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Nankai Business Review International

Auditors' unqualified opinions on internal controls and accrual quality


Liuchuang Li Gaoliang Tian Baolei Qi
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Liuchuang Li Gaoliang Tian Baolei Qi, (2012),"Auditors' unqualified opinions on internal controls and
accrual quality", Nankai Business Review International, Vol. 3 Iss 4 pp. 332 - 353
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NBRI
3,4 Auditors unqualified opinions
on internal controls and
accrual quality
332
Liuchuang Li, Gaoliang Tian and Baolei Qi
Accounting and Finance Department, Xian Jiaotong University,
Received 20 February 2012
Revised 26 June 2012 Xian, Peoples Republic of China
Accepted 1 August 2012
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Abstract
Purpose The purpose of this study is to examine whether auditors unqualified opinion on internal
control (ARIC) is a powerful proxy for the effectiveness of internal control in Chinese context. A rich
body of research conducts their designs on an assumption that companies have more effectiveness of
internal controls if they disclose ARICs. This study argues that the ARICs are not always reliable,
because audit market is well characterized by excessive competition and market supervision is poorer
in China compared to developed countries.
Design/methodology/approach The study uses 2008 and 2009 years Chinese listed-firms data
and the Tobit regression to test the relationship between ARIC and accrual quality. The paper employs
the Heckman model for self-selection bias, which are possibly introduced by choice in disclosing ARICs.
Findings The paper finds that firms disclose ARICs do not report lower abnormal accruals relative
the non-ARIC firms, and firms with ARICs issued by dominant auditors show more reliable accruals
relative to non-ARIC firms and firms that disclose ARICs but fail to be issued by dominant auditors.
The results are robust to additional accrual quality measure, additional audit quality measure, and the
correction of self-selection bias by using the inverse Millo ratio approach.
Originality/value The results suggest that implementing Chinese-SOX could be facilitated by
improving audit quality.
Keywords Chinese-SOX, Internal control, Accrual quality, Audit quality, China, Auditing
Paper type Research paper

1. Introduction
In order to rebuild investors confidence, the Sarbanes-Oxley Act was issued in the
USA in 2002 after the Enron event. The Sarbanes-Oxley Act requires that a public
company annual report contains an assessment (MRIC) by management of the design
and operating effectiveness of its internal control over the financial reporting and an
audit opinion (ARIC) by external auditor on the managements assessment of internal
control. Following the Sarbanes-Oxley Act, regulations on internal control are issued
by Shanghai Stock Exchange and Shenzhen Stock Exchange in 2005. In 2008, Chinese
Securities and Exchange Commission issued The Basic Standard for Enterprise
Internal Control commonly known as Chinese-SOX. Chinese-SOX came into effect in
2009, its main objective is to ensure the reliability of financial reporting. Chinese-SOX
Nankai Business Review have the disclosure regulations of similar quality to those of the Sarbanes-Oxley Act in
International the USA. However, investors have little confidence in its expected objective because
Vol. 3 No. 4, 2012
pp. 332-353
q Emerald Group Publishing Limited
2040-8749
Originally published in Chinese in the Nankai Business Review Li et al., Auditors unqualified
DOI 10.1108/20408741211283719 opinions on internal controls and accrual quality, NBR, 2011, Vol. 14 No. 5, pp. 109-17.
China has poor investor protection and excessive competition of audit markets as Auditors
compared to the USA. Literature addressed to internal controls of Chinese listed-firms unqualified
captures the ARICs as a proxy for effectiveness of firms internal controls[1], but
research to date provides mixed evidence on the relationship between ARICs and opinions
accrual quality, an important component of reliable financial statements. This paper
uses recently available data on ARICs to investigate the effect of ARICs on accrual
quality. We do not disagree with the effectiveness of internal controls in improving 333
accrual quality, but we have doubt whether the ARICs would act as a reliable proxy for
the effectiveness of internal controls due to poor market supervision and excessive
competition on the audit market in China.
We use ARIC disclosures to conduct cross-sectional tests of whether the ARIC is
a powerful proxy of effectiveness of firms internal controls by investigating the effect
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of ARICs on the quality of reported accruals. Specifically, we test whether:


.
firms that have ARICs exhibit lower abnormal accruals relative to firms that do
not disclose ARICs; and
.
firms that have ARICs issued by dominant audit suppliers exhibit lower
abnormal accruals relative to firms that do not disclose ARICs and disclose
ARICs but fail to be issued by dominant audit suppliers.

We use the fourth biggest audit firms (i.e. Deloitte & Touche, KPMG, Ernst & Young
and PwC) in China to proxy for the dominant audit suppliers in this study. We identify
the sample firms that disclose at least one ARIC in both 2008 and 2009. ARICs are
issued by both types of auditor (dominant audit suppliers and other audit suppliers)
allowing us to provide evidence on whether ARICs have differences in acting as a
proxy for effectiveness of firms internal controls.
We find that firms that disclose ARICs do not exhibit lower absolute abnormal
accruals, but firms that have dominant auditors ARICs on their internal controls
exhibit lower absolute abnormal accruals relative to other firms, which suggests all
ARICs cannot act as a reliable signal of the effectiveness of internal control. Our study
contributes to the internal control literature in several ways. First, most of the literature
that focuses on the effect of internal control weakness on accrual quality are conducted
in a developed country context, such as the USA. Our study is one of few, if not the
first, to examine the reliability of the disclosure of internal controls in the Chinese
emerging market, where not only is the competition of the audit market excessive but
also investor protection is weaker compared to developed markets. We empirically link
the auditors unqualified opinions on firms internal controls to the quality of accruals
and show that external auditors unqualified opinions provide ambiguous signals
about the effectiveness of firms internal controls.
Second, this study also contributes to the literature designed to assess the economic
consequences of internal control regulations, while the prior literature addresses the
earnings quality of firms under the SOX-mandated disclosures and provides mixed
evidence. Our study is among the first to provide evidence about potential benefits of
implementing and auditing Chinese-SOX requirements in terms of quality of externally
reported financial information.
Third, our evidence provides policy implications to market regulators in China.
An important policy objective in emerging markets is the efficient allocation of scarce
capital. In order to achieve the informational and functional efficiency of capital
NBRI markets, improving the reliability of firms disclosures is crucial. Our results suggest
3,4 that implementing Chinese-SOX could be facilitated by improving audit quality.
The remainder of our paper is organized as follows. Section 2 describes literature
review and hypotheses development. In Section 3, we present data and the empirical
research design, while Section 5 provides the empirical results. Finally, Section 5
provides a summary and conclusions.
334
2. Literature review and hypotheses development
2.1 MRICs act as a signal of reliability of financial reporting
The reliability of financial reporting is claimed to be a function of the effectiveness of a
firms internal control. Specifically, if a firm has weak internal control, managers are less
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able to determine reliable accrual amounts and a consequence of these unintentional


