The New Chinese Accounting Standards and Audit Report Lag

• Published date: 01 March 2015
• Date: 01 March 2015
• Author: Ahsan Habib
• DOI: http://doi.org/10.1111/ijau.12030

The New Chinese Accounting Standards and Audit Report Lag

Ahsan Habib

Massey University

The auditreport lag, defined as the period between a company’s fiscal year-end and the audit report date, has been

considered to be one of the few externally observable audit output variables allowing outsiders to evaluate audit

efficiency. Prior research on the determinants of the audit report lag has investigated a common set of firm

characteristics, including firm size, fiscal year-end, loss occurrence, presence of extraordinary items, client

complexity, and audit opinion. However, there is scant research on the effect of changes in reporting regulations

on the audit report lag. This paper examines empirically the effect on the audit report lag of a new set of Chinese

accounting standards introduced in 2007 that were based on the fair value accounting system. We document

empirical evidence of a significant increase in the audit report lag in China after the adoption of these new

accounting standards. This increase, however, is more pronounced for clients audited by small audit firms.

Key words: Audit report lag, new Chinese accounting standards, China, regulation

1. INTRODUCTION

This paper examines empirically the effect of a new set

of Chinese accounting standards (hereafter CAS)

introduced in 2007 on the audit report lag (hereafter

ARL). The ARL is defined as the period between a

company’s fiscal year-end and the audit report date, and

it is one of the few externally observable audit output

variables available for gauging audit efficiency (Bamber,

Bamber & Schoderbek, 1993). Audit delays are a likely

cause of delays in annual earnings announcements, and

these, in turn, generate a lowered market response owing

to the reduced informativeness of delayed disclosures.

Audit report timeliness may provide insights into audit

efficiency and, given the preference for timely

disclosures, it seems likely that more efficient auditors

will perform more timely audits.

The introduction of the new CAS has resulted in

fundamental changes to financial reporting practices in

China. Deloitte Touche Tohmatsu (2006) identifies 15 key

changes in the new CAS, eight of which are related to the

use of fair valuefor balance sheet items, and the inclusion

of fair value changes in earnings. Changes in accounting

standards have a profound effect on audit risk, as

auditors use accounting standards as the benchmark for

evaluating accounting information quality. Auditing also

plays a significant role in enforcing and protecting

investor rights by detecting expropriation by insiders,

and should benefit outsiders by signalling the reliability

of management-provided financial information, in an

era of increasing fair value-based financial reporting

practices (Newman, Patterson & Smith, 2005).

From an audit risk perspective, the introduction of fair

value-basedreporting practices under the new CAS gives

managers more discretion in financialreporting, courtesy

of the increased managerial judgment and estimation

required in fair value accounting. The resulting

significant inherent estimation uncertainty renders the

audit of fair value and other estimates much more

challenging. Although the preference for preparers is to

rely on quoted prices in active markets for identical assets

and liabilities (Level 1), without liquid markets, fair value

estimation relies on a more subjective Level 2 and Level 3

valuation hierarchy (Bratten et al., 2013). China provides

an interesting setting in which to examine the effects

of the adoption of a fair value-based reporting

infrastructure on audit efficiency, because there is

concern about a lack of active markets for Level 1

valuation (He, Wong & Young, 2012). Without such a

liquid market, verifying the true value of assets becomes

quite subjective and poses a significant auditing

challenge. The adoption of fair value measurement in the

new accounting standards makes firms disclose more

information about their market risk, requiring auditors to

spend additional time in verifying such estimations that

are inherently uncertain, before expressing an opinion

about the appropriateness of the financial statements.

This is expected to increase the ARL in the post-adoption

period. Of course, auditors could rely on external

valuation specialists, but the reasonableness of such

valuation needs to be validated by the engagement team

(Smith-Lacroix, Durocher & Gendron, 2012). Another

source of audit risk emanating from fair value reporting is

the opportunistic use of fair values for managerial

self-interest.

Investigation of the effect of adopting the new CAS on

the ARL in China is also motivated by the distinctive

characteristics of the accounting and auditing

environment in China, which differs substantially from

that of the Anglo-Saxon countries. For example, financial

reporting practices in China have historically followed a

uniform accounting system with strict emphasis on a

historical cost-based measurement system, thereby

allowing little room for managerial discretion in

corporate reporting (Tang, 2000).1A gradual shift in

reporting culture towards fair value accounting will have

significant repercussions for the Chinese auditing

profession. Because of the dominance of this historical

cost-based accounting system, the audit profession in

China has not been able to exercise professionaljudgment

in auditing financial statements (Piotroski & Wong, 2012).

Because the adoption of the new fair value-oriented CAS

might be expected to increase the inherent estimation

uncertainty and consequent subjective valuations, it will

be interesting to examine the changes in audit effort as

proxied by the ARL. Finally, the vast difference between

the Chinese audit market and that of her Western

counterparts also has implications for the ARL in the

post-CAS regime. Unlike Anglo-Saxon countries, where

Correspondence to: Massey University, Private Bag 102904, Auckland

0745, New Zealand. Email: a.habib@massey.ac.nz

International Journal of Auditing doi:10.1111/ijau.12030

Int. J. Audit. 19: 1–14 (2015)

© 2014 John Wiley & Sons Ltd ISSN 1090-6738