Auditor choice and accruals patterns of cross-listed firms

Wang, Bing; Xin, Qingquan Article Auditor choice and accruals patterns of cross-listed firms China Journal of Accounting Research Provided in Cooperation with: Sun Yat-sen University Suggested Citation: Wang, Bing; Xin, Qingquan (2011) : Auditor choice and accruals patterns of crosslisted firms, China Journal of Accounting Research, ISSN 1755-3091, Elsevier, Amsterdam, Vol. 4, Iss. 4, pp. 233-251, https://doi.org/10.1016/j.cjar.2011.09.002 This Version is available at: https://hdl.handle.net/10419/187559 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/3.0/ Auditor choice and accruals patterns of cross-listed firms Bing Wang a , Qingquan Xin b,⇑ a Department of Accountancy, Nanjing University, China b School of Economics and Business Administration, Chongqing University, China article info Article history: Received 26 June 2010 Accepted 14 September 2011 Available online 8 December 2011 JEL classification: G15 G38 M40 Keywords: Cross-listing Big 4 auditors Accruals Emerging markets abstract We examine the association between auditor choice and the accruals patterns of Chinese listed firms that cross-list in Hong Kong. Our evidence suggests that the clients of Big 4 auditors report lower unsigned discretionary accruals relative to the clients of non-Big 4 auditors. Further, we find that cross-listed firms with non-Big 4 auditors are more likely to understate their earnings and experience larger reversals of accruals in the future than cross-listed firms with Big 4 auditors. These findings suggest that Big 4 auditors play a meaningful role in improving earnings quality for cross-listed firms, which helps to explain why crosslisted firms have higher earnings quality than their domestic counterparts, as documented in the previous literature. Ó2011 China Journal of Accounting Research. Founded by Sun Yat-sen University and City University of Hong Kong. Production and hosting by Elsevier B.V. All rights reserved. 1755-3091/$ - see front matter Ó2011 China Journal of Accounting Research. Founded by Sun Yat-sen University and City University of Hong Kong. Production and hosting by Elsevier B.V. All rights reserved. doi:10.1016/j.cjar.2011.09.002 ⇑ Corresponding author. Address: Chongqing University, 174 Shazheng Street, Shapingba, Chongqing, China. Tel.: +86 23 E-mail address: [email protected] (Q. Xin). China Journal of Accounting Research 4 (2011) 233–251 Contents lists available at SciVerse ScienceDirect China Journal of Accounting Research journal homepage: www.elsevier.com/locate/cjar 1. Introduction In this study, we investigate the accruals patterns of Chinese listed firms that cross-list on the Hong Kong Stock Exchange (HKEx) to shed light on the role of auditor choice in improving cross-listed firms’ accounting quality. The extant literature shows that firms that cross-list on US exchanges have higher earnings quality. For instance, they have less aggressive earnings management, more conservative earnings, more timely loss recognition and a stronger association between accounting data and share prices, compared with non-cross-listed firms in their home markets (Lang et al., 2003; Huikgen and Lubberink, 2005). However, as Leuz (2006, p. 298) notes, ‘‘the mechanism by which cross listings improve corporate behavior is not well understood.’’ In this spirit, this study focuses on the effects of auditor choice on the characteristics of earnings for cross-listed firms in China. Previous research demonstrates the role of auditors in constraining firms’ ability to manipulate earnings (e.g., Becker et al., 1998; Francis et al., 1999). Thus, the characteristics of reported accounting data should be jointly shaped by managers and auditors. By examining the effect of auditor choice, we can identify a specific channel that helps to explain why cross-listed firms have better accounting quality than non-cross-listed firms. In particular, we are interested in investigating whether there are systematic differences in the accruals-based earnings of clients of Big 4 and non-Big 4 auditors. 