Featured faculty: Zhao Meiling
Written by Pan Jingyi

Reputation is the cornerstone for auditors to attract and retain clients. Investors rely on audited financial statements to assess a company’s financial health, and an audit is intended to provide assurance that the reported numbers are fairly stated. But what happens when an auditor suffers a reputation blow?

Despite hefty penalties and increasingly stringent regulatory standards, audit failures continue to occur. Even the prestigious Big Four are not immune to misconduct. EY in Germany, PwC and Deloitte in China, and KPMG in the UK have all been severely sanctioned for their high-profile audit failures in the past few years.

When a reputational crisis occurs, the public may begin to question the quality of all audits produced by the audit firm, and it may seem logical that clients would quickly switch to a different auditor to restore stakeholders’ trust. However, that is not always the case.

“The costs of switching are often evidently greater than the benefits. New auditors need time to understand the businesses, and there are always risks during the transition.”

Professor Zhao Meiling

A study by Zhao Meiling, an Assistant Professor at the School of Accountancy at the Chinese University of Hong Kong (CUHK) Business School, finds that around 90 percent of corporate clients remain with the embroiled audit office. The reason is largely practical.

“The costs of switching are often evidently greater than the benefits. New auditors need time to understand the businesses, and there are always risks during the transition,” she explains.

Professor Zhao’s study titled Auditor Office Reputation Damage and Their Audit Clients’ Voluntary Disclosures explores a straightforward question: If companies retain a “compromised” auditor, what actions do they take to rebuild stakeholders’ trust?

Voluntary disclosures to rebuild investors’ trust

Working with Cheng Mei and Paul Michas of the University of Arizona, Professor Zhao analysed data from more than 31,000 US-listed companies to see how companies respond when their auditors are caught in the spotlight. The key pattern is clear: clients that stay with the embroiled audit office increase the number of management forecasts by 5 to 10 percent.

Management forecasts are voluntary, forward-looking disclosures that companies issue throughout the year. Some forecasts focus on expected earnings while others provide more granular information on sales, expenses, or specific product lines.

Since the auditor’s reputation damage may undermine investors’ trust, company management compensates by offering more direct and timely information. “Financial disclosure is an important means for managers to communicate private information to outsiders, thereby reducing the information asymmetry and providing greater clarity on firm  performance,” says Professor Zhao.

Meanwhile, companies that switch auditors do not exhibit a similar increase in voluntary forecasting. Such a difference suggests companies weigh the costs and benefits of two credibility-repair strategies: either incur the cost of switching auditors or retain the auditor and increase disclosure to offset the loss of credibility.

When do companies talk even more?

The study also identifies when the increase in voluntary forecasting is strongest. Companies become particularly more open when demand for information is high. Typically, investors and financial analysts are hungry for clarity shortly after scandals come to light.

Companies with heavier coverage by external financial analysts not only issue more disclosures but also tend to provide more detailed forecasts, including revenue and cost figures, rather than aggregate earnings forecasts. Managers adjust the type and quality of disclosures to align with the information most valued and trusted by the market.

However, not all companies respond by disclosing more. In highly competitive industries, such as technology and retail, greater disclosure may reveal proprietary information that rivals could exploit, causing more harm than good for firms.

Therefore, even though companies may be expected to increase voluntary disclosures when their auditor is mired in scandal to rebuild trust, if the risks and downsides of sharing that extra information are too high, they are less likely to issue management forecasts.

If the scandal is less severe, managers may feel that their existing audit reports already convey enough information, despite the problems with the auditors. “Issuing management forecasts is costly and can consume significant resources,” Professor Zhao says. “Overall, companies weigh the risks and consequences of sharing information when deciding how much to disclose.”

Real financial benefits for companies

For the final question of whether “talking more” actually works, the team examines the shareholder’s expected returns and realized stock returns. The evidence suggests that voluntary disclosure is not just busywork but instead delivers real benefits for companies.