misrepresentations is that financial information is noisy and less reliable. In addition,
managers of firms with weak internal control can more readily override the controls and
intentionally prepare biased accrual estimates that facilitate meeting their opportunistic
financial reporting objectives. However, both the quality of internal controls and
financial statements cannot be observed directly. Thus, the MRIC would act as a signal
of effectiveness of internal control and hence reliability of financial statements.
The separation of ownership and control has long been recognized as the source of
the agency problem between managers and shareholders, which results in the
monitoring expenditures by shareholders, the bonding expenditures by managers and
residual loss (Jesen and Mecking, 1976). In order to decrease agency cost, not only
shareholders but also managers have the intention to seek for information equivalence
by signaling. Bronson et al. (2006) argue that institutional investors and controlling
block-holders have higher demand for reliability of financial statements and they also
find that such a demand is satisfied by managements assessments of the design and
operating effectiveness of firms internal control. Ashbaugh-Skaife et al. (2007) also
show that firms with more concentrated institutional owners have a stronger motive to
detect and disclose internal control deficiencies. In addition, Deumes and Knechel
(2008) indicate that firms with more financial risk, as proxied by the ratio of book value
of debt to the sum of market value of debt and equity, more often disclose information
of their internal control.
Why do managers disclose MRICs if the assessment of internal controls is cost?
Agency theory indicates that managers would be awarded by the stock market if
they have effective internal controls and disclose information about it, because the
information asymmetry is reduced in some extent. Doyle et al. (2007a, b) show that firms
with stronger corporate governance disclose more detailed information on internal
controls and reports less internal control deficiencies. McMullen et al. (1996) indicate that
companies with prior restatements and SEC enforcement actions were much less likely
to have a management report on internal control than the population of companies.
In addition, other researches also provide evidence similar to McMullen et al. (1996) in
Chinese public companies (Lin and Rao, 2009; Yang and Chen, 2009, 2010).
Disclosure of managements assessments of internal controls could act as a signal,
which in turn leads to enhanced internal controls in two ways. McMullen et al. (1996)
argue that, the assessments increase the internal control awareness of the CEOs and
other top officials and the increased awareness could in turn lead to greater attention
being paid to internal controls in procedures by which better controls are attained.
This is exactly the objective of internal control regulations. The second way Auditors
managements assessments can lead to better controls is that it sends a signal regarding unqualified
top management commitment to internal controls. The assessment thus helps in
communicating the decision by sending a clear message within the organization about opinions
the expected control environment. Ashbaugh-Skaife et al. (2008) test these deductions
and find that internal control deficiency disclosure helps to stimulate the managers
improving the internal control system and the quality of accounting accruals will be 335
greatly improved as the deficiencies are eliminated in following fiscals.
The internal control system contributes to prevent management from opportunism
behaviors which adversely affect accrual quality. The existence of internal control
deficiency suggests worse controls, as well as poorer quality of accrual. So, how would
investors value internal control deficiency if it is bad news for the stock market?
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Internal control deficiency disclosure, as a piece of negative information, will directly


increase the capital costs and the firm-special risk. Beneish et al. (2008) report that firm
has a short-term negative cumulative abnormal return around the internal control
deficiency disclosure. In addition, Kim and Park (2009) also find that internal control
deficiency disclosure can reduce the volatility of stock price. Furthermore, the
voluntary disclosure of internal control deficiency has a lower volatility of stock price
relative to mandatory disclosure. They interpret this evidence as the disclosure of
internal control helping to reduce the degree of information asymmetry between
mangers and investors. However, there is no regulation to define internal control
deficiency unambiguously and how to disclose it in China. Alternatively, researchers
concentrate on investors reaction to the disclosure of managements assessment of
Chinese firms internal controls. The findings show that the degree of internal control
disclosure is associated with the cumulative abnormal returns, trading volume and the
stability of stock price positively. But remediation of internal control deficiencies
would lead to a short-term negative cumulative abnormal return.

2.2 ARICs act as a further signal of reliability of financial reporting


Unfortunately, disclosure of MRICs does not always act as a signal of reliability of
financial statements. If disclosure regulations and market supervision are not fully
enforced, a company currently in the no-MRIC regime could costlessly transfer into the
MRIC regime without any change in the internal control environment. Under the
situation, MRICs would no longer be a signal. Yu and Tian (2009) and Wu (2009) report
that, in China, firms that have MRICs do not exhibit lower accounting accruals, higher
accounting conservation, higher value relevance and do not raise a difference in
investment efficiency and capital cost relative to non-MRIC firms. Research in the USA
also provide mixed evidence on the effect of disclosure of internal control deficiencies
on accrual quality (Hogan and Wilkins, 2005; Bedard, 2006; Doyle et al., 2007a, b).
MRICs with additional auditor involvement are claimed to lead to improvement in
internal controls. This is because, even if companies are currently self-selection into the
MRIC and no-MRIC groups at present, the companies which currently do not have an
MRIC cannot simply decide to issue an MRIC without performing any additional steps.
To satisfy the auditor who will be concerned about his or her own additional liability,
the company must take some steps towards documenting compliance with a certain
level of internal control which must be acceptable to the auditor. This forces the
managers to be more conscious of internal controls and would thus lead to reliability
NBRI of financial statements. In other words, companies cannot costlessly transfer from
3,4 no-MRIC group to MRIC group without performing steps which would presumably
increase control consciousness and thus enhance internal control. As a result, the
ARICs would act as a further signal of reliability of financial statements.
Note that whether ARICs would be a further signal depends on market supervision
and independence of auditors. Though Chinese-SOX has disclosure regulations of
336 similar quality to those in Sarbanes-Oxley, the degree of market supervision and
independence of auditors are far below that in the USA. The reliability of MRICs has
been widely questioned; however, we are still unsure whether the ARICs would provide
a guarantee for the reliability of MRICs.
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2.3 The processing of ARICs


The reliability of an ARIC depends on the degree of market supervision and
independence of auditor. The guideline of the Sarbanes-Oxley Act provides a complete
framework to support managements design, operating and assessment on its internal
controls, as well as auditors opinions on internal control. In addition, the Big Four
audit firms monopolize the audit service supply in the USA. The dominant audit
suppliers hold greater litigation risk and thus they face greater incentive to insure the
reliability of MRICs in order to avoid costly lawsuits. However, the market supervision
is minimum, but it is a mere formality and there is excessive competition on audit
market in China. These make a significant difference in operating, assessing and
auditing of internal controls between China and USA, though both centuries have the
similar requirements on the process of ARICs. The differences are as follows.
Operating internal controls. The effectiveness of a firms internal control depends
directly on the strength of operating internal controls including the design of internal
control system and its enforcement. To meet Chinese-SOX requirements, listed-firms
re-designed the internal control systems in a couple of months but they were yet to be
fully implemented. Deloitte (2009) reports that 58.82 percent of the Chinese listed-firms
acknowledge that the degree of implementation of internal control system does not
meet the design requirements, while the rest acknowledge that Internal control
system has no material enforcement. Other survey conducted by a business journal
CFO in 2009 and their observation summarizes as follows:
The weakness of operating internal control in Chinese listed-firms is not the design of control
systems, but that how to enforce these systems. [. . .], these systems turn out to be a mere
formality at least.
Managements assessment of internal controls. The important objectives of a MRIC are
detecting and improving internal control deficiencies and thus enhances internal
control. However, Chinese managers face three difficulties in their assessment. First,
Chinese-SOX acts as a conceptual framework, it does not provide operational guidance
for managers to support their assessment on their internal controls, as well as
disclosure. Second, the assessment is related to audit sampling, inspection and other
professional knowledge and judgment of auditing. Untrained employees are unequal to
such a complicated assessment task. The survey result of CFO indicates that,
53.54 percent of Chinese listed-firms agreed that the lack of professional talents prevent
firms from assessing their internal controls completely. Third, firms have not enough
resource available for internal control. SEC estimated that the average cost of SOX404
is about $9,110,000 per firm which takes up almost 20.76 percent of Chinas Auditors
listed-firms average net income in 2008 (Zhang, 2007). This is the biggest obstacle in unqualified
the assessment of internal control.
Audit on the effectiveness of internal control. In the USA, the Big Four audit firms opinions
monopolize audit service supply. There are two ways a dominant audit can lead to
enhanced internal controls. First, the dominant audit suppliers are likely to provide
higher quality of internal control that include more systematic examination relative to 337
other audit suppliers because dominant audits face greater loss of reputation by
conducting poor quality audits. Second, the dominant auditors invest more in
technology and training, which facilitates the discovery of internal control problems.
However, there are more than 80 audit firms and about 1,500 listed-firms in China. This
indicates that the Chinese audit market is highly competitive. Hence, there is more
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chance that auditors give unqualified opinions on its clients internal controls.
The combination of three factors discussed above would lead ARICs to not be a
wonderful signal, because mangers could disclose ARICs at a low cost due to the poor
market supervision and audit quality in China. We thus test the following hypothesis
in alternative form:
H1. Ceteris Paribus, firms that disclose ARICs do not exhibit lower abnormal
accruals than other firms.