1 Francis et al. (2009, p. 53) demonstrate that accruals can map onto earnings quality because accruals are the product of estimations and judgments by managers about future events and managers have discretion to distort accruals opportunistically to meet earnings targets. Furthermore, a number of studies have sought to link auditor size to accruals patterns and found that Big 4 clients have lower abnormal accruals than non-Big 4 clients, consistent with the theory that larger auditors are more effective at constraining opportunistic reporting by managers (DeAngelo, 1981; Dye, 1993). Nevertheless, exactly what drives the difference in audit quality between big and small auditors remains debatable in the extant literature. One explanation is based on reputation. DeAngelo (1981) argues that a large auditor has a greater reputation to lose (greater aggregate reduction in quasi rent) if it provides low-quality audits. An alternative hypothesis is that wealthier auditors are more at risk from litigation and therefore have a greater incentive to issue accurate reports (Dye, 1993). Although several papers conclude that the insurance rationale for audit quality appears to dominate the reputation rationale (Lennox, 1999; Willenborg, 1999; Khurana and Raman, 2004), some studies also show that reputation does matter for audit quality (e.g., Weber et al., 2008). China’s A-share firms cross-listed on HKEx provide a clean setting for us to investigate the reputation rationale of Big 4 audits in an emerging market. The regulations require A- share firms cross-listed on HKEx (referred to as CL firms) to perform dual–audit and dualreporting, based on Chinese GAAP and IFRS, respectively. Typically, a Hong Kong audit firm provides audit services for a CL firm based on IFRS. At the same time, another domestic audit firm provides audit services for the same firm based on Chinese GAAP. Generally, when a CL firm hires a mainland-based Big 4 firm for financial statement audits based 1 The term ‘‘Big 4’’ is used because of the collapse of Arthur Andersen in 2002. However, Arthur Andersen was viewed as one of the ‘‘Big 5’’ during our sample period of 1998–2001. The ‘‘Big 5’’ auditors were Deloitte Touche, Ernst & Young, KPMG, PricewaterhouseCoopers and Arthur Andersen. 234 B. Wang, Q. Xin / China Journal of Accounting Research 4 (2011) 233–251 on Chinese GAAP (referred to as a domestic auditor), it is common practice for the firm to hire the same Big 4 firm in Hong Kong (e.g., KPMG Huazheng versus KPMG Hong Kong) for financial statement audits based on IFRS (referred to as an overseas auditor). Because domestic auditors who provide audit services for CL firms are not exposed to jurisdiction and liability under the stock regulations or laws of Hong Kong, there is no substantial change in their litigation risk. However, given that reputation plays an important role in the Hong Kong audit market, domestic Big 4 member firms may consider the reputation of their Hong Kong counterparts because they share the same international brand name, which in turn changes the incentives of domestic Big 4 member firms and results in lower levels of accruals. Using a sample of cross-listed firms during the period 1998-2008, we find that firm size and leverage are the two main determinants of whether CL firms hire Big 4 firms to conduct their domestic audits. Moreover, we find that auditor choice affects the pattern of accruals in CL firms. CL firms with domestic Big 4 auditors have lower unsigned total accruals and unsigned abnormal working capital accruals, relative to CL firms audited by non-Big 4 auditors. This finding is robust to controlling for a number of variables, including firm size, leverage, performance, etc. In addition, to mitigate the self-selection problem in auditor choice, we compare the accruals patterns for Big 4 CL clients and non-Big 4 CL clients using a matched sample based on the propensity of CL firms to choose Big 4 auditors, and our conclusions are unchanged. Furthermore, by investigating the components of accruals, we find that the difference between the accruals of Big 4 and non-Big 4 clients can be attributed mainly to differences in the impairment of assets. One alternative explanation for the above results is the joint (two) Big 4 pair, per se, which may supply higher audit quality than other auditor pairs. Francis et al. (2009) use France as their research setting, where two (joint) auditors are required by law, and find that firms that use two Big 4 auditors have smaller income-increasing abnormal accruals compared with other firms. To rule out this explanation, we examine the association between auditor choice and accruals using another sample consisting of listed firms that issue both A-shares to domestic investors and B-shares to overseas investors (referred to as AB firms). Before 2007, AB firms were also required to report their accounting data using Chinese GAAP and IFRS and hire domestic and overseas auditors to audit their financial statements. However, AB firms are now subject to regulation by the CSRC and their financial reporting environment is similar to that of other A-share firms. We find that AB firms with Big 4 auditors have higher unsigned total accruals and similar levels of abnormal working capital accruals than AB firms with non-Big 4 auditors. Therefore, two (joint) Big 4 