Auditors’ Role in China: The Joint Effects of Incentive and Regulatory Sanction on Earnings
Management Attempts
Ning Du
Associate Professor
School of Accountancy and Management Information Systems
DePaul University
One East Jackson Boulevard, Chicago, Il 60604
Phone: 312-362-8308
Email: [email protected]
Joshua Ronen
Professor
Stern School of Business
New York University
44 West 4th St. New York, NY 10012
Phone: 212-998-4144
Email: [email protected]
Jianfang Ye
Associate Professor
Institute of Accounting and Finance
Shanghai University of Finance and Economics
No. 777 Guoding Road, Shanghai, P.R.China 200433
Phone: 86-21-65903253
Email: [email protected]
1
Auditors’ Role in China: The Joint Effects of Incentive and Regulatory Sanction on
Earnings Management Attempts
In this study we strive to gain insights into auditors’ behaviors in the unique setting of
China. Specifically, we focus on the role of Chinese auditors in detecting and preventing
earnings management. We conduct a 2X2 between-subject randomized experiment with 174
Chinese auditors evaluating a short case where managers have incentive to classify financial
assets for earnings management. We manipulate two conditions, 1) managers’ incentives for
earnings management attempts (EMA) by varying prior operating performance, and 2) the
severity of regulatory sanctions/penalties. Our results show that auditors are aware of the use of
investment transactions for earnings management; however, they believe managers’ choices are
ethical when there is a high need for earnings management. In addition, we find harsh
penalty/sanction to be effective in improving performance, especially when earnings
management incentive is high, but the use of harsh penalty/sanction can be a double-edged saw,
in that, when managers have low earnings management incentives, harsh penalty/sanction may
undermine auditors’ ability to correct earnings management attempts.
2
I. Introduction
Since the latter part of 2010 investors have lost billions of dollars as stocks of many
Chinese companies have plunged. The string of accounting scandals at many publicly traded
Chinese companies has sparked deep concerns about the quality of financial reporting of Chinese
firms. Recently the PCAOB and the SEC have sought to investigate some of the audit firms
involved with US listed Chinese companies, but their efforts have been stymied by Chinese
authorities. These tensions reached a climax when Deloitte's Chinese arm refused to turn over
documents tied to a U.S.-listed client under SEC investigation, citing prohibition by the Chinese
government. In September 2012, after trying for years to gain access to China, the PCAOB
finally reached a tentative agreement to observe official auditor inspections in China. The
agreement permits the observers to watch Chinese officials' examination of audit firms' quality
controls, but do not allow detailed reviews of specific audits. The concerns about audit quality
of Chinese companies are further fueled by a recent rule by the Chinese government to assert
more control over Chinese affiliates of major accounting firms. The new rule limits the
percentage of foreign-qualified partners and requires the Big Four accounting firms to appoint
Chinese citizens to head their mainland operations. The shift to domestic auditors highlights the
importance of understanding whether or not Chinese auditors are able to maintain independence
in the financial reporting process.
Similar to managers in other countries, managers of Chinese companies have strong
incentives to manage earnings. In China, listed companies have to meet the target profitability
level at the time of an IPO or to avoid being delisted (Jian and Wong 2010). In a recent study, He
et al. (2012) find that Chinese managers “cherry pick” their investment portfolio and are more
likely to sell AFS securities for a gain to avoid reporting financial losses. However, limited
3
understanding exists about Chinese auditors’ role in detecting and preventing opportunistic
management behaviors and curtailing aggressive financial accounting practices. China has been
trying to harmonize its audit standards with the international standards and to regulate the
behavior of auditors. Prior research evidence (e.g. DeFond et al. 2000) indicates that auditors can
and do provide high-quality audits in China, especially after regulations intended to increase
auditor independence. However, enforcing those regulations have been problematic in China.
The new Chinese Accounting Standards (CAS) adopted in 2007 are substantially in line with
IFRS and cover most of the topics therein, but the Chinese market is unique in many aspects: it
has high ownership concentration with a strong government influence, a weak legal system, a
negligible market control mechanism, the prevalence of related-party transactions, and an
inefficient managerial labor market (Firth et.al., 2006). For example, investigating the frequency
of modified audit report, DeFond et al. (2000) find that in fear of receiving modified report,
Chinese managers would prefer smaller, less independent auditors, and avoid larger, more
independent ones. The demand for lower, rather than higher, audit quality suggests a
compromise of auditor independence in China.
Prior studies identified various economic and institutional factors, but few have examined
the psychological factor that may have contributed to the pattern of Chinese auditors’ behavior.
In China, the conduct of business is often based on personal relationships (the guanxi code of
conduct). This relationship, more than just economic dependence, is personal and psychological.
With the strong psychological bond between auditors and manages, it might be impossible
maintain independence in mind. In addition, the expectation for auditors is different in China.
Chinese firm managers, counting on this relationship, often expect auditors to help them increase
profit, conceal frauds (illegal spending, tax evasion) or cover weaknesses of their businesses
4
(Yang 1995, Xiao et al. 2000). Thus, Chinese auditors may be vulnerable to management
pressure and likely to succumb to managers’ demand for earning management. In China, auditors
operate in a less litigious environment that also lacks traditional corporate governance
mechanisms (Gul et al. 2010). Despite its increase in recent years, litigation against managers
and auditors fails to protect investors. Instead, Chinese authorities often rely on regulatory
sanctions, such as warnings, fines, or withdrawal of license or certificates to regulate the auditing
industry (Yang et al. 2001). In a recent study, Keune and Johnstone (2012) find that auditors’
incentives to protect their reputations weaken the effect of managerial incentives for earnings
managements. As regulatory sanctions damage auditors’ reputation, penalty/sanction may serve
as a mechanism to improve auditor independence and substitute for a litigious environment to
encourage high quality auditing.