2.4 Which ARICs are reliable?


Given that firms can issue ARICs at a very low cost, are ARICs reliable? Are ARICs
issued by dominant auditors reliable?
Since auditors contribute to issuing ARICs, the auditors quality and reputation
have a direct impact on the reliability of ARICs. In general, the better the quality of
audit suppliers are, the higher their reputation will be. Dominant audit suppliers have
higher reputation and deeper pockets relative to other audit suppliers, they thus:
.
are likely to provide higher quality audits to avoid greater loss of reputation by
conducting poor quality audits;
.
invest more in technology and training that facilitates the detection of internal
control problems;
.
are more cautious to issue a unqualified opinion on internal control in order to
reduce litigation risk; and
.
have more clients and thus are less likely to compromise with clients or sale
unqualified opinions.

Therefore, ARICs which are issue by dominant audit suppliers are more reliable.
Non-dominant audit suppliers, however, have not enough resource available for
technology and training which facilitates the detection of internal control problems.
In addition, non-dominant audit suppliers are less independent in the poor supervision
market. As a result, non-dominant audit suppliers are likely to compromise with clients
and thus their unqualified opinions are not a wonderful signal of effectiveness of
internal controls. We test the following hypothesis in alternative form:
H2. Ceteris Paribus, firms that disclose ARICs issued by dominant audit suppliers
show lower abnormal accruals than other firms.
NBRI 3. Measures and data
3,4 3.1 Measure of accrual quality
We use the measure of accrual estimation error, which was developed by Dechow and
Dichev (2002) and modified by McNichols (2002) and Francis et al. (2005) to measure the
accrual quality. The measurement defines the quality of accruals as the extent to which
they map into past, current and future cash flows. We assume this measure can capture
338 the effect of internal control on accruals quality for two reasons. First, the effectiveness
of internal controls is related to specific accounts (Doyle et al., 2007a, b). These specific
accounts could have estimation errors, which capture by this measurement. For example,
if the inventory account is overstated, the obsolete inventory will not result in cash
inflows in the next period, resulting in a low correlation between the accrual and realized
cash flows. Second, compared to other measures of accruals quality, this measure in
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Dechow and Dichev (2002) does not rely solely on earnings management or assumptions
related to market efficiency. This measure can capture both biased discretionary
accruals and unintentionally poorly estimated accruals, which can use to predict the
effectiveness of an internal control system.
Specifically, the proxy for accruals quality is measured by estimating the following
regression with the industry and year:

DWC i;t a0 a1 CFOi;t21 a2 CFOi;t a3 CFOi;t1 a4 DREV i;t 2 DREC i;t 1


a5 DPPE i;t 1i;t

where, for firm i and year t, the DWC is the change in working capital accruals, which
defines as the difference in (Accounts Receivable Inventory 2 Accounts
Payable-Taxes Payable Other Assets) between year t and t 2 1, CFO is cash flow
from operations, REV is the sales and REC is accounts receivable, PPE is the net
property, plant and equipment. All variables are scaled by beginning of fiscal year
total assets. We estimate equation (1) by two-digit industry code of the Chinese
Securities and Exchange Commission. A firms unadjusted abnormal total accrual is
set equal to the difference between DWC and the predicted value of equation (1).
We then aggregate the residuals by firm and calculate the standard deviation of
residuals, denoted AQ, requiring a minimum of three years of residual data. Higher AQ
values indicate lower accrual quality.

3.2 Identifying ARICs


We code ARIC equals to one if a firm publicly discloses an audits unqualified opinion
on its internal control and zero otherwise. To measure the difference in reliability of
ARICs, we construct a dummy variable, which denotes High_ARIC that is equal to one
if the firms unqualified opinion on internal control is issued by the dominant auditor
including Deloitte & Touche, KPMG, Ernst & Young and PwC and zero otherwise.
By construction, High_ARIC is essentially an interaction term between ARIC dummy
and BIG4 dummy.

3.3 Control variables


Conceptually, we model accrual quality as a function of:
.
whether a firm discloses an ARIC;
.
firms business fundamentals and operating characteristics;
.
investment in internal controls; Auditors
.
accounting policy choices; and unqualified
.
corporate governance. opinions
Business fundamentals and operating characteristics. First, the volatility of firms
operations is systematically related to the propensity to make estimation errors in
accruals (Dechow and Dichev, 2002). We include the standard deviation of cash flow 339
from operation (STDCFO) to proxy for the effects of volatility of operations on accruals
quality. Second, rapidly growing firms are also likely to have noisier accruals caused
by absorption costing distortions to income when inventory build-ups occur in
anticipation of future sales growth. We use the ratio of inventory to total assets (INV )
and the ratio of PPE to total assets (FA) as proxies for these effects on accrual quality.
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Third, firms involved in mergers and acquisitions are likely to have noisier and
larger abnormal accruals due to the accounting for purchased in process R&D,
goodwill accounting and asset impairment charge that frequently accompany mergers
and acquisitions activity. We use M&A to capture the effect on accrual quality. Fourth,
firms financial risk acts as an important determinant of accrual quality (Kothari et al.,
2005). We include the financial leverage (LEV) to proxy for the effects of capital
structure on accrual quality.
Investment in internal controls. Internal control systems have a large cost
component, which are costly to install and maintain. Depending on their resources
available to invest in control systems, firms will make differential effectiveness of
internal controls. In addition, Dechow and Dichev (2002) hypothesize that larger firms
have more stable a predictable operations and, therefore, fewer and smaller accrual
estimation errors. We use SIZE and LOSS as proxies for firms investment in internal
controls, where SIZE is measured by the nature logarithm of total assets and Loss is
equal to one if the firm has a incidence of losses and zero otherwise.
Accounting policy choices. A myriad of accounting choices are likely to impact
accrual policy. We assume that major accounting policy choices are common within an
industry, thus we are controlling for this effect by estimation abnormal accruals within
industry classification (see details above). In addition, Ball and Shivakumar (2006)
argue that accounting conservatism, which results in more timely recognition of losses
than gains, increases the variance of earnings conditional on the variance of periodic
operating cash flows. They find a positive relation between measures of accrual
volatility and measures of economic loss after controlling for variation in cash flows.
R&D and advertising expenditures (two conservative accounting treatments) can
distort current accrual accounting income as a measurement of operating performance.
The increased variance and bias in accrual accounting earnings relative to operating
cash flows, which is caused by conservative accounting, implies a positive relation
between accounting conservatism and our accrual quality proxies. Alternatively,
conservative accounting may improve accrual quality due to the limitations
conservative accounting places on the type of information captured by the financial
statements. Conservative accounting results in accounting capturing only the value of
separable net assets (Roychowdhury and Warrs, 2007). Conservative accounting does
not recognize unverifiable increases in separable net assets or rents, this definition is
less verifiable estimation and it is also more difficult to estimate. Hence, only verifiable
information can be recorded and reported in the financial statements. The conservative
NBRI accounting may improve accrual quality. We use the book to market ratio (BM) and
3,4 the presence of an asset impairment or write-down (WRITEOFF) as a proxy for
accounting conservatism, where lower BM and WRITEOFF values indicate more
conservative accounting.
Corporate governance. Prior researches indicate that accrual quality is
systematically related to corporate governance mechanisms, including audit quality,
340 ownership structure and the government related largest shareholders. Audit market
leaders serve different clienteles (Francis and Wilson, 1988) and the quality of financial
information differs between large audit firm clients and small audit firm clients
(Ashbaugh et al., 2003). We add BIG4, the ratio of audit fee to total assets (AUDFEE)
and audits opinions (AUDOPN) to proxy for audit quality, where BIG4 is equal to one
if the firm has the audit contract with one of the four largest audit firms and zero
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otherwise. AUDOPN is equal to one if the firm got an unqualified audit opinion over its
financial statements. In addition, Fan and Wong (2002) argue that firms with a higher
concentration of ownership or government related largest shareholder have more
agency problems and they have lower quality of accruals. We use the government
related of the largest shareholders (SOE) and the Herfindahl index of the percentage of
shares (SHARE_HHI) holed by top ten shareholders to proxy for the effect of corporate
governance on accrual quality, where the SOE is equal to one if the firms largest
shareholder is government related and zero otherwise.

