Http://mns.zsu.edu.cn Is Big-Five trustable in emerging Market? Preliminary Evidence from China’s Capital Market LIU Feng ZHOU Fuyuan Sun Yatsen University

http://mns.zsu.edu.cnhttp://mns.zsu.edu.cn

Is Big-Five trustable in emerging Market?

Preliminary Evidence from China’s Capital Market

Is Big-Five trustable in emerging Market?

Preliminary Evidence from China’s Capital Market

LIU Feng

ZHOU Fuyuan

Sun Yatsen University

LIU Feng

ZHOU Fuyuan

Sun Yatsen University


Presentation AgendaPresentation Agenda

The issueTwo casesPreliminary Empirical evidencePossible (plausible) explanationsDiscussion

The issueTwo casesPreliminary Empirical evidencePossible (plausible) explanationsDiscussion


The IssueThe Issue

Term of Big 5.From Big 8 to Big 6, and then Big 5,

Big 4.

Big 5 initiated their office in mainland China since early 1980s.Launched cooperative firms in early

1990s.

Term of Big 5.From Big 8 to Big 6, and then Big 5,

Big 4.

Big 5 initiated their office in mainland China since early 1980s.Launched cooperative firms in early

1990s.


The IssueThe Issue

Now Big 5 already enjoys a quite big share in China’s auditing market.

The high rank officers of our government hold the belief that Big 5 provides much higher quality auditing than local firms do.They set up some market shares

exclusively to Big 5, or, internationally well recognized firms, according to the official documents.

Now Big 5 already enjoys a quite big share in China’s auditing market.

The high rank officers of our government hold the belief that Big 5 provides much higher quality auditing than local firms do.They set up some market shares

exclusively to Big 5, or, internationally well recognized firms, according to the official documents.


The IssueThe Issue

For example,January 2001, CSRC and M of F jointly

issued a regulation requires all listed companies of finance industry be dually audited by a Big 5 firm and a domestic firm;

December 2001, CSRC announced a regulation mandates same requirement for all IPO and seasonal equity offering firms.Thanks to Andersen’s document shredding, the

regulation is stopped.

For example,January 2001, CSRC and M of F jointly

issued a regulation requires all listed companies of finance industry be dually audited by a Big 5 firm and a domestic firm;

December 2001, CSRC announced a regulation mandates same requirement for all IPO and seasonal equity offering firms.Thanks to Andersen’s document shredding, the

regulation is stopped.


The IssueThe Issue

Shenzhen municipal government officer announced in January, 2004 that all infrastructure SOEs must be audited by Big Four.They later claimed that they never said so wh

en encountering pressures.Now 3 of 4 four national commercial bank

s are the clients of Big 4.Bank of China: PWC;China Industrial and Commercial Bank: Ernst

& Young;China Construction Bank: KPMG;

Shenzhen municipal government officer announced in January, 2004 that all infrastructure SOEs must be audited by Big Four.They later claimed that they never said so wh

en encountering pressures.Now 3 of 4 four national commercial bank

s are the clients of Big 4.Bank of China: PWC;China Industrial and Commercial Bank: Ernst

& Young;China Construction Bank: KPMG;


The IssueThe Issue

The Issue:Is Big Five as good as perceived by

China’s high rank officers in China’s capital market?

Or, compared with local firms which are blamed to provide low quality auditing, does Big 5 provide higher quality auditing in China’s capital market?

The Issue:Is Big Five as good as perceived by

China’s high rank officers in China’s capital market?

Or, compared with local firms which are blamed to provide low quality auditing, does Big 5 provide higher quality auditing in China’s capital market?


Two casesTwo cases

Before presenting empirical evidences, I would like to brief two cases to give you an idea how well Big 5 was.Also some institutional knowledge

that how Big 5 operate in China.

Before presenting empirical evidences, I would like to brief two cases to give you an idea how well Big 5 was.Also some institutional knowledge

that how Big 5 operate in China.


Baoshi and PWC: A Case DescriptionBaoshi and PWC: A Case Description

Baoshi: one of the 300 key SOEs in China (1996);

IPO B shares in June and A shares in September, 1996;

Main products:Black and white glass bulbs and kinescope

s;B & W tv cathode ray tubes;

All auditors reports are conducted by PricieWaterhouse Asia and PW Dahua, its cooperative firms in China.

