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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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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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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.
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:
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.
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.
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
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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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
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.
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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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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Table VII. Notes: Significant at: *0.10, * *0.05 and * * *0.001 levels; see the Appendix for variable definitions
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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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Jensen, M.C. and Meckling, W.H. (1976), Theory of the firm: managerial behavior, agency costs
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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