3.4 Sample and data


Chinese-SOX was issued in 2008. There are no audit opinions on internal controls of
listed-firms in China prior to 2008. Hence, our sample was limited to 2008 and after.
Our initial sample of Chinese listed-firms is obtained from the yearly company file in
CSMAR database. The initial sample spans from 2008 to 2009 and includes
3,342 firm-years. Then, 57 firm-years in financial section are deleted and additional
data requirement to estimate the multivariate regression model (described more fully
below) reduces the final sample to 2,669 firm-years. We manually collect all the ARICs
from official web site of Shanghai Stock Exchange and Shenzhen Stock Exchange.
There are 699 ARICs disclosed by 497 firms and of which 97 ARICs are issued by
dominant audit suppliers. Sample details are reported in Table I.

4. Results
4.1 Descriptive statistics and univariate analysis
Table II reports the descriptive statistics of main variables, where Panel A displays the
distributional properties of dependent variables and control variables and Panel B
shows the distributional properties of dependent variables and control variables by

Number of firm-years over 2008 and 2009 period 3,342


Elimination of observations in financial sections 257
Elimination of observations with insufficient data 2616
Total observations 2,669
Control observations 1,970
Table I. Total ARIC observations 699
Sample selection criteria Number of observations with ARICs issued by dominant audit supplier 97
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Panel A: distributional properties of variables by all observations


Mean Median SD Q1 Q3
AQ 0.0657 0.0555 0.1447 0.0224 0.0839
Jones_AQ 0.1517 0.0968 0.2202 0.0434 0.1836
SOE 0.4271 0.0000 0.4948 0.0000 1.0000
M&A 0.7748 1.0000 0.4178 1.0000 1.0000
WRITEOFF 0.8168 1.0000 0.3869 1.0000 1.0000
LOSS 0.1428 0.0000 0.3499 0.0000 0.0000
LEV 0.5588 0.5154 0.5715 0.3663 0.6543
SIZE 21.5958 21.4622 1.2992 20.7568 22.3137
STDCFO 0.0580 0.0541 0.0913 0.0113 0.1063
INV 0.1777 0.1376 0.1624 0.0672 0.2277
FA 0.2832 0.2516 0.1905 0.1362 0.4099
SHARE_HHI 0.1746 0.1439 0.1250 0.0762 0.2496
MB 3.4460 2.7721 4.9122 1.6572 4.4526
AUDOPN 0.9442 1.0000 0.2296 1.0000 1.0000
AUDFEE 0.0031 0.0001 0.0042 0.0000 0.0026
BIG4 0.0629 0.0000 0.2429 0.0000 0.0000
Panel B: distributional properties of variables by ARIC sample and control sample
SD Mean Median
ARIC 0 ARIC 1 ARIC 0 ARIC 1 Differencea ARIC 0 ARIC 1 Differencea
AQ 0.1352 0.0787 0.0681 0.0533 0.0168 * * 0.0577 0.0427 0.0150
Jones_AQ 0.2374 0.1623 0.1540 0.1452 0.0088 0.0953 0.1023 2 0.0007
SOE 0.4931 0.4984 0.4168 0.4564 2 0.0396 * 0.0000 0.0000 0.0000 *
M&A 0.4176 0.4186 0.7751 0.7740 0.0011 1.0000 1.0000 0.0000 * * *
WRITEOFF 0.3899 0.3786 0.8132 0.8269 2 0.0137 1.0000 1.0000 0.0000 * * *
LOSS 0.3717 0.2694 0.1655 0.0787 0.0868 * * * 0.0000 0.0000 0.0000 * * *
LEV 0.6528 0.1946 0.5870 0.4794 0.1076 * * * 0.5233 0.4941 2 0.0292 * * *
SIZE 1.2580 1.3791 21.5065 21.8474 2 0.3409 * * * 21.4287 21.6211 2 0.1924 * * *
STDCFO 0.0919 0.0890 0.0542 0.0687 2 0.0145 * * * 0.0514 0.0627 2 0.0113 * * *
INV 0.1641 0.1576 0.1790 0.1741 0.0049 0.1359 0.1409 2 0.0050
FA 0.1918 0.1870 0.2840 0.2809 0.0031 0.2524 0.2506 2 0.0018
SHARE_HHI 0.1234 0.1264 0.1661 0.1988 2 0.0327 * * * 0.1328 0.1733 2 0.0405 * * *
MB 5.5002 2.6031 3.3427 3.7371 2 0.3944 * 2.6367 3.2900 2 0.6533 * * *
AUDOPN 0.2562 0.1188 0.9294 0.9857 2 0.0563 * * * 1.0000 1.0000 2 1.0000 * * *
AUDFEE 0.2423 0.0003 0.0059 0.0003 0.0056 0.0002 0.0003 2 0.0001
BIG4 0.2429 0.2430 0.0629 0.0629 0.0000 0.0000 0.0000 0.0000
Notes: Significant at: *0.10, * *0.05 and * * *0.01 levels; adifferences in means (medians) are assessed using a t-test (Wilcoxon rank sum test); see the Appendix for variable definitions
unqualified
Auditors

Descriptive statistics
opinions

341

Table II.
NBRI ARIC and control samples. The descriptive statistics of mean values show that ARIC
3,4 firms have lower abnormal accruals, which indicates higher accrual quality and they are
more likely to have a government related largest shareholder, low financial leverage,
have more resource available to internal controls and incidence of losses, are more likely
to get a unqualified opinion of auditor on financial statements, have lower concentration
of ownership and have bigger the standard deviation of cash flow from operation.
342 The significance of differences in medians is similar to corresponding means. In addition,
Table II shows that ARIC firms are more likely to be undergoing mergers and
acquisitions activity and pay less audit fees. However, there is no difference in hiring a
dominant auditor between ARIC firms and no-ARIC firms. Overall, there are statistically
significant differences in these firm-specific characteristics between ARIC firms and
control firms, which indicate the important of controlling for these innate firm
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characteristics in our cross-sectional test of accrual quality differences.


Table III shows the pair-wise correlations, where the upper right-hand portion of the
table presents the Spearman rank-order correlations and lower left-hand presents
Pearson correlations. We mainly discuss the Person correlations, but note that
the patterns of two correlations are quite similar. The correlation is a significant
negative correlation of 2 0.0423 between AQ and ARIC, which indicates that firms who
disclose ARICs have lower accrual quality relative to other firms. The ARIC indicator
variable is significantly negatively correlated with LEV and LOSS and significantly
positively correlated with STDCFO, SIZE, SHARE_HHI and AUDOPN. As expected,
AQ are significantly correlated with most of the controls variables, which suggests
that the variables included in our multivariate model capture distinct features of firms
accrual quality. In addition, the largest correlation is the significant negative
correlation of 2 0.4716 between AF and INV, followed by a significant positive
correlation of 0.343 between AQ and LEV. The vast majority of other correlations fall
between 0.25 and 2 0.25, which indicates that we do not have to be concerned about
multicollinearity related problems in our multivariate model.

