Adoption of Sarbanes‐Oxley Act in China: Antecedents and Consequences of Separate Auditing

• Author: Jidong Zhang,Jing Han
• DOI: http://doi.org/10.1111/ijau.12057
• Published date: 01 July 2016
• Date: 01 July 2016

Adoption of Sarbanes-Oxley Act in China: Antecedents and Consequences of

Separate Auditing

Jidong Zhang and Jing Han

California State University Fullerton, USA

This study examined Chinese public companies’ reactions to regulations imposed by the Enterprise Internal

Control Standard (the Chinese version of the Sarbanes-OxleyAct). We found some Chinese public companies used

separate CPA firms to audit their internal control over financial reporting and financial statements – a practice that

has not been addressed in prior studies on SOX adoption. In this paper, we examine the antecedents and

consequences of separate auditing. First, because audit quality is an important aim of the Enterprise Internal

Control Standard, we tested the influence of separate auditing on audit quality. Moreover, we theorized and

hypothesized that a company’s decision to employ separate auditing was influenced by the presence and

proportion of directors on the board who performed multiple functions, thus affecting their concerns about the

company’s internal and external relations. An empirical analysis of 113 public Chinese companies that voluntarily

disclosed and audited their internal control reports confirmed our hypotheses. Contribution to the literature,

practical implications, and limitations are also discussed.

Key words: Corporate governance, SOX adoption, China, separate auditing, audit quality, social networks

INTRODUCTION

A brief review of the Sarbanes-Oxley Act

The United States Congress passed the Sarbanes-Oxley

Act (henceforth SOX) in July2002 in response to a wave of

corporate governance scandals. In particular, Section 404

of SOX required Securities and Exchange Commission

registrants to report on the effectiveness of their internal

controls over financial reporting. The legislation was

designed to increase the transparency of financial audits

and to restore public confidence in American firms.

Many countries followed the US in issuing similar laws

to guard against financial scandal and have incorporated

into their laws basic equivalents to the three main

provisions of SOX: (1) management must state its

responsibility for internal control efficacy in the firm’s

annual report; (2) managementmust report on the state of

those controls; and (3) an auditor must auditthis internal

control report.A number of jurisdictions have established

rules-based internal control requirements through

legislation; Japanese and French legislation, for example,

closely resembles the internal control requirements of

SOX. China and Canada also are moving toward a

rules-based approach, while other countries, including

Australia, Germany, and the United Kingdom, are

allowing firms to ‘comply or explain.’ The European

Commission’s Internal Market Directorate General

amended the eighth directive on statutory auditof annual

accounts and consolidated accounts, as well as the fourth

and seventh company law directives on corporate

governance and financial reporting. All three directives

have a wider and deeper scope than SOX. Other

countries, such as Mexico and Brazil, have onlyvoluntary

compliance requirements, if any.

Since the passage of SOX in 2002, however, its merits

have been vigorously debated (Ribstein, 2002; Solomon &

Bryan-Low, 2004; Gordon et al., 2006; Leuz, 2007; Ugrin &

Odom, 2010). Critics argued that SOX was hastily put

together in response to several high-profile corporate

scandals and that it imposed substantial costs on firms1

without commensurate benefits (Ribstein, 2002; Solomon

& Bryan-Low, 2004; Romano, 2005). Some scholars have

expressed deep concern that SOX was too strict to be

effectively implemented, and the regulatory burden of

SOX was a driving force causing the US capital market

to lose its leading position and competitiveness. For

example, Miu (2007) found the high cost of SOX law

enforcement caused many listed companiesin the United

States to consider delisting or turning to other countries

to be listed. Of the 105 institutional analysts and portfolio

managers responding to the survey conducted by Oshiki

of Broadgate Consultants, LLC, an overwhelming

majority (83%) said that the new rules in Section 404 of

the SOX relating to auditor testing and certification of

companies’ internalfinancial controls should be modified

to make compliance more cost-effective (Oshiki, 2005).

Sixty-one percent of the respondents to the Oshiki survey

believed that the cost of SOX is an unnecessary burden,

saying it is not worth the time and cost to provide an

internal control report, and the best way to enhance

shareholder value is to pay more attention to daily

work.

Despite the vigorous debates about the costs and

benefits of SOX, our knowledge about its effectiveness is

far from complete. In particular,although many countries

(e.g., France, Japan, and Canada) have followed the

United States in issuing laws similar to SOX to protect

against financial scandals, there is a scarcity of literature

on the impact of similar laws on public companies in

countries other than the US, especially in emerging

economies. One of the consequences of such an

unbalanced research focus is that we have little

knowledge to rely on to ensure the effective application

of International Financial Reporting Standards (IFRS) in

countries with different accounting traditions and

institutional conditions (Carmona & Trombetta, 2008;

Ding & Su, 2008).

Correspondence to: Jidong Zhang, Department of Accounting, Mihaylo

College of Business and Economics, California State University

Fullerton, Fullerton, CA 92834, USA. Email: Jizhang@fullerton.edu

International Journal of Auditing doi:10.1111/ijau.12057

© 2015 John Wiley & Sons Ltd ISSN 1090-6738

Int. J. Audit. 20:108–118 (2016)