Audit Quality for US‐listed Chinese Companies

• Author: Chien Minh Dang,Neil Fargher,Gladys Lee
• DOI: http://doi.org/10.1111/ijau.12085
• Date: 01 July 2017
• Published date: 01 July 2017

Audit Quality for US-listed Chinese Companies

Chien Minh Dang,

1

Neil Fargher

1

and Gladys Lee

2

1

The AustralianNational University

2

The Universityof Melbourne

PCAOB Staff AuditPractice Alert No. 6 raised concernsregarding the quality of auditreports on financial statements

filed by issuers with substantially all of their operations outside of the US. An area of specific concern is the audit of

companies with operations predominantly based in mainland China. Using a sample of Chinese companies listed

in the US, we examine whether measures of audit quality are affected by the location of the auditor. We find some

evidence of higher levels of discretionary accruals when a US-listed Chinese firm is audited by a small US auditor.

Key words: Audit quality, geographic proximity, Chinese firms

1. INTRODUCTION

PCAOB Staff Audit Practice Alert No. 6 (PCAOB, 2010)

draws attention to the increasing number of audit firms

located in the United States (US) issuing audit reports on

financial statements of firms whose business operations

are substantially located outside of the US. While not

inherently inappropriate, the concern is whether such

audits provide an appropriate level of audit quality. At

issue is the extent of work conducted by local auditors

and consultants other than the principal auditor when

auditing international businesses, and the supervision of

the work conducted (PCAOB, 2010).

1

An area of particular concern is the audit quality for the

audit of Chinese companies listed in the US (e.g. PCAOB,

2010, 2011; SEC, 2011).

2

The concerns noted by the PCAOB

include the mismatch in location between auditor and client,

quality control over the audit, an over-reliance on other

auditors and consultants engaged from outside the principal

audit firm,

3

the failure to adequately supervise, the failure to

evaluate source documents, and the failure to communicate

effectively with clients in the Chinese language.

4

This study examinesaudit quality for auditfirms located

in the US issuing audit reports on financial statements of

firms whose business operations are substantially located

in mainland China. Carcello et al. (2014) argue that the

PCAOB inspectionsof small US audit firms’Chineseclients

were largely ineffective in many instances because audit

work was outsourced to Chinese firms, leaving PCAOB

inspectors with no ability to assess the quality of audit

work undertaken in mainland China. We are unaware of

any research which provides evidence on the issue of

systematic low audit quality for audits conducted by

small US-based audit firms auditing Chinese companies.

We examine audit quality fora sample of firms based in

mainland China and listed on US stock exchanges during

the period 2000 to 2014. We find evidence of higher levels

of discretionary accruals when a US-listed Chinese firm is

audited by a small US principal auditorcompared to small

auditors located in Hong Kong. We consider two other

proxies for audit quality –restatements and allegations of

fraud. We find that firms experience a higher likelihood of

restatements when a US-listed Chinese firm is audited by

a small US principal auditor, but this result is only

significant at the alpha level of 10% (two tailed). Our

comparisons highlight the nature of this audit market

where small Chinese firms listed on US exchanges need

a PCAOB registered auditor, and many such firms

select smaller auditors located in the US, rather than

auditors located in Hong Kong or mainland China with

implications for the quality of audit provided.

This researchmakes two contributions. First, we provide

evidence on an issue of specific interest to the PCAOB

regarding the audit quality provided by auditors of firms

with operations primarily in China but listed on US

exchanges. Second, the results have broader implications

for regulators in China and other transitional economies,

foremost of which is that institutional structures need to

consider the ability of audit firms to obtain adequately

supervised audits of companies listed on foreign exchanges.

2. BACKGROUND

Considerable attention has been drawn to the reporting

practices of China-based firms listed on the US stock

exchanges (Lee, Li & Zhang, 2015; Ang, Jiang & Wu,

2016).

5

The SEC suspended trading on more than 20

Chinese firms in 2011 (Lee et al., 2015).

6

Auditors of some

of these firms have been criticised for their failure to

comply with professional standards in auditing financial

statementsand reporting financial misstatements (PCAOB,

2011). The lack of adequate audit quality has also been

raised with respect to seve ral US-listed Chinese firms

investigated for accounting frauds (SEC, 2012).

For Chinese firms seeking to raise international capital

by listing on the US markets, the use of a Big 4 auditor

was the accepted approach for companies and this led to

the dominationof Big 4 auditors in this audit market (Gillis,

2011).However, as smaller andriskier clients have listed in

the US, thesesmaller clients have tendedto rely on auditors

other than the Big 4 auditors. For listing in the US the

auditor must be registered with the PCAOB. As a result,

many Chinese firmslisting in the US have selected smaller

auditors, primarily US accounting firms. Arguably the

need for a US-registered auditor has led to more

internationalbusinesses using small US audit firms willing

to issue audit reports on financial statements of firms

whose business operations are located outside of the US –

the specific concern raised in PCAOB Staff Audit Practice

Alert No. 6 (PCAOB, 2010). Some prior evidence on audit

quality is availablefor these firms. Carcello et al. (2014)find

that US-listed Chinese companies were more likely than

companies from other countries to not hire high quality

annually-inspected US audit firms.

Correspondence to: Neil Fargher, Research School of Accounting, The

Australian National University, Canberra ACT 0200, Australia. Email:

neil.fargher@anu.edu.au

International Journal of Auditing doi: 10.1111/ijau.12085

Int. J. Audit. 21:150–163 (2017)

©2016 John Wiley& Sons Ltd ISSN 1090-6738