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Is Big-Five trustable in emerging Market? Preliminary Evidence from China’s Capital Market

Is Big-Five trustable in emerging Market? Preliminary Evidence from China’s Capital Market. LIU Feng ZHOU Fuyuan Sun Yatsen University. Presentation Agenda. The issue Two cases Preliminary Empirical evidence Possible (plausible) explanations Discussion. The Issue. Term of Big 5.

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Is Big-Five trustable in emerging Market? Preliminary Evidence from China’s Capital Market

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  1. Is Big-Five trustable in emerging Market?Preliminary Evidence from China’s Capital Market LIU Feng ZHOU Fuyuan Sun Yatsen University http://mns.zsu.edu.cn

  2. Presentation Agenda • The issue • Two cases • Preliminary Empirical evidence • Possible (plausible) explanations • Discussion http://mns.zsu.edu.cn

  3. The Issue • Term of Big 5. • From Big 8 to Big 6, and then Big 5, Big 4. • Big 5 initiated their office in mainland China since early 1980s. • Launched cooperative firms in early 1990s. http://mns.zsu.edu.cn

  4. The Issue • Now Big 5 already enjoys a quite big share in China’s auditing market. • The high rank officers of our government hold the belief that Big 5 provides much higher quality auditing than local firms do. • They set up some market shares exclusively to Big 5, or, internationally well recognized firms, according to the official documents. http://mns.zsu.edu.cn

  5. The Issue • For example, • January 2001, CSRC and M of F jointly issued a regulation requires all listed companies of finance industry be dually audited by a Big 5 firm and a domestic firm; • December 2001, CSRC announced a regulation mandates same requirement for all IPO and seasonal equity offering firms. • Thanks to Andersen’s document shredding, the regulation is stopped. http://mns.zsu.edu.cn

  6. The Issue • Shenzhen municipal government officer announced in January, 2004 that all infrastructure SOEs must be audited by Big Four. • They later claimed that they never said so when encountering pressures. • Now 3 of 4 four national commercial banks are the clients of Big 4. • Bank of China: PWC; • China Industrial and Commercial Bank: Ernst & Young; • China Construction Bank: KPMG; http://mns.zsu.edu.cn

  7. The Issue • The Issue: • Is Big Five as good as perceived by China’s high rank officers in China’s capital market? • Or, compared with local firms which are blamed to provide low quality auditing, does Big 5 provide higher quality auditing in China’s capital market? http://mns.zsu.edu.cn

  8. Two cases • Before presenting empirical evidences, I would like to brief two cases to give you an idea how well Big 5 was. • Also some institutional knowledge that how Big 5 operate in China. http://mns.zsu.edu.cn

  9. Baoshi and PWC: A Case Description • Baoshi: one of the 300 key SOEs in China (1996); • IPO B shares in June and A shares in September, 1996; • Main products: • Black and white glass bulbs and kinescopes; • B & W tv cathode ray tubes; • All auditors reports are conducted by PricieWaterhouse Asia and PW Dahua, its cooperative firms in China. http://mns.zsu.edu.cn

  10. http://mns.zsu.edu.cn

  11. The comments on Baoshi case • From clean opinion in 1996 to disclaimer (the first case in Chinese auditing mkt) in 1997: no transition • From the Prospectus and Listing Announcement for Baoshi B shares, we may find: • Failure in shedding concerns on the inherent risk existing in Baoshi • Baoshi on the brink of loss in its listing year http://mns.zsu.edu.cn

  12. The comments on Baoshi case • When the first disclaimer comes out, • Management explanation for disclaimer of opinion: main production line stopped due to outdated technology in June 1996. • How could not PW find such an obvious fact? • The ST system and delisting regulation • three years of ST in a line; • 1997 disclaimer makes Baoshe STed; • 1998 disclaimer: nothing to lose; • 1999: if disclaimer or qualified, Baoshi will face to be delisted. http://mns.zsu.edu.cn

  13. The comments on Baoshi case • 1999, Basshi is “good” enough to get an unqualified with explanation paragraph report; • Unqualified report is necessary; • Explanation paragraph: acceptable; • We have an extreme case (600633, 1998): an unqualified report plus 12 counts of explanation, including insolvency, etc. • However, Baoshi is in fact no manufacturing activity for a whole year; • Total operating revenue: 5.7m; http://mns.zsu.edu.cn

