Institutional Environment and the Quality of Big 4 Auditors

1. Institutional Environment and the Quality of Big 4 Auditors Bin Ke NanyangTechnological University CliveLennox Nanyang Technological University Qingquan XinChongqingUniversity

2. Motivational question • Do Big 4 accounting firms provide the same audit quality around the world? • Do Big 4 deliver the same quality in China? • Potential economic forces governing Big 4’s quality • Ability • Incentives (litigation risk, reputation, quasi-rent) • Focus of this study is the incentives of Big 4

3. Is the idea interesting? • I think so because Big 4 auditors play a direct role in determining the quality of financial reporting • There is a debate on whether Big 4 can deliver the same high quality audit in weak investor protection countries as in strong investor protection countries

4. Is the idea interesting? • Relevance to China and HK: • H shares’ financial reports are allowed to be audited by domestic auditors after December 15, 2010

5. How to test the idea? • What is the ideal experiment? • The most obvious approach is to compare the audit quality of Big 4 across different countries • Common limitations of cross country studies • Accounting standards • Auditing standards • Other cross-country differences

6. Prior research • Compare Big4 vs. non-Big4 across countries • This approach does not directly examine the effect of institutional environment on Big 4 • Unclear whether the cross-country differences are effectively controlled for because the effects of country factors could be different for Big4 and non-Big4 • Any differences in results between Big4 vs. non-Big4 could be due to systematic differences of the clients audited by Big4 and non-Big4

7. Our approach • Publicly traded firms listed on mainland China and audited by a domestic Big4 over 1995-2009 • Pure A shares • AH firms • AB firms

8. Our specific research question • Do domestic Big4 accounting firms provide the same audit quality in China for • Pure A shares, • AB firms, and • AH firms?

9. Mainland China Big 4 of Pure A Firm Mainland China

10. Mainland China Big 4 of AH Firm HK Big 4 of AH firm Hong Kong Mainland China ?

11. Mainland China Big 4 of AB Firm HK Big 4 of AB firm Hong Kong Mainland China ? ?

12. Incentives of HK Big4: AH firms versus AB firms

13. Mainland China Big4 Of ABFirms Mainland China Big4 Of AH Firms Mainland China Big4 Of Pure AFirms Hong Kong Mainland China ?

14. Advantages of our approach • We directly examine the effect of institutional environment on Big 4’s behavior • We can effectively isolate the country effects because we compare the audit quality of Big4 in the same country • We do not compare Big4 vs. non-Big4 and thus our results cannot be due to systematic differences of the clients audited by Big4 and non-Big4

15. Pure A share firms (firm years)

16. AH share firms (firm years) Domestic and HK auditors are the same for 256 firm years

17. AB firms (firm years)

18. Research design • Y = α0 + α1 HK_MONITOR + α2 MULTIPLE_OFFICES + CONTROL VARIABLES + u • Dependent variable= • Audit opinion • Earnings management (accruals and loss) • Audit fees (mainland)

19. Audit opinion model: key variables

20. Audit opinion model: control variables

21. Audit opinion model

22. Signed abnormal accrual model: dependent variable

23. Signed abnormal accrual model: control variables

24. Signed abnormal accrual model

25. Loss model

26. Loss model

27. Audit fee model

28. Audit fee model

29. Endogeneity of HK_MONITOR • Cross-listing bonding hypothesis would suggest that AH firms are better and thus the self selection would bias against our predictions • assess the severity of endogeneity: • SHORT is 1 if the distance between the fiscal year end and the HK IPO date for all AH firm years is less than 5 years (or 8) and zero otherwise

30. Endogeneity of HK_MONITOR

31. Descriptive stat for all regression variables

32. Descriptive stat for all regression variables