Legal Environments, Audit Quality and Initial Return:

Evidence from Chinese IPOs of SOEs

Yunxia BaiYunxia BaiGuanghua School of ManagementGuanghua School of Management

Peking UniversityPeking University

Research questions Does legal environments affect audit

quality?

Does audit quality convey information in an initial public offering?

1.Introduction

Existing literature On audit quality

Most literature examines micro-sources of differentiation in audit quality (Francis, 2004): Characteristics of accounting firms ( e.g., size)

Characteristics of clients (e.g., audit committees)

The engagement specific factors (e.g. audit tenure, compensation, non-audit service, and accounting firm alumni)

Existing literature On audit quality

Relatively little attention have been paid to the locality of auditors: The information perspective (Choi, et al., 2007) The collusion perspective (Gul, et al., 2006)

A few recent research has begun to investigate how a country’s legal environments affect auditor behavior (Francis and Wang, 2008; Venkataraman, et al., 2008; Wang, et al., 2008).

Existing literature On Initial Return

IPO underpricing phenomenon For a sample of 6249 American IPOs from 1980 to 2001 t

he average initial return is 18.8% (Ritter and Welch, 2002).

For 908 Chinese IPOs of A-shares from 1995 to 2003 the average initial return is 129% ( 刘煜辉等 , 2005).

Theoretical explanations of IPO underpricing Focusing on the setting of the offer price Assuming first-day market price as “fair value”

Purnanandam,et al., 2004. Are IPOs Really Underpriced? The Review of Financial Studies 17 (3), 811-848.

Existing literature On Initial Return

Audit quality and IPO underpricing Almost all literature exhibits that audit quality is invers

ely related to initial return (Rock, 1986; Beatty, 1989; Michaely et al., 1995).

Chang, et al. (2008 )document a positive relationship between audit quality and initial return.

Contribution This paper extends literature on audit quality by joi

ntly examining the effect of auditor choice and legal environments on audit quality in a single country.

This paper extends literature on IPO underpricing by examining the effect of audit quality on initial return in the context of Chinese IPOs where the offering price is controlled by the government.

The remainder proceeds as follows:

Hypotheses

Resign Design

Empirical Results

Conclusions and Limitations

Proposal for Future Research

Hypothesis 1: The difference in audit quality between local and n

on-local auditors are larger in regions with less developed legal institutions.

Collusion cost is lower in regions with less developed legal institution.

Relative to non-local auditors, the local governments (officials) can exert more influence on local auditors （ Gul, et al., 2006; Wang, et al., 2008) .

Prestigious auditors can increase the likelihood of being approved for listing and the after-issue market price.

2.Hypotheses

Hypothesis 2: The difference in initial return between clients of loc

al and non-local auditors are larger in regions with less developed legal institutions.

Due to the government control the offering price is unaffected by the quality audit.

The signaling role of audit (Titman and Trueman, 1986) predicts a lower post-issue market price for clients of low quality auditors, which leads to a lower initial return.

Table 1 Sample Distribution 1999-2003 1999 2000 2001 2002 2003

Panel A By Region

Developed 144 28 46 30 23 17

Less Developed 211 50 67 36 33 25

Full Sample 355 78 113 66 56 42

Panel B Percentage of Firms Choosing Local Auditors（%）

Developed 73 86 72 60 78 71

Less Developed 49 72 42 39 36 44

Full Sample 59 77 54 49 53 55

A province is classified as less (legally) developed regions if its average legal environment index over 2002-2003

constructed by Fan and Wang (2005) is below the 60th percentile value, and classified as (legally) developed regions

otherwise. An auditor is defined as local if its registry province or provincial-level region is the same as that of its

auditor.

3.Research Design3.1 The data

3.2 The Definition of variables Audit Quality: Following Meyers, et al. (2003) and Venkataraman, et

al. (2008), the audit quality is defined as the discretionary accruals

(DA) estimated by the following modified Jones model (1991):

1..21...11.01.. )(1 tjtjtjtjtjtjtjtj APPEAARREVAATAC

For firm i in year t,

tjTAC . ：Total accruals (=Net income-Operating cash flow)

1. tjA ：Total assets

tjREV . ：The change in sales revenue

tjAR . ：The change in accounts receivables

tjPPE . ：Fixed assets

The Definition of variables △ DA : The three year average DA from year t (the year of IPO)

to t+2 less the DA in year t-1.

Local Auditors: Dummy variable, which equals 1 if a client’ s registry province or provincial-level region is the same as that of its auditor.

Less Developed Regions: Dummy variables, which equals 1 if a province ’ average legal environment index over 2002-2003 constructed by Fan and Wang (2005) is below the 60th percentile value and 0 otherwise.

Size: The natural logarithm of the total assets in year t-1.