4.2 Multivariate analysis of accrual quality and ARICs


The following empirical model is used to test whether ARIC affect accrual quality and
the magnitude of abnormal accruals after controlling for firm characteristics:

AQi;t b0 b1 ARIC i;t b2 INV i;t b3 FAi;t b4 STDCFOi;t b5 LEV i;t


b6 M &Ai;t b7 SIZE i;t b8 LOSS i;t b9 MBi;t b10 WRITEOFF i;t
2
b11 AUDFEE i;t b12 AUDOPN i;t b13 BIG4i;t b14 SHARE_HHI i;t
b15 SOE i;t y i;t
where AQ is the accrual quality measure that a higher value represent lower accrual
quality and all other variables are as previously defined (See the Appendix for detail).
The first column of Table IV shows the Tobit regression result for equation (2), which
is estimated using Tobit regression because the dependent variable are restricted to be
positive (Greene, 1990). Alternatively, we also present the OLS regression result for
equation (2) in the second column of Table IV as a robust test, of which all coefficients
sign and significance are similar to that of the Tobit regression results.
We collectively discuss the Tobit regression results for brevity. The log-likelihood
ratios of the regression results are highly significant indicating that the independent
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1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

AQ 1 2 0.0283 2 0.1014 0.1290 2 0.1902 0.0820 0.1489 2 0.0679 0.1473 0.0937 2 0.0171 2 0.0804 2 0.0058 2 0.1718 0.0514 2 0.0569
ARIC 2 2 0.0423 0.0751 2 0.0021 2 0.0044 2 0.0060 2 0.0846 0.0873 2 0.1091 0.1019 0.0156 0.0352 0.1309 0.1077 2 0.0954 0.0008
STDCFO 3 2 0.1415 0.0701 2 0.1666 0.2183 2 0.0513 2 0.1750 0.0951 2 0.1949 0.0817 0.0042 0.0238 0.0866 0.1355 20.0693 0.1078
INV 4 0.1890 2 0.0134 2 0.2148 2 0.4181 0.0346 0.1863 0.0482 2 0.0820 0.0724 0.0395 2 0.0433 0.0108 0.1233 20.0549 2 0.0811
FA 5 2 0.1760 2 0.0070 0.1852 2 0.4761 2 0.0565 2 0.0004 0.0292 0.1537 2 0.1501 0.0418 0.0645 0.0314 2 0.0155 20.0425 0.0509
M&A 6 0.0734 2 0.0060 2 0.0542 0.0657 2 0.0531 0.1090 0.0396 2 0.0024 0.0536 0.0181 2 0.0372 2 0.0947 2 0.0285 2 0.0245 2 0.0462
LEV 7 0.3430 2 0.0828 2 0.1222 0.0161 0.0372 0.0510 0.2518 0.2224 2 0.0662 2 0.0141 0.0684 2 0.0171 2 0.2227 2 0.2222 0.0251
SIZE 8 2 0.1149 0.1154 0.0981 0.0756 0.0741 0.0336 2 0.1308 2 0.2023 2 0.2692 2 0.0135 0.3185 0.2615 0.2380 20.8538 0.3191
LOSS 9 0.1157 2 0.1091 2 0.1656 2 0.0742 0.1568 2 0.0024 0.1787 2 0.1888 2 0.0151 0.0825 2 0.0103 2 0.1373 2 0.3346 0.2089 2 0.0352
MB 10 2 0.0491 0.0353 0.0175 0.0283 2 0.0992 0.0275 2 0.1700 2 0.0900 0.0420 2 0.0081 2 0.0964 2 0.0265 0.0639 0.2347 2 0.1409
WRITEOFF 11 2 0.0183 0.0156 0.0072 2 0.0336 0.0313 0.0181 2 0.0245 2 0.0058 0.0825 0.0067 2 0.0120 2 0.0464 2 0.0139 0.0239 2 0.0009
SOE 12 2 0.0691 0.0352 0.0334 2 0.0495 0.0696 2 0.0372 2 0.0319 0.3377 2 0.0103 2 0.0169 2 0.0120 0.2561 0.0780 20.2595 0.1972
SHARE_
HHI 13 0.0371 0.1151 0.0773 0.0307 0.0334 2 0.0856 2 0.0508 0.3461 2 0.1228 0.0049 2 0.0524 0.2485 0.1607 20.2179 0.1597
AUDOPN 14 2 0.2542 0.1077 0.1077 0.0827 2 0.0397 2 0.0285 2 0.4194 0.2691 2 0.3346 0.0902 2 0.0139 0.0780 0.1418 20.2483 0.0563
AUDFEE 15 0.1653 2 0.0119 0.0756 2 0.0217 2 0.0290 0.0105 0.3012 2 0.0659 2 0.0074 2 0.1184 0.0088 2 0.0173 2 0.0221 2 0.0815 2 0.0943
BIG4 16 2 0.0559 0.0001 0.0969 2 0.0591 0.0569 2 0.0462 2 0.0109 0.4104 2 0.0352 2 0.0584 2 0.0009 0.1972 0.1832 0.0563 2 0.0052
Notes: Italic text indicates significance at the 0.05 level or better two-tailed; the up right-hand portion of the table presents Pearson correlations and the lower left-hand presents the
Spearman rank-order correlations
unqualified
Auditors

Correlation matrix
opinions

Table III.
343
NBRI
(1) (2)
3,4 Coefficient Coefficient
Predicted sign estimate t-statistic estimate t-statistic

Intercept ? 0.1391 * * * 4.2761 0.1289 * * * 4.2698


ARIC ? 2 0.0022 2 0.1295 20.0021 2 0.1189
344 INV 0.0786 * * * 4.0332 0.0785 * * * 4.0448
FA 2 2 0.0967 * * * 2 5.5323 20.0968 * * * 2 5.5288
STDCFO 2 0.0521 2 1.0665 20.0521 2 1.0715
LEV 0.0546 * * * 4.8472 0.0546 * * * 4.8619
M&A 0.0107 * * * 3.0325 0.0107 * * * 3.0222
SIZE 2 2 0.0042 * * 2 2.1448 20.0042 * * 2 2.1411
LOSS 0.0268 * * * 2.7467 0.0268 * * * 2.7489
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MB ? 2 0.0004 2 0.3341 20.0004 2 0.3352


WRITEOFF 2 0.0018 2 0.3456 20.0018 2 0.3505
AUDFEE 2 0.0444 * * * 5.0551 0.0445 * * * 5.0662
AUDOPN 2 2 0.0463 * * * 2 4.3338 20.0462 * * * 2 4.3453
BIG4 2 2 0.0072 2 1.1447 20.0072 2 1.1450
SHARE_HHI 0.1005 * * * 4.5845 0.0999 * * * 4.6012
SOE 0.0089 * * 2.0569 0.0088 * * 2.0791
Log-likelihood (adj. R 2) 1,874.2443 * * * (0.2523) * * *
Table IV. Observations 2,669 2,669
Accrual quality
and ARICs Notes: Significant at: *0.10, * *0.05 and * * *0.01 levels; see the Appendix for variable definitions

variables, as a whole, explain a significant portion of firms abnormal accruals.


