number of listed firms audited) are
mostly government affiliated, and collectively account for about one-third of the
auditing market for listed firms. Appendix B reports both the identity and rank-
ing of joint ventures and the top-ten 10 local Chinese auditors, showing that the
identity of the top-five Chinese auditors is relatively stable during our sample pe-
riod. Table 2, Panel B, classifies the interim audits in our sample based on the
audit type, auditor affiliation, auditor size, and auditor opinion. Consistent with
the findings of DeFond, Wong, and Li (1999) for annual audits, joint venture
TABLE 1
Attributes of Sample Firms: Auditing Status, Audit Type, Auditor Opinion,and Reasons for Mandated Audits
Full 1996 1997 1998 1999
No. % No. % No. % No. % No. %
Auditing status:
Unaudited 1,782 72.5 284 86.4 407 72.3 513 70.0 578 69.4
Audited 676 27.5 45 13.7 156 27.7 220 30.0 255 30.6
No. of obs. 2,458 100.0 329 100.0 563 100.0 733 100.0 833 100.0
Type of audit:
Voluntary 161 23.8 18 40.0 38 24.4 56 25.5 49 19.2
Mandatory 515 76.2 27 60.0 118 75.6 164 74.5 206 80.8No. of audits 676 100.0 45 100.0 156 100.0 220 100.0 255 100.0
Auditor opinion:
Unqualified 600 89.1 44 97.8 152 97.4 193 87.7 211 82.7
Modified 76 10.9 1 2.2 4 2.6 27 12.3 44 17.3
No. of opinions 676 100.0 45 100.0 156 100.0 220 100.0 255 100.0
Reasons for
mandated audit:
Dividend 97 18.8 2 7.4 18 15.2 41 25.1 36 17.0
ST 97 18.8 0 0.0 12 10.2 26 15.8 59 29.0
Rights Offer 321 62.4 25 92.6 88 74.6 97 59.1 111 54.0
No. of mandated 515 100.0 27 100.0 118 100.0 164 100.0 206 100.0
Note: Modified opinions include opinions other than clean opinions, such as qualified, adverse, dis-
claimer, or unqualified opinion with an explanatory note. In China, auditors frequently emphasize events
such as significant uncertainty, contingency, and related party transactions in the note, which usually reflects
a negative view from the auditor.
ST are special treatment firms due to reported losses in two consecutive years.
16. All university- and government-affiliated CPA firms became independent legal entities byth d f 1998 (S iti Ti J 5 1999)
76 JOURNAL OF ACCOUNTING, AUDITING & FINANCE
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TABLE2
Descr
iptive
Info
rma
tion
on
Au
dit
or
Affiliation
,A
ud
itor
Siz
e,
Num
bero
fCli
en
ts,
an
dA
udit
or
Op
inio
n
PanelA
:Distributionofauditorsandannua
lauditsfortheentireChineselisted
firmsbyauditoraffiliation,
auditorsize,
andyear
Numberofauditfirmsbyyear
Numberoflistedclientsbyyear
1996
1997
1998
1999
1996
1997
1998
1999
All
aud
itors
Jointventureauditors
7
7
7
7
36
39
50
59
Localauditors:University
6
6
6
6
78
87
101
1
06
Govern
ment
72
74
74
75
454
607
703
7
78
Total
85
87
87
88
568
733
854
9
43
Loca
lau
dit
ors
Topten:University
2
2
2
2
53
56
63
64
Govern
ment
8
8
8
8
156
179
203
2
32
Nonto
pten:University
4
4
4
4
25
31
38
42
Govern
ment
64
66
66
67
298
428
500
5
46
PanelB
:Distribution(%)ofauditedinterim
auditsinoursamplebyauditoraf
filiation,
auditorsize,
audittype,an
dauditoropinion
Auditor
affiliationandauditorsize
Numberofauditsb
yaudittype
Numberofauditsbyauditoropinion
Voluntary(%)
Mandatory(%)
Unqualified(%)
Modified(%
)
Affiliati
on
Jointventure
5(1%)
19(3%)
17(3%)
7(1%)
University
22(3%)
54(8%)
6
2(9%)
14(2%)
Govern
ment
134(20%)
442(65%)
521(77%)
55(8%)
Total
161(24%)
515(76%)
600(89%)
76(11%)
Top
ten
loca
lau
dit
ors
Topten
47(7%)
137(21%)
171(26%)
13(2%)
Nonto
pten
109(17%)
359(55%)
412(63%)
56(9%)
Total
156(24%)
496(76%)
583(89%)
69(11%)
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and university-affiliated auditors issue more modified opinions in 29 percent and
18 percent of their respective total interim audits, which is significantly higher
than the 9.6 percent (55 divided by a sum of 521 and 55) of government-affili-ated auditors.17 The type of auditing undertaken (voluntary vs. mandatory) is not
significantly related to the type of auditor affiliation or auditor size.