Leverage: The total liability divided by the total assets in year t-1.

Allocation Rate: The success rates of IPO applications.

The Definition of other variables Tradable Shares: The percentage of tradable shares over the

total shares outstanding on the first day of trading.

Offering Price to Equity: The ratio of the offering price to the year-end equity per share in year t-1.

Closing Price to Equity: The ratio of the first-day closing price to the first-day equity per share.

Initial Return (IPO Underpricing): The market adjusted percentage change from offering price to the first-day closing price.

ROE: Net income divided by year-end equity in year t-1.

Growth: The percentage change in sales revenue in year t-1.

Table 2 Distribution of the Means of Variables

Panel A By Region

Full Sample Developed Less Developed t Stat.

DAt-1

(t Stat.)

0.006

(0.31)

-0.015

(-0.67)

0.023

(0.70)

-0.96

△ DA

(t Stat.)

-0.061

(-2.67)***

-0.013

(-0.47)

-0.097

(-2.85)*** 1.94*

Size 20.26 20.47 20.10 3.12***

Leverage 0.554 0.559 0.551 0.60

Tradable Shares 0.310 0.285 0.329 -4.28***

ROE 0.189 0.192 0.187 0.53

Growth 0.246 0.277 0.222 1.09

Initial Return 1.321 1.380 1.276 0.89

Offering Price to

Equity 4.094 4.220 3.995 0.99

Closing Price to

Equity 4.590 4.776 4.447 1.35

***, ** and * indicate statistical significance at the 1%, 5% and 10% levels, respectively.

4.Empirical Results

Table 2 Distribution of the Means of Variables

Panel B By Auditor Type

Less Developed Region Developed Region

Local Non-local t Stat. Local Non-local t Stat.

DAt-1 0.101 -0.051 -0.021 0.002

(t Stat.) (1.79)* (-1.58)

2.34**

(-0.87) (-0.05)

-0.43

△ DA -0.184 -0.016 -0.023 0.013

(t Stat.) (-3.10)*** (-0.47)

-2.44**

(-0.77) -0.215

-0.53

Size 20.03 20.17 -1.22 20.18 21.32 -3.64***

Leverage 0.552 0.55 0.11 0.555 0.567 -0.52

Tradable Shares 0.321 0.337 1.37 0.304 0.234 3.37***

ROE 0.192 0.172 1.40 0.202 0.15 2.87***

Growth 0.232 0.212 0.31 0.303 0.211 0.97

Initial Return 1.137 1.407 -2.10** 1.531 0.983 3.31***

Offering Price to

Equity 4.282 3.785 1.66* 4.420 3.693 1.91*

Closing Price to

Equity 3.997 4.779 -2.53** 5.007 4.166 2.00**

***, ** and * indicate statistical significance at the 1%, 5% and 10% levels, respectively.

Table 3 The Impact of Legal Environments and Auditor Choice on Audit Quality

Panel A Dependent variable: Discretionary Accrual (DAt-1)

Full Sample Developed Less Developed

Intercept -1.493**

(-2.04)

-0.579

(-0.64)

-1.440

(-1.29)

Local Auditors 0.101**

(2.50)

0.014

(0.22)

0.154**

(2.51)

Size 0.064**

(2.12)

0.029

(0.81)

0.062

(1.31)

Leverage -0.539***

(-3.27)

-0.256

(-1.31)

-0.702

(-2.87)

Offering Price to Equity 0.210***

(4.21)

0.082

(1.29)

0.273***

(3.79)

Tradable Shares 0.853**

(2.30)

0.279

(0.60)

1.069**

(1.99)

ROE -0.900***

(-3.95)

-0.511

(-1.96)

-1.141***

(-3.28)

N 355 143 212

Adj. R2 0.12 0.01 0.16

***, ** and * indicate statistical significance at the 1%, 5% and 10% levels, respectively. The results reported are regressed using OLS approach and are consistent with those obtained using 2LSL to control for the possible endogenous effects of auditor choice.

Table 3 The Impact of Legal Environments and Auditor Choice on Audit Quality

Panel B Dependent Variable: Change in Disretionary Accrual (△ DA)

Full Sample Developed Less Developed

Intercept 0.897

(1.18)

0.291

(0.29)

0.809

(0.68)

Local Auditors -0.119**

(-2.51)

-0.037

(-0.55)

-0.163**

(-2.50)

Law 0.013

（0.81）

0.040

(0.27)

0.050

(1.14)

Size -0.029

（-0.95）

-0.003

(-0.09)

-0.033

(-0.66)

Leverage 0.493***

（2.79）

0.235

(1.04)

0.682***

(2.62)

Offering Price to Equity -0.255***

（-4.72）

-0.175**

（-2.33）

-0.294***

(-3.85)

