Determinants and consequences of voluntary switches to Chinese auditors in Hong Kong

Journal of Contemporary Accounting and Economics 15 (2019) 100158

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Determinants and consequences of voluntary switches to Chinese auditors in Hong Kong Zhenfeng Liu a,⇑, Stephen Lin b a b

University of Michigan-Flint, United States Florida International University, United States

a r t i c l e

i n f o

Article history: Received 31 March 2017 Revised 31 May 2019 Accepted 4 June 2019 Available online 12 June 2019 JEL classification: M40 M42 M48 Keywords: Auditor switches Audit quality Market reaction

a b s t r a c t Hong Kong market regulators have permitted 12 large Chinese accounting firms to audit the financial statements of Chinese firms that cross list in Hong Kong (i.e., H-share firms) since 2010. This paper examines the characteristics of H-share firms that voluntarily replaced their Hong Kong (HK) auditors with Chinese auditors, and the market reaction to auditor switches following this policy. We find that 38 out of 147 H-share firms voluntarily switched to Chinese auditors during 2011–2013. Switching firms are larger in size and are less likely to use Big4; they also have less need for external financing, a longer cross listing history, and a lower percentage of foreign revenue. We also find that investors negatively react to the auditor switches from HK non-Big4 to China non-Big4, but do not react to the auditor switches from HK Big4 to China Big4. This suggests that investors perceived lower audit quality for China non-Big4. Ó 2019 Elsevier Ltd. All rights reserved.

1. Introduction This study provides a preliminary evaluation on the consequences of an initiative to permit 12 large accounting firms based in Mainland China (hereafter Chinese auditors) to audit the financial statements of Chinese firms that cross list on the Hong Kong Stock Exchange (i.e., H-share firms). Specifically, we examine two issues in this study. First, we investigate the characteristics of H-share firms that voluntarily replaced their Hong Kong (HK) auditors with Chinese auditors.1 Second, we examine the market reaction to the switches from HK auditors to Chinese auditors following the new policy. The audit environment and market in China are rather different from those in other countries. First, the legal environment and investor protection in China are deemed to be weaker than those in developed economies, such as the U.S. and the E.U. Auditors in China, however, are subject to much lower litigation risk than their counterparts in developed economies (Huang et al., 2015). Second, unlike the dominance of Big4 accounting firms (hereafter Big4) in the global audit market, the market share of Big4 in China (hereafter China Big4) is only 19.46% in 2013 in terms of total revenue2. Third, foreign auditors including Big4 without joint venture with local Chinese accounting firms are not permitted to practice in Mainland China. ⇑ Corresponding author at: School of Management, University of Michigan-Flint, 303 E. Kearsley Street, Flint, MI 48502, United States. E-mail address: [email protected] (Z. Liu). Although Hong Kong is one part of China, to avoid confusion in this paper, ‘‘China” refers to Mainland China alone, excluding Hong Kong. As a result, Chinese (Hong Kong) auditors indicates auditors that are based in Mainland China (Hong Kong). 2 The Chinese Institute of Certified Public Accountants issued the ranking of accounting firms in China for the year of 2013. Details about this ranking are available at http://www.cicpa.org.cn/news/201405/W020140530620129219579.pdf. 1

https://doi.org/10.1016/j.jcae.2019.100158 1815-5669/Ó 2019 Elsevier Ltd. All rights reserved.

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Z. Liu, S. Lin / Journal of Contemporary Accounting and Economics 15 (2019) 100158

Recently, a series of changes in accounting and auditing policies have aimed to promote Chinese accounting firms in the HK international capital market and to further increase their audit market share. One of the changes is to allow 12 large Chinese accounting firms3 to gain access to HK audit market, one of the most lucrative markets for accounting services in the world, in order to further increase their market share (Gillis, 2011). The HK market regulators have permitted the financial statements of H-share firms that are prepared under the Chinese accounting standards – Accounting Standards for Business Enterprises (ASBEs) – to be audited by the selected 12 Chinese accounting firms starting from December 15, 2010. This service had previously been limited to HK-based accounting firms before this new policy. To the best of our knowledge, no study has examined the incentives of auditor changes and investors’ responses to auditor changes following this new policy in HK. This is an important issue for the following reasons. First, many studies based in China (e.g., DeFond et al., 2000; Chan et al., 2006; Wang et al., 2008; Yang, 2013; Guan et al., 2016; Chen et al., 2016) find that the unique institutional factors in China, such as state ownership, political connections, and weak regulatory enforcement, reduce managerial incentives to demand high-quality accounting information and auditors. Hence, a switch from HK auditors to Chinese auditors may reduce audit/accounting quality and trigger a negative market reaction. Second, unlike the rest of the world, China Big4 only have a very small slice of the Chinese audit market. Their market share may be further shrunk due to the increased competition between China Big4 and eight large local Chinese accounting firms following the new policy. This may also have a significant implication for the overall audit quality in HK and China. Finally, the Chinese government has attempted to promote Chinese accounting firms in the HK international capital market and increase their audit market share in HK. Little is known about the consequences of this attempt. Using data from 2011 to 2013,4 we find that 38 out of 147 H-share firms switched from HK to Chinese auditors. Among the 38 switching firms, 23 firms switched from Big4 affiliates in HK (hereafter HK Big4) to China Big4; 14 firms switched from HK non-Big4 to China non-Big4; only one firm switched from HK Big4 to China non-Big 4. We first investigate the characteristics of firms that switched from HK to Chinese auditors. We find that firms that are audited by HK Big4 and firms with a higher percentage of foreign revenue to total revenue are less likely to switch to Chinese auditors. In addition, consistent with prior research and our prediction, firms with larger firm size, less need of external financing, and a longer listing history on the Hong Kong Stock Exchange (SEHK)5 are more likely to switch to Chinese auditors. Surprisingly, most other explanatory variables that are used to explain voluntary auditor changes, such as accounting performance, accounting quality, growth rate, and reporting losses, in the studies based in the U.S. and other countries, do not appear to have explanatory power. Overall, we find consistent evidence that H-share firms that lack incentives to demand high-quality auditors are more likely to switch from HK auditors to Chinese auditors. We then examine the market reaction to auditor switch announcements. Univariate analysis demonstrates that investors do not react to auditor switches from HK Big4 to China Big4, indicating that investors perceive that both HK and China Big4 auditors provide similar audit quality, which is consistent with Choi et al. (2008) that Big4 auditors consistently provide high-quality audit services regardless of the legal and regulatory environment in which they operate. This also suggests that Big4 brand names are highly valued by international investors in HK. Another plausible explanation is that when those H-share firms employed HK Big4 firms, the bulk of the audit work was actually done by auditing personal of their counterparts in China, that is, China Big4. Hence, switching from HK Big4 to China Big4 may not affect audit quality significantly. We, however, find a significant negative market reaction (
1.71%) for auditor switches from HK non-Big4 to China nonBig4, indicating that investors may perceive lower audit quality for China non-Big4 and punish H-share firms who made such switches. This is also generally consistent with prior research (e.g., DeFond et al., 2000; Chan et al., 2006; Wang et al., 2008; Yang, 2013) that a switch from HK non-Big4 to China non-Big4 auditors may reduce audit quality. Although we find a strong positive market reaction to firms switching from HK Big4 to China non-Big4, the result needs to be interpreted with caution given that only one firm made such a switch. Multivariate analysis also shows consistent results with the univariate analysis. We find that auditor switches from HK non-Big4 to China non-Big4 are negatively associated with abnormal return on the auditor switch announcement day after controlling for other factors that may affect abnormal return. More specifically, we find that these switches on average reduce 3.0% of firm value. Different from the prior literature, change in accounting quality, change in audit fees, and reporting losses, cannot explain the abnormal return around auditor switch announcements. As an additional analysis, we also examine how investors in Mainland China react to the auditor changes in Chinese domestic markets given that 21 out of 38 H-share firms also issue A-shares in Chinese domestic markets and may change their auditors for the domestic markets accordingly.6 We find that only A-share firms that switched from one China nonBig4 to another China non-Big4 experience a significant negative market reaction (
1.04%).7 We also partition our sample firms based on the types of auditor changes in both HK and Chinese domestic markets. That is, we investigate the relative market

3

They include the international Big4’s Chinese affiliates and eight large local Chinese accounting firms. We only include data during this time period to capture the initial effect of the policy changes. We find that there were only very few auditor changes after 2013. Also, it is unclear whether the auditor changes after 2013 were directly caused by the policy changes. 5 Some of the H-share firms that switched to Chinese auditors are large state-owned business. 6 A-share firms are firms that trade shares on the Shanghai Stock Exchange and Shenzhen Stock Exchange and are quoted in Chinese RMB. 7 H-share firms may hire different auditors for the HK and Mainland China capital markets. For example, their financial statements are audited by HK Big4 in HK but are audited by China Big4 or China non-Big4 in Mainland China. 4