audits does not necessarily enhance audit quality in China. Our study extends the cross-listing literature by exploring the mechanism by which cross-listing has the potential to improve accounting quality. The paper also contributes to the quality-differential audit literature by providing evidence for how the auditing environment and reputation shape the behavior of Big 4 accounting firms. The remainder of the paper proceeds as follows. In Section 2, we provide some institutional background on the audit markets in mainland China and Hong Kong and develop our hypotheses. Section 3details our auditor choice and accruals measures and provides the main empirical results. Section 4presents additional tests and Section 5summarizes and concludes the study. B. Wang, Q. Xin / China Journal of Accounting Research 4 (2011) 233–251 235 2. Institutional background and hypotheses development The Tsingtao Brewery Company Limited (A-share code 600600) first issued H-shares (H-share code 00168) in 1993. By the end of 2008, a further 57 domestic firms had issued A-shares and H-shares. According to the HKEx listing rules, all listed firms’ accountancy reports must be prepared by certified public accountants who are qualified under the Professional Accountants Ordinance, and such accounting firms must normally have an international name and reputation and be a member of a recognized body of accountants. 2 Therefore, a domestic firm cross-listing on HKEx must hire a qualified Hong Kong auditor to audit its financial statements based on IFRS. Meanwhile, according to CSRC regulations, A-shares firms must prepare their financial statements based on Chinese GAAP and they must be audited by a designated domestic auditor. Thus, a CL firm is mandated to provide two financial statements (dual-reporting), audited by a domestic auditor and a Hong Kong auditor, respectively. In addition, CL firms must reconcile items for bottom-line net income and shareholders’ equity at a fairly summary level. Hong Kong has consistently been viewed as one of the best financial markets in terms of investor protection. International Big 4 auditors have dominated the audit market in Hong Kong. 3 Studies indicate that reputation is important for audit service pricing in Hong Kong. For example, DeFond et al. (2000a) examine the audit fees of Big 6 and non-Big 6 accounting firms using a sample of 348 publicly listed Hong Kong companies and find evidence of Big 6 premiums for both general brand name and for industry specialization. Firth and Lau (2004) analyze the 1997 merger between Kwan Wong Tan and Fong (KWTF) and Deloitte Touche and Tohmatsu (DTT) to become DTT, and the 1998 merger between Coopers and Lybrand (CL) and Price Waterhouse (PW) to form PricewaterhouseCoopers (PwC). Their evidence indicates that there are both across-firm and within-firm pre- and post-merger fee differences between Big 5 and non-Big 5 auditors in Hong Kong. In addition, some cross-country studies on accounting quality suggest that listed firms in Hong Kong have more conservative reported earnings and less earnings management than those in other emerging markets (e.g., Ball et al., 2003; Leuz et al., 2003; Bushman and Piotroski, 2006). Relative to Hong Kong, China’s emerging market is relatively immature and its weak investor protection has been criticized for extensive government intervention and significant expropriation of minority shareholders by majority shareholders and corporate managers (Jian and Wong, 2008; Jiang et al., 2010), which weaken the demand for high-quality accounting data and audit services. Research on accounting and auditing in China confirms this is the case. For example, DeFond et al. (2000b) find a decline in audit market share among large auditors following the release of new auditing standards in 1995. Chan et al. (2006) provide evidence that local auditors, who have greater economic dependence on local clients and are subject to more political influence from local governments, are inclined to report favorably on local government-owned companies to mitigate probable economic losses. Wang et al. (2008) document that Chinese state-owned enterprises are more likely to hire small auditors from the same region (low-quality auditors). They suggest that this pattern of auditor choice is likely to be explained by SOEs’ lack of demand for high-quality audit services. Both the existing literature and anecdotal evidence imply that 2 See ‘‘Rules Governing the Listing of Securities on the Stock Exchange of Hong Kong Limited (Chapter 4).’’ 3 DeFond et al. (2000a) reported that the Big 6 firms had approximately 80% market share as measured by the number of listed clientele. 