Baoshi: one of the 300 key SOEs in China (1996);

IPO B shares in June and A shares in September, 1996;

Main products:Black and white glass bulbs and kinescope

s;B & W tv cathode ray tubes;

All auditors reports are conducted by PricieWaterhouse Asia and PW Dahua, its cooperative firms in China.


Year Auditor Auditor Opinion Pre-tax Profit (000 RMB)

Overseas Domestic Overseas Domestic Overseas

Domestic

1996 PW Asia PW Dahua

Unqualified Unqualified 3 334 120 149

1997 PW Asia PW Dahua

Disclaimer Disclaimer 342 270 342 270

1998 PWC China

PW Dahua

Disclaimer Disclaimer 209 270 258 150

1999 PWC China

PW Dahua

Unqualified w/ explantion para.

Unqualified w/ explantion para.

97 786 56 887

2000 PWC China

PWC Zhongtian

Unqualified Unqualified 134 049 100 048


The comments on Baoshi caseThe comments on Baoshi case

From clean opinion in 1996 to disclaimer (the first case in Chinese auditing mkt) in 1997: no transition

From the Prospectus and Listing Announcement for Baoshi B shares, we may find: Failure in shedding concerns on the inhere

nt risk existing in Baoshi Baoshi on the brink of loss in its listing ye

ar

From clean opinion in 1996 to disclaimer (the first case in Chinese auditing mkt) in 1997: no transition

From the Prospectus and Listing Announcement for Baoshi B shares, we may find: Failure in shedding concerns on the inhere

nt risk existing in Baoshi Baoshi on the brink of loss in its listing ye

ar


The comments on Baoshi case


When the first disclaimer comes out, Management explanation for disclaimer of o

pinion: main production line stopped due to outdated technology in June 1996.

How could not PW find such an obvious fact?The ST system and delisting regulation

three years of ST in a line;1997 disclaimer makes Baoshe STed;1998 disclaimer: nothing to lose;1999: if disclaimer or qualified, Baoshi will f

ace to be delisted.

When the first disclaimer comes out, Management explanation for disclaimer of o

pinion: main production line stopped due to outdated technology in June 1996.

How could not PW find such an obvious fact?The ST system and delisting regulation

three years of ST in a line;1997 disclaimer makes Baoshe STed;1998 disclaimer: nothing to lose;1999: if disclaimer or qualified, Baoshi will f

ace to be delisted.




1999, Basshi is “good” enough to get an unqualified with explanation paragraph report;Unqualified report is necessary;

Explanation paragraph: acceptable;We have an extreme case (600633, 1998): an un

qualified report plus 12 counts of explanation, including insolvency, etc.

However, Baoshi is in fact no manufacturing activity for a whole year;

Total operating revenue: 5.7m;

1999, Basshi is “good” enough to get an unqualified with explanation paragraph report;Unqualified report is necessary;

Explanation paragraph: acceptable;We have an extreme case (600633, 1998): an un

qualified report plus 12 counts of explanation, including insolvency, etc.

However, Baoshi is in fact no manufacturing activity for a whole year;

Total operating revenue: 5.7m;




All profit are paper gains;A big bath in 1997 and 1998, then rever

se some in 1999, for example, an interest expense reversal of 136 million.

Sell land use rights and building to SBEG, a sub-subsidiary with a net profit of 27 m.To avoid consolidation of SBEG, reduce h

olding share from 51% to 49% in Oct., 1999.

Baoshi is deSTed, or listed as normal, successfully in 2000.

All profit are paper gains;A big bath in 1997 and 1998, then rever

se some in 1999, for example, an interest expense reversal of 136 million.

Sell land use rights and building to SBEG, a sub-subsidiary with a net profit of 27 m.To avoid consolidation of SBEG, reduce h

olding share from 51% to 49% in Oct., 1999.

Baoshi is deSTed, or listed as normal, successfully in 2000.