5. Empirical Results
5.1 Reasons Why Chinese Firms Voluntarily Purchase Audits for
Their Interim Reports
This section provides descriptive statistics and results from the logit regression
to identify motivating factors for voluntary interim auditing in eq. (1). We excludemandatorily audited firms because they are mandated by regulations, not voluntar-
ily initiated by managers. Table 3, Panel A, reports that on average, companies
purchasing voluntary audits are significantly larger in size (SIZE) and more profita-
ble (ROE) than unaudited companies. The percentage of tradable shares
(TRADESHR) and the proportion of assets tied up in receivables (REC) do not dif-
fer significantly between the two subsamples. The long-term debt divided by total
assets (LEV) and the proceeds from new equity issues (NEWSTOCK) are not signif-
icantly different between the two groups. Among the control variables, the propor-
tion of IPO firms is significantly lower for the audited firms, consistent with the
argument that IPO firms may have engaged more frequently in earnings manage-
ment (Aharony, Lee, & Wong [2000]) and thus may have less incentive to acquire
a voluntary audit. On the other hand, the proportions of firms that have issued
shares available to foreign investors, used quality auditors, and switched auditors
are not different between the two subgroups. Spearman correlations (not reported)
for the explanatory variables indicate that the correlations are generally moderate.
Table 3, Panel B, reports the coefficients and test statistics from the logistic
regression in eq. (1). The Chi-square statistic indicates that the logistic model is
highly significant, suggesting that it has a good overall explanatory power. The
likelihood of acquiring an interim audit is significantly associated with the per-centage of tradable shares (TRADESHR), profitability (ROE), and firm size
(SIZE). Unlike the univariate statistics in Panel A, the coefficient for the propor-
tion of tradable shares, b2, is positive and significant at the 5 percent level. The
result is consistent with Hypothesis 1. The coefficient for SIZE, b3, is positive
and significant at the 1 percent level, consistent with prior studies performed in
17. However, auditor size (the top ten or top five) is not significantly related to the type of theauditor opinions on interim reports issued by local Chinese auditors in our sample. While this differsfrom the results reported by DeFond, Wong, and Li (1999) for annual audits, our result is not directly
comparable because we use only a subset of the interim reports that are audited and none of our vol-untarily audited firms receives a modified opinion. Furthermore, DeFond, Wong, and Li (1999) rankChinese auditors based on the value of firms they audit, while we rank them based on the number ofli t d fi th dit
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TABLE3
MotivatingFactorsforV
oluntaryInterim
Audits
PanelA:Univariatestatisticsforlogisticregressionvariables
Unaudited
(N
1,7
82)
Voluntaryaudit(N
161)
t-(Z-)
teststa
tisticsa
Firm
siz
eMean
3,483.9
4,640
.10
10.6
8***
million
yuan)Median
2,336.1
3,250
.8
3.7
8***
ROEMean
0.0
39
0
.069
44.3
3***
Median
0.0
38
0
.062
10.6
8***
TRADES
HRMean
0.3
46
0
.352
0.3
5
Median
0.3
19
0
.332
1.1
8
RECMe
an
0.0
82
0
.097
1.4
3
Median
0.0
36
0
.055
1.2
9
LEVMe
an
0.0
59
0
.054
0.4
6
Median
0.0
28
0
.022
0.8
3
NEWSTO
CKMean
0.0
06
0
.006
0.0
6
Median
0.0
00
0
.000
0.4
2
%
ofIPOfirms
32.3
0%
25
.00%
2.0
3**
%
offirmswithsharesavailabletoforeigninvestors
15.4
5%
11
.25%
1.5
9
%
offirmswithqualityauditors
25.6
5%
24
.38%
0.3
6
%
offirmswithauditorswitches
5.3
0%
3
.13%
1.4
7
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TABLE
3(continued)
PanelB:Parameterestimatesfromlogisticregressionanalysis
Voluntar
yauditdummy
a
b1
ROEb
2
TRADESHR
b3
SIZE
b4
REC
b5
LEV
b6
NEWSTOCKg
1
IPO
dummy
g2
Foreignsharedummy
g3
Qualityauditordummy
g4
Auditorswitchdu
mmy
e
(1)
Intercept
ROE
TRADESHR
SIZE
REC
LEV
NEW-
STOCK
IPOdummy
Foreign
share
dummy
Quality
auditor
dummy
Auditor
switch
dummy
Chi-
Square
a
b1
b2
b3
b4
b5
b6
g1
g2
g3
g4
Predictio
ns
?
?
?
?