236 B. Wang, Q. Xin / China Journal of Accounting Research 4 (2011) 233–251 reputation considerations are less likely to drive the behavior of auditors in China’s audit market. To date, numerous studies have examined the quality differentials between Big 4 auditors and non-Big 4 auditors. The evidence supports the notion that Big 4 accounting firms supply higher-quality audits (see the review by Francis (2004)). However, some studies also indicate that differences in the proxies for audit quality between Big 4 and non-Big 4 audit firms could be a reflection of their respective clients’ characteristics (e.g., Lawrence et al., 2011), especially in non-US audit markets. Using a cross-country sample from 1994 to 2004, Francis and Wang (2008) find no difference in the earnings quality of Big 4 and non-Big 4 clients when investor protection is very weak. This suggests that in the absence of investor protection, Big 4 auditors simply do not have incentives to enforce high-quality earnings and risk dismissal by their clients. By investigating several audit proxies (e.g., propensity to issue modified audit opinions, discretionary accruals), Liu and Zhou (2007) find that audit quality differentials between Big 4 firms and non-Big 4 firms do not exist in China’s A-share market. However, studies also provide evidence that Big 4 firms play a stronger governance role in emerging markets and charge higher audit fees (e.g., Fan and Wong, 2005; Choi and Wong, 2007; Choi et al., 2008). The mixed and inconclusive results on the quality differential between Big 4 firms and non-Big 4 firms in emerging markets motivate the present study. If a CL firm’s domestic and overseas auditors are member firms of the same international Big 4 accounting firm, then investors should expect the two auditors to have similar professional judgment for the transactions and events of the same firm. Given that overseas (Hong Kong) Big 4 auditors provide high-quality audits in the Hong Kong market, and due to the deterrent effect of sharing the same international brand name, the domestic Big 4 auditor is unlikely to allow managers to opportunistically report its domestic earnings because it needs to take the reputation of its Hong Kong counterpart into account. In contrast, if the Hong Kong auditor does not supply high-quality audits, and/or the domestic auditor does not have the same brand name as the overseas auditor, then the deterrent effect is weak and domestic auditors would not necessarily supply higher quality audits for CL firms. In our sample, if a CL firm’s domestic auditor is a Big 4 firm, then the firms’ overseas auditor is generally the same brand name Big 4 firm. Conversely, if the domestic auditor is a non-Big 4 firm, then the firms’ overseas auditor generally does not share the same brand name. Therefore, we conjecture that domestic Big 4 auditors should be more effective at containing CL firms’ aggressive or opportunistic reporting of domestic earnings than non-Big 4 domestic auditors. 3. The association between auditor choice and accruals 3.1. Data We first obtain a list of A-share companies whose shares were cross-listed on HKEx (H- shares) at the end of 2008 from the CSMAR database. We then identify the listing date on the Chinese stock market (the Shanghai Stock Exchange and the Shenzhen Stock Exchange) and HKEx to determine the first cross-listing calendar-year for each CL firm. We discard firms in the finance industry because the characteristics of accruals for this industry differ from other industries. We thereby obtain 324 cross-listed firm-year observations for the period 1998–2008. Our sample period starts from 1998 because that is when B. Wang, Q. Xin / China Journal of Accounting Research 4 (2011) 233–251 237 Chinese listed companies were first required to disclose their cash-flow statements, which are pivotal for calculating accruals and each component of accruals. Table 1 provides a breakdown of our sample by auditor type, and by year and industry for Big 4 clients and non-Big 4 clients. As presented in panel A of Table 1, of the 324 crosslisted observations, 229 (70.67%) and 290 (89.51%) sample firms hire Big 4 auditors for domestic financial statements and overseas financial statements, respectively. Note that 225 cross-listed firms hire the same Big 4 firm for both domestic and overseas audits, whereas only 12 non-Big 4 audited cross-listed firms hire the same firm. Although the observations are spread among the industries, approximately 85% are in the manufacturing, transportation and mining industries. 