Effects of Audit Quality on Earnings Management and Cost of Equity Capital: Evidence from China
Jeff Zeyun Chen
University of Colorado at Boulder
Gerald J. Lobo
University of Houston - C.T. Bauer College of Business
August 1, 2010
Contemporary Accounting Research, Vol. 28, No.3, pp. 892-925, September 2011
We examine the effects of audit quality on earnings management and cost of equity capital for two groups of Chinese firms: state-owned enterprises (SOEs) and non-state-owned enterprises (NSOEs). The differences in the nature of the ownership, agency relations and bankruptcy risks lead SOEs to have weaker incentives than NSOEs to engage in earnings management. As a result, the effect of audit quality in reducing earnings management will be greater for NSOEs than for SOEs. In addition, investors’ pricing of information risk as reflected in the cost of equity capital will be more pronounced for NSOEs than for SOEs with high and low audit quality. We find empirical evidence consistent with these hypotheses. Our findings indicate that (1) while high-quality auditors play a governance role in China, that role is limited to a subset of firms, and (2) even under the same legal jurisdiction, the effects of audit quality (in the form of lower earnings management and cost of equity capital) vary across firms with different ownership structures. Our study extends prior research by focusing on the economic consequences of SOEs’ and NSOEs’ auditor choices and underscores the importance of controlling for ownership type when conducting audit research.
Number of Pages in PDF File: 55
Keywords: audit quality, cost of equity capital, earnings management, state-owned enterprises
JEL Classification: M40, M41, M42
Date posted: March 14, 2008 ; Last revised: September 30, 2011
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