The INV coefficient is positive and significant, which indicate that firms with greater
inventory level report lower quality accruals. Furthermore, the M&A, LEV and LOSS
coefficients are positive and significant which indicate that firms engaging in mergers
and acquisitions activity, financially distressed firms, financially weaker report larger
abnormal accruals and show lower accrual quality. The SHARE_HHI and SOE
coefficients are positive significant, which indicate that firms with more concentrated
ownership and government related controlling firms report lower quality accrual.
Consistent with expectations, FA and SIZE coefficients are negative and significant,
which indicate that firms with more investment in property, plant and equipment,
firms with more resource available for internal controls and they have more reliable
accruals. However, the BM, WRITEOFF and BIG4 are insignificantly negative, which
suggest that firms with more conservative accounting and firms who are audited by a
dominant auditor do not have more reliable accruals. Contrary to exception, the
AUDFEE coefficient on is positive and significant, indicating that firm pay more for
audit are more likely to report lower quality accruals in Chinese.
Turning to the variable of interest, we find that the coefficient on ARIC is not
significantly negative in both regressions after controlling for inner firm characteristics
that affect accrual quality. This finding leads us to conclude that firms with ARICs do
not report more quality accruals relative to firms that do not disclose ARICs, which
supports H1.
Our second set of analyses investigates whether ARICs issued by dominant
auditors affect accrual quality after controlling for firm characteristics that affect
the magnitude of abnormal accruals. We estimate the following Tobit and models:
AQi;t u0 u1 ARIC i;t u2 High_ARIC i;t u3 INV i;t u4 FAi;t u5 STDCFOi;t Auditors
u6 LEV i;t u7 M &Ai;t u8 SIZE i;t u9 LOSS i;t u10 MBi;t unqualified
3
u11 WRITEOFF i;t u12 AUDFEE i;t u13 AUDOPN i;t opinions
u14 BIG4i;t u15 SHARE_HHI i;t u16 SOE i;t y i;t

where High_ARIC is equal to one if the firm disclose a auditors unqualified opinion 345
which is issued by a dominant auditor and zero otherwise. By construction, High_ARIC
is essentially an interaction term between ARIC dummy and BIG4 dummy. All other
variable are defined previously.
Note that the u0 reflects the average abnormal accruals of controls firms, i.e. firms that
did not disclose an ARIC. With ARIC and High_ARIC both in the model, the coefficient
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on ARIC (u1) captures that incremental (relative to no-ARIC control firms) average
abnormal accruals of firms that disclose ARICs, but fail to be audited by dominant
auditors. Accordingly, we expect that u1 is not significantly different form zero.
The coefficient of u2 captures the incremental effects on High_ARIC (relative to firms
that disclose ARICs, but fail to be audited by dominant auditors) average abnormal
accruals of High_ARIC firms. We expect a negative coefficient on High_ARIC, because
these firms receive an unqualified opinion on internal control provided by dominant
auditors. The ARICs can act as a signal of effectiveness of their internal controls, which
should result in higher quality accruals and thus lower abnormal accruals. The sum,
u1 u2, measures the difference in abnormal accruals of firms that receive a ARIC
issued by dominant auditors and firms that fail to disclose ARICs. Thus, we also expect
u1 u2 is negative and it significantly different from zero.
The first column of Table V shows the Tobit regression result for equation (3) and
the second column shows the corresponding OLS regression result. Again, all
coefficients are qualitatively the same in both regressions. We discuss the Tobit
regression results collectively. In general, the coefficients of control variables are
similar to these in Table IV, which are not discussed further. We find that the
coefficient on ARIC is negative but not significant, suggesting that firms with ARICs
that fail to be issued by dominant auditors do not report lower abnormal accruals.
Moreover, consistent with expectation, after controlling for other innate firm
characteristics that affect accrual quality, the coefficient of High_ARIC is negative and
significant, which indicates that firms with dominant auditors unqualified opinions
report smaller absolute abnormal accruals relative to those firms that disclose ARICs
but fail to be audited by dominant auditors. In addition, we perform F-statistic to test
whether the linear combine, u1 u2, is negative and it significantly different from zero.
The sum is negative (u1 u2 2 0.0307) and significant (F-statistic 3.4684) at the
0.1 level two-tailed as showed in bottom of Table V shows that firms with dominant
auditors unqualified opinions report smaller absolute abnormal accruals relative to
non-ARIC firms. Thus, these findings provide evidence that firms with dominant
auditors unqualified opinions report more reliable accruals, supporting H2.

4.3 Robust tests


4.3.1 Multivariate analysis of additional accrual quality measure. Following Jones
(1991) and Dechow and Dichev (2002), we estimate Jones_AQ using the modified
Jones model:
NBRI
(1) (2)
3,4 Coefficient Coefficient
Predicted sign estimate t-statistic estimate t-statistic

Intercept ? 0.0867 * * * 4.1656 0.0868 * * * 4.1599


ARIC ? 0.0012 0.1702 0.0012 0.1787
346 High_ARIC 2 2 0.0319 * 2 1.6625 20.0319 * 2 1.6723
INV 0.0781 * * * 4.0519 0.0780 * * * 4.0643
FA 2 2 0.0966 * * * 2 5.5191 20.0967 * * * 2 5.5166
STDCFO 2 0.0571 2 1.0776 20.0571 2 1.0828
LEV 0.0646 * * * 4.8532 0.0646 * * * 4.8688
M&A 0.0147 * * * 3.0186 0.0148 * * * 3.0088
SIZE 2 2 0.0040 * * 2 2.0509 20.0040 * * 2 2.0472
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LOSS 0.0194 * * * 2.7801 0.0195 * * * 2.7830


MB ? 2 0.0007 2 0.3251 20.0007 2 0.3262
WRITEOFF 2 0.0023 2 0.3228 20.0023 2 0.3277
AUDFEE 2 0.0437 * * * 5.0625 0.0437 * * * 5.0746
AUDOPN 2 2 0.0645 * * * 2 4.3488 20.0644 * * * 2 4.3613
BIG4 2 2 0.0024 2 0.3555 20.0024 2 0.3521
SHARE_HHI 0.1000 * * * 4.5852 0.0999 * * * 4.6028
SOE 0.0090 * * 2.1063 0.0089 * * 2.1292
F-statistic of
(ARIC High_ARIC) 2 3.4684 * 3.4425 *
Table V. Log-likelihood (adj. R 2) 2,341.5231 * * * (0.2424) * * *
Accrual quality and Observations 2,669 2,669
ARICs issued by
dominant audit suppliers Notes: Significant at: *0.10, * *0.05 and * * *0.01 levels; see the Appendix for variable definitions

 
1
TAi;t a0 a1 a4 DREV i;t 2 DREC i;t a5 DPPE i;t 1i;t 4
Asset i;ti

Where TA is net income before extraordinary items plus depreciation and amortization and
minus CFO and other variable are as previously defined. We define Jones_AQ as absolute
value of the difference between the residuals of equation (4) and the median residuals for
firms in the same industry. Higher Jones_AQ values indicate lower accrual quality.
In Panel A of Table VI, we show our main results for the additional accrual quality
measure, Jones_AQ. Referring to the first column of Panel A in Table VI, consistent
with the results in Table IV, the coefficients on ARIC are negative but insignificant.
The second column shows that the coefficient of High_ARIC is negative and
significant and the linear combine of ARIC and High_ARIC (u1 u2 2 0.0465) is
negative and significant (F-statistic 3.1614) at the 0.1 level two-tailed.
4.3.2 Multivariate analysis of additional audit quality measure. Only 6.29 percent of
firms contract with one of the four biggest audit suppliers in our sample, As a result,
our measure of audit quality has limitations and the conclusions would not be warranted
due to possibility that these results are derived form a small fraction of firms.
Alternatively, we construct DAUDFEE as another proxy of audit quality. DAUDFEE is
an indicator variable that is equal to one if the firms AUDFEE are larger than the
median AUDFEE in the same year and zero otherwise. Then, we define
DAUDFEE_ARIC as interaction between DAUDFEE and ARIC to signal the reliable
ARICs.
Auditors
(1) (2)
Predicted Coefficient Coefficient unqualified
sign estimate t-statistic estimate t-statistic opinions
Panel A: Tobit regression results using additional accrual quality measure
Intercept ? 0.3024 * * * 3.1132 0.2938 * * * 3.0050
ARIC ? 2 0.0043 2 0.5698 2 0.0014 2 0.1854 347
High_ARIC 2 2 0.0451 * * 2 2.2591
INV 0.1867 * * * 5.1792 0.1879 * * * 5.2080
FA 2 2 0.1151 * * * 2 5.0579 2 0.1149 * * * 2 5.0454
STDCFO 2 0.0235 2 0.3406 2 0.0248 2 0.3587
LEV 0.0492 * * * 3.0287 0.0493 * * * 3.0350
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M&A 2 0.0034 0.4178 0.0032 0.4022