In this study we strive to gain insights into auditors’ behaviors in the unique setting of
China. Specifically, we focus on the role of Chinese auditors in detecting and preventing
earnings management. We propose that due to the unique culture in China, Chinese auditors may
not perceive earnings management, especially, those related to accounting transactions, as
unethical. This belief may undermine auditors’ willingness to correct earnings management. In
addition, we investigate whether an increased level of regulatory sanctions may weaken the
psychological tie between manager and auditor, and improve auditors’ performance. Because
both auditors and managers’ decisions are embedded in the resulting financial statements
(Nelson et al. 2002), we use an experiment to disentangle auditors’ decisions from those of
managers. We conduct a 2X2 between-subject randomized experiment with 174 Chinese auditors
evaluating a short case where managers have incentive to classify financial assets for earnings
management. We manipulate two conditions, 1) managers’ incentives for earnings management
5
attempts (EMA) by varying prior operating performance, and 2) the severity of regulatory
sanctions/penalties. Our results show that auditors are aware of the use of investment
transactions for earnings management; however, they believe managers’ choices are ethical when
there is a high need for earnings management. In addition, we find harsh penalty/sanction to be
effective in improving performance, especially when earnings management incentive is high, but
the use of harsh penalty/sanction can be a double-edged saw, in that, when managers have low
earnings management incentives, harsh penalty/sanction may undermine auditors’ ability to
correct earnings management attempts. Our study contributes to prior literature on auditors’
judgments. We identify and find evidence of a psychological force that may impair auditors’
independence in China. In addition, we provide direct evidence about the effects of regulatory
sanctions on auditors’ behaviors. Our evidence suggests that in countries with limited investor
protection, such as China, auditors will play a meaningful role in curtailing earnings
management attempts as long as there is a adequate regulatory enforcement in place.
II. Background and Literature Review
Auditors and Earnings Management
The quality of financial reporting depends on auditor independence. Prior research find
that auditor independence is affected by many factors such as audit fees, client sizes, non-audit
service, competition, audit firm size, regulation and reputation (DeFond et al. 2002, Ashbaugh et
al. 2003, Shockley 1981, Magee and Tseng 1990, Arrunada 2000, Wilson and Grimlund 1990,
DeAngelo 1981b, DeFond et al. 2000). Because auditors have to consider client retention,
sufficient evidence, immateriality, and/or compliance of rule and regulation, whether or not and
how much to correct earnings management attempts is a complex decision (see Nelson et al.
6
2003). Anderson et al. (2004) find that auditors are sensitive to the potential for earnings
management. They examine how quantification and the strength of earnings management
incentive influence the persuasiveness of management-provided explanations for an unexpected
balance in an account requiring significant estimation (i.e., revenue). They find that auditors are
skeptical of managers’ explanation when managers have strong incentives for earnings
management and are not more persuaded by a quantified explanation from management. In
addition, the authors find that auditors’ planning judgments were influenced similarly by
incentives to manage earnings. Results from Anderson et al. (2004) suggest auditors are quite
capable of maintaining independence in mind.
Other studies find that auditors’ ability to curtail earnings management may be limited.
Hackenbrack and Nelson (1996) find auditors’ decisions about earnings management attempts
depend on perceived audit risk. Specifically, auditors responded to moderate engagement risk by
permitting the aggressive reporting method and justified their choice with aggressive
interpretations of accounting standards; when faced with high engagement risk, the auditors
responded by requiring conservative reporting and justified their choice with conservative
interpretations of accounting standards (Hackenbrack and Nelson 1996). In addition, evidence in
Libby and Kinney (2000) shows that auditors are often opportunistic in correcting managers’
overstatement. They find that Big Five audit managers are less likely to correct managers’
overstatement in earnings when the correction would cause the company to miss the analysts’
consensus earnings forecast. Nelson et al. (2003) surveyed audit partners and managers from one
Big Five firm with a focus on managers’ decisions to attempt earnings management (EM) and
auditors’ decisions to waive earnings management attempts (EMAs). Results from their survey
show that even when auditors require adjustment for EMAs, they sometimes waive these
7
adjustments because a) they believe the EMA is allowed by GAAP, b) they lack sufficient
evidence of client’s incorrect position, or c) because of other reasons such as immateriality. In
addition, they find that auditors are more likely to waive an EMA that is structured (Nelson et al.
2003).
Auditor Independence in China
Though Chinese auditing standards are very similar to the international audit standards,
Chinese auditing operates in a very different environment from those experienced in Western
countries. The close links between the government and the audit practices and the adherence to
the guanxi code of conduct in the business culture deepens the concern about the lack of
independence in the Chinese auditing industry. First of all, significant conflicts of interests exist
in Chinese auditing practice. Historically, the majority of CPA firms were established by the
government and sponsored by the state. At the national level, the Chinese auditing profession is
not self-regulated, but government regulated. The audit-government association suggests that the
audit firm, in essence, is a government entity. Similarly, the controlling shareholders of many
listed or unlisted companies are also government entities. The government ownership of both
clients and their auditing firms makes it difficult for auditors to distance themselves from the
client and thus have a truly independent state of mind. Even though many firms have gone
through a disaffiliation program and are no longer owned by the government, the association still
exists informally because of the profession's historical ties with the government.
Despite the institutional feature, the unique business culture in China presents a challenge
for auditor independence. Auditors’ reputation is established and maintained by fulfilling the
obligations of guanxi (personal relationship), rather than by reporting modified opinions fairly
8
and trustfully. In the Chinese language guanxi refers to the network(s) of existing informal
relationships and favors’ exchange that dominate all businesses and social activities throughout
the country (Lovett et al. 1999). Guanxi is deeply rooted in the Chinese culture. Business people
first build personal relationships with potential customers, and then business will normally
follow the formation of a group (Hwang and Staley 2005). Guanxi creates obligations to conduct
business within the formed group and obligations to pay back associated debts. To ensure the
smooth operation of Guanxi, group members are expected to do favors for each other and meet
the expectation of the other members. If they fail then a loss of prestige and trust will follow.
Thus, in the Chinese culture, the establishment, development and maintenance of the guanxi
code are a fundamental priority of many business people in the country (Hwang and Baker 2000).
