The Influence of Qualified Foreign Institutional Investors on the Association between Default Risk and Audit Opinions: Evidence from the Chinese Stock Market

• Author: Chien‐Liang Chiu,Sin‐Hui Yen,Wei Ting
• DOI: http://doi.org/10.1111/j.1467-8683.2008.00699.x
• Date: 01 September 2008
• Published date: 01 September 2008

The Inf‌luence of Qualif‌ied Foreign Institutional

Investors on the Association between Default

Risk and Audit Opinions: Evidence from the

Chinese Stock Market

Wei Ting*, Sin-Hui Yen and Chien-Liang Chiu

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: Numerous studies demonstrate that audit opinions provide strong signals to investors/debt

holders warning of f‌irms’ default probability. When foreign investors were allowed to enter the Chinese stock market, the

role of audit opinions grew in importance. In this study, we examine the relationships between audit opinions and default

probability within the Chinese stock market, and explore whether there was any signif‌icant shift in this relationship

following the entry of Qualif‌ied Foreign Institutional Investors (QFIIs).

Research Findings/Insights: We f‌ind that audit opinions began providing signals of potential default risk only after QFIIs

entered the market; suggesting that in the post-December 2002 period, auditors’ decisions in China became more conser-

vative, and that institutional investors began to play a monitoring role.

Theoretical/Academic Implications: This study provides support for institutional theory through the provision of empirical

evidence showing that audit opinions, as signals of potential default risk, may actually be less eff‌icient in immature markets

than in more mature markets. Furthermore, the role of audit opinions in providing such signals to outside investors can

clearly be affected by the introductionof new monitoring mechanisms. The results imply that market maturitycould prompt

f‌irms to provide more accurate information.

Practitioner/Policy Implications: The strengthening of security laws could increase conf‌idence among investors in China,

thereby providing evidence to market participants showing that the more accurate information and greater eff‌iciency of

audit opinions, arising as a direct result of the entry of QFIIs, could lead to expansion of the Chinese investment

environment.

Keywords: Default Risk, Audit Opinions, Qualif‌ied Foreign Institutional Investors

INTRODUCTION

China has managed to achieve and maintain an

extremely rapid economic growth rate since the imple-

mentation of its economic reforms in 1978, a time when the

Chinese leadership demonstrated a signif‌icant shift toward

more pragmatic and open-door policies in virtually all

f‌ields.1Following this trend, many international investors

have also begun to experiment in the Chinese market.2In

order to keep pace with the changing times, the Chinese

government decided to amend many of its relevant laws and

administrative regulations so as to encourage international

capital inf‌lows into the f‌inancial markets of China. To this

end, the Chinese government promulgated the law on

“Provisional Measures for the Administration of Domestic

Securities Investments by Qualif‌ied Foreign Institutional

Investors” (hereafter referred to as “QFIIs”), which came

into effect on December 1, 2002, and for the f‌irst time,

allowed foreign investors to operate within the domestic

Chinese share market.

Nevertheless, a number of invisible problems in China

were to subsequently give rise to uncertainty for many

foreign investors. These problems were essentially created

by China’s distinctive political and institutional settings

*Address for correspondence: Department of Accounting, Chung Yuan Christian

University,200, Chung Pei Rd., Chung Li, Taiwan 32023, Taiwan. Tel: +886-3-2655325;

Fax: +886-3-2655399; Email: tingwei01@gmail.com

400 CORPORATE GOVERNANCE

Volume 16 Number 5 September 2008 © 2008 TheAuthors

Journal compilation © 2008 BlackwellPublishing Ltd

doi:10.1111/j.1467-8683.2008.00699.x

(Hamilton and Biggart,1988; Whitley, 1994). Thus,a growing

body of literature has begun to indicate the inappropriate-

ness of attempting to analyze the emerging Chinese

economy in conventional Western terms (Goto, 1982; Aoki,

1984; 1990; Biggart and Hamilton, 1992; Boisot and Child,

1996). To add insult to injury, with the rise in the Chinese

economy, a spate of corporate scandals also began to surface

within the country’s emerging market. Sun and Zhang

(2006) revealed that since the establishment of the Chinese

stock market in the early 1990s, about 20 per cent of all pub-

licly listed f‌irms in China had been found guilty of serious

fraud by the China Securities Regulations Committee. It

would therefore seem clear that foreign investors need to

pay particular attention to who may be best placed to

monitor and provide better signals of corporate risk for

outsiders.