4 Table 1 Frequencies of cross-listed firms from 1998 to 2008. Observations Frequency Panel A: Auditor type analysis Total 324 100.00 Domestic auditors – Big 4 229 70.67 – Non-Big 4 95 29.33 Overseas auditors – Big 4 290 89.51 – Non-Big 4 34 10.49 Domestic and overseas auditors are the same 237 73.14 – The same Big 4 225 69.44 – The same Non-Big 4 12 3.70 Year Big 4 audits Non-Big 4 audits Total Observations Frequency Observations Frequency Observations Frequency Panel B: Year analysis 1998 12 3.70 6 1.85 18 5.55 1999 14 4.32 5 1.54 19 5.86 2000 13 4.01 6 1.85 19 5.86 2001 17 5.24 7 2.16 24 7.40 2002 19 5.86 8 2.46 27 8.33 2003 20 6.17 9 2.78 29 8.95 2004 22 6.79 9 2.78 31 9.57 2005 22 6.79 8 2.47 30 9.26 2006 26 8.02 9 2.78 35 10.80 2007 32 9.87 13 4.01 45 13.89 2008 32 9.87 15 4.62 47 14.51 Total 229 70.67 95 29.33 324 100.00 Panel C: Industry analysis Mining 29 8.95 1 0.30 30 9.26 Manufacturing 127 39.20 61 18.82 188 58.02 Utilities 16 4.93 0 0.00 16 4.94 Construction 4 1.23 0 0.00 4 1.23 Transportation 35 10.80 21 6.48 56 17.28 IT 4 1.23 12 3.70 16 4.94 Real estate 3 0.93 0 0.00 3 0.93 Social Services 11 3.40 0 0.00 11 3.39 Total 229 70.67 95 29.33 324 100.00 Notes: The sample is comprised of A-share listed companies with H-shares from 1998 to 2008 (excluding finance industry). 4 Our results do not change substantially if we use the firm sample for these three industries alone. 238 B. Wang, Q. Xin / China Journal of Accounting Research 4 (2011) 233–251 Table 2 presents descriptive statistics of firm characteristics for CL firms audited by domestic Big 4 versus non-Big 4 auditors and results of difference tests between the groups. To mitigate the effects of outliers, all continuous variables are winsorized at the first and 99th percentiles. CL firms with Big 4 auditors are, on average, larger than CL firms with non-Big 4 auditors in terms of total assets and sales. The differences in mean (median) total assets and sales are RMB 44.88 billion (11.30 billion) and RMB 44.76 billion (7.72 billion), respectively, and are statistically significant at the 1% level. The leverage for Big 4 audited CL firms is also significantly higher at the 1% level than that of non-Big 4 audited firms. In terms of accounting performance, CL firms with Big 4 auditors have better ROA and are less likely to make a loss than CL firms with non-Big 4 auditors. In addition, the median market-to-book ratio (MTB) for Big 4 clients is significantly smaller than that of non-Big 4 clients. In contrast, CL firms with Big 4 auditors have greater median sales growth. Therefore, it is unclear whether Big 4 audited firms have higher growth prospects given that both MTB and sales growth could be used as measures of growth opportunities. In general, the above evidence suggests that CL firms with Big 4 auditors are better quality Table 2 Descriptive statistics of firm characteristics for Big 4 and Non-Big 4 samples. Variables Big 4 audits (N= 229) mean (median) Non-Big 4 audits (N= 95) mean (median) p-Value for tests of differences (two-tailed) Total Assets 56.88 12.001 <0.01 (RMB billion) (14.691) (3.391) <0.01 Sales 53.550 8.791 <0.01 (RMB billion) (9.790) (2.076) <0.01 Size 23.390 22.31 <0.01 23.410 21.94 <0.01 Leverage 0.467 0.547 <0.01 0.449 0.509 <0.01 OCF 0.089 0.073 0.10 0.089 0.063 0.01 ROA 0.040 0.024 0.09 0.041 0.026 0.03 Loss 0.153 0.326 <0.01 0.000 0.000 – MTB 3.187 3.660 0.19 2.371 2.843 0.04 Sales growth 0.233 0.176 0.24 0.184 0.132 0.02 State ownership 0.539 0.469 <0.01 0.571 0.482 <0.01 Foreign ownership 0.053 0.047 0.63 0.002 0.002 0.65 Protect dummy 0.689 0.274 <0.01 1.000 0.000 – Notes: The sample is comprised of A-share listed companies with H-shares from 1998 to 2008 (excluding finance industry). Size is the natural logarithm of total assets at the end of year. Leverage is the ratio of total liabilities to total assets at the end of year. OCF is current operating cash flow divided by average total assets. ROA is return on assets, measured as net income divided by average total assets. Loss is a dummy variable that takes the value of 1 if the company has an operating loss in the current year. MTB is the market-to-book ratio at the end of year. Sales growth is the percentage change in sales over the previous year. State ownership is the percentage of shares owned by state shareholders. Foreign ownership is the percentage of foreign ownership among the 10 largest shareholders at the end of the reporting period. Protect dummy is an indicator of whether firms are from protected industries. Petrochemical, energy, raw materials and transportation are viewed as protected industries. T-tests and rank-sum tests are employed to test the differences in the means and medians of variables, respectively. B. Wang, Q. Xin / China Journal of Accounting Research 4 (2011) 233–251 239 than CL firms with non-Big 4 auditors in terms of firm size, leverage and performance. In addition, CL firms with Big 4 auditors have higher mean and median state ownership than CL firms with non-Big 4 auditors, and the differences are significant at the 1% level. However, the two groups have similar foreign ownership. Finally, we also check whether Big 4 clients are more likely to be from protected industries than non-Big 4 clients. Following Aharony et al. (2000), we view petrochemical, energy and raw materials as protected industries. We also view firms in the transportation industry as protected firms in terms of monopoly practices in China. 