China Southern Airlines and its auditor KPMG

China Southern Airlines and its auditor KPMG

China Southern Airlines (CSA), one of the big three airlines in China, listed in Hongkong and New York in July 1997 and Shanghai in July 2003;KPMG acting as its auditor for 11 years.

Xiamen Airlines, invested by CSA and Xiamen C & D, a local SOE;CSA owns 60% shares.

China Southern Airlines (CSA), one of the big three airlines in China, listed in Hongkong and New York in July 1997 and Shanghai in July 2003;KPMG acting as its auditor for 11 years.

Xiamen Airlines, invested by CSA and Xiamen C & D, a local SOE;CSA owns 60% shares.


CSA and KPMGCSA and KPMG

Since Xiamen C & D sales its equity on Xiamen Airlines to its controlling shareholder, C & D Group, in June 2003, and C & D Group is not listed publicly, the only way to get Xiamen Airlines financial data is from CSA financial statements and no room to cross check.

Our discussion is mainly on year 2002.

Since Xiamen C & D sales its equity on Xiamen Airlines to its controlling shareholder, C & D Group, in June 2003, and C & D Group is not listed publicly, the only way to get Xiamen Airlines financial data is from CSA financial statements and no room to cross check.

Our discussion is mainly on year 2002.



According to Xiamen C & D 2002 annual report, Xiamen Airlines reported ¥78 million net income;

According to CSA 2003 prospectus, Xiamen Airlines realized 436 million net income;

Why do we have a huge difference of 358 million?

According to Xiamen C & D 2002 annual report, Xiamen Airlines reported ¥78 million net income;

According to CSA 2003 prospectus, Xiamen Airlines realized 436 million net income;

Why do we have a huge difference of 358 million?



CSA explanation: Due to different depreciation policy on aircraft an

d engine and other high-value rotable spares; Xiamen Airlines employ a more conservative depr

eciation policy, that is, less usable age and lower residual value, while CSA adjust XMA report with a less conservative depreciation policy.

Some data of depreciation expenses on owned and leased aircraft:XMA(2002): depreciation: 429m; owned/leased craft: 450

8 m; ratio: 9.51%;CSA(2003): depreciation: 1018m; owned/leased craft: 20

325m; ratio: 5.01%;

CSA explanation: Due to different depreciation policy on aircraft an

d engine and other high-value rotable spares; Xiamen Airlines employ a more conservative depr

eciation policy, that is, less usable age and lower residual value, while CSA adjust XMA report with a less conservative depreciation policy.

Some data of depreciation expenses on owned and leased aircraft:XMA(2002): depreciation: 429m; owned/leased craft: 450

8 m; ratio: 9.51%;CSA(2003): depreciation: 1018m; owned/leased craft: 20

325m; ratio: 5.01%;



More to say about CSA’s discretional accrual.

More to say about CSA’s discretional accrual.


2003 2002

Accounts Receivables

In thousand Allowance for D/A

In thousands

Allowance for D/A

Less than 1 year 896 722 ０ .５％ 771 411 ３ .７％1 to 2 years 42 408 100% 18 176 100%

2 to 3 years 14 383 100% 5 150 100%

Beyond 3 years 8 311 100% 8 343 100%

2003 2002

Other receivables In thousand Allowance for D/A

In thousand Allowance for D/A

Less than 1 year 285 290 0% 382 663 _______

1 to 2 years 20 568 0% 15 679 _______

2 to 3 years 7 330 0% 7 336 64.1%

Beyond 3 years 33 381 89.6% 28 505 88.4%

The change result in earning increasing by 33 m

The change result in earning increasing by 33 m



Why does CSA need a positive profit report so desperately? IPO for A shares in July, 2003, several

months after SARS; It will have a negative market reaction if a

company reports a net loss just after IPO. The doable way for CSA to go: using

accruals.KPMG endorses CSA’s accounting.

However, most researches tend to suggest that big 5 will have less discretionary accrual.

Why does CSA need a positive profit report so desperately? IPO for A shares in July, 2003, several

months after SARS; It will have a negative market reaction if a

company reports a net loss just after IPO. The doable way for CSA to go: using

accruals.KPMG endorses CSA’s accounting.