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reaction to different combinations of auditor changes in both HK and Chinese markets8 and confirm that the above documented negative market reaction in HK is mainly driven by the firms who switched from HK non-Big4 to China non-Big4 in HK and switched from one China non-Big4 to another China non-Big4 in Mainland China.9 Taken together, we find that investors continue to value the brand names of Big4 and perceive lower audit quality for China non-Big4. Our findings in this study should be of interest to the accounting standards setters, accounting firms, government, and investors around the world. This study makes several contributions. First, this paper provides initial evidence on the consequences of an initiative to permit Chinese auditors to perform audit service for H-share firms. Second, this study provides corroborating evidence that H-share firms with state control, a low need for external financing, or political connections have a lower demand for highquality audit. Second, the finding of this study provides additional support for the notion by DeFond et al. (2000) that regulation alone may not be enough to increase the perceived audit quality of accounting firms. We find that despite the effort from the Chinese government to promote Chinese accounting firms, investors negatively react to voluntary auditor changes from HK non-Big4 to China non-Big4. This suggests that investors anticipate a decrease in audit quality following the switch to China non-Big4 from HK non-Big4. Finally, while previous studies have examined how investors respond to auditor dismissals (e.g. Griffin and Lont, 2010) and resignations (e.g. Beneish et al., 2005), to the best of our knowledge this is the first study to investigate how investors respond to auditor changes encouraged by the government regulation. The rest of the paper is organized as follows: Section 2 provides institutional background and section 3 reviews the prior literature and develops our hypotheses. Sections 4 and 5 present sample and research design. Section 6 reports the empirical results. Section 7 presents our conclusions. 2. Institutional background 2.1. Background of Chinese public accounting profession The world has witnessed the rapid growth of both the capital and audit markets of Mainland China over the last two decades. The contemporary public accounting profession in China started again in the early 1990s after the government fully abolished auditing by public accountants for nearly 30 years (Gensler and Yang, 1996). Due to a lack of capital and experience, new accounting firms affiliated themselves to local governments, universities, or formed joint ventures with large international accounting firms including the international Big6 (the international Big4 now).10 With the rapid development of the capital market and the increase in foreign investments in China, the Chinese government gradually realized the importance of auditor independence in the public accounting profession. In 1998, the Ministry of Finance (MOF) and the China Securities Regulatory Commission (CSRC) issued regulations to disaffiliate the audit firms from governments and universities. In the meantime, China Big4 expanded their services very rapidly in China, creating a very active and competitive domestic audit market consisting of international affiliated, many national medium-size and small accounting firms. Aiming at creating larger and better Chinese accounting firms that can compete directly with China Big4 (Huang et al., 2015) and other international accounting firms in the future, the Chinese government has recently introduced new accounting rules and policies to achieve its ambitious goals: 1. In 2006, the MOF formally issued the Accounting Standards for Business Enterprises (‘‘ASBEs”), which marked a large step forward to integrating Chinese with international capital markets. The old Chinese Accounting Standards were largely replaced by the International Financial Reporting Standards (IFRS) to further bring Chinese accounting standards more in line with international accounting practices. The similarity between the new Chinese accounting standards and IFRS is said to be almost 90%. 2. The Chinese Institute of Certified Public Accountants (2007) released a proposal to encourage local Chinese accounting firms to combine through mergers and acquisitions in order to form several large-sized accounting firms. In 2013, the combined revenue (number of clients) of China Big4 accounts for only 19.46% (10%) of the total revenue (number of clients) of all accounting firms in China, which is very different from the overwhelming Big4 dominance in other countries. Two of the China Big4 – Ernst & Young Huaming and KPMG Huazhen – only ranked 5th and 6th, respectively in the accounting firms ranking in terms of their total revenue in China. 3. In 2010, the MOF and SEHK (2010) announced the permission of 12 large Chinese accounting firms including China Big4 and 8 large local Chinese accounting firms to audit the financial statements of H-share firms that are prepared under the ASBEs. Before 2010, Chinese accounting firms were not permitted to audit H-share firms.

8 There are four combinations including a switch from HK Big4 to China non-Big4 in HK and a switch from one China non-Big4 to another China non-Big4 in Mainland China and a switch from HK Big4 to China non-Big4 in HK and a switch from China Big4 to China non Big4 in Mainland China. Table 9 reports results from all four combinations. 9 Only one firm switched from HK Big4 to HK non-Big4 in HK and switched from one China non-Big4 to another China non-Big4, which experienced a significant negative market reaction. 10 In 1992, when KPMG first started a joint venture with a Chinese accounting firm, the international Big Six were Arthur Anderson, Coopers & Lybrand, Deloitte Touche Tomatsu, Ernst &Young, KPMG, and Price Waterhouse.

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4. The MOF (2011) released another new policy requiring that China Big4 reduce the percentage of foreign partners without Chinese CPA license to below 40% within one year, which will be further reduced to below 20% within a five-year time range. The percentage of foreign partners was 70%, 61%, 55% and 50% for KPMG, PWC, EY, and DTT, respectively, in 2010. 5. The MOF (2014) released another controversial proposal requiring that in order to audit Chinese firms that are listed overseas (including HK), foreign (including HK) accounting firms must use one of the selected top 100 Chinese accounting firms based in Mainland China to do the audit work, although foreign accounting firms have to undertake all the legal responsibilities of the audit report. The above new accounting rules and policies were used in a sequential order by the Chinese government to align Chinese accounting standards with international accounting practices, make Chinese accounting firms larger and more competitive, gain more experience from international capital markets and accounting firms, and eventually, increase the reputation and market share of Chinese accounting firms. 2.2. Background of HK capital market and audit market SEHK is one of the most mature capital markets in the world (ranking 6th internationally by market capitalization) with 124 years history. As of 30 November 2013, the SEHK had 1615 listed companies, which include 776 firms from Mainland China, 737 firms from Hong Kong, and 102 firms from other countries. SEHK has also played an important role in helping internationalize Chinese capital markets. Chinese firms are allowed to issue and trade H shares in HK market. Before 2010, H-share firms were only audited by the accounting firms whose signing auditors possess both HK CPA license and HK residence status, which almost limited the eligibility to HK accounting firms; Chinese accounting firms were not qualified to audit HK listed firms including H-share firms then.11 From Dec. 15, 2010, HKSE began to accept the financial statements of H-share firms that are prepared under the ASBEs and, more importantly, these financial statements can be audited by the selected 12 Chinese accounting firms. However, non H-share firms (including Chinese red-chip firms12) are still not allowed to use Chinese accounting firms as auditors. This new policy allegedly reduces the amount of accounting work of H-share firms and therefore the audit fee because H-share firms now can choose to use Chinese accounting standards and do not need to reconcile from Chinese accounting standards to Hong Kong standards or IFRS anymore. 3. Literature review and hypotheses development This section develops several testable hypotheses based on the key findings in the literature regarding the characteristics of firms that switch auditors and the consequences (market reaction) of auditor switches. 3.1. Characteristics of firms that voluntarily switch auditors Many studies have examined the extent to which the unique political environment and state-owned enterprises affect auditor choices and outcomes in China. DeFond et al. (2000) find that with stricter auditing standards, Chinese firms tend to choose smaller auditors to avoid receiving modified opinions. Chan et al. (2006) find that local auditors are more likely to provide favorable audit opinions on the local government-owned companies, compared to non-local auditors. They also find that compared to companies with unqualified opinions, companies with qualified opinions are more inclined to change from a non-local auditor to a local auditor. Wang et al. (2008) find that Chinese state-owned enterprises are more inclined to hire small local auditors, compared to non-state-owned enterprises. Hung et al. (2012) find that politically connected Chinese state-owned enterprises cross list in HK for political and personal benefits, such as more political media coverage and managers’ promotion to senior government positions. Yang (2013), Guan et al. (2016), and Chen et al. (2016) find that audit quality could be deteriorated if the engagement level auditors have a favorable connection to the government or the client. Overall, these studies find that Chinese firms are prone to choose small local auditors with strong political connections and auditors that are more likely to issue favorable audit opinions. This study follows previous China-related studies to predict that H-share firms that lack incentives to demand highquality auditors are more likely to switch from HK to Chinese auditors following the new policy. We have developed several related testable hypotheses as follows. First, we argue that companies that are state-controlled and politically connected are more likely to switch to Chinese auditors. Many H-share firms are state-owned enterprises whose operating, investing, and financing decisions are largely influenced by the Chinese government’s policy. Moreover, these companies have preferential access to government banks and thus have a lower demand for outside equity capital. We also predict that H-share firms that have been listed on the

11 Several good Chinese accounting firms expanded their audit services to HK in the last decade so their HK registered offices, which are legally independent accounting firms, also have the eligibility to audit HK listed firms. However, their market share is quite small in HK. 12 Chinese firms that are registered outside Mainland China and listed on the SEHK are called red-chip firms.

