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

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

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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