Two essays on auditing in China

Abstract

My thesis consists of two essays investigating audit fees and audit quality in the Chinese market. The first essay examines the association between audit market concentration and initial-year audit fee discounting in China. The second essay documents the role of regulatory intervention in the audit market by investigating the effect of a Chinese audit fee regulation on audit fees and audit quality. Previous research provides mixed evidence on the association between audit market concentration and audit fees (Bandyopadhyay and Kao, 2004; DeFond and Zhang, 2014). DeAngelo (1981a) and Chan (1999) argue that market competition is an important determinant of initial-year audit fee discounting. The lack of empirical evidence directly examining market concentration's effect on fee discounting, however, motivates my first essay. I find that a negative association between market concentration (measured by market share and the Herfindahl index) and initial-year audit fee discounting exists, which is more pronounced among small audit firms, but not significant among large audit firms. I also find this negative association is more pronounced in weak legal environments but diminishes in strong legal environments. Analysis at the individual auditor level shows the aforementioned results only exist when both the audit firm and signing auditors are different from those in previous years. Overall, my findings suggest that the audit market concentration decreases initial-year audit fee discounting in the Chinese audit market. Audit fees, in general, are negotiated by auditors and their clients (DeFond and Zhang, 2014). However, the Chinese government launched an audit fee regulation in 2010 that imposes a price floor on audit fees. In the second essay, I investigate whether that audit fee regulation affects audit fee and audit quality, especially for small audit firms. I find that compared to large audit firms, small audit firms exhibit greater increases in audit fees and audit quality following the audit fee regulation. Those results are robust to various measures of audit quality and alternative empirical specifications. Further, also after the audit fee regulation implementation, I find that the increases in audit fee and audit quality for small audit firms are more pronounced in a weak legal environment. Overall, my findings lend support for the role of government intervention in the emerging audit market.