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SEHK since early days may have a much closer relationship with the Chinese government through ownership and/or political connection and are more likely to respond to the government’s new policies to switch to Chinese auditors.13 Hence, we predict H1a: Firms that have a larger percentage of state ownership are more likely to switch from HK to Chinese auditors. H1b: Firms that have a longer listing history with the SEHK are more likely to switch from HK to Chinese auditors. H1c: Firms switching to Chinese auditors have less need for external financing. Moreover, other firm-characteristics may determine the decision of switching to Chinese auditors from HK Auditors. Many studies (e.g., Johnson and Lys, 1990; Shu, 2000; Chang et al., 2010) find that firms with larger size, lower growth, less complexity, and poorer profitability are more inclined to switch from large to small audit firms. This is because Companies that grow slowly or have poor financial performance are more likely to manage earnings and thus tend to avoid high-quality auditors. Hence, we formally test the following hypotheses with respect to firm-characteristics that may affect the decision of switching to Chinese auditors (in the alternative form): H1d: Firms switching to Chinese auditors have larger size; H1e: Firms switching to Chinese auditors have lower growth; H1f: Firms switching to Chinese auditors have poorer profitability. Finally, we predict that firms with strong incentives to demand high-quality accounting information and auditors are less likely to switch to Chinese auditors. For example, firms with a significant amount of foreign transactions are more likely to continue to use HK auditors due to their international experience and credibility. Since foreign business partners generally are less familiar with the legal, financial and accounting system in China, a plausible way to increase their confidence in the financial reports prepared by Chinese accountants is to have the financial reports audited by reputable international accounting firms such as Big4. Hence, H-share firms with a significant amount of foreign transactions are less likely to switch to Chinese auditors that generally lack international reputation and credentials. Previous studies also provide consistent evidence indicating that financial statements audited by Big4 auditors have higher quality (i.e. more reliable and credible than those audited by non-Big4). As a result, many H-share firms may signal the market by using Big4 auditors to gain international investors’ confidence in their financial statements. A switch from HK auditors to Chinese auditors is therefore likely to be seriously questioned or even punished by international investors. Hence, we formally test the following two hypotheses14 with respect to auditors’ reputation (in the alternative form): H1g: Firms that have more transactions with foreign firms are less likely to switch from HK to Chinese auditors. H1h: Firms that are audited by HK-based Big4 are less likely to switch from HK auditors to Chinese auditors. We develop our testable hypotheses for the market reaction to auditor switches in the next section. 3.2. Consequences of auditor switch A vast of literature supports the notion that Big N auditors are associated with higher audit quality, higher earnings quality, and lower earnings management. Auditor reputation appears to be an important factor for the superiority of Big N auditors.15 However, little is known about the relative audit quality and reputation between China Big4 and large local Chinese accounting firms. In the studies that examine the market reaction to auditor switches, researchers normally contend that auditor switches convey significant information to investors regarding changes of economic conditions for the company. Earlier studies argue that the market reaction to auditor switches should be negative because the switches signify that firms are attempting to influence auditors’ opinions. Empirical evidence, however, is generally mixed. Many studies (e.g., Nichols and Smith, 1983; Johnson and Lys, 1990; Klock, 1994) find no market reaction around disclosure of auditor

13 An interesting observation is that as the first listed H-share firm, Tsingdao Brewery was also the first H-share firm to change its auditor immediately after the policy was announced in 2010. In fact, five of all the six H-share firms that cross listed on the SEHK in 1993 switched their HK auditors to Chinese auditors within three months of the promulgation of the new policy. 14 We also consider firms that cross-list in capital markets overseas. However, our data shows that none of H-share firms that cross-list in other international markets replace HK auditors. 15 For example, previous studies provide evidence that large auditors are more independent (DeAngelo, 1981) and that auditors with better reputation use more powerful audit tests (e.g. Simunic, 1980; Francis and Simon, 1987). Many studies also provide evidence that Big-N firms have higher earnings quality, less earnings management (e.g. DeFond and Jiambalvo, 1991; Becker et al. 1998; Francis et al., 1999), and are less related to financial statements with errors and irregularities (DeFond and Jiambalvo, 1991). Moreover, Big-N firms are more likely to have disagreement with their clients in the case of earnings management and to issue going-concern warnings than non-Big-N auditors (Francis and Krishnan, 1999, 2002).

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switches, while other studies (e.g., Fried and Schiff, 1981; Smith, 1988; Eichenseher et al., 1989; Dhaliwal et al., 1993), find negative market reaction to auditor changes with adverse disclosures (e.g., auditor-company disagreement, and adverse financial situation). Recent studies divide auditor switches into two types: auditor dismissal and auditor resignation. They argue that a dismissal should normally convey positive information as long as managers act in the best interests of shareholders. In contrast, a resignation should convey negative information because normally auditors will not resign unless audit fees are insufficient to cover audit costs or audit risk is too high. Consistent with this prediction, empirical research find that auditor dismissals do not appear to trigger any market reaction (e.g., Whisenant et al., 2003; Griffin and Lont, 2010), while auditor resignation results in significant negative market reaction (e.g., Wells and Loudder, 1997; DeFond et al., 1997; Shu, 2000; Beneish et al., 2005). Recent studies that examine the market reaction to a switch between Big4 and Non-Big4 find significant positive market reaction. Whisenant (2006) find that market reaction to auditor switches from a Big4 or Arthur Anderson to Grant Thornton was positive during the period 2002–2006. Knechel et al. (2007) divide auditors into three levels based on predicted audit quality: Big4 Specialist, Big4 non-specialist, and Non-Big4, and find that any upgrade of auditors generates a positive market reaction, and any downgrade of auditor confers a negative market reaction. Chang et al. (2010) examine the market reaction to auditor switching from Big N to third-tier small accounting firms, and find that the average market reaction is positive from 2002 to 2006. They argue that investors may perceive better services provided by smaller accounting firms with lower audit fees and do not perceive a potential decline in audit quality and opinion shopping after switching to a smaller auditor. Overall, the literature predicts that market reaction to audit switches depends on the underlying reasons for the switches, switches between different tiers of audit firms, and more importantly, investors’ perception of potential changes in audit services, quality, and costs after the switches. This study examines how international investors in HK react to voluntary switches from HK to Chinese auditors following the new policy in HK to allow Chinese auditors to audit H-share firms. We have provided two competing theories to predict the market reaction to the switches from HK auditors to Chinese auditors. Using international data, Francis and Wang (2008) find that Big 4’s audit quality increases as a country’s investor protection becomes stronger, while non-Big4’s audit quality is largely unaffected. However, using international data, Choi et al. (2008) find that the fee difference between Big4 and non-Big4 auditors becomes smaller in stricter legal and regulatory regimes. Their findings suggest that non-Big4 auditors’ audit quality is shaped by a country’s institutional factors, while Big4 audit firms provide consistent audit quality across different legal and regulatory regimes in which they operate. These two studies support two different views and have rather different implications for the market reaction to a voluntary switch from HK to Chinese auditors. First, under the Francis and Wang (2008), switching from HK Big4 to China Big4 may trigger a negative market reaction because the audit quality of China Big4 may be compromised due to the influences from the government, weak enforcement, and weak investor protection in China. However, switching from HK non-Big4 to China non-Big4 may not trigger any market reaction given that non-Big 4’s audit quality is largely unaffected by country-specific institutional factors. On the other hand, under Choi et al. (2008), switching from HK Big4 to China Big4 auditors may not trigger any market reaction because Big 4 accounting firms provide consistent audit quality across different legal and regulatory regimes in which they operate. However, switching from HK non-Big4 to China non-Big 4 may trigger a negative market reaction. This is because previous studies find that Chinese local accounting firms have lower audit quality due to the unique political environment and state-owned enterprises in China. We argue that HK accounting and audit standards and practices have been aligned with international practices in the US and UK for a long time; the accounting profession in HK has also been well developed based on the UK and US model. Although China has largely aligned its accounting standards with IFRS, its accounting profession has not been wellrecognized by the international capital markets. Switching from HK to Chinese auditors could significantly lower the credibility of financial reports, which could trigger a negative market reaction. In contrast, H-share firms used to prepare two sets of financial statements under Chinese ASBEs and HK accounting standards (or IFRS) before the new policy; they now only need to provide a single set of financial statements under Chinese ASBEs for both capital markets. This saves a significant amount of reconciliation work for the firms and their auditors. Second, since Chinese auditors are more experienced with Chinese ASBEs, switching to Chinese auditors might benefit from not only lower audit fees, but also better audit services (Chang et al., 2010). As a result, a switch from HK to Chinese auditors could trigger a positive market reaction. Due to the competing theories and arguments above, we predict that (in the null hypothesis form) H2: The market does not react to auditor switches from HK auditors to Chinese auditors. We discuss sample selection and data collection in the next section.