The force of guanxi is often subtle and unspoken, but it is well understood by the members of the
network. Auditing industry is no exception. Unlike the economic dependence exists between
auditors and their clients (e.g., DeAngelo 1981b), guanxi connects auditors and their clients
psychologically and establishes a personal relationship between these two parties. Auditors are
expected to help managers in their business and meet managers’ expectations. In China, the
delisting rule (i.e., a firm will be delisted if it reports a loss in three consecutive years) creates
strong incentives for firms to manage earnings in order to maintain listing status. Given this
strong focus on profit, managers may expect auditors to help them avoid losses. Knowing this
expectation, auditors may become a willing participant in the act of earnings management. In
fact, many problems relating to Chinese auditing practice can be attributed to the guanxi network
where auditors act as an advocate for the manager, and even collaborate with the manager in the
illegal or unethical acts. For example, Yang et al. 2003 find that the clients in many cases
committed illegal acts, such as the forgery of accounts to mask true financial positions, evade tax,
9
embezzle state revenue, and appropriate state assets; the auditors involved in these cases were
found to be materially negligent or fraudulent, guilty of intentionally helping clients to falsify
accounts, or guilty of providing false certificates of capital contribution verification and
unqualified audit reports (Yang et. al 2003). This line of reasoning suggests that there exists a
personal relationship between Chinese managers and their auditors. The strong psychological
bond makes it difficult for Chinese auditors to maintain dependence in mind during the audit
work. Thus, we provide our hypothesis one in a null form.
H1: Chinese auditors are not sensitive to earnings management attempts.
Regulatory Enforcement in China
Prior research identifies investor protection and securities regulations as key institutional
factors which may jointly affect corporate policy choices (see Shleifer and Vishny 1997, La
Porta et al. 2000). Extensive investor-protection rights empower investors to sue management
and auditors if audited earnings are questionable (Francis and Wang 2008). The Chinese market
is characterized as low in investor protection. In China, auditors operate in an environment which
is almost devoid of investor litigation and lacks traditional corporate governance mechanisms
(Graham1996, DeFond et al. 2000, Gul et al. 2003, Gul et al. 2010). Despite the increase in
litigation against managers and auditors in recent years, the auditing industry is mostly regulated
by the government’s use of warnings, fines, withdrawal of certificate, and other sanctions (Yang
et al. 2001).
The enforcement of securities regulations is jointly carried out by the Chinese Institute of
Certified Accountants (CICPA) and China Securities Regulatory Commission (CSRC). CICPA
is responsible for developing and enforcing Independent Auditing Standards by periodically
10
conducting auditor practice reviews and taking “punitive measures” against auditors for noncompliance. Penalties for violating auditing standards in China can be harsh. Examples include
revocation of the auditor's license to practice and even imprisonment. CSRC was created in 1992
and governs over all securities exchanges and futures markets activity within China. Similar in
its role to the Securities and Exchange Commission (SEC) in the United States, the CSRC is the
regulatory body that enforces securities laws and regulations. The CSRC imposes various
sanctions against auditors such as admonitions (correcting the situation, internal criticism, public
criticism in newspapers and on websites), fines, and temporary loss of license to practice, or
more severe measures such as permanent loss of license to practice, damages, penalties, and even
criminal prosecution. The subjects of punishment include listed firms, the directors of listed
firms, supervisors, listing sponsors, and secretaries of boards of directors (Chen et al. 2005, Mao
2002).
In a recent study, Jaggi and Low (2011) document a positive relationship between audit
quality and the strictness of securities regulation in low investor-protection countries. They
hypothesize that when audit risk is low in low investor-protection countries, investors lack power
and incentives to sue managers and auditors, but strict securities regulations increase audit risk
and the scope of audit work because violation of securities regulations may result in fines and
other penalties. Moreover, DeFond and Hung (2004) argue that law enforcement institutions are
more important than investor protection laws in encouraging good corporate governance
practices, which, in turn, leads to increased investor confidence. In a recent study, Keune and
Johnstone (2012) examine the detected misstatements, and find that auditors are less likely to
allow managers to waive material misstatements when managers have strong incentives to
manage earnings. Their evidence supports the notion that despite auditors’ catering to managers
11
for economic reason, auditors protect their reputation by rejecting managers’ demands when
downside risk to doing so is high (Reynolds and Francis 2001). Being penalized by regulatory
agency potentially ruins auditors’ reputation and bring disgrace to all members in the guanxi
network. Thus, we expect auditors’ incentives to protect their reputations may improve auditor
independence.
The above discussion suggests that Chinese auditors are entrenched in the guanxi culture
and psychologically connected to their clients. This psychological tie created by guanxi leads
auditors to trust their clients and acted as an advocate for the client. However, regulatory
sanction may ruin the reputation of auditors, and constrains auditors’ catering to managers.
Because of weak investor protection in China, regulatory enforcement plays an important role in
maintaining the integrity of the financial reporting process, we expect the strictness of
punishment and sanction by the regulatory agency to influence the extent to which Chinese
auditors are willing to challenge managers’ position. As the harshness of penalties increases,
auditors will assess higher audit risk, which affects the level of effort planned for the audit, and
be more likely to correct earnings management attempts. We consider harsh penalties such as the
permanent loss of license to practice, damages, penalties, and even criminal prosecution, as well
as mild penalties including admonitions (such as internal or public warning and criticism on the
newspaper or website), fines, and temporary loss of license to practice. This leads to our second
and third hypotheses.
H2: The effect of earnings management on auditors’ recommendation for corrective
action is greater under harsh penalties than under weak penalties.
12
H3: The effect of earning management on auditors’ risk assessment is greater under
harsh penalties than under weak penalties.
III. METHOD
We test our hypotheses in a randomized 2X2 experiment. We manipulate earnings
management incentives (weak vs. strong) and the severity of regulatory punishment (mild vs.
harsh) as between-subjects variables. Participants evaluated a short case and then made
judgments related to the case.
