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Abstract
We explore the effects of social ties (including alumni relations, regional connections and employment affiliation) between the two signatory auditors (engagement and review auditors) on audit quality in China. We find that client firms with socially connected auditors have lower audit quality. The negative effect is more pronounced when the two signatory auditors are partners in their audit firms or when financial irregularities exist in their client firms. Conversely, this adverse effect is alleviated if the two auditors have attended elite schools or work for one of the Big 4 audit firms. We further find that social ties between the two auditors is negatively associated with firm value through impaired market confidence, while this negative relationship can be partially explained by impaired audit quality. Overall, our results indicate that the costs of the two signatory auditors’ social ties outweigh their benefits.
Acknowledgements
We thank two anonymous reviewers and associate editor Gilad Livne for their insightful and constructive comments and advice.
Disclosure statement
No potential conflict of interest was reported by the author(s).
Supplemental data
Supplemental data for this article can be accessed here doi:10.1080/00014788.2024.2306531
Notes
1 The differences of institutional ownership between mainland China and Taiwan markets market provide evidence for the divergence between their results and ours, given by the evidence from the test for SOEs and non-SOEs by using Huang et al.’s (Citation2021) social ties measure and our own (Section 6.3).
2 In practice, in China, the primary role of supervision and monitoring is typically assigned to the review auditor (Lennox et al. Citation2020).
3 The CICIPA information system on this website was modified in 2021. Although the system does not provide as much information to the public as it used to, we can download this demographic information of CPAs from the CSMAR database.
4 It is the actual audit opinion on the audit report rather than the probability of receiving the opinion.
5 According to Kwon and Yi (Citation2018), school ties offer several distinctive advantages, as they often create more homogamy than other social ties. In addition, the associated measurement errors and endogeneity concerns are less pronounced because such experiences are time-invariant.
6 Birthplace could also be used to measure the townsmen tie, but such data is not readily available. Although we have manually examined the signing auditors’ information spanning the 2004−2018 study period, only 1,640 of the audit reports included identity numbers. Among these 1,640 individuals, 796 come from the same province, and 382 come from the same city. In addition, their regressions for audit quality are not significant.
7 To avoid overlapping measurements, we exclude those observations if the two signatory auditors have attended the same college or university because they are already captured by School Tie.
8 This effect on irregularity has been tested in our robustness test (Panel D of ).
9 Based on our observations, signatory auditors’ positions include partner, executive director, engagement team director, chief accountant, and accountant. We focus on partners in our study because this position best accounts for auditors’ incentives and audit quality compared to other positions that a signatory auditor could hold in a firm.
10 Project 211 is a government initiative aimed at increasing the number of Chinese universities ranked within the top 100 in the twenty-first century, whereas Project 985 is a government initiative launched on May 4, 1998 to allocate more funds to 39 outstanding Chinese universities. This website lists top universities of ‘Project 211’ and ‘Project 985’: https://www.shanghairanking.cn/institution?name=&c=0&r=0&l=0&e=0.
11 In addition to control variables that are already included in our audit quality model, there are additional financial characteristics and board characteristics that may affect firm value (Carter et al. Citation2003, Hermalin & Weisbach Citation2003, Tan et al. Citation2021, Villalonga & Amit Citation2006). Specifically, we include several additional control variables in Equations (5) and (7): Beta risk, calculated as , where
is the return of
and
is the market return; Director_Num, measured by the total number of board members; and Duality, a dummy variable coded as 1 if the CEO is also the chairman of the board and zero otherwise. Although these control variables have been included in firm value models in prior studies, they are not commonly used in models for estimating audit quality, and incorporating them into our model does not change our main results. Thus, to make our audit quality specification consistent with that adopted by other authors, we do not tabulate them.
12 We tabulate the results of path analysis (Table S1) in the online appendix.
13 As Larcker and Rusticus (Citation2010) note, a concern of using such means as instruments is that these instruments have both the exogenous and the endogenous components of the original variables. However, as suggested by Francis et al. (Citation2021), the concern from Larcker and Rusticus (Citation2010) could be alleviated to the extent that the endogenous component of average IV decreases when we aggregate to the mean and when we exclude the values of the actual observations in the calculation of the IV. In addition, we have confirmed that our IV is valid through underidentification and weak-identification tests.
14 We control for city fixed effects following the Heckman procedure described by Guan et al. (Citation2016). IV_Social Ties is defined earlier in the section Three stage least-squares approach.