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Z. Liu, S. Lin / Journal of Contemporary Accounting and Economics 15 (2019) 100158

4. Sample selection and data Our sample period covers 2011–2013 because almost all the auditor changes occurred within three years following the new policy.16 Table 1 outlines the sample selection procedure. We first identify 195 H-share firms from the SEHK website. 26 financial firms17 are deleted from our sample. We identify and delete 24, 21, and 14 firms that were not yet listed on the SEHK in 2011, 2012 and 2013, respectively. Finally, we delete 36 firm-years that have missing data for further analysis.18 In total, we have 38 switching firms19 and 109 non-switching firms that generate 412 firm-years of observation across the test period for the following empirical analyses. We collect stock return and accounting data from Datastream, and manually collect state ownership, audit fee and auditor data from annual reports of individual companies. Cross-listing data are obtained from the China Stock Market and Accounting Research (CSMAR) database. Firm listing history data are calculated from the initial listing date provided by the SEHK. 5. Research design The research methods used to examine the determinants of voluntary switches from HK to Chinese auditors and the market reaction to auditor switches are discussed in detail in this section. 5.1. Determinants of auditor switches We use the following logistic model to investigate the determinants of voluntary auditor switches following the new policy.

PrðCN AUD ¼ 1Þ ¼ b1 þ b2  Size þ b3  MTB þ b4  FRN Sales þ b5  LEV þ b6  ROA þ b7  LOSS þ b8  BIG4 þ b9  AGE þ b10  STATEOWN þ b11  DA þ e

ð1Þ

where: CN_AUD

=

SIZE MTB FRN_Sales LEV ROA

= = = = =

LOSS BIG4 AGE STATEOWN DA

= = = = =

1 if the firm uses a Chinese auditor for current fiscal year audit, 0 if the firm uses a HK auditor throughout 2011–2013; natural logarithm of total assets at year-end; market value of common shareholders’ equity divided by book value of common shareholders’ equity; percentage of foreign revenue divided by total revenue; financial leverage, calculated as common shareholders’ equity divided by total assets * 100; return-on-assets, calculated as net income plus interest expenses(1-tax rate) divided by average total assets; 1 if a firm reports losses, else 0; 1 if the firm uses Big4 auditor, else 0; number of years that the firm has been listed on the SEHK. percentage of state ownership; discretionary accruals (see below for definition).

DA is measured as the absolute value of the relative magnitude of discretionary accruals (residual from estimating the following Dechow et al. (1995) modified Jones model)20 to non-cash working capital accruals. In other words, a lower value of DA indicates higher audit quality.



 WC ACCi;t =TAi;t
1 ¼ a1  1=TAi;t
1 þ a2  DREVi;t
DREVi;t =TAi;t
1 þ a3  PPEi;t =TAi;t
1 þ ei;t

ð2Þ

where: 16 We only identified 2 additional auditor changes in 2014 and 2015. It is unclear to the authors whether these changes were mainly driven by the new policy or other concerns. 17 Although we take off all the 26 financial firms, we do find that none of the financial firms adopted the new policy to switch from HK auditors to Chinese auditors. 18 Eight firms were delisted from the Growth Enterprises Market and then listed on the Main Board during 2010–2012 are kept in the sample because they are the same firms. 19 4, 23, 9, and 2 firms switched auditors for 2010, 2011, 2012, and 2013 annual report, respectively. We include the four 2010 annual report firms in the year 2011 group (announcing auditor change in 2011 for annual report 2011), because they announce the auditor change in late December 2010 and early 2011 before 2010 annual reports are issued. We believe it is better to study their firm characteristics using the 2010 year end data than 2009 year end data. 20 We follow Dechow et al. (1995) to use the balance sheet approach to derive accruals. Untabulated results using the cash flow statement approach (Dechow and Dichev, 2002) to derive accruals are generally consistent.

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Z. Liu, S. Lin / Journal of Contemporary Accounting and Economics 15 (2019) 100158

Table 1 Sample selection.

31

2011

2012

2013

Total

Starting total Less: Financial firms Less: Not listed yet in current year Less: Missing data or not listed in prior year

195
26
24
19

195
26
21
9

195
26
14
8

585
78
59
36

Final sample Switching firms Control firms31

126 27 99

139 36 103

147 38 109

412 101 311

Total sample

126

139

147

412

Control firms are firms that are audited by Hong Kong auditors.

WC_ACCi,t 4CA 4CL 4Cash 4STD TA 4REV 4REC PPE

= = = = = = = = =

(4CAi,t
4CLi,t
4Cashi,t + 4STDi,t)/TAi,t
1 change in current assets; change in current liabilities; change in cash; change in short-term debt; total assets; change in sales revenue; change in receivables; and gross value of property, plant and equipment.

We require firms that switched to Chinese auditors in year t to have financial data available for year t
1 in order to construct some of the variables listed above. All the H-share firms have the same fiscal year end as of Dec. 31. We restrict the control sample to those firms that never take advantage of the new policy by the end of 2013. 5.2. Event study method We follow the traditional event study design to investigate the short-term market reaction around auditor change announcements. The cross-sectional analysis is conducted to examine the relationship between observed abnormal returns and certain characteristics of switching firms. This section discusses the research design used for both tests. 5.2.1. Event date In order to determine the date when firms announce auditor switches, we refer to the official website of the SEHK (www. HKEXnews.hk) to view all the official announcements and filings from H-share firms and identify the first public announcement that brought about auditor switches. In general, auditors have a one-year contract with their clients. Firms normally announce their auditors for the following fiscal year at the current Annual General Meeting (AGM) or at the Extraordinary General Meeting (EGM). However, a ‘‘notification to shareholders about the general meeting” is normally released before the general meetings to inform all shareholders about the date and discussion content of the general meetings including auditor appointment. As a result, the first public announcement about auditor changes should be the date when investors receive the notification. In theory, the chance to accept or reject the proposal of switching auditor in the general meetings is the same, but it is very rare that shareholders reject the proposal of the auditor choice or change. In fact, for all 38 firms that switched to Chinese auditors, none of these proposals were rejected at the AGM. Therefore, we use the release date of the notification21 of general meetings as the event date for auditor changes. There are 13 firms that change auditor after the AGM. They chose to have a separate announcement on auditor switches. We, therefore, use the specific announcement date as the event date.22 These event dates cannot be anticipated and are fairly scattered in our test period.23 5.2.2. Abnormal return on announcement day We calculate the abnormal returns on the auditor change announcement day (day 0) using the market model below. 21 Sometimes firms have several notification of AGM to the investors, each attaching the meeting agenda, which includes the auditor change issue. Therefore, we use the date of the first notification of AGM that contains auditor switch issue as the event date. 22 We also have firms that switched their auditors between two AGMs, i.e. dismiss the current auditor that is selected at the AGM and appoint another auditor. For these firms, they have a specific announcement of auditor change, so we use the date of this announcement as the event date. 23 We use two methods to deal with potential confounding announcements. First, we control for potential confounding announcements around the event dates in the cross-sectional regression analysis. Second, we search for any confounding announcements using the official website of the SEHK (www. HKEXnews.hk). We particularly pay attention to significant confounding announcements, such as earnings and dividend announcements. Overall, we do not find any cofounding announcements that may significantly change our results and conclusion.