However, most researches tend to suggest that big 5 will have less discretionary accrual.


Empirical evidenceEmpirical evidence

Since auditing quality could not be measured directly, proxy measurement for auditing quality is necessary.

Two ways to proxy for auditing quality:Market reaction, for example, CAR;Discretionary accruals.

Our paper adopts DA method.We mainly follow Krishnan (2003) and

make some modification.

Since auditing quality could not be measured directly, proxy measurement for auditing quality is necessary.

Two ways to proxy for auditing quality:Market reaction, for example, CAR;Discretionary accruals.

Our paper adopts DA method.We mainly follow Krishnan (2003) and

make some modification.



OP: operational profit;A: total assets;

OP = OC+TA = OC+NDA+DA,

We further introduce Big 5 as dummy variable.

OP: operational profit;A: total assets;

OP = OC+TA = OC+NDA+DA,

We further introduce Big 5 as dummy variable.

tt

t

t

t

A

OP

A

OP

10

1

tt

t

t

t

t

t

t

t

A

DA

A

NDA

A

OC

A

OP

13

12

110

1



Test

Dum1= 1 when audited by Big 5, Dum1=0 when audited by Non-Big 5. If Big Five is effective enough to

control client’s opportunistic accounting and make DA more meaningful to predict profitability, then :

Test

Dum1= 1 when audited by Big 5, Dum1=0 when audited by Non-Big 5. If Big Five is effective enough to

control client’s opportunistic accounting and make DA more meaningful to predict profitability, then :

tt

t

t

t

t

t

t

t

A

DAdum

A

NDA

A

OC

A

OP

13

12

110

1 )1(

0


SampleSample

All listed corporations in both Shanghai and Shenzhen Stock Exchange. It is as late as 1999 that our government made accounting fi

rm fully independent. Our sample covers from 1999 to 2001.

Delete all financial corporations, all negative net assets corporations and st-corporations;

No auditors change subsequent to the observation year.

Clean auditor report subsequent to the observation year.

Clean auditor report for the observation year. Total sample size: 1950 firm-year observation.

1999: 525; 2000: 585; 2001: 840. Big 5: only 84 observations left.

All listed corporations in both Shanghai and Shenzhen Stock Exchange. It is as late as 1999 that our government made accounting fi

rm fully independent. Our sample covers from 1999 to 2001.

Delete all financial corporations, all negative net assets corporations and st-corporations;

No auditors change subsequent to the observation year.

Clean auditor report subsequent to the observation year.

Clean auditor report for the observation year. Total sample size: 1950 firm-year observation.

1999: 525; 2000: 585; 2001: 840. Big 5: only 84 observations left.


SampleSample

The distribution of 84 observations for Big 5:1999: 172000: 272001: 40.

2001 is the only testable year;We will report 2002 and 2003

sometime later.

The distribution of 84 observations for Big 5:1999: 172000: 272001: 40.

2001 is the only testable year;We will report 2002 and 2003

sometime later.


2001 Statistics

SIZE MKBK

LEV LIYEAR

LOSS ORA

Clients of Big 5

( 40)

Mean 21.724

5.139 0.179 5.350 0.875 0.049

Std.Deviatio

n

1.0031

5.6332

0.1412

2.3593

0.3349

0.0702

Clients of Non-Big

5(840)

Mean 20.969

5.581 0.226 4.438 0.831 0.038

Std.Deviatio

n

0.7849

5.9294

0.1353

2.4220

0.3747

0.0767

T statistics -5.853

0.460 2.017 -2.325

-0.724

-0.928

Descriptive statisticsDescriptive statistics


Estimation of DAEstimation of DA

Year Estimate of δ2 （ Predicted Sign ： +）

Estimate of δ3（ Predicted sign： -）

Estimate of δ4（ Predicted sign： -）

1999 0.009146（ 1.310）

-0.0301***

（ -3.068）-.0.0754（ -1.476）

2000 0.01083***

（ 2.160）-0.0353***

（ -4.519）-.148***

（ -9.293）2001 0.009923***

（ 2.688）-0.0329***

（ -7.349）-0.0426***

（ -5.663）CorrectSign(100%)