5 In Table 2, 68.9% of the CL firm-years with Big 4 auditors are from protected industries, compared with 27.4% of the CL firm-years with non-Big 4 audited auditors, and the difference is statistically significant at the 1% level. 3.2. Firm characteristics and auditor choice In addition to the descriptive evidence presented in Table 2, we also run a probit regression for the pooled sample of 324 firm-year observations to investigate how firm characteristics affect auditor choice for CL firms. The dependent variable is a dichotomous indicator for Big 4 versus non-Big 4 domestic auditors. The independent variables include firm size (natural log of total assets), leverage, ROA, 6 loss, market-to-book (MTB), sales growth, state ownership, foreign ownership and a protected industry dummy. We also control for calendar-year fixed effects. The coefficients and the corresponding z-values based on robust standard errors corrected for heteroskedasticity are presented in Table 3. We find that only size, leverage, ROA and loss have statistically significant coefficients. Consistent with Table 3 Firm characteristics and auditor choice. Variables Predicted sign Size + 1.021(3.88) *** Leverage 3.988(2.17) ** ROA + 10.468(2.17) ** Loss 1.209(2.26) ** MTB + 0.035(0.47) Sales growth + 0.276(0.67) State ownership + 0.325(0.14) Foreign ownership + 0.791(0.33) Protect dummy + 0.597(0.78) Year fixed effect Yes N 324 Pseudo-R2 0.248 Notes: The sample is comprised of A-share listed companies with H-shares from 1998 to 2008 (excluding finance industry). The results are based on the probit model. The dependent variable is the auditor choice dummy variable that takes a value of 1 if clients hire a Big 4 auditor for domestic audits in that year and 0 otherwise. The Z- statistics in parentheses are based on robust standard errors clustered by firm. Other variables are defined in Table 2. The sample is winsorized at the top and bottom 1% of firm-year observations. ** Represent statistical significance at the 5% levels, respectively. *** Represent statistical significance at the 1% levels, respectively. 5 The results presented in the following tables do not change if we view transportation as an unprotected industry. 6 If we use OCF to replace ROA as a measure of accounting performance in Table 3, then the coefficient for OCF is -4.504 and significant at the 5% level, similar to ROA. 240 B. Wang, Q. Xin / China Journal of Accounting Research 4 (2011) 233–251 reported in columns (2) and (3) suggest that AB firms audited by Big 4 firms have significantly higher income-increasing total accruals than AB firms audited by non-Big 4 firms. Considering the results using abnormal working capital accruals in columns (4)–(6), three of the coefficients for Big 4 are negative but insignificant, suggesting that there is no systematic association between auditor choice and discretionary accruals. Overall, the evidence reported in Table 7 suggests that Big 4 auditors are not more effective at constraining clients’ aggressive earnings reporting than non-Big 4 auditors in the B-share market, consistent with our prediction and with prior studies in China. The evidence also indicates that dual-audits per se do not improve clients’ quality of earnings, contrary to the findings reported by Francis et al. (2009). 4.2. Analysis of industry-adjusted accruals components In Tables 4 and 5, we find some evidence that CL firms with non-Big 4 auditors are more likely to understate their earnings than CL firms with Big 4 auditors. A natural question is how CL firms manage their earnings. We aim to answer this by examining the differences in the accruals components between clients of Big 4 auditors and clients of non-Big 4 auditors. Specifically, we compute four accruals components: depreciation and amortization (DEPAMO), provision for asset impairment (PAIM), annual change in inventory ( D INV) and annual change in accounts receivable ( D AR). To remove size and industry effects, the four accruals components are scaled by average total assets and adjusted by industry-year median values. In Table 8, we present the four accruals components separately for Big 4 and non-Big 4 subsamples and conduct difference