Participants
The experiment was conducted at the Chinese National Accounting Institute, where
Chinese CPAs attend annual training sessions held by the Chinese Institute of Certified Public
Accountants (CICPA) for continuing education credits. All of the auditors are from the top 100
accounting firms in China and audit domestically listed companies (A shares) on the Shanghai
and Shenzhen stock exchange in 2012. Auditors volunteered to participate at the end of a training
session in response to in-class announcements made by the training officer. All experimental
instruments were translated from English to Chinese and presented to participating auditors in
Chinese.
In total, we received 181 completed instruments. Seven were deleted because of failing
the manipulation check; so our sample includes 174 auditors, 93 male and 81 female. 139 of
them have CPA designation. Among all the auditors, 24 are partners, 83 managers, 43 senior
auditors, and 24 junior auditors. In terms of education, 155 auditors have bachelor’s degrees, 17
have master degrees, and 2 have doctor’s degrees (see Panel A of Table 1). The average auditing
experience for the sample is 8.83 years. In terms of audit firm size, 19 auditors work for audit
firms with less than 50 auditors, 24 for firms with 50 to 100 auditors, and 131 for firms with
13
more than 100 auditors. In addition, we examine the industry specialization of participating
auditors, 65% specialize in the manufacturing industries, 14% in the service industry, 7% in the
finance industry, 4% in real estate, 2% in the not for profit sector, and 8% in other industries.
To gain a better understanding of the Chinese auditing practice, we asked auditors to
answer three questions about corporate policy decisions. Our first question was as follows:
“Given your experience, please indicate who hires the auditor.” Ninety-eight auditors selected
management, 17 selected audit committees, and 59 selected the Board of Directors. Second, we
asked: “Given your experience, indicate who decides on the audit fee”. Ninety-two selected
management, 26 selected audit committees, and 56 selected the Board of Directors. Last, “Given
your experience, indicate who most likely chairs the Board of Directors.” Forty-six selected
management, and 128 selected major stakeholders. Clearly, auditors view management as
exerting a significant influence on auditor hiring and audit fee decisions, and indicates a weak
corporate governance structure in China. Lastly, we asked auditors to list the common penalties
for CPAs and CPA firms. Internal criticism was listed 14 times, warnings, 24 times; public
criticism in newspaper or websites, 9 times; fines, 4 times; temporary loss of license and
certificate, 23 times; permanent loss of license and certificate, 78 times; criminal prosecution, 27
times; and civil liability, 12 times.
[Insert Table 1]
Procedure and Task
In this study, we investigate the role played by Chinese auditors to limit earnings
management with a focus on managers’ investment transactions decisions. We select the sale of
financial assets in the Chinese market as the experiment setting for two reasons. First, the
adoption of the new Chinese Accounting Standards (CAS 22) in 2007, which is essentially in
line with IFRS, requires a shift from historical cost to fair value accounting in investment
14
valuation. The shift represents a significant change in standards and requires adjustments in
practices at both the firm and the individual levels, and presents opportunity for earnings
management. It also allows us to examine the extent to which auditors tolerate managers’
aggressive accounting choices. Second, Unlike SFAS 115 and IAS 39 which state that AFS can
be classified as either current or noncurrent assets, CAS 22 classifies AFS as noncurrent assets.
By this classification any investment with intent to sell within 12 months should be designated as
trading securities and beyond 12 months as AFS. Because the longer time horizon associated
with AFS allows managers to sit on the financial assets and wait for the right moment to sell,
many Chinese companies choose not to designate the securities as part of a trading portfolio;
rather, they simply classify the investment as AFS despite the initial intention to sell in the short
term. Once an opportunity for sale arises within a year (e.g., as a result of higher stock prices),
some managers claim a change in initial holding intent and sell the investment for gains.
Falsifying the initial investment holding intention (designed to manage earnings) is clearly in
violation of CAS 22. Thus, earnings management associated with investment classification in
China presents an unambiguous setting to investigate auditors’ role in curbing EM.
In the experiment, we asked the participating auditors to assume they are independent
auditors recently hired by Company A. Specifically, they were told that A is an investment firm
listed in the Shanghai stock exchange with a fiscal year ending on December 31, 2011; and
during their 2011 audit, they had noticed some transactions which may require further
investigation. In the weak earnings management (EM) incentives condition, participants were
told that “During your audit, you noticed that Company A has been profitable in the past two
years.” In the strong EM condition, they are told that “During your audit, you noticed that
Company A has suffered financial losses in the past two years. In addition, the management of
15
Company A approached you and expressed concerns that future losses may lead to delisting the
firm from the Shanghai stock exchange.” In both conditions, participants were provided the
following information about A’s investment in X:





As of December 31, 2011, Company A has 3% equity ownership of Company X. This
ownership was purchased on August 15, 2011 and was subsequently sold on February 21,
2012.
This ownership was initially classified as available for sale (AFS) equity investment.
However, the holding period for these equity shares turned out to be only 6 months, less
than one year.
An explanation was provided about the sale of the investment in X. The management
stated that it decided to sell the X shares because it changed its intended holding period.
You also noted that on February 21, 2012, Company X shares were trading at an all-time
high. The realized gain resulting from this sale on February 21 is considered to be
material.
The management of A states that given the accounting rule, they had the option of
classifying Company X shares either as trading or available for sale securities.
We manipulated the severity of penalty and sanctions against auditors at two levels, mild or
harsh. In both conditions participants were told: “While conducting your audit, you heard news
that Firm Y, a fellow CPA firm was recently sanctioned by the Chinese Securities Regulatory
Commission (CSRC). The CSRC found that the financial statements of the company audited by
Firm Y were materially misstated, and thus imposed significant penalties on Firm Y.” The harsh
penalty condition includes the following statement: “Sanctions against Firm Y included the
permanent loss of license to practice, damages, penalties, and criminal prosecution.” On the
other hand, the statement in the low penalty condition was: “Sanctions against Firm Y included
admonitions (such as public warning and criticism on the newspaper), fines and temporary loss
of license to practice.”
After reading the short case, participants were asked to answer a series of questions. At the
end of the experiment participants answered a series of manipulation checks and demographic
16
questions and were fully debriefed. The entire experiment took 30 minutes on average to
complete.
