Regulation, External Auditing, And Rights Issues

China is a typically transitional economy which has currently been transformingfrom a plan-driven to market-driven model.Though characterized by a poorinstitution,the legal environment in China evolved rapidly in recent years.Due toregulation embedded in the traditional culture and history of China,the regulation hasalmost prevailed over other schemes,such as legal governance.Based on the specialinstitutional setting of China,we seek to investigate the relationship betweenregulation,external auditing,and rights issues by addressing the following questions.Does the regulation of rights issues matter or be effective in the capital allocation inthe emerging Chinese stock market? Furthermore,how does the toughness ofregulation of rights issues over time affect the information content of modified auditopinions and equity-financing behavior of Chinese listed firms who demand externalfunds? In addition,does big auditor always perform better as an economic agent thansmall auditor in the poor institution setting of China?Using a sample of Chinese listed firms,we document some evidences as follows.1.China's regulation of rights issues was generally effective to guide the flow ofcapital to better performing listed firms during the study period,based on theaccounting and stock performance after announcement of rights issue proposalapproved at the board meeting,as well as the direct and indirect effect of theregulation.Furthermore,we find the regulation of rights issue was stricter and moreeffective over time.The detail evidences from the tests of direct and indirect effect ofthe regulation are as follows.In the tests of the direct effect of regulation,it issignificant effectiveness in both of the two different regulation periods in terms ofaccounting performance;however it is significantly effective only in the laterregulation period in terms of stock performance.In the tests of indirect effect ofregulation,it is significantly effective only in the later regulation period in terms ofaccounting and stock performance respectively.Interestingly,effectiveness of directeffect of the regulation had been significantly improved over time only for the listedfirms with rights issue proposal denied by China's regulators while having accountingperformance increased significantly in the later regulation period,however theeffectiveness is only supported by tests of accounting performance.2.Under the pressure of improved regulation of rights issues in 2001,the firmsthat wanted to raise equity took self-selection action to avoid the rejection of therights issue proposal by the regulators,and this self-selection led to a significantdecline in number of firms of which rights issue proposal was rejected by theregulators due to receiving modified audit opinions.Furthermore,improved regulationof rights issues in 2001 distorted and diluted the information content of modified audit opinions of the firms that gained rights issue approval,as afterward that the modifiedaudit opinions were not considered any longer by the regulator and modified auditopinions no longer affect long-term stock performance.3.Compared to small auditors,big auditors monitor earnings management in therights issuers more effectively,as earnings management is measured by positivediscretionary accruals and absolute discretionary accruals.This monitoring effect ofbig auditors is significantly stronger for the group with right offerings than thatwithout right offerings,because discretionary accruals and positive discretionaryaccruals of rights issuers are significantly higher than those of non-issuers.However,the evidence superficially suggests that big auditors don't constrain earningsmanagement of the whole sample firms consisting of both rights issuers andnon-issuers more effectively than small auditors.