Coefficient
-statistics
10.9
81
9.337
1.288
0.367
0.3
69
0.3
48
5.4
07
0.527
0.587
0.111
0.639
66.9
7***
(4.05)***
(5.8
0)***
(1.9
1)**
(2.9
9)***
(0.5
3)
(0.3
2)
(1.3
7)
(2.5
6)**
(1.9
5)*
(0.5
4)
(1.3
2)
aTh
et-(WilcoxonZ-)testexamineswhethermeanandproportion(median)ofeachvariableforunauditedfirmsequalsthatofvoluntarilyaudited
irms.
?indicatesnopredictedsign.
*,**,and***suggeststatisticalsignificancelevelsatthe10percent,the5percent,andthe1percentlevels,one-tailedforpredictedsignsinPanelB,and
two-tailedin
PanelA,
respectively.N
1,933.
Note:Thevariablesaredefinedasfollow
s:
Voluntar
yauditdummy
adummyvariablethatequals1foravoluntaryinterimaudit,and0foranunauditedinterimreport.
ROE
netincomediv
idedbystockholdersequity.
TRADESHR
thepercentage
oftradableshares.
SIZE
thenaturallogarithmoffirmsize,whichisdefinedasthesumofmarketvalueofequityandbookvalueofshort-andlo
ng-
termdebt.
REC
receivablesdeflatedbytotalassets.
LEV
long-termdebtdividedbytotalassets.
NEWSTOCK
theproceedsreceivedfromnewequitysecurityissuancescaledbytotalassets.
IPOdummy
adummyvariablethatequals1foranIPOduring
thelastyear,and0otherwise.
Foreignsharedummy
adummyvariablethatequals1forfirmsthathaveissuedsharesavailabletoforeign
investors,and0otherwise.
Quality
auditordummy
adummyvariablethatequals1ifafirmsauditor
isamongthetop-fivelocalChineseauditorsorjointventuresaffiliatedto
internationalauditors,and0otherwise.
Auditor
switchdummy
adummyvariablethatequals1ifafirmswitches
itsauditorduringtheyearbeforetheinterimaudit,and0otherwise.
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the United States (Chow [1982]; Ettredge et al. [1994]; Manry, Tiras, & Wheat-
ley [2003]). The coefficient for ROE, b1, is positively significant at the 1 percent
level, supporting Hypothesis 2 that the more profitable the firm, the more likelyit is to have its interim reports voluntarily audited. Similar to the findings of
Manry, Tiras, and Wheatley (2003), the coefficients for receivables (REC) and
leverage (LEV) are not significant at the conventional level, and neither is that of
the issuance of new equity shares (NEWSTOCK).18
Among the control variables, the coefficient on the IPO dummy is negative
and significant at the 5 percent level. The fact that IPO firms are less likely to
have their interim reports voluntarily audited is consistent with Aharony, Lee,
and Wong (2000), who find evidence that IPO firms manage earnings in the pe-
riod surrounding the IPO year. The coefficient for the firms with shares available
to foreign investors (Foreign share dummy) is also negative and significant atthe 10 percent level, suggesting that such firms are less likely to purchase an in-
terim audit voluntarily. One plausible explanation is that the annual financial
statements of these firms are audited by the Big Five international firms and are
therefore already perceived as credible by investors, diminishing the need for the
voluntary auditing of their interim reports. The coefficients on the auditor switch
dummy and the quality auditor dummy are not significant.19
In summary, consistent with our hypotheses, the results indicate that the vol-
untary audit choice of interim reports is positively associated with the proportion
of tradable shares and profitability, reflecting Chinas unique institutional envi-
ronment. We also find that larger firms, non-IPO firms, and firms with only A-
shares are more likely to acquire an interim audit.
5.2 Market Perception of the Quality of Audited Interim Reports
Table 4, Panel A, reports the descriptive statistics for selected market and fi-
nancial variables for the full sample. As shown in the top rows, the mean interim
earnings and market capitalization are 29.4 and 2,576.9 million yuan respec-
tively, and the mean (median) interim earnings change (DE) is 0.005 (0.00).