IV. RESULTS
Manipulation Checks and Post Experimental Questions
To ensure that auditors had the adequate knowledge for this experiment, we asked them
to evaluate the following questions on an 11 point scale, 1 being small and 11 being large: 1)
Indicate the extent of your familiarity with the Chinese delisting rule upon 3 years’ consecutive
losses; 2) Please indicate to what extent you are familiar with the investment classification
(trading vs. available for sale) rule. Descriptive statistics provided in Table 2 indicate that
auditors are very familiar with the delisting rule (mean = 9.44) and fairly familiar with the
investment designation rule (mean = 8.47).
To evaluate the validity of the earnings management incentive manipulation, we asked
participants whether Company A suffered losses in the past two years. Seven auditors failed to
choose the correct answer. Therefore, we excluded these auditors from the sample we analyzed
(Note: Results do not change if these seven auditors are included in the analysis). All these
questions suggest that our manipulation for EM incentive is effective. In addition, we asked one
question related to penalty: “Please rate the severity of CSRC sanctions against the CPA firms”
on an 11 point scale (1 being low and 11 being high). We find that participants in the mild and
harsh penalty groups differ significantly across penalty conditions, with means of 7.48 for the
mild condition and 8.70 for the harsh condition (mean difference = 1.21, t=2.4, p<0.05). This
evidence suggests the manipulation of severity of penalty is effective.
[Insert Table 2]
Analysis
17
Hypothesis 1 focuses on auditors’ ability to detect earnings management. Panel A of
Table 3 presents the descriptive statistics. In the experiment, we asked the auditors to rate “How
likely is it that Company A’s sale of its Company X shares was designed to manage earnings?”
on an 11 point scale (1 being very unlikely, 11 being very likely). The high average likelihood
rating (grand mean =9.09) suggests that auditors are aware of the fact that in the present case
managers are strategically using investment decisions for earnings management. This awareness
is heightened as EM incentives increase. Table 3 presents results for ANOVA with likelihood
rating as the dependent variable. The two independent variables are EM incentives and the
severity of penalty. The analysis shows only a main effect of EM incentives (F (1, 170) =4.41, p
< 0.05) with no significant penalty and interaction effects. Apparently, auditors are more
suspicious of EM attempts as the likelihood rating is significantly higher in the strong EM
incentive condition (mean =9.46) than in the weak EM incentive condition (mean = 8.65). This
evidence rejects our null hypothesis of H1.
To unravel the psychological force underlying auditors’ responses, we asked two
additional questions related to earnings management on an 11 point scale (1 small, 11 large): 1)
Please indicate to what extent A needs to increase its earnings for 2011; 2) Please indicate how
ethical it is to manage earnings for a specific goal. Results in Table 2 indicate that auditors rate
the need for earnings management significantly higher in the strong incentive condition (mean =
10.52) than in the weak condition (mean =6.66, mean difference =3.86, t=10.6, df =172, p<0.05).
On average, auditors rate earnings management attempts as quite ethical, with an average rating
over 8. This supports the complex reactions auditors have towards the real earnings management
using transaction decision such as investment classification. Specifically, auditors in the strong
incentive condition (mean = 8.82) rate earnings management as more ethical than those in the
18
weak incentive condition (mean =7.43, mean difference = 1.39, t=3.67, p<0.05). The relation
between loss and the ethical rating for EM suggests that auditors may internally justify EM
activities. This evidence is consistent with our conjecture that auditors form personal relationship
with managers, and view themselves as an advocate for managers.
[Insert Figure 1]
[Insert Table 3]
Being able to detect EM does not necessarily mean that auditors are willing to challenge
managers’ positions. H2 predicts that auditors are more likely to recommend error correction
under strong incentives than under weak incentives, and that harsh penalties intensify this
likelihood. In the experiment, we asked auditors to answer this question: “Before the financial
statements are issued, how likely is it that you would recommend to management to include the
Company X investment in the 12/31/2011 financial statements as trading securities, rather than
available for sale securities as initially declared by Management?” on an 11 point scale (1 being
very unlikely, 11 being very likely). In this case the stocks were bought on August 15, 2011 but
subsequently sold on February 21, 2012 with a holding period of less than 6 months. CAS
classifies available for sale investment as non-current assets, so Company A clearly erred by
classifying the stocks as AFS instead of trading securities. Therefore, the corrective action would
be to reclassify AFS from noncurrent assets to trading securities as current assets in the balance
sheet.
Panel A of Table 4 provides descriptive statistics about auditors’ recommendation for
reclassification. In general, the likelihood rating is quite high (grand mean = 8.83). We observe
that the mean rating under strong EM incentive (mean=9.22) is higher than under weak EM
incentive (mean=8.35). ANOVA results (see Panel B of Table 4) indicate that, in addition to the
19
significant effects of EM incentive (F(1, 170)=10.93, p<0.05), the interaction between EM
incentive and penalty is statistically significant (F(1,170)=3.61, p<0.05). This suggests that
penalty and EM incentive jointly affect auditors’ reclassification decision with harsh penalties
intensifying the rating for reclassification. Analysis of simple effects suggests that in the mild
penalty condition, the difference in rating between weak and strong incentives is not significant,
but in the harsh penalty condition, the rating under strong EM incentives (mean = 9.45) is
significantly higher than under the weak EM incentives (mean = 8.09), (mean difference = 1.36,
p<0.05). In other words, harsh penalties magnify the effect of earnings management incentives
on auditors’ behavior. Therefore, the evidence supports H2.
[Insert Figure 2]
[Insert Table 4]
H3 investigates auditors’ assessment of audit risk. In general, auditors assess relatively
high audit risk for Company A, as the grand mean rating is 8.61 on an 11 point scale (1 being
very low, 11 being very high). ANOVA results (see Panel B of Table 5) suggest that both
independent variables of EM incentives (F(1,170)=14.88, p<0.05) and Penalties (F(1, 170)=3.81,
p<0.05) and their interactions (F(1,170)=5.89, p<0.05) are statistically significant. This suggests
that auditors’ audit risk assessment is jointly affected by EM incentives and the harshness of
penalties. Analysis of simple effects suggests that harsh penalties intensify the assessed audit risk.
