Research On The Effect Of Audit Quality On Earnings Management In Chinese Listed Companies

Audit service is named as a kind of special goods that owns "social credibility", the level of which will directly affect CPA's survival and development. Therefore, the extent of earnings management to the listed companies is bound to reflect the degree of conservatism and independence of CPA effectively during their practice. As a result, the effective restriction of audit quality on the behavior of earnings management has become an important issue both in theoretical and practical aspects when it is applied in positive accounting and auditing research.The study of the relationship between audit quality and earnings management in western country has experienced more than 20 years, with a wide range of comprehensive and constructive conclusions. The auditor scale and specialty represented by Big4 accounting firms as proxy of audit quality in almost ideal market environment has nearly proved its function of detecting and controlling firm's earnings management. In contrast, researchers in our country just set out to test the conclusion and gather the evidence for this issue in our developing Securities Auditing market. Based on the difference on the degree of market effectiveness, the difference of institutional background, and the limitations of research methods etc, however, conclusions haven't reach an agreement. On the other hand, the studies of auditor specialty as proxy of audit quality is relatively rare in China. This paper is aimed to conduct the further research of internal relationship between audit quality and earnings management in our stock market.After reviewing the former studies both from China and abroad, we start from the general definition of audit quality and analyze that based on auditor independence as well as auditor qualification. Since audit supply and demand both affect how auditors exert their impact on firm's earnings management, this paper will balance the two interactive powers at the same time. Realizing that audit quality is a self-selection decision, we empirically apply a Heckman(1979) two-stage model to test whether audit quality is an endogenous variable. Using the financial data of Chinese listed companies from year 2002 to 2007, we first use Probit model to test the effect of endogeneity to the OLS and estimate the inverse mill's ratio in the demand side of audit service. Second, we use an accrual selection model included the inverse mill's ratio from the last stage to test whether the audit scale and specialty as proxy of audit quality can control the earnings management based on both demand and supply aspects. We also conduct further test in a separate sample of each year from 2002 to 2007. We conclude that, owing to the difference on governance environment, market traits and risk level of audit market, audit quality in China does exert a gradual effect to earnings management. The impact cannot be detected significantly during the year 2002 to 2005 but become significant after the year of 2006 for the reason that the accumulative effect of developing strategy in scale and industrial expertise need a time span to indicate. Our results support the policy of enlarging scale and cultivating industrial expertise, mending audit principle, and regulating internal governance for CPA firm etc.