9

Z. Liu, S. Lin / Journal of Contemporary Accounting and Economics 15 (2019) 100158

Rjt ¼ aj þ bj  Rmt þ ejt ; where Rjt is the rate of return of the common stock of the jth firm on day t; Rmt is the observed return on the market index of b j and b HKEX – Hangseng Chinese Enterprises Index24 – on day t; ejt is the residual item. The coefficients a b j are the parameter estimates using the OLS during the estimation period (from day -260 to day -1125). We then define the abnormal return for the common stock of the jth firm on day t as:

  bj þ b ARjt ¼ Rjt
a b j  Rmt

The 38 switching firms are further divided into categories as ‘‘HK Big4 to China Big4”, ‘‘HK Non-Big4 to China Non-Big4”, and ‘‘HK Big4 to China Non-Big4” for further analyses. 5.2.3. Market reaction measures To detect the magnitude of market reaction and its statistical significance, we follow previous studies to use traditional parametric test – Patell Z test (1976; 1979) and non-parametric tests – rank test in this study. We provide details of these tests in the appendix. 5.3. Cross-sectional analysis We use cross-sectional analysis to explore the underlying factors for any observed abnormal return, including switches between different types of auditors, timing of announcement (TIMING26), dual listing status (XLIST), state ownership (STATEOWN), accounting quality (DA), change in accounting quality (DDA), change in audit fees (DAF27), and listing history (AGE). In doing so, we also can control for the effect from potential confounding announcements around auditor switching announcements. We construct two dummy variables to capture the effect of switches between different types of auditors, i.e. HK Non-Big4 to China Non-Big4 auditors (StS) and HK Big4 to China Non-Big4 auditors (BtS) given that a switch between Big4 may not trigger any significant market reaction (Choi et al., 2008). Following previous studies, we predict a negative (positive) coefficient for DAF, AGE, and LOSSNY (TIMING, XLIST, STATEOWN, DA and DDA) but have no prediction over BtS and StS. The model used for cross-sectional analysis is shown as follows:

AR ¼ c1 þ c2  BtS þ c3  StS þ c4  TIMING þ c5  XLIST þ c6  STATEOWN þ c7  DA þ c8  DDA þ c9  LOSSNY þ c10  DAF þ c11  AGE þ e

ð3Þ

where: AR BtS StS TIMING XLIST STATEOWN DA DDA LOSSNY DAF AGE

= = = = = = = = = = =

Abnormal return on the announcement day; 1 if firm switches from HK Big4 to China non-Big4, else 0; 1 if firm switches from HK Big4 to China Big4, else 0; 1 if firm announces auditor switches at the AGM, else 0; 1 if firm lists both in HK and China, else 0, Percentage of state ownership; Discretionary accruals before the auditor switches; Change in DA after the auditor switches; 1 if firm reports losses following auditor switches, else 0; Percentage change in audit fee after the auditor switches, Number of years that the firm has been listed on the SEHK.

6. Empirical results 6.1. Descriptive statistics Table 2 Panel A presents the major industries of our sample firms. More than half of our sample firms are in the manufacturing industry, followed by the transportation industry. Panel B demonstrates that 23 (14) firms switched from HK Big4 (HK non-Big4) to China Big4 (China Non-Big4). Untabulated result shows that 33 out of 38 firms switched their auditors 24

This index is specifically for H-share firms. We require that only firms with at least 30 days of stock return data prior to the event date are included in this test. 26 We include TIMING variable because argue that early change of auditor facilitates the audit planning and improves reporting timeliness. Therefore, nonAGM auditor change will be perceived more negatively than regular switches. 27 We include audit quality and change in audit quality to proxy for the market’s perceived audit quality change at the time of announcement of auditor switch. Similarly, we include audit fee change to proxy for the perceived audit fee change at the time of the announcement of auditor switch. We include the loss of next year to proxy for the perceived loss of the firm, because firms are more likely to take advantage of the new policy if the firm anticipates a loss in the next year. 25

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Z. Liu, S. Lin / Journal of Contemporary Accounting and Economics 15 (2019) 100158

Table 2 Sample descriptive statistics. Panel A: Sample composition by industry Industry group

# in full sample

%

# in switching firms

%

Agricultural, Forestry and Fishing Mining Construction Manufacturing Transportation Communications Utilities Wholesale Trade Retail Trade Services

3 27 18 215 48 6 31 21 9 34

0.7% 6.6% 4.4% 52.2% 11.7% 1.5% 7.5% 5.1% 2.2% 8.3%

0 2 3 24 4 0 1 1 0 3

0.0% 7.3% 7.3% 61.0% 12.2% 0.0% 2.4% 2.4% 0.0% 7.3%

Total

412

38

Panel B: Number of observations by switching category Type

Count

HK Big4 ? China Big4 (BtB) HK Big4 ? China Non-Big4 (BtS) HK Non-Big4 ? China Non-Big4 (StS)

23 1 14

Total

38

Panel C: Number of observations by year Year

Count

2011 2012 2013

2732 9 2

Total Panel D: Timing of announcement for switching to Chinese auditors

38

2010

2011

2012

2013

Total

AGM Non-AGM

0 1

19 7

4 5

2 0

25 13

Total

1

26

9

2

38

Notes: Panel A reports the industry distribution of the full sample and the switching firm sample. Industry groups are based on the SIC division structure classification. Panel B presents the number of firms that switch to Chinese auditors under different category. Panel C presents the number of firms that switch to Chinese auditors in every year and their effective fiscal years. Panel D presents the number of firms that announce the switching in each year under two categories – in the AGM or between two AGMs (i.e. Non-AGM). 32 One firm announced its auditor change on Dec. 30, 2010, and three firms announced their auditor changes in early 2011 before the annual reports were issued, but their 2010 financial statements are audited by Chinese auditors.

within the same brand name of accounting firms, with 22 Big4 switches and 11 non-Big4 switches. In other words, these firms simply replaced their chief audit partners in HK with other audit partners in Mainland China without switching to different accounting firms. Although Choi et al. (2009) predict that Big4 accounting firms consistently provide high-quality audit services, it is unclear ex-ante whether investors would react to auditor switches between the same accounting firms that are located in different regions with very different regulatory environment and political regimes. It is well documented that the audit environment and capital market in China are rather different from those in other countries. Only one firm switched from PWC HK to DTT China (i.e. a switch between two Big4 accounting firms). Also, only one firm changed from HK Big4 to China Non-Big4. Panel C shows that one firm (i.e. Tsingdao Brewery) announced auditor change on Dec. 30, 2010, only 15 days after the official announcement of the new policy. Three firms announced their auditor switches within three months after the yearend of 2010 and had their 2010 annual reports audited by Chinese auditors. In 2011, another 23 firms announced and switched to Chinese auditors for the 2011 annual report. Another 9 and 2 firms announced and switched to Chinese auditors in 2012 and 2013, respectively. Panel D shows that about two thirds of the firms that announced auditor switches in the notification for AGM, while the rest of firms chose to announce the switches in separate announcements after the AGM. Table 3 presents descriptive statistics for the variables used to investigate the determinants of audit switches. About one quarter of the H-share firms switched to Chinese auditors. Only 10% of the H-share firms reported losses the year after auditor switches. Approximately 62% of the H-share firms use HK Big4, which is much lower than the market share of Big4 worldwide.

11

Z. Liu, S. Lin / Journal of Contemporary Accounting and Economics 15 (2019) 100158 Table 3 Descriptive statistics – 412 firms sample. Variable

N

Mean

Std Dev

Median

Q1

Q3

CN_AUD SIZE ROA MTB LEV DA BIG4 LOSS AGE STATEOWN FRN_Sales

412 412 412 412 412 412 412 412 412 412 412

0.245 16.155 5.776 1.839 40.654 3.126 0.617 0.097 9.723 40.054 9.486

0.431 2.284 10.752 3.649 68.065 15.993 0.487 0.296 4.765 25.810 19.943

0.000 16.428 4.970 1.080 46.325 0.961 1.000 0.000 9.000 48.840 0.000

0.000 14.487 2.990 0.660 27.280 0.713 0.000 0.000 6.000 14.210 0.000

1.000 58.805 8.225 1.840 61.545 1.300 1.000 0.000 13.500 58.805 8.555

Notes: This table presents mean, standard deviation, median, minimum and maximum values for the variables included in the regression model. Variable definition: CN_AUD = 1 if the firm uses a Chinese auditor for current fiscal year audit and 0 if the firm does not change auditor throughout 2011–2013; SIZE = natural log of total assets at year-end; MTB = market value of common shareholders’ equity divided by book value of common shareholders’ equity; FRN_Sales = percentage of foreign revenue divided by total revenue; LEV = financial leverage, calculated as common shareholders’ equity dividend by total assets * 100; ROA = return-on-assets, calculated as net income plus interest expenses  (1-tax rate) divided by average total assets; LOSS = 1 if a firm reports losses, else 0; BIG4 = 1 if the firm uses Big 4 auditor, else 0; AGE = number of years that the firm has been listed on the SEHK. STATEOWN = percentage of state ownership; DA = discretionary accruals (see below for definition). DA is measured as the absolute value of the relative magnitude of discretionary accruals (residual from estimating the following Dechow et al., 1995 modified Jones model) to non-cash working capital accruals: WC_ACCi,t/TAi,t-1 = a1  (1/TAi,t-1) + a2  (DREVi,t
DREVi,t)/TAi,t-1 + a3  PPEi,t/TAi,t-1 + ei,t where: WC_ACCi,t = (4CAi,t
4CLi,t
4Cashi,t + 4STDi,t)/TAi,t
1 4CA = change in current assets; 4CL = change in current liabilities; 4Cash = change in cash; 4STD = change in short-term debt; TA = total assets; 4REV = change in sales revenue; 4REC = change in receivables; and PPE = gross value of property, plant and equipment.