In other words, auditors are more sensitive to EM incentives under that harsh penalties condition.
Specifically, auditors assess higher audit risk (mean=9.14) when they face strong EM incentives
than when facing weak EM incentives (mean=7.26), and the difference is statistically different
only under the harsh penalty condition (mean difference = 1.88, p<0.05), but the difference is not
significant under the mild penalties condition.
20
[Insert Figure 3]
[Insert Table 5]
It is puzzling that auditors rate audit risk the lowest and are least likely to recommend reclassification in the low incentive/harsh penalty condition. This seems very counter-intuitive.
We conduct simple effect analysis for re-classification recommendation and audit risk across two
different incentive conditions. The difference of re-classification decision between mild and
harsh penalty is not statistically significant in the weak incentive condition, but the difference of
audit risk is statistically significant (see Panel C of Table Five). We provide a possible
explanation for why auditors rate audit risk significantly lower in the low incentive/harsh penalty
condition. We think that auditors in our study believe harsh penalty is very serious, but highly
unlikely, and thus, they are unwilling to assess high audit risk and exert extra audit effort. This
explanation is consistent with our conjecture that auditors highly value the personal relationship
(guanxi) with manager. This evidence shows that harsh penalty/sanction can be effective in
improving auditor performance, especially when earnings management incentive is high, but the
use of harsh penalty/sanction can be a double-edged saw, in that, when managers have low
earnings management incentives, harsh penalty/sanction may undermine auditors’ ability to
correct earnings management attempts.
V. Conclusions
This study attempts to gain insight into auditors’ behavior in the unique Chinese setting.
We investigate the auditors’ role in curtailing or allowing earnings management and the potential
moderating effects of regulatory sanctions. We focus on Chinese auditors for two reasons:
Chinese companies have strong incentives to manage earnings in order to maintain listing status
and have also been historically tied to their auditors. We use a 2X2 experiment, where we
21
manipulate earnings management incentives (weak vs. strong) and auditor penalty severity (mild
vs. harsh). 174 Chinese auditors participated in the experiment and reviewed a case about equity
investment classification. Because the classification of AFS is often strategic in China, this
setting presents an unambiguous opportunity to test for earnings management, where we can
assess the auditors’ role in curbing earnings management. In the experiment, auditors were asked
to judge the likelihood for earnings management attempts and assess the likelihood for corrective
action and audit risk. Our results show that Chinese auditors are aware of the use of investment
transactions for earnings management; however, they believe managers’ choices are ethical when
there is a high need for earnings management. In addition, we find harsh penalty/sanction to be
effective in improving audit performance, especially when earnings management incentive is
high, but the use of harsh penalty/sanction can be a double-edged saw, in that, when managers
have low earnings management incentives, harsh penalty/sanction may undermine auditors’
ability to correct earnings management attempts.
This study has several limitations. The use of Chinese auditors may limit the
generalization of our findings to other countries or regions where the institutional environment is
different from that of China, or where accounting serves a different role. In addition, the
participating auditors work in Chinese domestic public CPA firms. These auditors differ from
other Chinese auditors who work for international firms, such as the Big-Four affiliates, in their
experience, knowledge, and most importantly, cultural background. Future studies should
investigate international auditors whose ability to detect and deter earnings management may be
different from that of domestic auditors. Moreover, we find Chinese auditors rate earnings
management as more ethical when managers suffer loss and have a need for earnings
management; however, we also find that these auditors recommend corrective actions and assess
22
higher audit risk when earnings management incentives are high. This appears to be a
disconnection between belief and action and requires further research. Finally, this study focuses
on the psychological aspect of Chinese auditors’ independence, but we only provide a narrow
view of the judgment and decision making process of Chinese auditors. Future studies should
investigate the underlying cognitive process and gain broader understanding of their decision
making.
23
Figure 1: Likelihood to Detect Earnings Management Rating (H1)
10
9.5
9
8.5
8
7.5
7
6.5
6
5.5
5
9.53
9.39
8.61
8.69
High Incen
Low Incent
Low Penalty
High Penalty
The figure shows the rating for the likelihood of detecting earnings management and is
based on the question “How likely is it that Company A’s sale of its Company X shares
was designed to manage earnings?” The rating is on an 11 point scale and presented in
the vertical line.
Figure 2: Re-classification Recommendation (H2)
10
9.5
9
8.5
8
7.5
7
6.5
6
5.5
5
9.45
8.98
8.61
8.09
High Incen
Low Incent
Low Penalty
High Penalty
The figure shows the rating for the question “Before the financial statements are issued,
how likely is it that you would recommend to management to include Company X
investment in the 12/31/2011 financial statements as trading securities, rather than
available for sale securities as initially decided by Management?” The rating is on an 11
point scale (1 being very unlikely, 11 being very likely). The vertical line represents the
rating scale.
24
Figure 3: Audit Risk (H3)
10
9.5
9
8.5
8
7.5
7
6.5
6
5.5
5
9
8.57
High Incen
9.14
7.26
Low Incent
Low Penalty
High Penalty
The figure shows the rating for the question “Faced with Management’s decision on the
classification as explained above, how would you assess Company A’s audit risk?” The
rating is on an 11 point scale (1 being very low, 11 being very high). The vertical line
represents the rating scale.
25
Table 1: Descriptive Statistics of Demographics
Panel A: Demographics of Participating Auditors (in Frequency)
Gender
Male
Female
Position
93
81
Partner
Manager
Senior
Auditor
Junior
Auditor
CPA
24
83
43
Yes
No
Education
139
35
Bachelor
Master
155
17
2
Doctor
24
Panel B: Questions about Corporate Policies
Auditor Audit
Hiring Fee
Management
98
92
Appointment of Chairman of
Board of Director
46
Audit
Committee
17
26
Board of
Directors
59
56
Major
Stakeholder
128
Panel A of Table 1 presents the frequency of answers to demographic questions about gender,
position, CPA designation, or education level. Panel B presents answers to three questions: 1)
Given your experience, please indicate who hires the auditor. 2) Given your experience, indicate
who decides on the audit fee. 3) Given your experience, indicate who most likely chairs the
board of directors.
