Is there an association between accounting firm ranks and audit quality? An examination of the top 100 accounting firms in China

• DOI: http://doi.org/10.1111/ijau.12156
• Author: Stephanie Hairston,Ting‐Chiao Huang,Yi‐Hung Lin
• Date: 01 July 2019
• Published date: 01 July 2019

ORIGINAL ARTICLE

Is there an association between accounting firm ranks and

audit quality? An examination of the top 100 accounting firms

in China

Ting‐Chiao Huang

1

|Yi‐Hung Lin

1

|Stephanie Hairston

2

1

Department of Accounting, Monash Business

School, Monash University, Melbourne,

Australia

2

School of Accountancy, Georgia Southern

University, Statesboro, GA, USA

Correspondence

Ting‐Chiao Huang, Department of Accounting,

Monash Business School, Monash University,

20 Chancellors Walk, Level 10, Clayton

Campus, Clayton, Victoria 3800, Australia.

Email: ting.huang@monash.edu

Using 15,354 firm‐year observations from Chinese listed companies from 2003 to

2013, we examine the association between accounting firm ranks, disclosed by the

Chinese Institute of Certified Public Accountants (CICPA), and audit quality. The

results show that clients audited by higher ranked accounting firms report lower

discretionary accruals and are more likely to receive modified audit opinions. Addi-

tionally, accounting firm ranks are found to better capture audit quality after recent

modifications by the CICPA to include nonrevenue metrics. Finally, we find that

clients are more likely to replace downgraded accounting firms and pay higher audit

fees when switching to a higher ranked firm. Our results suggest that accounting firm

ranks capture audit quality, have economic implications, and would serve as an audit

quality indicator. This study should be useful to global accounting regulators,

practitioners, and academics concerned with auditor quality in China and who seek

to develop audit quality indicators.

KEYWORDS

Audit Quality, Audit Quality Indicators, Auditor Ranks, China

JEL CLASSIFICATION

M41; M42

1|INTRODUCTION

After several accounting scandals and the collapse of Arthur Andersen,

regulators, legislators, and the public have expressed concerns about

the quality of audit services (Government Accountability Office

[GAO], 2003, 2008; House of Lords, 2010; Oxera, 2006, 2007; The

American Assembly, 2005; US Treasury, 2006, 2008). To restore pub-

lic confidence in audit services and capital markets, several potential

measures and solutions have been proposed (European Commission

[EC], 2010; Oxera, 2007, Sec. VIII: 4; US Treasury, 2008).

1

For exam-

ple, the EC (2010) suggests several ideas to increase market participa-

tion by non‐Big 4 auditors and create a quality certification to

recognize the capacity of non‐Big 4 auditors to audit large public com-

panies (EC, 2010, p. 16). This suggests that it is inherently more diffi-

cult to evaluate audit quality when there are more players in the

market, as is the case in the Chinese audit market, which is comprised

of thousands of small accounting firms. However, a competitive audit

market is not synonymous with audit quality, as evidenced by the

Securities and Exchange Commission (SEC) imposing sanctions against

four China‐based accounting firms associated with the Big 4 and reg-

istered with the Public Company Accounting Oversight Board

(PCAOB) for their refusal to provide audit work papers and other doc-

uments for an investigation of potential accounting fraud against US

investors (SEC, 2015). One potential solution is to create metrics for

the public to evaluate audit quality.

To assist in the evaluation of audit quality, several global initiatives

have begun to identify audit quality indicators (AQIs) that can be used

We thank reviewers of 2016 AFAANZ Conference, 2016 AAA Annual Meeting, and 2017

EAA Congress for their valuable comments. Errors and omissions are our responsibility.

Received: 1 May 2018 Revised: 15 February 2019 Accepted: 4 March 2019

DOI: 10.1111/ijau.12156

204 © 2019 John Wiley & Sons Ltd Int J Audit. 2019;23:204–230.wileyonlinelibrary.com/journal/ijau

to provide a common basis for comparison of audit quality across

accounting firms worldwide (Center for Audit Quality [CAQ], 2014;

Federation of European Accountants [FEA], 2016; PCAOB, 2015). As

a response to the call for more AQIs, the Chinese Institute of Certified

Public Accountants (CICPA) created a metric designed to evaluate

audit quality in a competitive audit market. In 2003, CICPA released

an annual list of the top 100 accounting firms in China. In this study,

we examine whether an association exists between accounting firm

ranks and audit quality, if changes in the construction of firm ranks

affect its relationship with audit quality, and the economic impact of

accounting firm ranks on the audit market.