A scandal-ridden auditor office could create a negative image for clients, leading to higher perceived risks and weaker stock performance, especially for companies that stay silent. Companies that increase management forecasts after a reputational shock can mitigate, and in some cases fully offset, those negative effects.

In other words, voluntary disclosure is not merely a public relations tool in this setting. The study suggests that it can reduce firms’ cost of equity and improve realized returns. As Professor Zhao says, “More voluntary disclosures during reputational shock save companies real money and help protect their stock price.”

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For investors, a rise in management forecasts can be a meaningful signal that the company is trying to reduce uncertainty and enhance transparency. For regulators, the results highlight that self-correction measures taken by the companies can help authorities build a clearer picture of where oversight is most needed and when more rules might add value.

Regulators could encourage greater transparency through voluntary disclosure, especially when audit quality concerns arise, and analyse circumstances in which such disclosures might do more harm. In such cases, there might be a greater need for targeted disclosure requirements to protect investors.

For company executives, given that changing auditors can be disruptive and expensive, increasing voluntary disclosures can be a lower-cost alternative to rebuilding credibility. “By stepping forward and communicating more, companies can use their own voice to rebuild trust,” Professor Zhao adds.

The post Why do clients stay with embroiled audit firms? first appeared on China Business Knowledge.

Featured faculty: Wu Donghui, Xin Xiangang
Written by Aaron Woolner

The pandemic has changed the world for the better or worse. While the borders have been opened and lockdowns have lifted, the new normal dictates that attitudes to remote work may stay. However, many businesses remain undecided on this issue.

Corporates that embraced remote working during the pandemic have now shifted the practice, with more than 80 per cent of senior executives surveyed by KPMG for its 2024 CEO Outlook expected to see a full office within the next three years. On the other hand, employees are less keen to return, and debate over this issue has been hampered by a lack of clear data showing whether working from home or in the office is more productive.

The unprecedented scale and speed of the pandemic does, however, also offer the opportunity for researchers to test out the impact of the efficacy of remote work in specific industries and locations. According to Xin Xiangang, Associate Professor at the School of Accountancy at the Chinese University of Hong Kong (CUHK) Business School, China’s auditing industry is one such example.

The timing of the outbreak of COVID-19 in January 2020 coincided with the busiest part of the 2019 audit season, and combined with the swift imposition of lockdowns by Chinese authorities, Professor Xin says this provided the opportune background to test the quality of remote auditing. “As a result of the imposition of lockdown and travel restrictions by the local governments, a significant portion of firms were audited remotely in China,” he adds.

“In addition, the audit profession in China is the first to respond to the pandemic by remote auditing. Without precedents to follow, auditors in China undertook different audit practices to improve remote auditing. We can thus observe these practices and evaluate their effectiveness and efficiency in remote auditing,” Professor Xin explains.

Before the pandemic ended, the Chinese Institute of Certified Public Accountants set out a four-year development plan in 2021 for the sector that called for firms to apply “frontier information technology” — big data, artificial intelligence, cloud computing and blockchain — to the audit process.

Some audit firms had been using remote-auditing procedures before the pandemic, but social restrictions brought by it have jump-started the digital transformation process, enabling the switch away from the office during the pandemic, which shows no sign of slowing down.

“The views of the auditors in the field suggest remote auditing, triggered by the pandemic, becomes an irreversible trend in the auditing industry.”

Professor Xin Xiangang

Weighing between challenges and benefits

In a recent paper titled, Remote auditing and audit quality: Evidence from the field, Professor Xin and his colleague from the same department, Professor Wu Donghui, who is also the Director of the CUHK’s Centre for Institutions and Governance, along with Tian Gaoliang and Jin Yige of Xi’an Jiaotong University, evaluated the quality of audits conducted remotely in China during the pandemic.

