Review Journal "A Continuous Relation between Audit Firm Size and Audit Opinions : Evidence from China"

Title	A Continuous Relation between Audit Firm Size and Audit Opinions : Evidence from China
Author	Chanto Li, Frank M. Song and Sonia M.L. Wong
Year	2008

Introduction

This study examines the relation between audit firm size and audit opinion in China’s emerging audit market for publicly listed firms from 2001 to 2003. Our study has two motivations. First, our study documents developments in China’s rapidly changing audit market since 2000. DeFond et al.’s (2000) substantial study of audit quality in China between 1993 and 1996 finds that large audit firms in China issued more modified audit opinions, leading them to conclude that large audit firms are more independent than smaller firms. However, they also find that large audit firms’ market share decreased in 1996 when China’s regulators imposed policies to increase the level of audit independence. This implies a lack of demand for high-quality audits during that period. The audit size quality relation would have been negative rather than positive if this trend had persisted. Nevertheless, new policies mandated by Chinese government in the late 1990s were likely to promote the demand for and supply of higher-quality audits. We investigate audit firm size and audit quality in the period following China’s new policies to determine whether the demand and supply of higher-quality audits has changed.

SAMPLE AND RESEARCH DESIGN

Sample

We exclude 24 firms that are only listed on the B-share market and also firms from the finance industry (52 firm-year observations) as they follow a different accounting reporting system from firms in other industries.10 We also drop observations of firms in their IPO year. For each listed firm, we obtain data on the name of the audit firm, the corresponding audit fee and the auditor’s opinion from its annual report. Out of the 1,136 (1,200, 1,263) firms listed at the end of 2001 (2002, 2003), we have complete data for 1,016 (1,158, 1,222) listed firms.

EMPIRICAL RESULTS

Descriptive statistics

Table 5 reports the correlations between the variables. A negative, significant correlation exists between Client Size and Opinion, suggesting that small listed firms tend to receive modified opinions. We also find a significantly positive correlation between Opinion and earnings management (EM) as well as Opinion and ST Loss dummy, indicating that firms with increased earnings management and/or higher default risks are associated with more modified audit opinions. The correlations between the three audit firm size measures are quite high, with correlations ranging from 0.81 to 0.93. This is not surprising as audit firm size is being measured from different dimensions. The correlation between Assets Audited and Client Size is positive and significant, indicating that large listed firms are more likely to be audited by large audit firms. Furthermore, Assets Audited is negatively related to ST and Loss, suggesting that large audit firms tend to select listed firms that have lower default risks as their clients.

CONCLUSIONS

Using panel data of audit firms and listed firms in China from2001 to 2003, Our study provides a useful addition to the existing literature on audit firm size effects because of China’s unique market structure. Unlike most developed audit markets where the market has been dominated by a few large audit firms such as the Big 8/6/4, a far greater number of smaller audit firms exist in China’s audit market. Our evidence suggests that positive audit firm size effects are not specific to audit markets that are dominated by a few large audit firms. Among a sample of