tests. The results show that the mean and median DEPAMO and D AR are similar for the two groups. However, the mean (median) PAIM is 0.005 (0.000) for Big 4 clients, which is lower than for non-Big 4 clients. The differences are statistically significant, indicating that clients of non-Big 4 auditors write down more asset impairment losses. The finding that Big 4 audit clients have a lower provision for impairment losses may explain why CL firms with Big 4 auditors have lower income-decreasing accruals than CL firms with non-Big 4 auditors. In terms of the change in inventory, although the t-test suggests that Big 4 audit clients have a greater positive increase in inventory than non-Big 4 clients (the p-value is 0.04), the rank-sum test indicates that the difference in D INV is insignificant (the p-value is only 0.36). In summary, the evidence presented in Table 8 shows that asset impairment is an Table 8 Analysis of industry-adjusted accruals components. Accruals components Big 4 Audits (N=229) Non-Big 4 Audits (N=95) p-Value for tests of differences (two-tailed) Mean Median Mean Median t-test Rank-sum test DEPAMO 0.011 0.009 0.010 0.006 0.37 0.28 PAIM 0.005 0.000 0.009 0.002 0.07 0.04 D INV 0.010 0.000 .001 0.001 0.04 0.36 D AR 0.016 0.008 0.019 0.015 0.57 0.63 Notes: The sample is comprised of A-share listed companies with H-shares from 1998 to 2008 (excluding finance industry). DEPAMO is the industry-year adjusted depreciation and amortization scaled by average total assets in the year. PAIM is the industry-year adjusted provision for asset impairment scaled by average total assets in the year. PINV is the industry-year adjusted annual change in inventory scaled by average total assets. PAR is the industry-year adjusted annual change in accounts receivable scaled by average total assets in the year. T-tests and rank-sum tests are employed to test the differences in the means and medians of variables, respectively. B. Wang, Q. Xin / China Journal of Accounting Research 4 (2011) 233–251 247 important factor in explaining the accruals pattern differential between clients of Big 4 and non-Big 4 auditing firms. 4.3. Using a matched sample There is an endogeneity concern for the above findings because auditor choice is not random. Big 4 firms are more likely to choose clients with high earnings quality to mitigate reputation and/or litigation losses. Clients with lower earnings quality may also prefer to select non-Big 4 auditors to reduce costs (Johnson and Lys, 1990). To an extent, this selfselection bias could be an alternative explanation for the difference in the accruals patterns of Big 4 and non-Big 4 clients. Many previous studies apply the Heckman two-stage model to correct for this selectivity problem. However, Francis and Lennox (2008) point out that many accounting researchers have been misusing the Heckman model. As an alternative and preferable technique, Francis and Lennox (2008) suggest using ‘‘matched propensity scores,’’ thus avoiding the need to impose any exclusion restrictions as in the Heckman model. Several recent auditing studies have applied the matched propensity approach (e.g., Chan and Wu, 2011; Lawrence et al., 2011). Following Francis and Lennox (2008), we implement the matching technique by first estimating a probit model to predict the propensity for CL firms to choose Big 4 auditors, using the pooled 324 CL firm-year observations. The explanatory variables are the same as those in Table 3. We then sort the sample by the predicted probabilities. For each Big 4 client-year observation, we identify the two observations that have the closest predicted probabilities and adopt the following matching rule: (a) if only one of the two potential matches is a non-Big 4 client, then we choose that one as the match; (b) if both potential Table 9 Univariate analysis of accruals using a propensity-score matched sample. Accruals variables Big 4 Audits Non-Big 4 Audits p-value for tests of differences (two-tailed) Panel A: Total accruals analysis |TAC| Mean 0.063 0.083 0.12 Median 0.049 0.057 0.26 N. 73 73 |TAC| Mean 0.047 0.040 0.63 (TACP0) Median 0.032 0.033 0.81 N20 20 |TAC| Mean 0.069 0.097 0.06 (TA<0) Median 0.061 0.077 0.13 N53 53 Panel B: Abnormal working capital current accruals analysis |AWCA| Mean 0.082 0.137 0.07 Median 0.059 0.092 0.08 N73 73 |AWCA| Mean 0.097 0.098 0.98 (AWCAP0) Median 0.068 0.078 0.35 N36 34 |AWCA| Mean 0.067 0.171 0.06 (AWCA<0) Median 0.042 0.111 0.07 N37 39 Notes: The sample includes 73 Big 4 client-year observations and 73 matched observations of non-Big 4 client-years using the propensity score matching approach. T-tests and rank-sum tests are employed to test the differences in the means and medians of variables (two-tailed), respectively. 