Legal Environments,
Audit Quality and Initial Return:
Evidence from Chinese IPOs of SOEs
Yunxia Bai
Guanghua School of Management
Peking University
1.Introduction

Research questions
Does legal environments affect audit
quality?
Does audit quality convey information
in an initial public offering?

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
the 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), 811848.

Existing literature
On Initial Return
Audit quality and IPO underpricing
Almost all literature exhibits that audit quality is
inversely 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
jointly 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
2.Hypotheses

Hypothesis 1:
 The difference in audit quality between local and
non-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.
 Hypothesis 2:
 The difference in initial return between clients of
local 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.
3.Research Design
3.1 The data
Table 1
Sample Distribution
1999-2003
1999
2000
2001
2002
2003
Developed
144
28
46
30
23
17
Less Developed
211
50
67
36
33
25
Full Sample
355
78
113
66
56
42
Panel A
Panel B
By Region
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.
3.2 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):





TAC j .t A j .t 1   0 1 A j .t 1   1 (REV j .t  AR j .t ) A j .t 1   2 PPE j .t A j .t 1
For firm i in year t,
TAC j .t ：Total accruals (=Net income-Operating cash flow)
A j .t 1 ：Total assets
REV j .t ：The change in sales revenue
AR j .t ：The change in accounts receivables
PPE j .t ：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.
4.Empirical Results
Table 2
Panel A
Distribution of the Means of Variables
By Region
Full Sample
Developed
Less Developed
t Stat.
DAt-1
0.006
-0.015
0.023
-0.96
(t Stat.)
(0.31)
(-0.67)
(0.70)
△DA
-0.061
-0.013
-0.097
(t Stat.)
***
***
1.94*
(-2.67)
(-0.47)
(-2.85)
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
4.094
4.220
3.995
0.99
4.590
4.776
4.447
1.35
Offering Price to
Equity
Closing Price to
Equity
***, ** and * indicate statistical significance at the 1%, 5% and 10% levels, respectively.
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
2.34**
-0.021
0.002
-0.43
(t Stat.)
(1.79)*
(-1.58)
(-0.87)
(-0.05)
△DA
-0.184
-0.016
-0.023
0.013
(-3.10)***
(-0.47)
(-0.77)
-0.215
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***
4.282
3.785
1.66*
4.420
3.693
1.91*
3.997
4.779
-2.53**
5.007
4.166
2.00**
(t Stat.)
Offering Price to
Equity
Closing Price to
Equity
-2.44**
***, ** and * indicate statistical significance at the 1%, 5% and 10% levels, respectively.
-0.53
Table 3 The Impact of Legal Environments and Auditor Choice on Audit Quality
Panel A Dependent variable: Discretionary Accrual (DAt-1)
Intercept
Local Auditors
Full Sample
Developed
Less Developed
-1.493**
-0.579
-1.440
(-2.04)
(-0.64)
(-1.29)
0.101
0.014
0.154**
(2.50)
(0.22)
(2.51)
0.064
0.029
0.062
(2.12)
(0.81)
(1.31)
-0.256
-0.702
(-1.31)
(-2.87)
0.082
0.273***
(4.21)
(1.29)
(3.79)
0.853**
0.279
1.069**
(2.30)
(0.60)
(1.99)
-0.511
-1.141***
(-3.95)
(-1.96)
(-3.28)
355
143
212
0.12
0.01
0.16
**
**
Size
Leverage
***
-0.539
(-3.27)
Offering Price to Equity
Tradable Shares
***
0.210
***
ROE
-0.900
N
2
Adj. R
***, ** 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
Panel B
The Impact of Legal Environments and Auditor Choice on Audit Quality
Dependent Variable: Change in Disretionary Accrual (△DA)
Intercept
Local Auditors
Law
Size
Full Sample
Developed
Less Developed
0.897
0.291
0.809
(1.18)
(0.29)
(0.68)
-0.037
-0.163**
(-2.51)
(-0.55)
(-2.50)
0.013
0.040
0.050
（0.81）
(0.27)
(1.14)
-0.029
-0.003
-0.033
（-0.95）
(-0.09)
(-0.66)
0.235
0.682***
(1.04)
(2.62)
-0.119
**
***
Leverage
0.493
（2.79）
***
Offering Price to Equity
-0.255
（-4.72）
ROE
N
2
Adj. R
-0.175
-0.294***
（-2.33）
(-3.85)
-0.402
-1.059*
（-2.10）
(-0.74)
(-1.85)
0.908***
0.586*
1.120***
（3.64）
(1.86)
(3.03)
355
143
212
0.12
0.02
0.15
**
Tradable Shares
**
-0.845
***, ** and * indicate statistical significance at the 1%, 5% and 10% levels, respectively.
Table 4
The Impact of Auditor Choice on Audit Quality for Firms Located in Legally Less Developed Regions
Discretionary Accrual (DAt-1)
Change in Discretionary Accrual (△ DA)
-1.410
0.778
(-1.26)
(0.66)
Auditors from Less Developed
-0.025
0.026
Regions
(-0.35)
(0.34)
0.169**
-0.177**
(2.28)
(-2.28)
0.060
-0.032
(1.27)
(-0.63)
-0.705***
0.684***
(-2.87)
(2.62)
1.074**
-1.065*
(1.99)
(-1.86)
0.273***
-0.294***
(3.78)
(-3.84)
-1.143***
1.122***
(-3.28)
(3.03)
N
213
213
Adj. R2
0.15
0.14
Intercept
Local Auditors
Size
Leverage
Tradable Shares
Offering Price to Equity
ROE
***, ** 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
Intercept
Local Auditors
Less Developed Regions
(1)
(2)
9.992***
9.325***
(6.17)
(5.66)
-0.048
0.235
(-0.43)
(1.28)
*
-0.219
0.006
(-1.96)
(0.36)
-0.440**
Less Developed Regions ×
Local Auditors
(-1.99)
***
-1.738
ROE
(-2.90)
***
-0.411
Size
Leverage
Growth
Tradable Shares
Allocation Rate
Industries and Years
N
2
Adj. R
-1.787***
(-2.99)
-0.389***
(-5.92)
(-5.55)
0.009
0.025
(0.02)
(0.06)
0.077
0.074
(0.67)
(0.64)
-1.142
-1.104
(-1.38)
(1.34)
-0.108
-0.107
(-1.40)
(-1.38)
control
control
312
312
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
Intercept
13.162
***
Closing Price to Equity
25.010***
(4.42)
(7.95)
-0.034
0.397*
(-0.12)
(1.96)
Less Developed
-0.368
0.090
Regions
(-1.28)
(0.30)
0.400
-0.895**
(1.14)
(-2.41)
8.879***
-0.593
(8.17)
(-0.52)
Local Auditors
Less Developed
Regions×
Local Auditors
ROE
***
-0.517
Size
Leverage
Growth
(-4.08)
(-7.33)
0.091
0.593
(0.12)
(0.72)
-0.192
-0.101
(-0.92)
(-0.45)
**
Tradable Shares
-3.043
(-2.03)
**
Allocation Rates
Industries and Years
N
2
Adj. R
-0.982***
-6.007***
(-3.80)
-0.309
-0.378**
(-2.10)
(-2.20)
Control
Control
312
312
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 nonlocal 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 litigation
 Chen, et al. (2005): Is China’s securities regulatory agency a
toothless tiger?
Thanks！
Yunxia Bai
NOV. 17, 2008
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