SIZE 2 2 0.0071 2 1.5749 2 0.0067 2 1.4832
LOSS 2 0.0013 2 0.1309 2 0.0007 2 0.0775
MB ? 2 0.0010 2 1.2040 2 0.0010 2 1.1852
WRITEOFF 2 0.0206 2 1.4001 2 0.0203 2 1.3800
AUDFEE 2 0.1646 * * * 12.0142 0.1648 * * * 12.0208
AUDOPN 2 2 0.0467 * * * 2 2.6381 2 0.0473 * * * 2 2.6692
BIG4 2 2 0.0266 * * 2 1.9928 2 0.0153 2 1.0521
SHARE_HHI 0.2816 * * * 6.5721 0.2815 * * * 6.5700
SOE 0.0212 * * 2.3364 0.0217 * * 2.3910
F-statistic of (ARIC High_
ARIC) 2 3.1614 *
Log-likelihood 436.3692 * * * 437.0933 * * *
Observations 2,669 2,669
Panel B: Tobit regression results using additional audit quality measure
Intercept ? 0.1556 * * * 3.2503 0.1481 * * * 3.0670
ARIC ? 2 0.0008 2 0.1979 0.0104 1.6155
DAUDFEE_ARIC 2 2 0.0199 * * 2 2.4830
INV 0.0862 * * * 3.9719 0.0879 * * * 4.0493
FA 2 2 0.0721 * * * 2 5.6324 2 0.0711 * * * 2 5.5560
STDCFO 2 0.0501 2 1.0510 2 0.0498 2 1.0443
LEV 0.0472 * * * 4.8936 0.0474 * * * 4.9288
M&A 0.0123 * * * 3.1145 0.0125 * * * 3.1541
SIZE 2 2 0.0023 2 1.0517 2 0.0021 2 0.9467
LOSS 0.0169 * * * 2.7707 0.0175 * * * 2.8561
MB ? 2 0.0002 2 0.3320 2 0.0003 2 0.3622
WEITEOFF 2 0.0014 2 0.2613 2 0.0014 2 0.2697
AUDOPN 2 2 0.0645 * * * 2 4.3679 2 0.0653 * * * 2 4.4233
BIG4 2 2 0.0067 2 1.0656 2 0.0071 2 1.1314
DAUDFEE 2 0.0097 * * 2 2.1380 2 0.0048 2 0.9324
SHARE_HHI 0.0998 * * * 4.5877 0.0986 * * * 4.5526
SOE 0.0089 * * 2.0916 0.0086 * * 2.0254
F-statistic of
(ARIC DAUDFEE_ARIC) 2 4.7926 * *
Log-likelihood 2,421.9833 * * * 2,424.5873 * * *
Observations 2,669 2,669
Table VI.
Notes: Significant at: *0.10, * *0.05 and * * *0.001 levels; see the Appendix for variable definitions Robust tests
NBRI The Panel B of Table VI reports the Tobit regression result for equation (3), in which
we, respectively, use DAUDFEE_ARIC and DAUDFEE to replace High_ARIC and
3,4 AUDFEE. The first column of Panel B in Table VI shows that the coefficients on ARIC
are negative but insignificant, while the second column shows that the coefficient
on High_ARIC is negative and significant and the linear combine of ARIC and
DAUDFEE_ARIC (u1 u2 20.0095) is negative and significant (F-statistic 4.7926)
348 at the 0.05 level two-tailed.

4.4 Self-selection of disclosing ARICs


In our main analysis, we include known determinates of accrual quality as an independent
variable and focus on material ARICs, which are effectively required to be disclosed,
thereby eliminating much of the choice to disclose. Nevertheless, it is still possible that
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firms can choose both the quality of their internal controls and the quality of reporting
accruals. This choice introduces possible self-selection bias into our observed sample. We
address the self-selection bias by two-stage treatment effect procedure. In the first-stage,
we estimate a Probit regression of ARIC on the determinants of disclosing ARICs. This
first-stage regression closely follows Doyle et al. (2007a, b), Ashbaugh-Skaife et al. (2007)
and Lin and Rao (2009) and is presented as equation (5). From this first-stage regression,
which identifies the likelihood of a firm being selected as an ARIC firm, we calculate the
inverse Mills ratio (Heckman, 1979) and include this ratio in our accrual quality regression.
This ratio helps control for likelihood of self-selecting into ARIC group in our main
regression:
ProbitARIC i;t d0 d1 GROWHT i;t d2 VIOLATION i;t d3 SEOi;t
d4 COMMIT i;t d5 POSIT i;t d6 AGE i;t d7 CROSSLIST i;t
5
d8 SIZE i;t d9 LOSS i;t d10 M &Ai;t d11 BIG4i;t
d12 SOE i;t d13 SHARE_HHI i;t ci;t
The result in Table VII is similar to those in Tables IV and V after including the inverses
Mills ratio. The coefficient of Mills ratio is positive and not significant. As per the second
column of Table VII, r, the coefficient of High_ARIC is 20.0416 and it is negative and
significant at 0.05 level in two-tailed, test and the coefficient one is. In additional, the linear
combine of ARIC and High_ARIC (u1 u2 20.0643) is negative and significant
(F-statistic 6.7182) at the 0.01 level in two-tailed test.
These robust regressions provide evidences that continue to support H1 and H2
and we suggest that firms with dominant auditors unqualified opinions report more
reliable accruals, but firms which ARICs fail to be issued by dominant auditors do not
report lower absolute abnormal accrual relative to non-ARIC firms.

5. Conclusion
A fundamental premise is that effective internal control provides significant benefit to
investors by reducing both intentional and unintentional misstatements in measuring,
recording and processing financial information that leads to more reliable financial
statements. Previous studies use the auditors unqualified opinion on internal controls
over financial reporting to proxy for the effectiveness of internal control, which provide
evidence on positive effect of effective internal control on accrual quality. However, these
studies are conducted in developed countries, such as the USA. We agree with the
Auditors
First-stage Second-stage unqualified
Coefficient estimate t-statistic Coefficient estimate t-statistic
opinions
Panel A: accrual quality and ARICs
Intercept 21.3936 * * * 210.5292 0.4857 * * * 4.8750
GROWTH 20.2333 20.0833
VIOLATION 20.1822 * * * 23.1606 349
SEO 0.1061 1.1983
COMMIT 0.0712 1.1414
POSIT 20.1267 * * * 23.6552
AGE 20.0512 * * * 26.9945
CROSSLIST 20.0958 21.1003
0.1291 * * * 2 0.0212 * * *
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SIZE 5.0540 2 4.1646


