Market Implications of the Audit Quality and Auditor Switches: Evidence from China

44 Pages Posted: 18 Dec 2008

See all articles by Z. Jun Lin

Z. Jun Lin

Hong Kong Baptist University (HKBU) - Department of Accountancy & Law

Ming Liu

Hong Kong Baptist University (HKBU) - Department of Accountancy & Law

Zhemin Wang

University of Wisconsin - Parkside - School of Business and Technology

Abstract

Independent audits enhance the credibility of corporate financial reports and assist investors to make rational decisions in the capital market. Nonetheless, the utility of the auditing function depends upon the quality of audits, which is determined by the independence and expertise of auditors. Hence, auditor choice and switch will not only affect an audit's quality, but will also influence decisions made by investors and other market participants. The purpose of this paper is to investigate how investors respond to the quality of audits and auditor switches in the Chinese context. Empirical results show that the quality of an audit and switching to a larger auditor have a positive (negative) impact on earnings response coefficients (ERCs) for firms with positive (negative) abnormal earnings. In contrast, switching to a smaller auditor has a negative (positive) impact on ERCs for firms with positive (negative) abnormal earnings. These results suggest that large auditing firms (Top 10) in China are perceived as more effective for curbing income-increased earnings management, which leads to higher (lower) ERCs for clients with positive (negative) abnormal earnings. Firms' switching to a larger auditor may signal high-quality earnings. Therefore, investors more often increase stock prices when firms have positive abnormal earnings and less often depreciate prices for negative abnormal earnings. Similarly, switching to a smaller auditor may signal lower earning quality, resulting in opposite market responses. In general, the empirical evidence suggests that audit information is valued by the capital market in China. Large auditing firms have been able to product-differentiate themselves within the Chinese stock market.

Suggested Citation

Lin, Z. Jun and Liu, Ming and Wang, Zhemin, Market Implications of the Audit Quality and Auditor Switches: Evidence from China. Journal of International Financial Management & Accounting, Vol. 20, Issue 1, pp. 35-78, Spring 2009. Available at SSRN: https://ssrn.com/abstract=1317932 or http://dx.doi.org/10.1111/j.1467-646X.2009.01026.x

Z. Jun Lin (Contact Author)

Hong Kong Baptist University (HKBU) - Department of Accountancy & Law ( email )

Kowloon Tong, Kowloon
Hong Kong
+852-3411-7537 (Phone)
+852—3411-5581 (Fax)

Ming Liu

Hong Kong Baptist University (HKBU) - Department of Accountancy & Law ( email )

Kowloon Tong, Kowloon
Hong Kong

Zhemin Wang

University of Wisconsin - Parkside - School of Business and Technology ( email )

Kenosha, WI 53141-2000
United States

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