For questions 1 and 2, auditors must choose one of the three: the company’s management (CEO
or CFO), the audit committee, or the Board of Directors. For question 3, auditors must choose
from the company’s management (CEO or CFO), an outsider, or a major stock holder.
26
Table 2: Descriptive Statistics of Post-Experimental Questions
Familiarity
with Delisting
Rule
Weak
Incentive Mean
Std.
N
Strong
Incentive Mean
Std.
N
Average
Familiarity with
Investment Rule
Degree to
Need for
which
Earnings
Earnings
Management
Management is
Ethical
9.61
8.33
7.43
6.66
1.77
2.26
2.51
3.27
80
80
80
80
9.36
8.57
8.82
10.52
2.30
2.05
2.44
1.21
94
94
94
94
9.44
8.47
8.18
8.74
Table 2 presents answers to these four questions: 1) Indicate the extent of your familiarity with
the Chinese delisting rule upon 3 years’ consecutive losses on an 11 point scale (1 being small,
11 being large). 2) Please indicate to what extent you are familiar with the investment
classification (trading vs. available for sale) rule on an 11 point scale (1 being small, 11 being
large). 3) Please indicate how ethical it is to manage earnings for a specific goal on an 11 point
scale (1 being unethical, 11 being ethical). 4) Please indicate to what extent A needs to increase
its earnings for 2011 on an 11 point scale (1 being small 11 being large).
27
Table 3: Likelihood of Earnings Management (Test of H1)
Panel A: Likelihood Rating (Mean) (std)
Mild Penalty
Harsh Penalty
Weak Incentives
8.69 (0.36)
n=31
8.61
(0.36)
n=49
Strong Incentives
9.53 (0.37)
n=45
9.39 (0.36)
n=49
Panel B: Two-Way ANOVA with Likelihood Rating as the Dependent Variable
Source
SS
df
MS
F
P (2-sided)
Earnings Management
Incentives
27.35
1
27.35
4.41
.04
Harshness of Penalties
0.54
1
0.54
0.09
.77
Incentives x Penalty
0.44
1
0.44
0.00
.93
Within Cells (Error)
1055
170
6.20
The tables present results related to H1: Auditors are insensitive to earnings management
attempts. The dependent variable is the likelihood rating which is on an 11 point scale (1
being very unlikely, 11 being very likely) and based on the question “How likely is it that
Company A’s sale of its Company X shares was designed to manage earnings?” The two
independent variables are earnings management incentives (EM incentives) (strong vs.
weak) and Harshness of Penalty (mild vs. harsh).
28
Table 4: Re-classification Recommendation Likelihood (Test of H2)
Panel A: Likelihood for Re-classification Rating (Mean)
Mild Penalty
Harsh Penalty
Weak
Incentives
8.61 (0.24)
n=31
8.09
(0.25)
n=49
Strong
Incentives
8.98 (0.25)
n=45
9.45 (0.24)
n=49
Panel B: Two-Way ANOVA with Re-classification Recommendation Likelihood as the
Dependent Variable
Source
Earnings Management
Incentives
SS
df
MS
F
P (2-sided)
30.96
1
30.96
10.93
.00
Harshness of Penalties
0.02
1
0.02
0.00
.93
Incentives x Penalty
10.22
1
10.22
3.61
.06
Within Cells (Error)
481.44
170
2.83
Panel C: Results of Simple Effects
Mean
Diff.
Std.
Sig.
Mild
Penalty
Strong vs. Weak Incentive
0.37
0.35
0.29
Harsh
Penalty
Strong vs. Weak Incentive
1.35
0.39
0.00
The tables present results related to H2: Auditors are more likely to recommend
corrective action under strong incentives than under weak incentives; the difference in
29
likelihood is greater under harsh penalties than under mild penalties. The dependent
variable is the likelihood rating which is on an 11 point scale (1 being very unlikely, 11
being very likely) and based on the question “Before the financial statements are issued,
how likely is it that you would recommend to management to include Company X
investment in the 12/31/2011 financial statements as trading securities, rather than
available for sale securities as initially declared by Management? ” The two independent
variables are earnings management incentives (EM incentives) (weak vs. strong) and
Harshness of Penalty (mild vs. harsh).
30
Table 5: Audit Risk (Test of H2)
Panel A: Audit Rating (Mean)
Mild Penalty
Harsh Penalty
Weak
Incentive
8.57 (0.28)
n=31
7.26
(0.35)
n=49
Strong
Incentive
9.00 (0.46)
n=45
9.14 (0.28)
n=49
Panel B: Two-Way ANOVA with Audit Risk Rating as the Dependent Variable
Source
Earnings Management
Incentives
SS
df
MS
F
P (2-sided)
56.16
1
56.16
14.88
.00
Harshness of Penalty
14.38
1
14.38
3.81
.05
Incentives x Penalty
22.25
1
22.25
5.89
.02
Within Cells (Error)
641.94
170
3.78
Panel C: Results of Simple Effects
Mean
Diff.
Std.
Sig.
Mild
Penalty
Strong vs. Weak Incentives
0.43
0.40
0.29
Harsh
Penalty
Strong vs. Weak Incentives
1.89
0.45
0.00
Weak
Incentive
Harsh vs. Mild Penalty
-1.31
0.45
0.00
Strong
Mild vs. Harsh Penalty
0.14
0.40
0.72
31
Incentive
The tables present results related to H: Auditors will assess higher audit risk under strong
incentives than under weak incentive; the difference in risk assessment is greater under
harsh penalties than under mild penalties. The dependent variable is the likelihood rating
which is on an 11 point scale (1 being very low, 11 being very high) and based on the
question “Faced with Management’s decision on the classification as explained above,
how would you assess Company A’s audit risk?” The two independent variables are
earnings management incentives (EM incentives) (weak vs. strong) and Harshness of
Penalty (weak vs. harsh).
