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Effects of Audit Quality on Earnings Management and Cost of Equity Capital: Evidence from China

55 Pages Posted: 14 Mar 2008 Last revised: 30 Sep 2011

Hanwen Chen

University of International Business and Economics

Jeff Zeyun Chen

Texas Christian University

Gerald J. Lobo

University of Houston - C.T. Bauer College of Business

Yanyan Wang

Xiamen University

Date Written: August 1, 2010

Abstract

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.

Keywords: audit quality, cost of equity capital, earnings management, state-owned enterprises

JEL Classification: M40, M41, M42

Suggested Citation

Chen, Hanwen and Chen, Jeff Zeyun and Lobo, Gerald J. and Wang, Yanyan, Effects of Audit Quality on Earnings Management and Cost of Equity Capital: Evidence from China (August 1, 2010). Contemporary Accounting Research, Vol. 28, No.3, pp. 892-925, September 2011 . Available at SSRN: https://ssrn.com/abstract=1105539

Hanwen Chen

University of International Business and Economics ( email )

10# Huixin East Street,Chaoyang District
Beijing, Beijing 100029
China

Jeff Zeyun Chen

Texas Christian University ( email )

2900 Lubbock Ave
Fort Worth, TX 76109
United States

Gerald J. Lobo (Contact Author)

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States
713-743-4838 (Phone)
713-743-4828 (Fax)

HOME PAGE: http://www.bauer.uh.edu/acct/acctprofile.asp?search=Gerald%20Lobo

Yanyan Wang

Xiamen University ( email )

Xiamen, Fujian 361005
China

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