Data from China are particularly interesting because of the

unique institutional features of the Chinese audit market. First, and

most importantly, the accounting firm ranking system by an account-

ing oversight body (i.e. CICPA) in China is rare,

2

which presents an

opportunity to examine whether such a public oversight system pro-

vides relevant information to assess audit quality in a competitive

audit market. Second, compared with developed countries, where

the Big 4 constitute more than 80% of the audit market, China is

characterized as having many small accounting firms, facing higher

market competition but lower litigation risk (Ball, Robin, & Wu,

2003; Chen, Firth, Gao, & Rui, 2006; DeFond, Wong, & Li, 2000;

Huang, Chang, & Chiou, 2016; Huang, Raghunandan, Huang, &

Chiou, 2015). Additionally, as the importance of China in the global

economy is increasing, the Chinese government is encouraging the

development of large Chinese accounting firms as alternatives to

the Big 4. The Chinese government has proposed several mecha-

nisms to enhance audit quality by increasing accounting firm size.

3

However, the relatively weak legal environment and lower litigation

risk in China have exacerbated the competition between accounting

firms and prevented the cultivation of large Chinese accounting firms

(see Ball et al., 2003; Chen et al., 2006; Huang et al., 2016). As such,

despite the recent economic and institutional improvements and the

increased attention on audit issues in China (Chen, Sun, & Wu,

2010), ex ante it remains unclear whether accounting firm ranks

are informative and economically important in the Chinese audit

market.

Using a sample of 15,354 firm‐year observations from Chinese

nonfinancial listed companies audited by the top 100 accounting firms

between 2003 and 2013, we find that clients of higher ranked

accounting firms

4

have lower absolute and income‐increasing discre-

tionary accruals (higher earnings quality) and are more likely to receive

modified audit opinions; these relationships remain significant when

controlling for client fixed effects and using propensity‐scored

matched samples. In addition, these associations become slightly

weaker but remain significant when controlling for accounting firm

size, which suggests that accounting firm ranks do capture some com-

ponents of audit quality beyond firm size. We also find some evidence

that accounting firm ranks better capture audit quality after recent

modifications by CICPA to include nonrevenue metrics in the determi-

nation of firm ranks. We also explore the influence of the individual

components of firm rank by decomposing firm rank into its compo-

nents during our sample period. We find that the association between

higher ranks and higher audit quality may be jointly explained by

accounting firm revenue, number of certified public accountants

(CPAs), punishment score, and comprehensive quality score con-

structed by CICPA. Finally, we find that clients are more likely to

replace downgraded accounting firms and pay higher audit fees when

switching to a higher ranked firm, whereas clients staying with the

current accounting firm do not pay higher audit fees even when the

accounting firm is upgraded. Collectively, our results suggest that

accounting firm ranks capture audit quality and are economically

important in the audit market. The results provide some support for

CICPA's recent decision to include accounting firm characteristics

other than revenue and suggests that it would be necessary to further

modify the components of accounting firm ranks. Our results also

suggest that accounting firm ranks do not give much bargaining power

to auditors, particularly when the clients stay with the current

accounting firm.

Our study makes several contributions to the literature on public

oversight systems (DeFond & Francis, 2005; Lennox & Pittman,

2010; Nelson, 2006; Palmrose, 2006). First, we provide evidence that

a ranking system for auditors provides useful information in evaluating

audit quality. Such evidence is particularly relevant to the SEC and the

PCAOB, who are concerned with audit quality in China. Whereas the

PCAOB is required to inspect overseas audit firms with US‐listed cli-

ents, the PCAOB has been blocked from entering China to inspect

Chinese auditors (Ke, Lennox, & Xin, 2015). As a result, accounting

firm ranks may be helpful to global regulators and investors in evaluat-

ing audit quality. Second, we provide relevant insight into the recent

modifications of accounting firm ranks by CICPA to include accounting

firm characteristics other than revenue. Our results suggest that

CICPA should continue polishing and improving accounting firm ranks.

Additionally, our findings should be of interest to the Chinese govern-

ment in their attempt to cultivate large domestic audit firms to com-

pete with the Big 4 (MOF, 2011). Third, we respond to the calls of

the International Auditing and Assurance Standards Board (IAASB)

and CAQ to identify potential AQIs by providing Chinese evidence

on whether a ranking system for auditors provides information rele-

vant to audit quality in a competitive audit market (CAQ, 2014; FEA,

2016; PCAOB, 2015). Our findings are particularly important given

the recent call for increased participation in the audit market from

non‐Big 4 auditors (EC, 2010; Oxera, 2007, Sec. VIII: 4; US Treasury,

2008). Our findings should be useful to global and Chinese accounting

regulatory bodies, investors, practitioners, and academics who are

concerned about audit quality and intend to develop meaningful

auditor quality indicators. Finally, our results should be relevant to

accounting firms developing competitive strategies and to audit com-

mittees and directors for their oversight and evaluation/selection of

accounting firms.

The remainder of this paper is organized as follows. Section 2

describes the institutional background of this work. Section 3

reviews related studies and develops our research questions. Section

4 describes our models and data. Section 5 presents our empirical

analysis and sensitivity tests. Finally, Section 6 provides our

conclusions.

HUANG ET AL.205