100% 100% 100%

tt

t

t

t

t

t

tt

t

A

IA

A

PPE

A

REV

AA

TA

)()()()

1(

14

13

12

11

1


Comparison of DAComparison of DA

Panel 3:Samples of

2001

Mean T-statist

ics

Median Z-statist

icsBig 5 Non-

Big 5

Big 5 Non-Big 5

Income-Increasing

DA

0.0630

0.0508 -1.058 0.0505 0.0413 -0.649

Income-Decreasing

DA

-0.0522

-0.05

13

0.108 -0.0503 -0.03

82

-0.492

Absolute DA 0.0561

0.0510 -0.717 0.0394 0.0503 -0.757


Empirical resultsEmpirical results

Year 2001: adjust R2=0.281Sample size: 40 for Big 5; 840 for Non-Big 5;

Regression coefficient

Coefficient value T statistics

δ1 0.610*** 17.891

δ2 1.380*** 9.938

δ3 0.535*** 12.230

π 0.044 0.285

tt

t

t

t

t

t

t

t

A

TDAdum

A

TNDA

A

TOC

A

TOP

13

12

110

1 )1(



We further assort all samples by 3-digit SIC code and delete some outliers; Matching by 3-digit SIC code, we delete the

observations if no matching observation within the same industry;

Then matching by decile of operating return on total assets to eliminate the potential difference of profitability.

Then matching by size and eliminate outliers;Only 176 observations for three years lef

t ; 28 from Big 5 and 148 from Non-Big 5;

We further assort all samples by 3-digit SIC code and delete some outliers; Matching by 3-digit SIC code, we delete the

observations if no matching observation within the same industry;

Then matching by decile of operating return on total assets to eliminate the potential difference of profitability.

Then matching by size and eliminate outliers;Only 176 observations for three years lef

t ; 28 from Big 5 and 148 from Non-Big 5;



Since only 28 observations of Big 5 for three years left, we cannot run regression for any single year;

Before doing pooling test we have to run test first to make sure there is no structure change among the three year data;F value=0.592, it is quite safe to say

that there is no significant structure change for these three year data.

Since only 28 observations of Big 5 for three years left, we cannot run regression for any single year;

Before doing pooling test we have to run test first to make sure there is no structure change among the three year data;F value=0.592, it is quite safe to say

that there is no significant structure change for these three year data.


Comparison of DAComparison of DA

Pooled, 28 for Big 5;148 for Non-Big

5

Mean T-Statistics

Median Z-statist

icsBig 5 Non-

Big 5

Big 5 Non-Big 5

Income-Increasing DA

0.0649 0.0477 -0.931

0.0592

0.0495

-1.253

Income-Decreasing

DA

-0.0439

-0.0421

0.199 -0.0468

-0.0308

-1.020

Absolute DA 0.0476 0.0454 -0.289

0.0485

0.0358

-1.286


12

adjust R2=0.291

Regression coefficient

Coefficient value T statistics

Υ1 -0.013 -0.965（ -0.256）Υ2 -0.012 -0.843（ -0.342）

δ11.064*** 8.492（ 16.66）

δ 21.062*** 2.441（ 23.14）

δ 31.015*** 7.212（ 18.76）

π 0.014 0.064（ 0.206）

tt

t

t

t

t

tii

t

t

A

TDAdum

A

TNDA

A

TOCD

A

TOP

13

12

110

1 )1(



Robust testRobust test

We add more control variables widely used in literatures such as leverage, book to market ration etc, no significant change found.

We add more control variables widely used in literatures such as leverage, book to market ration etc, no significant change found.


Possible explanationPossible explanation

According to DeAnglo (1981), auditor size is positively correlated with auditing quality;

According to reputation mechanism, Big 5 treasures its reputation;

This is contradicted with the empirical evidence and case;

Is there something missing?

According to DeAnglo (1981), auditor size is positively correlated with auditing quality;

According to reputation mechanism, Big 5 treasures its reputation;

This is contradicted with the empirical evidence and case;

Is there something missing?



Three implicit presumption for DeAnglo (1981) to hold:No serious agency cost;High Inspection (or supervising?) risk

s for these opportunistic parties;High litigation risks for these convict

ed opportunistic parties.

