Legal Liability, Government Intervention, and Auditor Behavior: Evidence from Structural Reform of Audit Firms in China

Abstract

This paper investigates how legal liability influences audit quality and audit fees, particularly in the presence of government intervention. Since 2010, all Chinese audit firms were required to transform from a structure of limited liability company (LLC) to limited liability partnership (LLP), which removes the cap on the liability exposure of negligent auditors. By adopting this natural experiment, we document the following findings: first, after audit firms reorganize as LLPs, auditors are more likely to (1) issue modified audit opinions and going-concern opinions, (2) constrain clients’ earnings management, and (3) charge a premium in audit fees, which suggest that exerting unlimited legal liability on negligent auditors improves both audit quality and audit fees. Second, the effect of the LLP adoption is more pronounced when auditors are from local audit firms, and clients are controlled by local governments. Further analyses suggest that the stock prices of clients positively react to the reform event, which indicates that LLP adoption improves the overall value of audits. In summary, our empirical findings are consistent with the argument that legal liability is able to effectively shape auditor behavior in emerging markets where the other institutional mechanisms are relatively weaker and government intervention is heavy.

Acknowledgements

We are grateful to the valuable comments by anonymous referees, and the suggestions by Guochang Zhang (the Associate Editor) and Laurence van Lent (the Editor). We are also grateful for valuable comments received from Vernon Richardson, Jenny Stewart, Reza Monem and other participants at the first China Finance and Accounting Conference, 15–16 July 2014, Xiamen, China, and the seminar organized by the Department of Accounting, Finance and Economics, Griffith University, 15 August 2014.

Notes

¹This new structure is called Te Shu Pu Tong He Huo Zhi in Chinese, meaning ‘Special Partnership’. However, this ‘Special Partnership’ is actually LLP, and the English version of the Chinese Partnership Enterprise Law actually calls this structure ‘Limited Liability Partnership’ (Huang, 2010).

²To gain a better understanding of the litigation risks of Chinese auditors, we further interview some partners and managers of the special licensed audit firms. From the interviews, we note that the number of civil litigation cases initiated against auditors keeps increasing in the Chinese market. However, due to the underdeveloped judicial system, it usually takes several months or even years for courts to make a final decision. Because of the huge cost, a large proportion of these cases is resolved privately and not publicly disclosed. In addition, the payouts by audit firms to settle these lawsuits range from thousands to millions RMB.

³This assumption is reasonable because unlike the USA, the auditing market shows high competition in China (Yang, 2013). In this study, we also calculate the CR4 (the total market shares of the Top Four firms in a certain industry) and the Herfindahl Index of the Chinese auditing market over our sample. The CR4 is only 47.43%, and the Herfindahl Index is only 2.48%, both implying a highly competitive market.

⁴Chinese accounting standards have been revised and published twice, in 2001 and 2007.

⁵Fan et al. (2011) assess the relative progress in marketization of Chinese districts using a comparative method, considering 23 indicators in the following 5 fields: (1) the relation between the government and the market; (2) the development of the non-state sector in the regional economy; (3) the development of the product market; (4) the development of the factor market; and (5) the development of market intermediaries and the legal environment. Data to calculate these indicators are obtained from either the National Bureau of Statistics or enterprise and household surveys. In 2001, the worst- and best-performing regions for a particular indicator received a score of 0 and 10, respectively, while other districts obtained scores in between. Provinces/municipalities can acquire scores below 0 or above 10 in later years, depending upon their evolution over time.

⁶Nevertheless, earnings management is a less direct or even a noisy measurement of audit quality, because auditor's influence on the financial statements of client firms is likely to be more limited than his/her influence over issuing audit opinions (DeFond & Zhang, 2014). Therefore, we use both direct measurement of auditor quality and earnings management as their proxies. Besides, we do not employ other measurements such as restatement because they are relatively rare events in China.

⁷Chinese companies which suffer financial losses for two consecutive years will be subject to special treatment (e.g. a daily price change limit of 5%), and will be delisted if they cannot generate profits in the third year.

⁸Liu et al. (2012) only report the value of the natural logarithm of audit fees, which is 13.429, compared with 13.410 in our study.

⁹We get the Pearson correlation coefficients for test and control variables used in this study but for the sake of brevity do not report them. In the unreported results, all the pair-wise correlations among the independent variables are less than 0.3, suggesting there would be no serious potential problem of multicollinearity in our empirical models.

¹⁰We thank the reviewer to point out this issue.

¹¹We thank the anonymous reviewer for this suggestion.

¹²Source access: http://finance.sina.com.cn/stock/t/20070629/08181506670.shtml.

¹³Source access: http://news.changsha.cn/hn/3/200910/t20091022_1021904.htm.

¹⁴Source access: http://finance.sina.com.cn/g/20080831/13595255667.shtml.

¹⁵Source access: http://finance.sina.com.cn/stock/s/20140923/012220382541.shtml; http://www.csrc.gov.cn/pub/zjhpublic/G00306212/201307/t20130726_231847.htm; http://www.csrc.gov.cn/pub/zjhpublic/G00306212/201307/t20130726_231832.htm; http://finance.ifeng.com/a/20130726/10279264_0.shtml.