6.2. Determinant of using Chinese auditors Table 4 presents the Pearson (above the diagonal) and Spearman (below the diagonal) correlation matrices. We find Big4 auditors are negatively correlated with auditor switches (CN_AUD) and state-owned business (STATEOWN) but positively correlated with the number of years of being listed on the SEHK (AGE). We also find that the percentage of foreign revenue and is negatively correlated with leverage (LEV) and return on assets (ROA). Moreover, firm performance (ROA) is positively correlated with market-to-book ratio, Big4 auditor, and leverage, but is negatively correlated with the percentage of foreign revenue and reporting losses. The result of the logistic model is shown in Table 5. All the p-values are based on the one-tail tests. We find that SIZE (0.111, p = 0.080) is positive and significant at the 10% level, indicating that larger firms are more likely to switch to Chinese auditors. LEV (0.009, p = 0.073) is positive and significant at 10% level, indicating that firms with less need for external financing are more likely to switch to Chinese auditors. Big4 (
0.477, p = 0.049) is negative and significant at the 5% level, suggesting that firms using Big4 auditors are less likely to switch to Chinese auditors. AGE (0.085, p < 0.001) is positive and significant at less than 1% level, indicating that firms with a longer listing history with the SEHK are more likely to switch their auditors. Further analysis shows that many H-share firms that switched to Chinese auditors were also those firms that were first selected by the Chinese government to cross list on the SEHK in the early 1990s. This suggests that firms with a closer relationship with the government or a strong political connection are more likely to respond to the government’s new policy and to switch auditors28. State ownership does not have the predicted sign, suggesting that state ownership is not directly associated with the decision of switching to Chinese auditors. Finally, the percentage of foreign revenue (
0.012, p = 0.055) is negative and significant at the 10% level, indicating that firms with significant transactions with foreign firms

28 We do not think saving in audit fee is the main concern of these firms because it is relatively trivial. On average the audit fee reduces about 4.9% after the switches.

12

CN_AUD

SIZE

ROA

MTB

LEV

DA

BIG4

LOSS

AGE

STATEOWN

FRN_Sales

CN_AUD

1

SIZE


0.0718 0.1457
0.00425 0.9315
0.00752 0.8791 0.06405 0.1945 0.01805 0.7149
0.09593 0.0517 0.0037 0.9403 0.13834 0.0049
0.11698 0.0175 0.04716 0.3397


0.02648 0.592 1


0.00638 0.8972 0.00912 0.8536 1

0.01807 0.7145
0.1724 0.0004 0.01798 0.716 1

0.06017 0.223 0.05253 0.2875 0.37235 <0.0001
0.00495 0.9202 1

0.00131 0.9788 0.05773 0.2424 0.00327 0.9472 0.00354 0.9428 0.00977 0.8433 1


0.09593 0.0517 0.47915 <0.0001 0.08542 0.0833
0.09245 0.0608 0.09249 0.0607 0.04944 0.3168 1

0.0037 0.9403
0.27292 <0.0001
0.43625 <0.0001 0.05418 0.2725
0.25515 <0.0001
0.02012 0.6839
0.29775 <0.0001 1

0.18488 0.0002
0.01086 0.8261
0.05327 0.2807
0.04797 0.3314 0.03304 0.5036 0.08295 0.0927
0.13081 0.0078 0.11035 0.0251 1


0.06363 0.1974 0.54015 <0.0001
0.06657 0.1775
0.14637 0.0029 0.06223 0.2075 0.02708 0.5836 0.37632 <0.0001
0.15316 0.0018 0.02102 0.6705 1


0.06747 0.1717 0.15552 0.0015
0.08449 0.0867
0.07525 0.1273
0.00213 0.9656
0.00431 0.9306
0.03592 0.4672 0.08987 0.0684 0.00674 0.8915
0.02996 0.5442 1

ROA MTB LEV DA BIG4 LOSS AGE STATEOWN FRN_Sales


0.05416 0.2728 0.05202 0.2921
0.44124 <0.0001 0.08203 0.0963 0.4396 <0.0001
0.2165 <0.0001
0.05616 0.2554 0.48847 <0.0001 0.3325 <0.0001

0.41381 <0.0001 0.44624 <0.0001
0.03414 0.4895 0.17189 0.0005
0.51096 <0.0001
0.06229 0.2071
0.06277 0.2036
0.10717 0.0296

0.01664 0.7364 0.02298 0.6418 0.0566 0.2517
0.11211 0.0229
0.05445 0.2702
0.01021 0.8364
0.02145 0.6643


0.03003 0.5434
0.00422 0.932
0.09374 0.0573 0.09051 0.0664
0.15661 0.0014
0.15533 0.0016


0.00021 0.9966 0.06017 0.2229 0.04804 0.3307
0.01002 0.8394 0.11262 0.0222


0.29775 <0.0001
0.14114 0.0041 0.37637 <0.0001 0.01793 0.7167

0.11615 0.0184
0.14399 0.0034
0.00235 0.9621


0.07985 0.1056 0.03968 0.4219

0.0197 0.6901

Notes: The table reports the correlation matrix for the full sample (412 firm-year observations). Pearson (Spearman) correlations are presented above (below) the diagonal. All the variables are defined in Table 3.

Z. Liu, S. Lin / Journal of Contemporary Accounting and Economics 15 (2019) 100158

Table 4 Correlation Matrix.

Z. Liu, S. Lin / Journal of Contemporary Accounting and Economics 15 (2019) 100158

13

Table 5 Logistic regression of auditor choice on firm characteristics. Variable

Predicted Sign

Coefficient

One-tailed P-value

Intercept SIZE ROA MTB LEV DA BIG4 LOSS AGE STATEOWN FRN_Sales Year fixed effect Pseudo R2

? + – – – + – – + + – Yes 0.0604


3.333 0.111
0.016 0.021 0.009
0.002
0.477
0.242 0.085
0.009
0.012

0.006*** 0.080* 0.218 0.258 0.073* 0.386 0.049** 0.312 <0.001*** 0.056 0.055*

Notes: *, **, *** Significant at the 10 percent, 5 percent, and 1 percent levels, respectively. All p-values are based on one-tailed tests. This table examines the relation between auditor choice and firm characteristics. We estimate the following logistic model: Pr(CN_AUD = 1) = b1 + b2  Size + b3  MTB + b4  FRN_Sales + b5  LEV + b6  ROA + b7  LOSS + b8  BIG4 + b9  AGE + b10  STATEOWN + b11  DA + e Variable definition: CN_AUD = 1 if the firm uses a Chinese auditor for current fiscal year audit and 0 if the firm does not change auditor throughout 2011–2013; SIZE = natural log of total assets at year-end; MTB = market value of common shareholders’ equity divided by book value of common shareholders’ equity; FRN_Sales = percentage of foreign revenue divided by total revenue; LEV = financial leverage, calculated as common shareholders’ equity dividend by total assets * 100; ROA = return-on-assets, calculated as net income plus interest expenses  (1tax rate) divided by average total assets; LOSS = 1 if a firm reports losses, else 0; BIG4 = 1 if the firm uses Big 4 auditor, else 0; AGE = number of years that the firm has been listed on the SEHK. STATEOWN = percentage of state ownership; DA = discretionary accruals (see below for definition). DA is measured as the absolute value of the relative magnitude of discretionary accruals (residual from estimating the following Dechow et al., 1995 modified Jones model) to non-cash working capital accruals: WC_ACCi,t/TAi,t-1 = a1  (1/TAi,t
1) + a2  (DREVi,t
DREVi,t)/TAi,t
1 + a3  PPEi, t/TAi,t
1 + ei,t where: WC_ACCi,t = (4CAi,t
4CLi,t
4Cashi,t + 4STDi,t)/TAi,t
1 4CA = change in current assets; 4CL = change in current liabilities; 4Cash = change in cash; 4STD = change in short-term debt; TA = total assets; 4REV = change in sales revenue; 4REC = change in receivables; and PPE = gross value of property, plant and equipment.

are less likely to switch auditors. Surprisingly, all other explanatory variables that are used to explain auditor changes, such as accounting performance, accounting quality, growth rate, and reporting losses, in previous studies do not load in our model. Overall, we find evidence supporting H1b (cross listing history), H1c (need of external financing), H1d (firm size), H1g (foreign revenue), and H1h (Big4 auditors).

6.3. Market reaction This study investigates how the market reacts to the auditor switches of H-share firms using both univariate and multivariate analyses. The former analysis focuses on the average market reaction to these announcements, while the latter analysis focuses on what firm-specific factors can explain the market reaction around auditor change announcements.

