Legal Environments, Audit Quality and Initial Return: Evidence from Chinese IPOs of SOEs

1. Legal Environments, Audit Quality and Initial Return:Evidence from Chinese IPOs of SOEs Yunxia Bai Guanghua School of Management Peking University

2. 1.Introduction • Research questions • Does legal environments affect audit quality? • Does audit quality convey information in an initial public offering?

3. Existing literature • On audit quality • Most literature examines micro-sources of differentiation in audit quality (Francis, 2004): • Characteristics of accounting firms ( e.g., size) • Characteristics of clients (e.g., audit committees) • The engagement specific factors (e.g. audit tenure, compensation, non-audit service, and accounting firm alumni)

4. Existing literature • On audit quality • Relatively little attention have been paid to the locality of auditors: • The information perspective (Choi, et al., 2007) • The collusion perspective (Gul, et al., 2006) • A few recent research has begun to investigate how a country’s legal environments affect auditor behavior (Francis and Wang, 2008; Venkataraman, et al., 2008; Wang, et al., 2008).

5. Existing literature • On Initial Return • IPO underpricing phenomenon • For a sample of 6249 American IPOs from 1980 to 2001 the average initial return is 18.8% (Ritter and Welch, 2002). • For 908 Chinese IPOs of A-shares from 1995 to 2003 the average initial return is 129% (刘煜辉等, 2005). • Theoretical explanations of IPO underpricing • Focusing on the setting of the offer price • Assuming first-day market price as “fair value” • Purnanandam,et al., 2004. Are IPOs Really Underpriced? The Review of Financial Studies 17 (3), 811-848.

6. Existing literature • On Initial Return • Audit quality and IPO underpricing • Almost all literature exhibits that audit quality is inversely related to initial return (Rock, 1986; Beatty, 1989; Michaely et al., 1995). • Chang, et al. (2008 )document a positive relationship between audit quality and initial return.

7. Contribution • This paper extends literature on audit quality by jointly examining the effect of auditor choice and legal environments on audit quality in a single country. • This paper extends literature on IPO underpricing by examining the effect of audit quality on initial return in the context of Chinese IPOs where the offering price is controlled by the government.

8. The remainder proceeds as follows: • Hypotheses • Resign Design • Empirical Results • Conclusions and Limitations • Proposal for Future Research

9. 2.Hypotheses • Hypothesis 1: • The difference in audit quality between local and non-local auditors are larger in regions with less developed legal institutions. • Collusion cost is lower in regions with less developed legal institution. • Relative to non-local auditors, the local governments (officials) can exert more influence on local auditors（Gul, et al., 2006; Wang, et al., 2008). • Prestigious auditors can increase the likelihood of being approved for listing and the after-issue market price.

10. Hypothesis 2: • The difference in initial return between clients of local and non-local auditors are larger in regions with less developed legal institutions. • Due to the government control the offering price is unaffected by the quality audit. • The signaling role of audit (Titman and Trueman, 1986) predicts a lower post-issue market price for clients of low quality auditors, which leads to a lower initial return.

11. 3.Research Design 3.1 The data

15. 4.Empirical Results

22. 5.Conculsions • In regions with less developed legal institutions the audit quality of local auditors are lower than non-local auditors; Whereas in regions with developed legal institutions there are no differences in audit quality of local and non-local auditors. • In regions with less developed legal institutions the initial return of clients of local auditors is lower than of non-local auditor, whereas in regions with developed legal institutions there are no differences in initial return between clients of local and non-local auditors, suggesting that the initial return is positively related to audit quality in Chinese IPOs market.

23. 6.Proposal for Future Research • The Impact of CSRC Enforcement Actions on audit quality • Governmental Investigation and Earnings Management • Cahan (1992): The Effect of Antitrust investigations on discretionary accruals. • Jones (1991): Earnings management during import relief investigations. • Studies on Firms Subjected to Enforcement Actions by the Security Regulatory Agencies • Dechow, et al. (1996): Causes and consequences of earnings manipulation • Bonner, et al. (1998): Fraud type and auditor litigation • Chen, et al. (2005): Is China’s securities regulatory agency a toothless tiger?

24. Yunxia Bai NOV. 17, 2008 Thanks！

25. References • 刘煜辉、熊鹏，2005，“股权分置、政府管制和中国IPO 抑价”，《经济研究》第5期。 • Beatty, R., 1989. Auditor reputation and the pricing of initial public offerings. The Accounting Review 64(4), 693-709. • Bonner, Sarah E., Zoe-Vonna Palmrose, and Susan M. Young, 1998. Fraud type and auditor litigation: An analysis of SEC accounting and auditing enforcement releases. The Accounting Review 73(4), 503-533. • Cahan, Steven F, 1992. The Effect of Antitrust investigations on discretionary accruals: A refined test of the political-cost hypothesis. The Accounting Review 67(1), 77-95. • Chen, Gongmeng, Michael Firth, Daniel N. Gao, Oliver M. Rui, 2005. Is China’s securities regulatory agency a toothless tiger? Evidence from enforcement actions. Journal of Accounting & Public Policy 24(6), 451-488. • Choi, Jong-Hag C., Jeong-Bon Kim, A. Qiu, and Y. Zang, 2007. Auditor locality, audit quality and audit pricing. Working paper. • Dechow, Patricia M. Richard G Sloan, and Amy P. Sweeney, 1996. Causes and consequences of earnings manipulation: An analysis of firms subject to enforcement actions by the SEC. Contemporary Accounting Research 13 (1), 1-36.

26. Francis, Jere R, and Dechun Wang, 2008. The Joint Effect of Investor Protection and Big 4 Audits on Earnings Quality around the World. Contemporary Accounting Research 25(1), 157-91. • Francis, Jere R., 2004. What do we know about audit quality? The British Accounting Review 36, 345–368. • Gul, F. A, J.–B. Kim, and A. Qiu, 2006. Does the political economy affect auditor incentives? Some Chinese evidence on non-Big 4 audit quality. Working paper. The Hong Kong Polytechnic University. • Jones, Jennifer J., 1991. Earnings management during import relief investigations. Journal of Accounting Research 29(2), 193-228. • Michaely, R. and Wayne H. Shaw, 1995. Does the choice of auditor convey quality in an initial public offering? Financial Management 24(4), 15-30. • Venkataraman, Ramgopal, Joseph P. Webe, and Michael Willenborg, 2008. Litigation risk, audit quality, and audit fees: Evidence from initial public offerings. The Accounting Review 83(5), 1315-1345. • Wang, Q., T. J. Wong and L. Xia, 2008. State ownership, the institutional environment, and auditor choice: evidence from China. Journal of Accounting and Economics 46, 112-134.