248 B. Wang, Q. Xin / China Journal of Accounting Research 4 (2011) 233–251 matches are non-Big 4 clients, then we choose the one with the closest predicted probability; and (c) if both potential matches are Big 4 clients, then we determine that there is no suitable match. This rule ensures that we obtain extremely close matches, implying that the scored distributions are virtually identical for Big 4 and non-Big 4 clients. We are able to identify 73 pairs of firm-year observations. We then use these 146 observations to compare the accruals patterns for Big 4 CL and non-Big 4 CL clients. Tables 9 and 10 present the results for the univariate analysis and multivariate analysis, respectively. The results in Table 9 show that Big 4 clients have a smaller absolute amount of accruals, especially for abnormal working capital accruals. In Table 10, the coefficients for Big 4 are negative and statistically significant in column (1) and column (4), reinforcing the conclusion from the univariate analysis. From the signed accruals tests, we also find that non-Big 4 clients have more negative abnormal working capital accruals than Big 4 clients, similar to the findings in Table 5. Therefore, the evidence from the matched-pairs technique supports our conclusion that Big 4 audits are associated with firms’ accruals patterns. 5. Conclusion This study examines the association between auditor choice and accruals properties using a sample of Chinese firms that cross-list their shares on HKEx over the period 1998–2008. We find that the clients of Big 4 auditors have lower unsigned accruals, especially discretionary accruals, relative to the clients of non-Big 4 auditors. In addition, we find that non-Big 4 clients are more likely to understate their earnings than Big 4 clients. The results are robust to controlling for firm characteristics and using a matched sample. Moreover, using a sample of listed firms with B-shares, we find that the results cannot be Table 10 Regression analysis of accruals using a propensity-score matched sample. |TAC| (1) |TAC| (TACP0) (2) |TAC| (TAC<0) (3) |AWCA| (4) |AWCA| (AWCAP0) (5) |AWCA| (AWCA<0) (6) Big 4 0.013 0.003 0.013 0.068 0.002 0.114 (1.87) * (0.23) (1.44) (2.91) *** (0.05) (1.94) * Size 0.012 0.021 0.199 0.001 0.011 0.005 (1.48) (2.32) ** (1.71) * (0.04) (0.85) (0.34) Leverage 0.137 0.097 0.169 0.014 0.044 0.053 (2.56) ** (1.58) (2.87) *** (0.17) (0.38) (0.51) OCF 0.372 0.678 0.627 0.658 0.033 1.204 (2.43) ** (4.15) *** (2.81) *** (2.45) ** (0.14) (2.32) ** Loss 0.053 0.032 0.077 0.019 0.022 0.051 (2.78) *** (2.96) *** (4.54) *** (0.81) (0.76) (0.87) Firm/Year cluster Yes Yes Yes Yes Yes Yes N 146 40 106 146 70 76 R 2 0.338 0.552 0.469 0.110 0.024 0.209 Notes: The sample includes 73 Big 4 client-year observations and 73 matched non-Big 4 client-year observations using the propensity score matching approach. This table reports estimates from pooled time-series cross-sectional OLS regressions. The dependent variables are accruals proxies. The dependent and independent variables are defined in Table 2 and Table 4. tstatistics are presented in parentheses below the coefficients and are corrected for heteroskedasticity and cross-sectional and time-series correlations, using a two-way cluster at the firm and year level. The sample is winsorized at the top and bottom 1% of firm-year observations. * Represent statistical significance at the 10% levels, respectively. ** Represent statistical significance at the 5% levels, respectively. *** Represent statistical significance at the 1% levels, respectively. B. Wang, Q. Xin / China Journal of Accounting Research 4 (2011) 233–251 249 explained by dual-audits per se. Taken together, our evidence suggests that Big 4 firms play a meaningful role in enhancing the earnings quality of cross-listed firms, which helps to explain why cross-listed firms have higher earnings quality than their domestic counterparts, as documented in the extant literature. The findings also suggest that reputation shaped by the institutional environment can change Big 4 incentives in an emerging market. The study is subject to numerous caveats. The most significant limitation is the small sample size, and the results should therefore be interpreted with caution. In addition, we assume that the observed difference in the accruals patterns of Big 4 audit clients and non-Big 4 audit clients is driven by the auditing quality differential between Big 4 and non-Big 4 firms. It may be that we do not adequately control for other unobserved differences between the two groups and that these may be driving the observed differences in accruals patterns. 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