32
References
Anderson, U., Kadous, K., and Koonce L., 2004. The role of incentives to manage earnings and
quantification in auditors’ evaluations of management-provided information. Auditing: A
Journal of Practice & Theory 23: 11-27.
Arrunada, B., 2000. Audit quality: attributes, private safeguards and the role of regulation. The
European Accounting Review 9 (2): 205-224.
Ashbaugh, H., LaFond, R., and Mayhew, B. W., 2003. Do nonaudit services compromise auditor
independence? Further evidence. The Accounting Review 78 (3): 611–639.
Chen, G.M., Firth, M., Gao, D. N., and Rui, O. M., 2005. Is China's securities regulatory agency
a toothless tiger? Evidence from enforcement actions. Journal of Accounting and Public
Policy 24(6):451-488.
DeAngelo, L. E., 1981b. Auditor independence, “low balling”, and disclosure regulation. Journal
of Accounting and Economics 3: 113–127.
DeFond, M. L., and Hung, M., 2004. Investor protection and corporate governance: Evidence
from worldwide CEO turnover. Journal of Accounting Research 42: 269-312.
DeFond, M. L., Raghunandan, K., and Subramanyam, K. R., 2002. Do non-audit service fees
impair auditor independence? Evidence from going concern audit opinions. Journal of
Accounting Research 40:1247-1274.
DeFond, M. L., Wong, T.J., and Li, S.H. 2000. The impact of improved auditor independence on
auditor market concentration in China. Journal of Accounting and Economics 28: 269 – 305.
33
Francis, J. R., and Wang, D., 2008. The joint effect of investor protection and Big 4 audits on
earnings quality around the world. Contemporary Accounting Research 25(1): 157 -191.
Firth, M., Fung, M.Y P., and Rui, M. O., 2006. Corporate performance and CEO compensation
in China. Journal of Corporate Finance 12: 693–714.
Graham, L.E., 1996. Setting a Research Agenda for Auditing Issues in the People’s Republic οf
China. The International Journal of Accounting 31(1): 19 – 37.
Gul, F. A., Sun, S. Y. and Tsui, J. S., 2003. Audit quality, earnings, and the Shanghai Stock
Market reaction. Journal of Accounting, Auditing, and Finance 18 (3): 411-427.
Gul, F.A., Kim, J.B. and Qiu, A.A., 2010. Ownership Concentration, Foreign Shareholding,
Audit Quality, and Stock Price Synchronicity: Evidence from China. Journal of Financial
Economics 95 (3): 425-442
Hackenbrack, K., and Nelson, M., 1996. Auditors’ incentives and their application of financial
accounting standards. The Accounting Review 71 (1): 43-59.
He, X.J., Wong, T.J., and Young, D.Q., 2012. Challenges for implementation of fair value
accounting in emerging markets: Evidence from China. Contemporary Accounting
Research 29(2): 538–562.
Hwang, D. B. K. and Baker, R. L., 2000. Proceedings of Global Awareness Society.
International Conference, New York, 71 – 76.
34
Huang, D. B.K., and Staley, A.B., 2005. An Analysis of Recent Accounting and Auditing
Failures in the United States on U.S. Accounting and Auditing in China. Managerial
Auditing Journal 20(3): 227-234.
Jaggi, B., and Low, P. Y., 2011. Joint effect of investor protection and securities regulations on
audit fees. The International Journal of Accounting 46 (3):241–270
Jian, M., and Wong, T. J., 2010. Propping through related party transactions. Review of
Accounting Studies 15 (1):70-105.
Lovett, S., Simmons, L. C., and Kali, R., 1999. Guanxi versus the market: ethics and Efficiency.
Journal of International Business Studies, Summer, 30:2, 231.
Keune, M., and Johnstone, K., 2012. Materiality Judgments and the Resolution of Detected
Misstatements: The Role of Managers, Auditors, and Audit Committees. The Accounting
Review 87( 5): 1641–1677
La Porta, R., Lopez-De-Silanes, F., Shleifer, A., and Vishny, R., 2000. Investor protection and
corporate governance. Journal of Financial Economics 58:3-27.
Magee, R. P., and Tseng, M.-C., 1990. Audit pricing and independence. The Accounting Review
65 (2):315–336.
Mao, Z.R., 2002. A study of penalties to information disclosure violation. Shenzhen Stock
Exchange Research Report 0054, Apr. 9. (Chinese version).
Nelson, M.W., Elliott, J.A., and Tarpley, R.L., 2002. Evidence from auditors about managers'
and auditors' earnings management decisions. The Accounting Review 77 Supplement: 175202.
35
Reynolds, J. K., and Francis, J. R., 2000. Does size matter? The influence of large clients on
office level auditor reporting decisions. Journal of Accounting and Economics 30: 375400.
Shleifer, A. and Vishny, R., 1997. A survey of corporate governance. Journal of Finance 52:
737-784.
Shockley, Randolph A., 1981. Perceptions of Auditors’ Independence: An Empirical
Analysis. The Accounting Review (October): 785-799.
Wilson Jr, T., and Grimlund, R., 1990. An Examination of the Importance of an Auditor’s
Reputation. Auditing: A Journal of Practice & Theory 9 (Spring): 43-59
Xiao, J. Z., Zhang, Y., and Xie, Z., 2000. The making of independent auditing standards in China.
Accounting Horizons 14(1): 69-89.
Yang, L., Dunk, A., Kilgore, A., Tang, Q., and Lin, Z.J., 2003. Auditor independence issues in
China. Managerial Finance 29(12) 57 – 64.
Yang, L., Tang, Q., Kilgore, A., and Jiang, Y., 2001. Auditor-government associations and
auditor independence in China. British Accounting Review 33 (2): 175-189.
Yang, Y., 1995. An important measure of accounting and auditing reform. CPA Newsletter (1):
44–45.
36