The effect of regulatory oversight on auditors : evidence from China

Abstract

This study investigates whether client firms replace their external auditors and improve their audit quality after receiving China's National Audit Office (NAO) inspection reports that disclose accounting irregularities. By using a sample covering 1,681 firm-year observations across 2009-2017 in the China A-share market, our difference-in-difference analysis compares the auditor replacement rate and audit quality in the pre-disclosure period with those in the post-disclosure period for both deficient state-owned enterprises (SOEs) (i.e. those that are revealed to have accounting irregularities according to the NAO inspection disclosures) and a control group (matched SOEs determined via a propensity matching method). We document that, compared with the control group, the frequency of auditors being replaced increases for deficient SOEs around the NAO inspection disclosures, and also that the audit quality of these SOEs is improved following the disclosures. We further find that the audit quality improvement is greater when companies change their auditors from small auditors to large, well-known audit firms (which we class as the move-up group). The auditor replacement rate and audit quality improvement are higher when the client firms face highly severe auditing issues. We further document an externality effect from the NAO inspections. That is, client companies sharing the same auditors with deficient SOEs tend to change their auditors too; and the audit quality of those clients is also improved. Taken together, our results accentuate the importance and effectiveness of the auditors' reputation and of regulators to provide alternative disciplinary mechanisms to improve the audit market's audit quality.