Many of the prior studies have shown that auditing opin-

ions provide a clear signal summarizing information

on f‌irms for use by outsider investors (Dye, 1993; Franz,

Crawford and Johnson, 1998; Willenborg, 1999; O’Reilly,

Leitch and Tuttle, 2006). Lennox (2000) found that highly

leveraged companies, who clearly had inherently higher

bankruptcy risk, were also more likely to receive modif‌ied

audit reports, while Haskins and Williams(1990) and Citron

and Taff‌ler (1992) also noted that f‌inancial distress was an

important indicator and a strong reason for auditors to issue

modif‌ied opinions. These studies, among others, have indi-

cated that auditor reports are useful in predicting the risk

of bankruptcy (Hopwood, McKeown and Mutchler, 1989;

1994) and provide some explanatory power with regard to

predicting bankruptcy resolution (Kennedy and Shaw,

1991). Put simply, an audit report communicates the audi-

tor’s f‌indings to market participants and plays a crucial role

in warning f‌inancial statement users of the glossing of f‌inan-

cial statements and/or impending bankruptcy risk.

Hay and Knechel (2004) went on to argue thatthe demand

for auditing would be raised when stakeholderswere placed

within an immature security environment characterized by

a lack of legal protections for outsider investors as such

investors would naturally place signif‌icant reliance upon the

supervisory role of auditors. This points to the important

role of audit opinions in discriminating against those f‌irms

with higher default risk within emerging markets character-

ized by immature security systems; however, studies focus-

ing on this relationship within the emerging markets are

extremely rare. Furthermore, of the few prior studies which

have been undertaken, there is a general indication that

the reliability of auditors in China tends to fall short of

the requirements of the independent auditing profession

(Cheung and Zhang, 1996; Xiang, 1998; DeFond, Wong and

Li, 2000). We will therefore explore in the present study

whether audit opinions provide an appropriate signal for

investors in China to capture the bankruptcy risk of f‌irms in

this – the world’s largest emerging market.

It is clear, however, that many studies havealready exam-

ined the inf‌luence of new laws, regulations, and monitoring

mechanisms on auditors, in terms of the resultant, more

discreet and discerning, issuing of audit opinions. Geiger,

Raghunandan and Rama (2005), for example, indicated that

the attitudes of auditors within the US had been greatly

affected by the implementation of the Sarbanes-Oxley Act in

2002, noting that auditors were subsequently more likely to

issue modif‌ied audit opinions in the post-Sarbanes-Oxley

Act period. Thus, the role of audit opinions in signaling

information on inconspicuous agency problems to outsider

investors can clearly be affected by the introduction of new

monitoring mechanisms.

Several studies have provided evidence to show that

institutional investors are active monitors (Wall Street

Journal, 1995a,b; 1996a,b; 1997); nevertheless, Kane and

Velury (2004) went on to extend the research on the moni-

toring role of institutional investors within the context of

auditing. They found that institutional owners were quite

inf‌luential and that they demanded high-quality earnings

information; thus, institutional investors should have a posi-

tive association with the provision of high-quality auditing.

In addition, given their greater capital resources, institu-

tional investors are more capable of litigating against audi-

tors who issue irrelevant audit opinions.

Thus, we posit that following the promulgation of the law

on “Provisional Measures for the Administration of Domes-

tic Securities Investments by Qualif‌ied Foreign Institutional

Investors,” thereby allowing foreign institutional investors

into the Chinese stock market, auditors will, as a result, be

more careful when issuing opinions. Thus, the signaling role

of audit opinions, warning outside investors of risks and

hidden agency problems, will undoubtedly have become

more prudent.

Our study makes several important contributions to the

literature in this f‌ield. First, investments in unsafe and def‌i-

cient markets will be accompanied by higher risk; therefore,

audit opinions providing signals warning investors or debt

holders of the probability of a f‌irm defaulting are extremely

important. We intend to determine whether such audit opin-

ions can provide good signals for investors warning of the

default risk of f‌irms in the Chinese market. Second, we

examine whether the relationship between audit opinions

and default risk has been changed by the promulgation of

“Provisional Measures for the Administration of Domestic

Securities Investments by Qualif‌ied Foreign Institutional

Investors.”

Finally, our resultant empirical f‌indings should help

investors gain an understanding of the warningrole of audit

opinions and thereby provide support for their appropriate

investment decision making. These results may also provide

some suggestions for the Chinese government that a good

auditing environment and complete legal systems will

provide better protection for investors and attract more

foreign capital f‌lows into the f‌inancial markets.

We use the random-effects panel regression model in this

study, as opposed to ordinary least square (OLS) estimation

because the panel data regression is capable of supplying

more accurate inferences for the parameters and can also

reduce any collinearity that may exist among the explana-

tory variables. Our results show that in the period prior

to the promulgation of the “Provisional Measures for the

Administration of Domestic Securities Investments by

Qualif‌ied Foreign Institutional Investors,” audit opinions

failed to capture the default risk of f‌irms. However, in the

period after the promulgation of this law, audit opinions

were clearly able to capture such default risk; that is to say

that the introduction of foreign institutional investors into

THE INFLUENCE OF QFIIs ON THE ASSOCIATION BETWEEN DEFAULT RISK AND AUDIT OPINIONS 401

Volume 16 Number 5 September 2008© 2008 TheAuthors

Journal compilation © 2008 BlackwellPublishing Ltd