The yearly statistics in the middle rows indicate that the average market value of
18. Ettredge, Simon, Smith, and Stone (1994) show that the purchase of a timely review ispositively associated with company size, the issuance of new securities, and financial leverage, andnegatively associated with the percentage of common stock owned by managers and directors, andthe proportion of assets held in receivables (used as a proxy for the incremental cost). Manry, Tiras,and Wheatley (2003) find that only firm size and ownership variables are statistically significant aspredicted. Our results reflect Chinas unique market and regulatory environment in which long-termdebt is not a significant source of long-term financing for listed firms. For example, the averageyear-to-year changes of long-term debt are only 0.37 percent for the voluntarily audited firms and0.15 percent for the unaudited firms, respectively, and are not significantly different. Almost none ofthe listed Chinese firms issues corporate bonds because the preference for bond issuance is given tononlisted SOEs on the ground that listed firms are able to raise funds from shareholders through
rights issues. Long-term borrowing from banks is also infrequent.19. Results are similar when we include as quality auditors the sixth- to tenth-largest local Chi-nese auditors or use only joint ventures affiliated with international auditors, or when we measure
dit i b th i li t t t l t
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listed firms has nearly doubled from 1996 (1,777 million yuan) to 1999 (3,263
million yuan). The bottom rows do not show significant differences in market or
financial performance measures between firms listed on the Shanghai and Shenz-hen Stock Exchanges.
Table 4, Panel B, provides descriptive statistics for selected variables by
their auditing status and the reasons for having mandatory audits. The top rows
suggest that voluntarily audited firms have significantly higher earnings and mar-
ket capitalization than unaudited firms, and perform better in DE and three-day
abnormal returns. Firms with voluntary audits are also larger in size and experi-
ence better earnings and market performance than firms with mandatory audits.
The bottom rows indicate that, among firms with mandatory audits, those plan-
ning to distribute dividends perform better in DE and market returns than the
special treatment firms and rights-offering firms.
5.2.1 Regression Results of Eq. (2)
Table 5, Panel A, provides descriptive statistics for the first three control
variables used in eq. (2). F-tests indicate that they vary with the status of the
audits undertaken, and the voluntarily audited firms are larger in size and have a
higher growth potential (in median) than the unaudited firms. This indicates the
need for their inclusion as control variables.
We first run the simple return-earnings regression testing the value relevance
of interim earnings (not tabulated). The earnings response coefficient for interimearnings is positive and statistically significant at the 1 percent confidence level
(with an adjusted R2 of 0.014). The result is consistent with those of prior studies
in mature markets, and with those reporting that investors respond significantly
to the announcement of annual earnings in the Chinese market.
Table 5, Panel B, reports the regression results for eq. (2). The adjusted R2
is 0.028, consistent with the magnitude reported by most previous short-window
studies. The coefficient for unaudited earnings (b1) is 0.465, significant at the
1 percent level. More important, the ERCs are higher for the audited firms than
for the unaudited firms, as evidenced by the positive coefficients for the interac-
tion terms between the voluntary and mandatory audit dummies and earningsnews. The coefficient for voluntary audits (b2) is 1.196, significant at the 1 per-
cent level. The coefficient for mandatory audits (b3) is 0.450, significant at the
5 percent level. The results suggest that auditing enhances the credibility and
informativeness of interim earnings. Among the control variables, the coefficients
for the interaction terms with modified auditor opinions, firm size, and loss firms
are statistically significant at conventional levels.20
20. Following Basu (1997) and DeFond and Park (2001), we also control for good and badnews effects by partitioning earnings surprises into positive and negative items and interacting them
with variables of interest. The regression results (not tabulated) show that the ERCs are asymmetricbetween good news and bad news. The coefficient of the interaction term between voluntary (manda-tory) audit and good earnings news is 1.805 (0.485), significant at the 1 percent (10%) level, consis-t t ith th lt t d i T bl 5 P l B
83THE ECONOMIC CONSEQUENCE OF VOLUNTARY AUDITING
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TABLE5
RegressionofThre
e-DayMarket-AdjustedRe
turnsonEarningsChangesandAuditStatus
PanelA:
Univariatestatisticsforcontrolvariablesa
Unaudited
Voluntaryaudit
Mandatory
audit
Mean
Median
Mean
Median
Mean
Median
F-s
tatistics
w2-s
tatistics
Marketv
alue
3600.8
2443.6
4639.8
3250.6
3490.0
2645.4
5.5
8***
17.5
9***
Book/marketratio
0.17
0
0.1
98
0.1
86
0.1
72
0.2
15
0.1
59
80.6
1***
41.4
9***
Beta
0.93
9
0.9
60
0.9
77
0.9
50
0.9
71
0.9
39
2.9
7*
4.4
6*
PanelB:
Regressionanalysisb
CAR
a
b1
DE
b2
(Voluntaryauditdummy
DE)
b3
(Mandatoryauditdummy
DE)
g1
(ModifiedopiniondummyD
E)
g2
(Firmsizedummy
DE)
g3
(Market-to-bookdummy
DE)
g4
(Betadummy
DE)
g5
(Qualityauditordummy
DE)
g6
(Lossdummy
DE)
e
(2)
Auditstatusandearningssurprise
Controlvariables
Voluntary
auditdummy
Mandatory
auditdummy
Mo
dified
op
inion
du
mmy
Firmsize
dummy
Market-to-
bookdummy
Betadummy
Quality
auditor
dummy
Lossdummy
Intercept
DE
DE
DE
DE
DE
DE
DE
DE
DE
a
b1
b2
b3
g1
g2
g3
g4
g5
g6
Predictio
ns
?
