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Abstract
This study examines whether auditors’ local knowledge of clients can compensate for a weaker regulatory oversight in the audits of foreign companies. Based on a sample of Chinese companies that were listed in the U.S. and after controlling for other factors that may affect audit quality, we find that the audit quality of Hong Kong and Chinese non-Big 4 auditors is comparable to that of U.S. auditors with an affiliate in China and higher than that of U.S. auditors without a Chinese affiliate. Additional analysis indicates that U.S. auditors provide higher audit quality to U.S.-based listed firms than U.S.-listed Chinese firms and the quality difference is reduced for U.S. auditors with a Chinese affiliate. These results indicate that auditors’ local knowledge of foreign clients has a positive effect on audit quality and in certain circumstances, it can compensate for a weaker regulatory oversight in an international setting.
Disclosure statement
No potential conflict of interest was reported by the author(s).
Notes
1 PCAOB states that ‘some firms may be issuing audit reports based on the work of another firm, … , without complying with relevant PCAOB standards.’. Specifically, the PCAOB standards (AU sec. 543) allows an audit firm to use the work and reports of other independent auditors who have audited the financial statements of one or more subsidiaries, divisions, branches, components, or investments of an issuer. However, there must be proper supervision of the auditing work.
2 See the relevant SEC press releases (http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171486452) for more information.
3 PCAOB inspections typically consist of a review of selected audit engagements and a review of the accounting firms’ quality controls. The PCAOB selects audits to review based on its assessment of the risks of misstatement (Gillan Citation2005, McDonough Citation2005). For each inspection, the PCAOB assesses auditor compliance with SEC rules, the GAAP, the PCAOB’s auditing standards and other professional practice standards (Sarbanes–Oxley Act, Section 104).
4 In 2012, the SEC sanctioned the Big 4 auditors and BDO in mainland China for their refusal to produce documents (http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171486452).
5 The PCAOB has signed cooperative agreements with Finland, Germany, Luxembourg, Greece, Hungary, Denmark, Sweden, France, Spain, Dubai, Netherlands, Taiwan, Israel, Japan, Norway, Switzerland, the United Kingdom, Singapore, Australia, Korea and Canada. The PCAOB also signed a memorandum of understanding on enforcement cooperation with China in 2013. The memorandum covers mutual assistance in enforcing and securing compliance with laws and regulations applicable in their respective jurisdictions. (see www.pcaobus.org/International). However, at present, the assistance is limited and consists mainly of exchanges of information.
6 Audit firms subject to practice review are required to submit a complete list of their audit clients (including local and overseas) to the Quality Assurance Department of the HKICPA before site visits. Checks will be made to ensure completeness of the client list during the practice review. The practice review team then selects completed audit engagements from the client lists for detailed review (HKICPA Citation2016).
7 If the review involves cross-border engagements with Chinese clients, the Quality Assurance Department of the HKICPA will refer the engagements to the Ministry of Finance (MOF) in Mainland China for review under the memorandum of understanding between the MOF and HKICPA that provides for mutual assistance in discharging respective regulatory functions (HKICPA Citation2015). In addition, the introduction of the Mainland and Hong Kong Closer Economic Partnership Arrangement (CEPA) facilitates cooperation between professional bodies in mainland China and Hong Kong (available at https://www.tid.gov.hk/print/english/cepa/tradeservices/accounting.html).
8 The Practice Review Committee may act under the power vested in it by the Professional Accountants Ordinance to (1) conclude a practice review without recommending a follow-up action; (2) make recommendations and specific requests to an auditing firm to ensure appropriate follow-up action is taken to address weaknesses and shortcomings that have been identified by the reviewer; (3) require another visit; or (4) make a formal complaint, thereby initiating disciplinary action.
9 Details of the roles and responsibilities of the regulatory bodies in Hong Kong can be found at HKICPA (http://www.hkicpa.org.hk/en/about-us/organization/overview/), FRC (http://www.frc.org.hk/en/role.php), and HKSFC (http://www.sfc.hk/web/EN/about-the-sfc/our-role/regulatory-objectives.html).