Three implicit presumption for DeAnglo (1981) to hold:No serious agency cost;High Inspection (or supervising?) risk

s for these opportunistic parties;High litigation risks for these convict

ed opportunistic parties.



It may be true that agency problem is quite serious and may positively correlated with firm size.David Duncan ignored the warning fr

om Professional Standards Group (PSG);

In China, my case study shows that personalisation of client resources may be observed;

This may weaken quality increment due to size effect;

It may be true that agency problem is quite serious and may positively correlated with firm size.David Duncan ignored the warning fr

om Professional Standards Group (PSG);

In China, my case study shows that personalisation of client resources may be observed;

This may weaken quality increment due to size effect;



Inspection risk for Big 5 in China: Zero or nearly zero; Founding member firms with Ministry of Finance; No peer review done by CICPA;

I have no idea if there is any peer review done by Big 8 members firms within China;

Working papers are prepared in abbreviated English which makes peer review almost impossible for domestic professionals;

This implies that there is no possibility for Big 5 to be caught for opportunistic behavior if they behave “reasonably”. Reasonable:

No harm on reputation system;

Inspection risk for Big 5 in China: Zero or nearly zero; Founding member firms with Ministry of Finance; No peer review done by CICPA;

I have no idea if there is any peer review done by Big 8 members firms within China;

Working papers are prepared in abbreviated English which makes peer review almost impossible for domestic professionals;

This implies that there is no possibility for Big 5 to be caught for opportunistic behavior if they behave “reasonably”. Reasonable:

No harm on reputation system;



Litigation risk: Extremely low even to domestic auditors fir

m;Case of Jinzhou Port (600190);

Civil suit motion against KPMG was reported accepted by Shenyang middle court in Feb. 2003, no further report was found.

Disciplinary risk;Domestic firm may face to pretty high discipl

inary proceedings.No single case of disciplinary proceedings a

gainst Big 5 is reported;

Litigation risk: Extremely low even to domestic auditors fir

m;Case of Jinzhou Port (600190);

Civil suit motion against KPMG was reported accepted by Shenyang middle court in Feb. 2003, no further report was found.

Disciplinary risk;Domestic firm may face to pretty high discipl

inary proceedings.No single case of disciplinary proceedings a

gainst Big 5 is reported;



Market partition exclusive to Big 5;Jan 2001, bank and securities industry list

ed company;Complimentary auditing done by Internationall

y well known firms, Big 5, for IPO;Dec. 2001, extended to all IPO and SEO;

It was stopped due to Andersen document shredding.

Jan 2004, vice mayor of Shenzhen specified a market share exclusively for Big 4.

No risk to lose potential qusi-rent for these opportunistic parties.

Market partition exclusive to Big 5;Jan 2001, bank and securities industry list

ed company;Complimentary auditing done by Internationall

y well known firms, Big 5, for IPO;Dec. 2001, extended to all IPO and SEO;

It was stopped due to Andersen document shredding.

Jan 2004, vice mayor of Shenzhen specified a market share exclusively for Big 4.

No risk to lose potential qusi-rent for these opportunistic parties.



Theoretical prediction:Big 5 may lower their auditing quality

in China;There should be no systematic

quality difference between Big 5 and Non-Big 5 auditing.

Theoretical prediction:Big 5 may lower their auditing quality

in China;There should be no systematic

quality difference between Big 5 and Non-Big 5 auditing.


DiscussionDiscussion

More work to do;We plan to extend the research to year

2002 and 2003;

More refined research design:Searching for more appropriate method for

DA testing;Alternative examination of auditing quality;

Understand Big-5’s internal structure to discuss agency problem and perceived litigation risk, etc;

More work to do;We plan to extend the research to year

2002 and 2003;

More refined research design:Searching for more appropriate method for

DA testing;Alternative examination of auditing quality;

Understand Big-5’s internal structure to discuss agency problem and perceived litigation risk, etc;

Documents

Http://mns.zsu.edu.cn Is Big-Five trustable in emerging Market? Preliminary Evidence from China’s Capital Market LIU Feng ZHOU Fuyuan Sun Yatsen University