?
Coefficient
0.0
04
0.4
65
1.1
96
0.4
50
0
.415
0.2
22
0.0
91
0.0
75
0.1
49
0.3
53
-statistics
(3.2
7)***
(4.5
2)***
(3.5
2)***
(2.2
9)**
(
1.9
5)*
(2.0
9)**
(1.4
5)
(1.2
9)
(0.6
5)
(3.5
4)***
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PanelC:Statisticaldifferencebetweencoefficientsforvoluntaryauditandmandatoryaudit
F-statistictotestb2
=b3:3.7
8**
*,**,and***indicatestatisticalsignificancelevelsatthe10percent,the5p
ercent,and1percentlevels,respectiv
ely,one-tailedforpredictedsignsin
PanelB,
othersar
etwo-tailed,respectively.
N
2,4
58.
?indicatesnopredictionfordirection.
aThevariablesaredefinedasfollows:
Marketv
alueisthemarketvalueofcommone
quityatthedateofinterimearningsannouncementinmillionyuan.
Book/ma
rketratioisthebookvalueofcommo
nequitydividedbythemarketvalueofcommonequityattheendofJuneofyeart.
BetaisthemarketbetaofthefirmattheendofJuneofyeart.
bTheadjustedR2
is2.8
0percent.Thevariablesintheregressionaredefinedas
follows:
CAR
market-adjusted
abnormalreturnsaccumulatedoverthethreetradingdays(1,
0,1),where0istheinterim
earnings
announcementdate,adjustedfordividendsandstoc
krights.
DE
unexpectedsem
i-annualearnings,definedasthedifferencebetweenreportedearningsinthefirsthalvesofyearstandt
1,
deflatedbythe
marketvalueatthebeginningofthethree-dayeventwindow
inyeart.
Voluntar
yauditdummy
adummyvariablethatequals1iftheinterim
reportisvoluntarilyaudited,and0other
wise.
M
andatoryaudit
dummy
adummyvariablethatequals1iftheinterim
reportismandatorilyaudited,and0othe
rwise.
Modifiedopinion
dummy
adummyvariablethatequals0iftheauditopinion
isclean,and1otherwise.
Firmsizedummy
1ifthemarket
valueofthefirm
attheendofJune
ofyeartisabovethesamplemedian,and0otherwise.
Market-to-bookdummy
1ifthemarket
valueofthecommonequitydividedbythebookvalueofcommonequ
ityattheendofJuneofyeartisabove
thesamplemed
ian,and0otherwise.
Betadummy
1ifthemarket
betaofthefirm
attheendofJuneofyeartisabovethesamplemedia
n,and0otherwise.
Qualityauditordummy
adummyvariablethatequals1ifafirmsauditorisamongthetop-f
ivelocalChinese
auditorsorjointventuresaffiliated
to
internationalauditors,and0otherwise.
Lossdummy
1ifthesemi-an
nualearningsisnegative,and0oth
erwise.
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Table 5, Panel C, tests the difference in market reaction to voluntary and
mandatory audits. The F statistic is 3.78 and significant at the 5 percent level,
indicating that the coefficient for voluntary audits (b2) is greater than that formandatory audits (b3). This suggests that investors perceive that voluntary audits
are more credible than mandatory audits in our interim sample. However, we
should be cautious of this interpretation, as the effect of mandatory audits might
merely reflect their unique economic circumstances (such as two consecutive
losses and rights offering). In sum, audits enhance the credibility of interim earn-
ings, and voluntary audits in particular convey a strong management commitment
to disclose accurate and reliable earnings reports to investors. Our finding also
provides insights in the quality of auditing in China (DeFond, Wong, and Li
[1999]).21
5.2.2 Regression Results for Specific Reasons of Mandatory Audits
This section examines whether investors respond differently to the release
of interim reports that are mandated for audit because of their economic circum-
stances, as specified by the CSRC (namely, special treatment due to two consec-
utive annual losses, applying for offering stock rights, or distributing interim
stock or cash dividends). As each of these reasons underlying mandated audits
may convey different information on the quality of a firms earnings and future
cash flows, we further partition mandated audits into three subgroups and allowseparate coefficients in regression. The interim dividend dummy equals 1 if divi-
dend distribution is the reason for a mandated audit, and 0 otherwise. Special
treatment and rights-offer dummies are defined analogously. We make no direc-
tional predictions for the coefficients on the interactions between these dummies
and earnings as their ERCs will depend on the trade-off between the enhanced
credibility resulting from audits and the ex ante perception by investors of their
earnings quality related to specific economic circumstances.