  14. The comments on Baoshi case • All profit are paper gains; • A big bath in 1997 and 1998, then reverse some in 1999, for example, an interest expense reversal of 136 million. • Sell land use rights and building to SBEG, a sub-subsidiary with a net profit of 27 m. • To avoid consolidation of SBEG, reduce holding share from 51% to 49% in Oct., 1999. • Baoshi is deSTed, or listed as normal, successfully in 2000. http://mns.zsu.edu.cn

  15. China Southern Airlines and its auditor KPMG • China Southern Airlines (CSA), one of the big three airlines in China, listed in Hongkong and New York in July 1997 and Shanghai in July 2003; • KPMG acting as its auditor for 11 years. • Xiamen Airlines, invested by CSA and Xiamen C & D, a local SOE; • CSA owns 60% shares. http://mns.zsu.edu.cn

  16. CSA and KPMG • Since Xiamen C & D sales its equity on Xiamen Airlines to its controlling shareholder, C & D Group, in June 2003, and C & D Group is not listed publicly, the only way to get Xiamen Airlines financial data is from CSA financial statements and no room to cross check. • Our discussion is mainly on year 2002. http://mns.zsu.edu.cn

  17. CSA and KPMG • According to Xiamen C & D 2002 annual report, Xiamen Airlines reported ¥78 million net income; • According to CSA 2003 prospectus, Xiamen Airlines realized 436 million net income; • Why do we have a huge difference of 358 million? http://mns.zsu.edu.cn

  18. CSA and KPMG • CSA explanation: • Due to different depreciation policy on aircraft and engine and other high-value rotable spares; • Xiamen Airlines employ a more conservative depreciation policy, that is, less usable age and lower residual value, while CSA adjust XMA report with a less conservative depreciation policy. • Some data of depreciation expenses on owned and leased aircraft: • XMA(2002): depreciation: 429m; owned/leased craft: 4508 m; ratio: 9.51%; • CSA(2003): depreciation: 1018m; owned/leased craft: 20325m; ratio: 5.01%; http://mns.zsu.edu.cn

  19. CSA and KPMG • More to say about CSA’s discretional accrual. http://mns.zsu.edu.cn

  20. The change result in earning increasing by 33 m http://mns.zsu.edu.cn

  21. CSA and KPMG • Why does CSA need a positive profit report so desperately? • IPO for A shares in July, 2003, several months after SARS; • It will have a negative market reaction if a company reports a net loss just after IPO. • The doable way for CSA to go: using accruals. • KPMG endorses CSA’s accounting. • However, most researches tend to suggest that big 5 will have less discretionary accrual. http://mns.zsu.edu.cn

  22. Empirical evidence • Since auditing quality could not be measured directly, proxy measurement for auditing quality is necessary. • Two ways to proxy for auditing quality: • Market reaction, for example, CAR; • Discretionary accruals. • Our paper adopts DA method. • We mainly follow Krishnan (2003) and make some modification. http://mns.zsu.edu.cn

  23. Empirical evidence • OP: operational profit; • A: total assets; • OP = OC+TA = OC+NDA+DA, • We further introduce Big 5 as dummy variable. http://mns.zsu.edu.cn

  24. Empirical evidence • Test • Dum1= 1 when audited by Big 5, • Dum1=0 when audited by Non-Big 5. • If Big Five is effective enough to control client’s opportunistic accounting and make DA more meaningful to predict profitability, then : http://mns.zsu.edu.cn

  25. Sample • All listed corporations in both Shanghai and Shenzhen Stock Exchange. • It is as late as 1999 that our government made accounting firm fully independent. • Our sample covers from 1999 to 2001. • Delete all financial corporations, all negative net assets corporations and st-corporations; • No auditors change subsequent to the observation year. • Clean auditor report subsequent to the observation year. • Clean auditor report for the observation year. • Total sample size: 1950 firm-year observation. • 1999: 525; 2000: 585; 2001: 840. • Big 5: only 84 observations left. http://mns.zsu.edu.cn