LOSS 20.1290 * * * 23.8873 0.0391 * * * 3.1876
M&A 0.0076 0.1308 2 0.0004 2 0.0406
BIG4 20.2968 * * * 22.8380 0.0075 0.3973
SOE 0.1261 * * 2.3701 2 0.0187 * 2 1.7987
SHARE_HHI 0.1999 0.7441 0.2175 * * * 3.3089
INV 0.1442 * * * 3.6314
FA 2 0.1031 * * * 2 5.4041
STDCFO 2 0.0527 2 0.9996
LEV 0.0374 * * 2.2984
MB 2 0.0011 2 1.6237
WRITEOFF 2 0.0268 * * * 2 2.6234
AUDFEE 0.1943 * * * 14.8331
AUDOPN 2 0.0417 * * 2 2.7454
ARIC 0.3042 1.5746
Inverse Mills 2 1.4135 * * * 2 20.2116
Log-likelihood 1,308.5774 * * * 1,009.4344 * * *
Observations 2,669 2,669
Panel B: accrual quality and ARICs issued by dominant audit suppliers
Intercept 23.9750 * * * 26.8621 0.1441 * * * 3.3634
GROWTH 20.1199 21.3932
VIOLATION 20.2435 * * 22.4701
SEO 0.0399 0.3257
COMMIT 0.0214 0.3119
POSIT 20.2672 * * * 24.7511
AGE 20.1036 * * * 213.6184
CROSSLIST 20.1327 20.6626
SIZE 0.1994 * * * 7.1271 2 0.0031 2 1.5375
LOSS 20.2479 * * * 22.6983 0.0172 * 1.9672
M&A 0.0501 0.7456 0.0141 * * * 3.0566
BIG4 20.4690 * * * 23.3377 2 0.0060 2 0.8254
SOE 0.1557 * * 2.5400 2 0.0092 * * 2 2.3019
SHARE_HHI 0.1571 0.6056 0.1058 * * * 4.5238
INV 0.0826 * * * 3.8828
FA 2 0.0649 * * * 2 5.2190
STDCFO 2 0.0585 2 1.2272
LEV 0.0457 * * * 4.7840
MB 2 0.0003 2 0.4545 Table VII.
WRITEOFF 2 0.0008 2 0.1482 Accrual quality
AUDFEE 0.0434 * * * 5.1809 and ARICs with
(continued) self-selection controls
NBRI First-stage Second-stage
3,4 Coefficient estimate t-statistic Coefficient estimate t-statistic

AUDOPN 2 0.0636 * * * 2 4.2722


ARIC 2 0.0416 * * 2 2.0753
High_ARIC 2 0.0227 * 2 1.8944
350 Inverse Mills 2 2.4455 * * * 2 37.3721
F-statistic of (u1 u2) 6.7182 * * *
Log-likelihood 1,326.4369 * * * 1,206.3987 * * *
Observations 2,669 2,669

Table VII. Notes: Significant at: *0.10, * *0.05 and * * *0.001 levels; see the Appendix for variable definitions
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effectiveness of internal controls in improving accrual quality. However, we have doubt


whether auditors unqualified opinion would act as a reliable proxy of the effectiveness
of internal control due to their poorer investor protection in emerging markets. We
investigate whether the auditors unqualified opinion on internal control is associated
with accrual quality in an important emerging market China, in which audit market
are well characterized by excessive competition and market supervision are poor
compare to developed countries. We assess accrual quality by documenting how well
accruals map into past, present and future operating cash flows, following Dechow and
Dichev (2002) and Francis et al. (2005).
After controlling for a variety of innate firm characteristics that prior research
shows to be related to accrual quality, as a whole we find that firms disclose ARICs do
not show low abnormal accruals compare to the non-ARIC firms. Further tests show,
however, that firms with dominant auditors unqualified opinions on their internal
controls report more reliable accruals relative to other firms including non-ARIC firms
and firms who disclose unqualified opinions on internal controls but fail to be issued
by dominant auditors. Moreover, the results are robust to additional accrual quality
measure, additional audit quality measure and the correction of self-selection bias
using the inverse ratio approach. These evidences indicate that what matter is
dominant auditors unqualified opinion on internal control rather than other auditors
unqualified opinion which could not act as a signal of effective internal control.
Our study has limitations. First, we rely on the disclosure of an ARIC. Therefore, to the
extent that there is a systematic bias in the choice to audit and disclose the auditors
opinions on internal control over financial statements-beyond those variables used as
controls-our sample may not represent the true underlying population of firms with
ARICs. Second, since the Chinese-SOX has been issued for a relatively short time, our
ability to infer causality between disclosure of ARICs and accrual quality is limited.
Finally, we must rely on proxy for accrual quality. We use the model developed by
Dechow and Dichev (2002) as modified by Francis et al. (2005). As with any measure,
ours is subject to limitations and might measure the accrual quality construct with noise.
Our findings have implications for regulators, auditors and researches. First, our
findings add to the debate on the benefits of Chinese-SOX, suggesting that
auditors opinions on internal control are not appropriately identifying good quality
firms specifically, those with good quality of accruals. Second, an important policy
objective in Chinese emerging market is the efficient allocation of scarce capital. In order
to achieve the informational and functional efficiency of capital markets, improving the Auditors
reliability of firms disclosures is crucial. Our results suggest that implementing unqualified
Chinese-SOX could be facilitated by improving audit quality. Further research is needed
to generalize our findings to other emerging markets with investor protection of similar opinions
quality to that in China.

Note 351
1. Before 2009, all ARICs contain auditors unqualified opinions. Therefore, the ARIC is
regarded as a proxy for the auditors unqualified opinions on internal controls in China
before this study was conducted.
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Appendix Auditors
unqualified
Variables Definitions opinions
AQ The standard deviation of the firms abnormal accruals from Dechow and Dichev
(2002) accruals quality measure and modified by McNichols (2002) and Francis et al.
(2005) 353
Jones_AQ Absolute value of the firms abnormal accruals from Jones (1991) and Dechow and
Dichev (2002), accruals quality measure, minus the median abnormal accruals for firms
in the same industry
ARIC Equal to one if the firm get and disclose an unqualified opinion issued by external
auditor on its internal control and zero otherwise
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SOE Equal to one if the firms largest shareholder is government related and zero otherwise
M&A Equal to one if the firm involves in mergers and acquisitions and zero otherwise
WRITEOFF Equal to one if the firm involves in assets impairments or write-down and zero
otherwise
LOSS Equal to one if the firm has a incidence of losses and zero otherwise
LEV The ratio of debt to total assets
SIZE Nature logarithm of total assets
STDCFO The standard deviation of cash from operations scaled total assets over previous five
years
INV The ratio of inventory to total assets
FA The ratio of fixed assets to total assets
SHARE_ The Herfindahl index of the percentage of shares holed by top ten shareholders
HHI
MB The ratio of book value of equity to market value of equity
AUDOPN Indicator variable, equal to one if the firm get an unqualified audit opinion over its
financial statements and zero otherwise
AUDFEE The ratio of audit fee to total assets
BIG4 Equal to one if the firm contract with one of Deloitte & Touche, KPMG, Ernst & Young
and PwC and zero otherwise
GROWTH The ratio of sales minus previous sales, scaled previous sales
VIOLATION Equal to one if the firm involves in violation and zero otherwise
SEO Equal to one if the firm involves in secondary equity offering and zero otherwise
COMMIT Equal to one if the firm set an internal auditing department and zero otherwise
POSIT Equal to one if the firm is listed on Shanghai Stock Exchange and zero otherwise
AGE The number of years that the firm has been established as of current year
CROSSLIST Equal to one if the firm is listed on domestic and abroad stock exchange and zero Table AI.
otherwise Variable definitions

About the authors


Liuchuang Li is a PhD candidate at the School of Management in Xian Jiaotong University.
His research mainly focuses on internal control and corporate governance. Liuchuang Li is the
corresponding author and can be contacted at: xjtu.llc@stu.xjtu.edu.cn
Gaoliang Tian is an Associate Professor at the School of Management in Xian Jiaotong
University. His research mainly focuses on internal control and corporate governance.
Baolei Qi is a PhD candidate at the School of Management in Xian Jiaotong University.
His research mainly focuses on internal control and corporate governance.

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