The regression results shown in Table 6 remain consistent with Hypothesis
3. The coefficient for the voluntary audit dummy, b2, remains positive and signif-
icant at the 1 percent level. Among mandated audits, only the ERC for rightsoffer dummy is significantly positive at the 10 percent level, and others are not
significant at conventional levels.
21. Teets and Wasley (1996) argue that cross-sectional ERCs based on pooling observationsacross firms and over time are likely to be biased because the cross-sectional model assumes theequality of the coefficient and equal variance of unexpected earnings across firms. They point out
that the bias depends on the cross-firm variability of earnings and the ERC in the sample. While wecontrol for firm-specific factors such as growth, size, and risk, it is possible that the ERCs of oursample are downward biased. Because the history of listed Chinese firms is relatively short, however,
t bl t l t th t ti l ff t f thi bi lt
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TAB
LE6
Regr
essionofThree-DayMarket-AdjustedReturnsonEar
ningsChanges,AuditStatu
s,andMandatedAuditRe
asonsa
C
AR
a
b1
DE
b2
(Voluntaryauditdummy
DE)
b3
(Interimdividenddummy
DE)
b4
(Specialtreatmentdummy
DE)
b5
(Rightsofferdummy
DE)
g1
(Modifiedopiniondummy
DE)
g2
(Firmsizedummy
DE)
g3
(Market-to-bookdummy
DE)
(3)
g4
(Betadummy
DE)
g5
(Qualityauditordummy
DE)
g6
(Lossdummy
DE)
e
Specificmandatedau
ditsandearningssurprises
Contro
lvariables
Voluntary
audit
dummy
Interim
dividend
dummy
Special
treatment
dummy
Rights
offer
dummy
Modified
opinion
dummy
Firmsize
dummy
Market-
to-book
dummy
Beta
dummy
Quality
auditor
dummy
Loss
dummy
Intercept
DE
DE
DE
DE
DE
DE
DE
DE
DE
DE
DE
a
b1
b2
b3
b4
b5
g1
g2
g3
g4
g5
g6
edictions
?
?
?
?
efficien
t
0.0
04
0.4
65
1.1
96
0.3
53
0.4
72
0.4
72
0
.436
0.2
22
0
.090
0.0
75
0.1
45
0
.353
tatistics
(3
.27)***
(4.5
2)***
(3.5
2)**
*
(0.8
3)
(1.4
2)
(1.7
8)*
(1
.29)
(2.0
7)**
(1
.45)
(1.2
9)
(0.6
3)
(3
.54)**
*
*,
**,
and***indicatestatisticalsignifican
celevelsat10percent,5percent,and
1percent,one-t
ailedforpredictedsig
ns,othersaretwo-t
ailed
,respectively.
2,4
58
.ThevariablesintheregressionaredefinedasthoseofTable5
,exceptforthefollow
ing:
terimdividenddummy
1ifdividenddistributionisthereasonformandated
au
dit
,and0otherwise.
ecialtre
atmentdummy
1ifspecialtreatment(twoconsecutiveannuallosses)isthereasonformandatedau
dit,
and0otherwise.
Rightsofferdummy
1ifrightsofferingisthereasonformandatedau
dit,
and0otherwise.
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5.2.3 Sensitivity Analyses
Our hypotheses are still supported even after the following sensitivity analy-
ses. (1) We add intercept dummies for voluntary and mandatory audits to regres-
sion eq. (2). (2) We rerun the regression by adding year dummies. (3) We rerun
the regression, after excluding A-share firms that have also issued shares that are
available to overseas investors. (4) We delete loss firm-years from the sample,
because the ERC of loss firms is lower than that of profitable firms (Hayn
[1995]). (5) To reduce the undue influence of outliers, we winsorize (and alterna-
tively drop) each of continuous variables used in this study at the first and
ninety-ninth percentile. We also replicate the regression by partitioning our sam-
ple into the more recent two-year period (199899) and the earlier two-year pe-
riod (199697) because of the rapid changes in auditing and the marketenvironment in China. We find that our results are stronger in the more recent
period than in the earlier one. This implies that the credibility-enhancing effect
of auditing has become stronger over time, as the CSRC has tightened up finan-
cial reporting and auditing regulations.