  26. Sample • The distribution of 84 observations for Big 5: • 1999: 17 • 2000: 27 • 2001: 40. • 2001 is the only testable year; • We will report 2002 and 2003 sometime later. http://mns.zsu.edu.cn

  27. Descriptive statistics http://mns.zsu.edu.cn

  28. Estimation of DA http://mns.zsu.edu.cn

  29. Comparison of DA http://mns.zsu.edu.cn

  30. Empirical results http://mns.zsu.edu.cn

  31. Empirical results • We further assort all samples by 3-digit SIC code and delete some outliers; • Matching by 3-digit SIC code, we delete the observations if no matching observation within the same industry; • Then matching by decile of operating return on total assets to eliminate the potential difference of profitability. • Then matching by size and eliminate outliers; • Only 176 observations for three years left ; • 28 from Big 5 and 148 from Non-Big 5; http://mns.zsu.edu.cn

  32. Empirical results • Since only 28 observations of Big 5 for three years left, we cannot run regression for any single year; • Before doing pooling test we have to run test first to make sure there is no structure change among the three year data; • F value=0.592, it is quite safe to say that there is no significant structure change for these three year data. http://mns.zsu.edu.cn

  33. Comparison of DA http://mns.zsu.edu.cn

  34. Empirical results http://mns.zsu.edu.cn

  35. Robust test • We add more control variables widely used in literatures such as leverage, book to market ration etc, no significant change found. http://mns.zsu.edu.cn

  36. Possible explanation • According to DeAnglo (1981), auditor size is positively correlated with auditing quality; • According to reputation mechanism, Big 5 treasures its reputation; • This is contradicted with the empirical evidence and case; • Is there something missing? http://mns.zsu.edu.cn

  37. Possible explanation • Three implicit presumption for DeAnglo (1981) to hold: • No serious agency cost; • High Inspection (or supervising?) risks for these opportunistic parties; • High litigation risks for these convicted opportunistic parties. http://mns.zsu.edu.cn

  38. Possible explanation • It may be true that agency problem is quite serious and may positively correlated with firm size. • David Duncan ignored the warning from Professional Standards Group (PSG); • In China, my case study shows that personalisation of client resources may be observed; • This may weaken quality increment due to size effect; http://mns.zsu.edu.cn

  39. Possible explanation • Inspection risk for Big 5 in China: Zero or nearly zero; • Founding member firms with Ministry of Finance; • No peer review done by CICPA; • I have no idea if there is any peer review done by Big 8 members firms within China; • Working papers are prepared in abbreviated English which makes peer review almost impossible for domestic professionals; • This implies that there is no possibility for Big 5 to be caught for opportunistic behavior if they behave “reasonably”. • Reasonable: • No harm on reputation system; http://mns.zsu.edu.cn

  40. Possible explanation • Litigation risk: • Extremely low even to domestic auditors firm; • Case of Jinzhou Port (600190); • Civil suit motion against KPMG was reported accepted by Shenyang middle court in Feb. 2003, no further report was found. • Disciplinary risk; • Domestic firm may face to pretty high disciplinary proceedings. • No single case of disciplinary proceedings against Big 5 is reported; http://mns.zsu.edu.cn

  41. Possible explanation • Market partition exclusive to Big 5; • Jan 2001, bank and securities industry listed company; • Complimentary auditing done by Internationally well known firms, Big 5, for IPO; • Dec. 2001, extended to all IPO and SEO; • It was stopped due to Andersen document shredding. • Jan 2004, vice mayor of Shenzhen specified a market share exclusively for Big 4. • No risk to lose potential qusi-rent for these opportunistic parties. http://mns.zsu.edu.cn

  42. Possible explanation • Theoretical prediction: • Big 5 may lower their auditing quality in China; • There should be no systematic quality difference between Big 5 and Non-Big 5 auditing. http://mns.zsu.edu.cn

  43. Discussion • More work to do; • We plan to extend the research to year 2002 and 2003; • More refined research design: • Searching for more appropriate method for DA testing; • Alternative examination of auditing quality; • Understand Big-5’s internal structure to discuss agency problem and perceived litigation risk, etc; http://mns.zsu.edu.cn

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