Auditor choice is an important strategic decision for companies that can help to solve agency problem and signal firm value (Fama 1980; Titman and Trueman 1986; Beatty 1989). It also directly affects the magnitude of audit fee. The purpose of this study is to investigate the joint effect of audit firm size and locality on audit fees in China, which is potentially one of the world's largest audit markets. In particular, we are interested in the following questions: Do companies pay different audit fee to auditors that are located in the same region (i.e., local auditors) than they do for non local auditors? Do companies pay different audit fees to large local auditors than they do for small local auditors?
Inspired by the China's fast growing economy and audit firms' international focus, China's audit market is playing an increasingly important role in the global accounting world. A productive stream of research have explored the unique features of the Chinese auditing profession in terms of audit fees (Li, Song, & Wong 2005; Chen, Su, & Wu 2007), audit opinion (Chen, Su, & Zhao 2000), auditor choice (Wang, Wong, & Xia 2008), and auditor industry specialization (Wang, O, & Iqbal 2009, Wang, O, & Iqbal 2010). However, much of these studies have employed aggregated firm-level data in the analyses, but overlooked the fact that local offices often enjoy significant autonomy over contracting and other audit decisions. Empirical studies focused on mature capital market, have demonstrated that market leadership calculations based on market share data at the national level do not accurately portray city-specific audit markets for about 70 percent of audits in their sample (e.g., Francis, Stokes, & Anderson 1999). In a similar vein, Penno and Walther (1996) note that local concentration measures could be more appropriate than the previously documented national measures for accounting services. Our study attempts to take a local perspective and examines whether audit fees in China are impacted by the location of audit firms.
In a sample of 1,028 publicly listed companies, we find that local auditors, in general, do not charge significantly different audit fees as compared to non local auditors. However, after partitioning the local audit firms into large and small local auditors, we find State-owned Enterprises (SOEs) are more likely to choose small local auditors instead of large and non local audit firms. This result is consistent with prior literature that report SOEs have lower demand for reputable (presumably large or non local) auditors to signal their quality operation due to the preferential treatment SOEs receive from governments or state banks (Wang et al. 2009). As for audit fees, we find large local audit firms charge significantly higher fees to their clients than non local auditors. Small local auditors, on the other hand, offer fee discount to local SOEs, but not to central SOEs. A possible explanation is that large local auditors are more capable of offering specialized local service than small auditors, and as a result, earn fee premiums from the differentiated service.
The issues addressed in this study are important at a time when the Chinese audit market is undergoing major changes due to mergers and acquisitions, altering the underlying market structure for audit services. Our findings that audit fees are affected by the location and the size of audit firms point to a dimension that may need to be considered by government officials when carrying out further plans for restructuring. Results from our study are also of potential relevance to accounting firms and listed companies, as the Chinese government is undertaking a wide range of initiatives to address accounting and auditing issues specific to the public sector.
The remainder of the paper is structured as follows. The next section offers background information regarding the audit market in China and reviews prior literature. Section three explains sample selection and data collection. Empirical results and analysis are provided in Section four. The final section presents conclusions and limitations of the study.
BACKGROUND AND HYPOTHESES
2.1 CPA Profession and Auditing Standards in China
Chinese Certified Public Accountants (CPAs) did not exist as a profession until 1980 when the government issued its first regulation on practicing accountants to meet the country's urgent need for direct foreign investments. The resurgence of the stock markets since the early 1990s further expanded the market for independent auditing in China and led to the promulgation of the first set of Independent Auditing standards (AS) in 1995, followed by the second and third set of standard enacted in 1997 and 1999 respectively. Overall, these AS were patterned after the generally accepted international auditing standards with some modifications.
In China, all CPA firms were initially established by, and affiliated with, a government-related organization (a government agency, a university, or a large state-owned enterprise or SOE). After the establishment of stock enterprise and opening of stock exchanges, the Chinese Institute of Certified Public Accountants (CICPA) required that all firms should gradually sever ties with their parent organizations in order to protect professional independence from undue interference. After cutting such ties, CPA firms are reorganized as private professional firms in the form of either a partnership or a limited liability company. Among the pool of entire Chinese CPA firms, only 105 were authorized to audit listed companies at the end of 1997. The practice of these firms is closely monitored by both the CICPA and Chinese Securities Regulatory Commission (CSRC), which have the power to revoke their licenses to audit listed companies if they violate standards.
China's publicly listed companies are the most sought-after clients of China's audit firms. Among the listed companies, the majority are former State-owned Enterprise (SOEs) with the government (both central and local) holding a certain percentage of shares (People's Daily 2006). In recent years, although the state remains the controlling shareholder, most listed companies have been granted considerable latitude in making business decisions, including the selection of auditors. Consequently, auditor selection and accounting choices within Chinese GAAP are now made at the discretion of the management. Given the small number of listed companies (1,309 at the end of 2006) relative to the number of CPA firms authorized to audit them, the Chinese auditing market is highly competitive.
In order to tackle competition from international accounting firms, CICPA is engaged in aggressive reform of the auditing profession by improving audit integrity and quality of local auditors (People's Daily 2006). One of its new policies states that, in the next five to ten years, China should cultivate ten accounting firms capable of operating internationally to support domestic companies that go global, and another 100 firms big enough to serve large domestic enterprises. To this end, China's local accounting firms have undergone more market-driven mergers and acquisitions, or partnerships with second-tier international auditors (e.g., Horwath and BDO). For example, seven Chinese local firms have partnered with Horwath since 2001, including Shanghai Shulun Pan CPAs, one of the largest local CPA firms in China. By capturing the market shares of its partners, Horwath became the largest audit firm immediately following the Big 4 operations in the Chinese market.
2.2 Research Hypotheses
There is a growing body of research that examines the Chinese auditing market in terms of audit fee (Chen, Su, & Wu 2007), audit opinion (DeFond et al. 2007), auditor choice (Wang, Wong, & Xia 2008), and auditor industry specialization (Wang, O, & Iqbal 2009; Wang, O, & Iqbal 2010). The main findings based on these research include: 1) Big 4 audit firms normally charge higher audit fees for their brand reputation, especially in the less competitive B share market; 2) industry specialized auditor could also earn fee premiums due to differentiated service quality; 3) the market share of the Top-10 audit firms, which presumably provide better quality and more independent audits, has been declining; and 4) SOEs controlled by local governments are more likely to hair small auditors within the same region (small local auditors) since they enjoy preferential access to capital and they can receive government bailout.
The findings from prior research are indeed valuable. However, much of these studies have employed aggregated firm-level data in their analyses, even though local offices often enjoy significant autonomy over contracting and other audit decisions. Empirical studies focused on mature capital market, have demonstrated that market leadership calculations based on market share data at the national level do not accurately portray city-specific audit markets for about 70 percent of audits in their sample (e.g., Francis et al. 1999). In a similar vein, Penno...
The impact of audit firm size and locality on audit fees in an emerging economy: evidence from China.
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