6. Conclusion
Theory suggests that auditing enhances the credibility of financial data, but
prior research provides little empirical evidence on whether voluntary auditingincreases the economic value of the accounting numbers. In this paper, we use
the unique institutional setting provided by the Chinese stock market to investi-
gate why some listed firms voluntarily have their financial reports audited, and
whether voluntary auditing enhances their credibility. Our first research question
adds onto the prior studies of Chow (1982), Ettredge et al. (1994), and Manry,
Tiras, and Wheatley (2003). Our second research question is a direct examination
of the economic value of voluntary auditing for the informativeness of account-
ing information, which has not been addressed in the existing literature. Thus,
our study contributes to the literature on voluntary auditing.
Based on 2,458 interim reports from 1996 to 1999, we find that the choiceof voluntary auditing is positively associated with the percentage of tradable
shares, profitability, and company size. We also show that the ERCs of voluntar-
ily audited firms are greater than those of unaudited firms, suggesting that volun-
tary auditing enhances the credibility and informativeness of interim earnings.
They are also greater than the ERCs of mandated audits. However, we should be
cautious of this interpretation as the ERCs of mandated audits depend on firm-
specific economic circumstances, such as reporting two consecutive annual losses
and applying for stock rights issues. Our main results are robust even after
controlling for auditor quality, auditor opinions, loss firms, and other ERC
determinants.
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Overall, our results are consistent with theoretical propositions that managers
voluntarily acquire auditing services to enhance the credibility of accounting
numbers (e.g., Akerlof [1970]; Beaver [1998]) and that certified informationreduces information risk when investors assess the future cash flows of firms
(e.g., Collins & Kothari [1989]). Given the prevalence of earnings management
in China, the voluntary purchase of auditing service has become an effective
means for listed firms to communicate credibly the higher quality of their interim
earnings. This differentiates them from firms that might have manipulated earn-
ings, hence enhancing the informativeness of their earnings.
The empirical regularities shown in this study provide useful insights to for-
eign investors and international auditors. As a member of the World Trade Orga-
nization, China is attracting more and more direct and financial investment from
the international community. Chinese regulators recently granted licenses toselected foreign investment banks to participate directly in Chinas A-share mar-
ket, which had hitherto been reserved exclusively for Chinese investors. Our
findings suggest that the users of financial statements of listed Chinese firms
should be aware of the managerial incentives in acquiring voluntary interim
audits and the informativeness of audited interim reports. International auditors
need to pay more attention to the determinants of the audit demand for interim
reports and the economic value attached by investors to the audited reports. Our
study sheds light on the effectiveness of the recent reporting and auditing regula-
tions in China, suggesting that auditing has begun to play a more effective role
in the Chinese market.
APPENDIX A
Examples of Interim Audit Reports in China
1. Unqualified Auditor Report (by Shenzhenshi CPAs on August 18, 1998)
We were appointed to audit the consolidated balance sheet of Shenzhen Hongkai
(Group) Co., Ltd (the Company) as of June 30, 1998, and the income statement and cash
flow statement for the period from January to June 1998. These financial statements arethe responsibility of the Companys management. Our responsibility is to express an opin-
ion on these financial statements based on our audit. We conducted our audit in accor-
dance with the Independent Audit Standards for Chinese CPAs. Our audit also includes an
examination, on a test basis, of the Companys accounting records and other audit proce-
dures which we consider appropriate.
In our opinion, the Companys financial statements have been prepared in accordance
with the requirements of Accounting Standards for Enterprises, Accounting System
for Joint Stock Companies, and the relevant laws and regulations, and present fairly, in
all material respects, the financial position of the Company as of June 30, 1998, and the
results of the operations and cash flows for the half-year then ended, and the accounting
policies have been consistently applied.
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2. Unqualified Auditor Report with Explanatory Notes (by Shekou Xinda CPAs on
August 17, 1998)
We were appointed to audit the consolidated balance sheet of Shenzhen Energy
Investment Co., Ltd (the Company) as of June 30, 1998, and the income statement and
cash flow statement for the period from January to June 1998. These financial statements
are the responsibility of the Companys management. Our responsibility is to express an
opinion on these financial statements based on our audit. We conducted our audit in ac-
cordance with the Independent Audit Standards for Chinese CPAs. Our audit also includes
an examination, on a test basis, of the Companys accounting records and other audit pro-
cedures which we consider appropriate.
In our opinion, the Companys financial statements have been prepared in accordance
with the requirements of Accounting Standards for Enterprises, Accounting System
for Joint Stock Companies, and the relevant laws and regulations, and present fairly, inall material respects, the financial position of the Company as of June 30, 1998, and the
results of the operations and cash flows for the half-year then ended, and the accounting
policies have been consistently applied.
In addition, we noticed that:
1. As discussed in Note 4 to the financial statements, a subsidiary of the Com-
panyShenzhen Mawan Electricity Ltd.recorded an interest income of
RMB35.56 million yuan, which is yet to be confirmed.
