Do Big 4 firms benefit or suffer losses when another Big 4 firm fails to detect fraud?

Abstract

This paper examines how investors and companies in China benefit or penalize other audit firms (and their clients) when one Big 4 audit firm fails to detect a fraud. Using a detailed archival study of a fraud by a manufacturing firm (Kelon), we propose that an audit failure by one Big 4 firm hurts not only itself and shareholders of its clients, but also competing Big 4 firms and their clients. Unlike results in developed countries, clients of both the failing auditor (Deloitte) and other foreign (Big 4) auditors experience more negative stock market reactions than local non-Big 4 auditors’ clients at the disclosure event pertaining to Kelon. Negative effects are more pronounced for companies in Kelon’s industry. Shareholder losses are moderated by government ownership. Furthermore, companies are less likely to switch to other Big 4 auditors after disclosure of the fraud case. Our results are robust to additional analyses, including controls for self-selection of Big 4 auditors.

Keywords:

• Contagion
• auditor reputation
• audit market competition
• fraud

Acknowledgements

We appreciate the helpful comments from Xia Chen, Mohamed Drira, Marina Ebner, Yanmin Gao, Christopher Hodgdon, Kalin Kolev, Michael Maier, Brad Pomeroy, Stephen Taylor, Alfred Wagenhofer, Heather Wier, Zhifeng Yang, workshop participants at Peking University and the University of Graz, conference participants at the 2011 American Accounting Association Auditing Section Midyear Meeting, 2011 American Accounting Association International Accounting Section Midyear Meeting, the 2011 Canadian Academic Accounting Association Annual Conference, and the 2011 American Accounting Association Annual Meeting.

Notes

1. Listed companies in China can issue three categories of shares – A shares, B shares, and H shares. A shares are issued by local Chinese companies, denominated in RMB (the local Chinese currency), and traded primarily among local investors in the Shanghai or Shenzhen Stock Exchange. Qualified Foreign Institutional Investors (QFII) with special permission from the Chinese government can also trade A shares. B shares are issued by Chinese companies with face values denominated in RMB. B shares are traded primarily by international investors in US dollars in the Shanghai Stock Exchange or in Hong Kong dollars in the Shenzhen Stock Exchange. Mainland Chinese investors with legal foreign currency accounts may also trade B shares since 1 June 2001. H shares are issued by Chinese companies and listed in Hong Kong. H shares are freely tradable by anyone and quoted in Hong Kong dollars. For the A shares market, Chinese accounting and auditing standards are applied. For the B shares or H shares market, international or Hong Kong accounting and auditing standards are applied.

2. According to Rule 13.1.1 of the ‘Shenzhen Stock Exchange Listing Rules’, where the occurrence of abnormal financial position or other abnormality of a listed company exposes the company to the risk of delisting or makes investors unable to judge the company’s prospects and therefore may harm their rights and interests, the Exchange shall put the shares of this company under ‘special treatment’. For the company which receives ‘special treatment’, the trading price of its shares is limited to daily five percent swings, up or down.

3. Private Securities Litigation Rules promulgated by the Supreme Court in January 2003 require that plaintiffs need administrative sanction actions or criminal court rulings as a precondition to initiate civil lawsuits against audit firms.

4. As far as we know, the Kelon fraud had big publicity and it is the first major audit failure of a Big 4 auditor in China in terms of the misstated accounting numbers and social influence.

5. We do not expect a hangover effect of the collapse of Arthur Andersen as the debacle of Arthur Andersen incurred in 2002, which was several years before the audit failure of Kelon by Deloitte became known to public in 2005. Prior clients of Arthur Andersen may have already switched to the remaining Big 4 audit firms, just like what Kelon did.

6. See http://www.szse.cn/.

7. According to the CSMAR database, a listed company’s actual controlling party should satisfy any of the following criteria: (1) the party holds the largest amount of shares among the listed firm’s shareholders, except that there is opposite evidence; (2) the voting power owned or controlled by the party overwhelms the largest shareholder; (3) the party holds or controls at least thirty percent of the listed firm’s shares or voting power, except that there is opposite evidence; (4) by exercising the voting power, the party can decide appointments of more than half the members for the listed firm’s board of directors; and (5) other scenarios determined by the CSRC.

8. In the case of change in the audit firm’s name resulting from audit firm mergers, the incumbent auditor-client relationship does not change and there is no switch of audit firms.

9. We use multinomial logit regression to examine how audit clients make their decisions among three alternatives: staying with the incumbent audit firms, switching to non-Big 4 audit firms, and switching to Big 4 audit firms. In other words, the regression results reveal how attractive Big 4 audit firms appear to clients. The significantly negative coefficient on the interaction term between Big4_it−1 and Year2005 implies that the client that has a Big 4 auditor for fiscal year 2004 is less likely to choose another Big 4 auditor for fiscal year 2005. This provides some evidence on that Big 4 auditors as a whole are less favored by their prior clients in financial statements audits for fiscal year 2005 than for other fiscal years.