14

Z. Liu, S. Lin / Journal of Contemporary Accounting and Economics 15 (2019) 100158

Table 6 HK market reaction statistics on announcement day. Sample

Obs

Mean AR

Median AR

Pos:Neg

Patell Z

Rank Test

Full BtB BtS StS

38 23 1 14


0.47%
0.09% 8.23%
1.71%


0.47%
0.16% 8.23%
1.02%

12:26** 10:13 1:0 1:13***


0.831
0.038 4.400***
2.496***


1.71**
0.66 1.714**
2.538***

Notes: *, **, *** Significant at the 10 percent, 5 percent, and 1 percent levels, respectively, using a generic one-tail test. Patell Z = Standardized abnormal return test implemented by Patell (1976) and subsequently adopted by Dodd and Warner (1983) and many others. Rank Test = Non-parametric rank test implemented by Corrado (1989) and subsequently adopted by Campbell and Wasley (1993) and many others.

6.3.1. Univariate analysis Table 6 Panel A summarizes the market reaction to auditor changes by various firm groups. All the tests are again based on the one-tail tests. For the full sample, the mean (median) abnormal return on the announcement day (day0) is
0.47% (
0.47%), significant at the 5% level using the Rank test (z-statistics =
1.71). 26 out of 38 announcements show a negative abnormal return, which is also significant at the 5% level using the binomial test. For the ‘‘BtB” firm group, the mean (median) market reaction on day0 is
0.09% (
0.16%), which is insignificant, implying that investors in HK perceive that the audit quality of HK Big4 and China Big4 is similar, consistent with Choi et al. (2009). There are three potential reasons for this finding. First, Ke et al. (2015) find that China Big4 normally assign more experienced and well-trained auditors and partners to audit H-share firms, which results in higher audit quality. Second, for firms that switched to China Big4 from HK Big4 following the new policy, the bulk of audit work was actually completed by the auditing personnel of China Big4. In other words, the audit work of these firms is done mostly by the same group of personnel before and after the switch of auditor. Third, this finding could also be driven by the fact that investors in HK understand the only change after switching from HK Big4 to China Big4 is to replace a HK audit partner with a Chinese audit partner within the same accounting firms (e.g., HK PWC audit partner is replaced with China PWC auditor partner). Overall, our finding shows that investors value the brand names of Big4, even though China Big4 are under the Chinese regulatory oversight. For the ‘‘BtS” firm group, we find a positive and significant market reaction of 8.23% on day0 using both the Patell Z (z = 4.400, significant at the 1% level) and Rank tests (z = 1.714, significant at the 5% level). This result needs to be interpreted with caution because only one firm made this switch. Further analysis for this specific firm reveals the fact that this firm has good financial performance and reputation. Chang et al. (2010) find that firms may switch to smaller accounting firms for higher quality services and lower audit fees, which may explain the positive market reaction to this downward auditor switch. For the ‘‘StS” firm group, we find a significant negative market reaction on day0. The mean (median) abnormal return is
1.71% (
1.02%), which is significant at the 1% level using both the Patell Z (z =
2.496) and Rank tests (z =
2.538). The result using the Binomial test is also consistent. Investors in HK appear to punish H-share firms that switched from HK Non-Big4 to China Non-Big4. This finding implies that investors prefer HK non-Big 4 accounting firms to local Chinese accounting firms. Overall, our univariate analysis shows that investors perceive similar audit quality of HK Big4 and China Big4, and a switch between them does not trigger any significant market reaction. This is generally consistent with the literature that Big4 brand names are highly valued by international investors. However, there is evidence suggesting that investors punish firms that switched from HK Non-Big4 to China Non-Big4, indicating that investors may perceive lower audit quality of nonBig4 firms in China. 6.3.2. Cross-sectional analysis This section examines the association between abnormal returns and some firm-specific characteristics.29 Table 7 presents the descriptive statistics of the variables used in the cross-sectional analysis. The mean and median abnormal return on day0 is
0.50%. One firm (2.6%) switched from HK Big4 to China Non-Big4 whereas 14 firms (39.5%) switched from HK non-Big4 to China non-Big4. 65.8% of firms announced auditor switches at the AGM. 57.9% of firms list their shares both in HK and China. The mean (median) state ownership is 35.7% (42.9%). Mean (median) DA, measured by discretionary accruals over working capital the year before auditor switches, is 1.185 (0.961), while mean (median) DDA, change in discretionary accruals over working capital in the year of auditor switch, is 0.345 (
0.010). Three out of 38 firms (7.9%) reported a loss the year following auditor switches. The mean (median) decrease in audit fees after auditor switches is 4.9% (6.5%). Finally, the mean (median) number of years that the firm has been listed on the SEHK is 9.921 (8). Untabulated results show that abnormal returns are not correlated with any explanatory variables except BtS. Table 8 presents the cross-sectional analysis results. Using the one-day test window (i.e. day 0),30 we find a switch from HK Non-Big4 to China Non-Big4 reduces approximately 3.0% (p = 0.015) of firm value; a switch from HK Big4 to China Non-Big4 29 30

We winsorize the sample at the bottom 5% and top 95%. We also try the day (
1,+1) test window, but the result is much weaker.

15

Z. Liu, S. Lin / Journal of Contemporary Accounting and Economics 15 (2019) 100158 Table 7 Descriptive statistics – 38 firms sample. Variable

N

Mean

Std Dev

Median

Minimum

Maximum

AR BtS StS TIMING XLIST STATEOWN DA DDA DAF LOSSNY AGE

38 38 38 38 38 38 38 38 38 38 38


0.005 0.026 0.395 0.658 0.579 0.357 1.185 0.345
0.049 0.079 9.921

0.034 0.162 0.495 0.481 0.494 0.230 0.934 1.673 0.347 0.273 5.421


0.005 0.000 0.000 1.000 1.000 0.429 0.961
0.010
0.065 0.000 8.000


0.078 0.000 0.000 0.000 0.000 0.000 0.089
1.141
0.614 0.000 2.000

0.119 1.000 1.000 1.000 1.000 0.673 4.628 6.678 1.000 1.000 18.000

Notes: This table presents mean, standard deviation, median, minimum and maximum values for the variables included in the regression model. Sample consists of 412 firm-years. Variables are defined as: AR = Abnormal return on announcement day; BtS = 1 if firm switches from HK Big4 to China non-Big4, else 0; StS = 1 if firm switches from HK non-Big4 to China non-Big4, else 0; TIMING = 1 if firm announces auditor switches at the AGM, else 0; XLIST = 1 if firm lists both in HK and China, else 0; STATEOWN = Percentage of state ownership; DA = Discretionary accruals; DDA = Change in DA; DAF = Percentage change in audit fee; LOSSNY = 1 if firm reports losses following auditor switches, else 0; AGE = Number of years that the firm has been listed on the SEHK.

Table 8 Cross-sectional analysis on market reaction to auditor switch. Variable

Predicted Sign

Coefficient

P value

Intercept BtS StS TIMING XLIST STATEOWN DA DDA DAF LOSSNY AGE

? ? ? +
?
+

+

0.007 0.101
0.030 0.004
0.026
0.044 0.009
0.001
0.001
0.007 0.002

0.333 0.003*** 0.015** 0.373 0.023** 0.067* 0.090* 0.405 0.473 0.372 0.096*

Adj. R2

0.1393

Notes: *, **, *** Significant at the 10 percent, 5 percent, and 1 percent levels, respectively. All p-values are one-tailed values. This table examines the determinants of the abnormal market return on auditor change announcement: AR = c1 + c2  BtS + c3  StS + c4  TIMING + c5  XLIST + c6  STATEOWN + c7  DA + c8  DDA + c9  LOSSNY + c10  DAF + c11  STATEOWN + e Variables are defined as: AR = Abnormal return on announcement day; BtS = 1 if firm switches from HK Big4 to China non-Big4, else 0; StS = 1 if firm switches from HK non-Big4 to China non-Big4, else 0; TIMING = 1 if firm announces auditor switches at the AGM, else 0; XLIST = 1 if firm lists both in HK and China, else 0, STATEOWN = Percentage of state ownership; DA = Discretionary accruals; DDA = Change in DA; DAF = Percentage change in audit fee. LOSSNY = 1 if firm reports losses following auditor switches, else 0; AGE = Number of years that the firm has been listed on the SEHK.