11 Reports of the Ministry of Finance and the CSRC on annual filing and the verification of accounting firms with securities qualifications are available at:http://www.csrc.gov.cn/pub/shenzhen/xxfw/tzzsyd/ssgs/szcwkjysj/zjjgjgxggd/kjsjswsjggd/201208/W020120806603489842178.pdf.
12 According to the CSRC enforcement actions database (http://www.csrc.gov.cn/pub/zjhpublic/), there were about fifty enforcement actions against auditing firms and/or audit engagement partners in the period 2001–2015.
13 According to figures made available by the University Grants Committee in Hong Kong (http://cdcf.ugc.edu.hk/cdcf/searchUniv.do?lang=EN), there were close to 12,000 mainland students enrolled in the eight government-funded universities in Hong Kong in the academic year 2015–16. This figure represents about 11.98 percent of all students enrolled in government-funded universities in Hong Kong in 2015–16. Currently, there are over 1,600 accounting graduates per year in Hong Kong (HKSAR Citation2019).
14 The offices set up by U.S. audit firms are branches or representative offices registered in China, with a few cases of U.S. audit firms setting up subsidiaries in China. U.S. audit firm’s Chinese affiliates will serve as the firm’s agent in China as this is the purpose of having an affiliate.
15 The Chinese and Hong Kong non-Big 4 auditors are PCAOB-registered but do not have offices in the U.S.
16 We deal with the endogeneity problem arising from self-selection bias as it is most relevant for auditor choice decisions. We acknowledge that there could be other sources of endogeneity, but we focus on the self-selection problem based on prior studies on auditor selection and audit quality (Chaney et al. Citation2004).
17 When a multinomial logistic model rather than a probit model is used in the first stage, the expected outcome residuals (not inverse Mills ratio) should be added to the second stage model. An inverse standard normal cumulative density function transformation is required for calculating the expected outcome residuals (Vella Citation1998, p. 147–148, Greene Citation2002, pp. 23–79; Tucker Citation2011).
18 In a sensitivity test, we use Chinese auditors as the benchmark variable and the conclusions are the same.
19 As a sensitivity test, we include year dummies to control for time-specific effects. The un-tabulated results are similar.
20 Though some of the control variables are correlated, the VIF tests in our regression analyses indicate that there is no multicollinearity problem.
21 The pseudo and adjusted R2 for the regressions are comparable to other prior studies on audit quality (e.g., Blankley et al. Citation2012, Newton et al. Citation2013). The variance inflation factors (VIF) for the variables in the RES, RES_UNMAO and |PMDA| models are 1.94, 1.94 and 6.02, respectively. As none of the VIFs exceeds 10, multicollinearity does not seem to be a problem in our regression analysis (Wooldridge Citation2013, p. 98).
22 Marginal effects refer to the percentage point change in y (the dependent variable) in response to a one percent point change in x.
23 The coefficients on CHN are 0.347 (Z-stat. = 1.18) in the RES model, 0.387 (Z-stat. = 1.54) for RES_UNMAO and 0.044 (t-stat. = 1.33) for the |PMDA| model.
24 The variance inflation factors (VIF) for the variables in the RES, RES_UNMAO and |DA| models are 2.78, 1.79 and 5.49, respectively. As none of the VIFs exceeds 10, multicollinearity does not seem to be a problem in our regression analysis (Wooldridge Citation2013, p. 98).
25 The PSM results for other tests are likewise similar. For example, corresponding to Panel B, for the matched sample of Hong Kong auditors vs. Chinese auditors, the coefficient on CHN in the RES_UNMAO model is −0.447 (t = −1.826, significant at 10%) whereas for the HK vs. USA matched sample, the coefficients on USA are 0.469 (t = 2.323, significant at 5%) and 0.449 (t = 2.057, significant at 5%) for the RES and RES_UNMAO models respectively.
26 We do not intend to generalise the results to all economies.