2. As discussed in Note 41 to the financial statements, as of June 30, 1998, the contin-
gent loss of the Company amounts to RMB16.6 million yuan. (Renminbi [RMB] is
the official currency on the mainland of the Peoples Republic of China [PRC]).
3. Qualified Auditor Report (by Shenzhen Tongren CPAs in 1999)
We were appointed to audit the consolidated balance sheet of Shenzhen Huabao Co.,
Ltd (the Company) as of June 30, 1999, and the income statement and cash flow state-
ment for the period from January to June 1999. These financial statements are the respon-
sibility of the Companys management. Our responsibility is to express an opinion on
these financial statements based on our audit. We conducted our audit in accordance with
the Independent Audit Standards for Chinese CPAs. Our audit also includes an examina-
tion, on a test basis, of the Companys accounting records and other audit procedures
which we consider appropriate.
As discussed in footnote 5.6 to the financial statements, the construction of the
Dongguan Waterpark, a property project invested and constructed by the Company,
stopped for a long time, and the book value of the project amounts to RMB253.5 million
yuan as of June 30, 1999. The Company is studying the alternatives about the project in
the future. There is no reliable evidence indicating whether there exists substantial write-
down in the value of the property.
In our opinion, except for the effects of such adjustments, the Companys financial
statements have been prepared in accordance with the requirements of Accounting
Standards for Enterprises, Accounting System for Joint Stock Companies, and the rel-
evant laws and regulations, and present fairly, in all material respects, the financial posi-tion of the Company as of June 30, 1998, and the results of the operations and cash flows
for the half year then ended and the accounting policies have been consistently applied
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Ranking
Rankingbyyear
NumberofListedClients
1996a
1997
1998d
1999d
1996
1997
1998
1999
ointventuresb
1
Pricewaterhouse
Pricewaterhouse
Ande
rsen
BDO
7
7
13
12
2
BDO(17)
KPMG
Price
waterhouse
Andersen
7
7
9
11
3
Ernst&Young(4)
Andersen
BDO
Pricewaterhouse
6
7
8
8
4
KPMG(3)
BDO
KPM
G
KPMG
6
6
7
8
5
C&L
Ernst&Young
C&L
C&L
4
5
6
6
6
Andersen
C&L
Deloitte&Touche
Deloitte&Touc
he
4
5
5
6
7
Deloitte&Touche
Deloitte&Touche
Ernst&Young
Ernst&Young
2
2
2
4
Topten
localauditors
1
Shanghai(2)
Shanghai
Dahu
a
Dahua
37
37
41
41
2
Dahua(1)
Dahua
ShanghaiShangkuai
ShanghaiShangkuai
31
34
36
34
3
ShenzhenZhonghua
(5)
ShenzhenZhonghua
ShenzhenZhongtian
ShenzhenZhongtian
22
24
28
32
4
Lixin(7)
Lixin
ShenzhenZhongshen
ShenzhenZhongshen
22
22
27
30
5
Shenzhenshi(10)
Shenzhenshi
SichuanJunhe
SichuanJunhe
20
22
25
29
6
Sichuan(6)c
Sichuanc
Zhejiang
ZhejiangTianjia
n
18
21
23
28
7
Guangzhou(9)
Zhejiang
Lixin
ShenzhenTongr
en
16
20
22
28
8
Zhejiang(N/A)
ShenzhenZhongcheng
Huna
nKaiyuan
BeijingJingdu
16
19
22
26
9
Chengdu(N/A)c
Chengduc
Hube
iDaxin
HunanKaiyuan
15
18
21
25
0
ShekouZhonghua(8)
HubeiDaxin
ShenzhenTongren
Lixin
12
18
21
23
APPEN
DIXB
MarketShareofQualityAuditorsin
TermsofNumberofListed
Clients
Numbersinparenthesesarethe1996rankin
gsoftherespectiveauditorsinTab
le8ofDeFond,Wong,andLi(199
9).
AlljointventureswereaffiliatedwithBigS
ixinternationalauditors,exceptShekouXindaBDO,whichwasoneofthetop-tenauditorsinChinaduring
199395
inDeFond,Wong,andLi(1999).
Sichuan
CPAsandChengduCPAsweredis
solvedbytheMinistryofFinancein1998forsevereviolationsoflawsandregulationsinauditing.
Alluniv
ersityandgovernmentaffiliatedCP
Afirmsbecameindependentlegalentitiesbytheendof1998(SecuritiesTimes,January5,1999).Conseq
uently,
thefollo
wingCPAfirmsweretransformed
tonewentities:ShanghaiCPAstoShanghaiShangkuai,ShenzhenZhonghuatoShenzhenZhongtian,Shen
zhenshi
toShenzhenZhongshen,andShenzhenZho
ngchengtoShenzhenTongren.
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