Tradable Shares -0.845**

（-2.10）

-0.402

(-0.74)

-1.059*

(-1.85)

ROE 0.908***

（3.64）

0.586*

(1.86)

1.120***

(3.03)

N 355 143 212

Adj. R2 0.12 0.02 0.15

***, ** and * indicate statistical significance at the 1%, 5% and 10% levels, respectively.

Table 4 T h e Im p a ct o f A u d ito r C h o ice o n A u d it Q u a lity fo r F irm s L o ca ted in L eg a lly L ess D ev e lo p ed R eg io n s

Discretionary Accrual (DAt-1) Change in Discretionary Accrual ( DA△ )

Intercept -1.410

(-1.26)

0.778

(0.66)

Auditors from Less Developed

Regions

-0.025

(-0.35)

0.026

(0.34)

Local Auditors 0.169**

(2.28)

-0.177**

(-2.28)

Size 0.060

(1.27)

-0.032

(-0.63)

Leverage -0.705***

(-2.87)

0.684***

(2.62)

Tradable Shares 1.074**

(1.99)

-1.065*

(-1.86)

Offering Price to Equity 0.273***

(3.78)

-0.294***

(-3.84)

ROE -1.143***

(-3.28)

1.122***

(3.03)

N 213 213

Adj. R2 0.15 0.14

***, ** and * indicate statistical significance at the 1%, 5% and 10% levels, respectively.

Table 5 The Impact of Legal Environments and Auditor Choice on Initial Return

(1) (2)

Intercept 9.992***

(6.17)

9.325***

(5.66)

Local Auditors -0.048

(-0.43)

0.235

(1.28)

Less Developed Regions -0.219*

(-1.96)

0.006

(0.36)

Less Developed Regions ×

Local Auditors

-0.440**

(-1.99)

ROE -1.738***

(-2.90)

-1.787***

(-2.99)

Size -0.411***

(-5.92)

-0.389***

(-5.55)

Leverage 0.009

(0.02)

0.025

(0.06)

Growth 0.077

(0.67)

0.074

(0.64)

Tradable Shares -1.142

(-1.38)

-1.104

(1.34)

Allocation Rate -0.108

(-1.40)

-0.107

(-1.38)

Industries and Years control control

N 312 312

Adj. R2 0.25 0.25

The dependent variable is the market adjusted percentage change from offering price to the first-day closing price. ***, ** and *

indicate statistical significance at the 1%, 5% and 10% levels, respectively. The results reported are regressed using OLS approach

and are consistent with those obtained using 2LSL to control for the possible endogenous effects of auditor choice

Table 6 The Impact of Legal Environments and Auditor Choice on Offerring and Closing Price

Offering Price to Equity Closing Price to Equity

Intercept 13.162***

(4.42)

25.010***

(7.95)

Local Auditors -0.034

(-0.12)

0.397*

(1.96)

Less Developed

Regions

-0.368

(-1.28)

0.090

(0.30)

Less Developed

Regions×

Local Auditors

0.400

(1.14)

-0.895**

(-2.41)

ROE 8.879***

(8.17)

-0.593

(-0.52)

Size -0.517***

(-4.08)

-0.982***

(-7.33)

Leverage 0.091

(0.12)

0.593

(0.72)

Growth -0.192

(-0.92)

-0.101

(-0.45)

Tradable Shares -3.043**

(-2.03)

-6.007***

(-3.80)

Allocation Rates -0.309**

(-2.10)

-0.378**

(-2.20)

Industries and Years Control Control

N 312 312

Adj. R2 0.35 0.37

***, ** and * indicate statistical significance at the 1%, 5% and 10% levels, respectively.

5.Conculsions In regions with less developed legal institutions the audit

quality of local auditors are lower than non-local auditors; Whereas in regions with developed legal institutions there are no differences in audit quality of local and non-local auditors.

In regions with less developed legal institutions the initial return of clients of local auditors is lower than of non-local auditor, whereas in regions with developed legal institutions there are no differences in initial return between clients of local and non-local auditors, suggesting that the initial return is positively related to audit quality in Chinese IPOs market.

6.Proposal for Future Research The Impact of CSRC Enforcement Actions on

audit quality Governmental Investigation and Earnings Management

Cahan (1992): The Effect of Antitrust investigations on discretionary accruals.

Jones (1991): Earnings management during import relief investigations.

Studies on Firms Subjected to Enforcement Actions by the Security Regulatory Agencies

Dechow, et al. (1996): Causes and consequences of earnings manipulation

Bonner, et al. (1998): Fraud type and auditor litigationChen, et al. (2005): Is China’s securities regulatory agency a toot

hless tiger?

ThanksThanks ！！

Yunxia BaiYunxia Bai

NOV. 17, 2008NOV. 17, 2008

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