16

Z. Liu, S. Lin / Journal of Contemporary Accounting and Economics 15 (2019) 100158

increases approximately 10% of firm value (p = 0.003). The latter result needs to be interpreted with caution because only one firm made this switch. The results remain consistent after adjusting for the potential cluster effect. Overall, the cross-sectional analysis shows that investors in HK perceive that a switch from HK non-Big4 to China NonBig4 is bad news. We also find that dual list status, state ownership, and listing history are associated with abnormal return and have predicted signs, while change in accounting quality, change in audit fees, and reporting losses cannot explain the abnormal return around auditor changes. 6.3.3. Market reaction to auditor changes in Chinese markets We find that 21 out of 38 H-share firms also issue A-shares in Chinese domestic markets, who may hire local Chinese auditors to audit their financial statements for domestic filing purposes. As a result, a switch from HK to Chinese auditors in HK could also trigger an auditor switch in Chinese domestic market for firms that issue both A- and H-shares. For example, firm A used HK PWC as the auditor in HK but a small Chinese accounting firm in Mainland China. When the firm changed to a sole auditor – China PWC, it means that the change is classified as BtB in HK market, but it is classified as StB in Chinese domestic market. It is also possible that firm A might change their HK Big4 auditor to a China non-Big4 auditor. In this case, for HK market the change is classified as BtS, while for Chinese market it is classified as StS if the company switches from one China non-Big4 to another China non-Big4 following the auditor change in HK. We investigate how Chinese investors react to auditor switches following the new policy in Chinese domestic markets in this section. Panel A of Table 9 shows that 21 H-share firms also issue and trade A-shares in Chinese domestic market. Among them, 9 A-share firms continued to use the same China Big4 (BtB) after switching from HK Big4 to China Big4 in HK. Five firms switched their auditors from China Non-Big4 to China Big4 (StB). Seven firms continued to use China non-Big4 for Chinese domestic market. Among them, two firms changed from one China Non-Big4 to another China non-Big4 (StS), and five firms kept the same China Non-Big4. Panel A also shows that there is no significant market reaction at conventional levels to the auditor change announcements for the BtB (z =
0.031) and StB (z = 0.037) firm groups. However, we observe a negative market reaction to the auditor change announcements (z =
1.624, significant at the 10% level) for the StS firm group when using the Patell Z test. We further partition our sample firms based on the types of auditor changes in both HK and Chinese domestic markets. Results reported in Panel B of Table 9 show that investors in both HK and Chinese domestic markets do not appear to react to auditor changes for 9 firms that switched from HK Big4 to China Big4 in HK (z =
1.162) but continued to use the same China Big4 in Chinese domestic market (z =
0.031). We also find no market reaction for 5 firms that switched from HK Big4 to China Big4 in HK (z =
1.05) but switched from China Non-Big4 to China Big4 in China (z = 0.037). Moreover, investors in Chinese domestic markets do not react to the auditor switch from one China non-Big4 to another China Non-Big4 (z =
0.437). However, investors in HK market positively reacts to the auditor switch from HK Big4 to China non-Big4 (z = 4.400). Again, the latter result needs to be interpreted more cautiously because only one H-share firm made such a change. Finally, for the 6 firms who switched from HK Non-Big4 to China Non-Big4 in HK and switched from one China Non-Big4 to another China non-Big4, investors in both HK (
2.27%, z =
2.141, significant at the 5% level using the Patell Table 9 Chinese market reaction statistics on the announcement day. Panel A. Market reaction in different switch groups Sample

Obs

Mean AR

Median AR

Pos:Neg

Patell Z

Rank Test

Full BtB StB StS

21 9 5 7


0.28% 0.22%
0.03%
1.04%


0.06%
0.23%
0.08%
0.02%

8:12 4:4 1:4 3:4


0.98
0.031 0.037
1.624*


0.044 0.254
0.301
0.632

Panel B. Further partitioning 21 A-share firms Sample China

HK

Obs

Market

Mean AR

Median AR

Pos:Neg

Patell Z

Rank Test

BtB

BtB

9

China HK

0.22%
0.65%


0.23%
0.16%

4:04 3:06


0.031
1.162

0.254
0.831

StB

BtB

5

China HK


0.03%
1.31%


0.08%
0.45%

1:04 2:03

0.037
1.05

0.301
0.835

StS

BtS

1

China HK


0.89% 8.23%


0.89% 8.23%

0:01 1:00


0.437 4.400***


0.616 1.714**

StS

StS

6

China HK


1.07%
2.27%

0.26%
1.00%

3:03 1:5*


1.575*
2.141**


0.442
1.919**

Notes: *, **, *** Significant at the 10 percent, 5 percent, and 1 percent levels, respectively, using a generic one-tail test. Patell Z = Standardized abnormal return test implemented by Patell (1976) and subsequently adopted by Dodd and Warner (1983) and many others. Rank Test = Non-parametric rank test implemented by Corrado (1989) and subsequently adopted by Campbell and Wasley (1993) and many others.

Z. Liu, S. Lin / Journal of Contemporary Accounting and Economics 15 (2019) 100158

17

z test; z =
1.919, significant at the 5% level using the Rank test) and Chinese domestic markets (
1.07%, z =
1.575, significant at the 10% level using the Patell z test) negatively react to these auditor changes. Overall, we find consistent evidence that investors in both HK and Chinese domestic markets punish firms that switched from HK non-Big4 to China non-Big4 auditor. A potential explanation for the negative market reaction to a switch from HK non-Big4 to China non-Big4 is that investors anticipate that accounting/audit quality could reduce after the switch. However, we do not find evidence of reduced accounting/audit quality when investigating the change in absolute discretionary accruals following the switch of auditor from HK non-Big4 to China non-Big4. 7. Conclusion This paper provides preliminary empirical evidence on the consequences of an initiative to permit 12 large Chinese accounting firms, including four China Big4 and eight local Chinese accounting firms, to audit the financial statements of H-share firms. Specifically, we examine the characteristics of H-share firms that switched from HK to Chinese auditors and the market reaction to the auditor switches following to the above new policy. We find that H-share firms that chose to switch to Chinese auditors have larger firm size, a percentage of foreign sales, less need for external financing, and are less likely to use HK Big4. One interesting characteristic we identify is that firms with a longer listing history with the SEHK are inclined to switch to Chinese auditors, suggesting political connection may play a role in these auditor changes. We also find that the market reacts negatively to firms switching from HK nonBig4 to China non-Big4, although there is no significant market reaction to firms switching from HK Big4 to China Big4. Our result indicates that the market values the brand names of Big4 but perceive lower audit quality for China non-Big4 than HK non-Big4. Our results are robust after considering simultaneous auditor switches in Chinese domestic markets. Overall, we find evidence indicating that despite the efforts of Chinese government to promote Chinese accounting firms in HK market, investors in HK appear to prefer Big4 affiliated auditors even when they are under the Chinese domestic rules. Our finding is mainly preliminary but should be of interest to the accounting regulators, accounting firms, government, and investors around the world. We admit some limitations in this study. First, the sample size of this study is small. Second, a low explanatory power in the cross-sectional analysis suggests that there might be some missing variables in the regression model. Finally, this study only focuses on the consequences of switching from HK auditors to Chinese auditors. Future study should further examine the consequences of other changes in accounting rules and policies introduced by the Chinese government to promote Chinese accounting firms. We are grateful for helpful comments provided by Mingchen Deng (discussant), Kannan Raghunandan and other workshop participants at the 2016 AAA International Accounting Section Midyear Meeting in New Orleans and Florida International University. We are responsible for all remaining errors. Appendix Patell Z test Following Patell (1976), the abnormal return (AR) for each security has been standardized by dividing the security’s own estimate of variance to test the null hypothesis that the average announcement effect is equal to zero. Define standardized abnormal return as:

SARjt ¼

AR
jt  ; s ARjt

where


 s ARjt ¼

vffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi PT2 2 u
2 u Rmt
RmEst 1 k¼T1 Rjk þP  t1 þ 2 : T2
Mj Mj
2 k¼T1 Rmt
RmEst

Rmt is the observed return on the market index on day t, RmEst is the mean market return over the estimation period, and Mj is the number of non-missing trading day return in the interval T1 and T2 used to estimate the parameters for firm j. The test statistic for the null hypothesis is: N 1 X ZT1; T2 ¼ pffiffiffiffi Z jT1;T2 ; N j¼1

where

18

Z. Liu, S. Lin / Journal of Contemporary Accounting and Economics 15 (2019) 100158 T2 X 1 Z jT1;T2 ¼ qffiffiffiffiffiffiffiffiffiffiffiffiffi SARjt ; Q jT1;T2 t¼T 1

and

Q jT1;T2 ¼ ðT1
T2 þ 1Þ

Mj
2 : Mj
4

2. Non-parametric rank test The non-parametric rank test is the ratio of the mean deviation of the securities’ day 0 ranks (ki0) to the estimated standard deviation of the portfolio mean abnormal rank: 1 N

PN

i¼1 ðki0


Eðki ÞÞ sðkÞ

where E(ki) is the expected rank for security i which is equal to [.5T0 i + .5] and T0 i is the number of non-missing trading days for firm i in the estimation and event periods. The standard deviation of the portfolio mean abnormal return rank is:

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