The researchers first interviewed four partners of international Big Four audit firms in China, two partners from local top-10 audit firms, and two chief financial officers of Chinese listed firms about the challenges that auditors face in remote auditing, the advantages and disadvantages of remote auditing, adjustments made in remote auditing, measures taken to improve quality in remote auditing, and the possible ways to improve remote auditing in the future.

“Several senior auditors shared the view that auditors face great challenges in remote auditing, such as heavier workloads, higher audit risk, and lower communication efficiency,” says Professor Xin. “However, they also believed remote auditing may not necessarily lead to lower audit quality.”

One of the auditors suggests that remote auditing is as efficient as onsite auditing as all the necessary audit procedures have been completed. Another auditor discloses that remote auditing saves 70 million Chinese yuan (US$9.7 million) in one year of travelling expenses, accounting for 15.7 per cent of revenue in their audit firm.

Based on the interviewees’ responses, the researchers then developed 36 questions for a survey of 3,508 auditors of 3,639 listed firms in China. The survey received 2,275 usable responses and found that, similar to the interview with senior auditors, the respondents admitted the benefits of remote working, such as saving time and reducing costs through lower travel expenses.

The transition to remote auditing indeed posed challenges that affected audit quality, mostly due to communication issues with clients and team members, as well as evidence collection issues. However, the survey found solutions to address them. Almost all respondents in the survey answered that exploiting information and communication technologies could tackle the common issues raised in remote auditing.

The survey also found that remote auditing will account for approximately 86 per cent of auditing practices in the future, suggesting a strong expectation that remote auditing will become the dominant method of conducting audits. “The views of the auditors in the field suggest remote auditing, triggered by the pandemic, becomes an irreversible trend in the auditing industry,” says Professor Xin. “Given the increasingly important role of remote auditing during the digital transformation age, our study is timely.”

Remote auditing is here to stay

The researchers then further corroborated their results by running an out-of-sample test based on data from Shanghai’s February 2022 lockdown following an outbreak of the omicron variant. The out-of-sample test result also found that the adverse effect of remote auditing can be mitigated by adjusting audit procedures timely, adopting risk-based approaches, emphasising the sufficiency and reliability of digital evidence, and greater use of information technology.

This provides useful information to the audit sector on adopting digital technologies in practice. “Our paper findings on good practices in remote auditing included things such as relying more on audit risk evaluation and data analysis, emphasising the sufficiency and reliability of digital evidence, and exploiting information and communication technology,” says Professor Xin.

“The advantages of remote auditing can be reflected in these good practices. Securities regulators, accounting or auditing standard setters, and financial-statement users should be aware of how remote auditing may influence audit quality when making their decisions.”

The post Is remote auditing the future of financial oversight? first appeared on China Business Knowledge.

By Putro Harnowo, Senior Content Manager, China Business Knowledge @ CUHK

There are many avenues for insurance companies or insurers to invest and generate profits while fulfilling their financial obligations. Among various options, bonds are particularly appealing due to their relatively stable returns and low risk. As a matter of fact, bonds play a crucial role in the overall investment strategy of insurers.

The US National Association of Insurance Commissioners (NAIC) points out in its Year-end 2023 capital markets update that the US insurance industry has a total investment of around US$2.85 trillion in corporate bonds, which accounts for 35 per cent of the industry’s total cash and assets. The European Central Bank also reported in September last year that US insurers hold nearly 40 per cent of US corporate bonds.

In many countries, insurers are highly regulated and mandated to report the value of their investment in financial statements to regulators and investors. Considering its significant portion, an estimated value or “fair value” of invested bonds would affect the insurers’ balance sheet and overall financial health. While insurers can value their own bond investments, many outsource this task to third parties to enhance transparency and comply with regulatory requirements.

However, a new study found that insurers strategically switch between external sources to seek out favourable fair value estimates of their bond investments. This practice is called fair value opinion shopping, which involves selecting sources that provide higher estimates and potentially inflate the real value of bond investments.

“There is a very common way of valuation where insurers switch the pricing sources, called third-party source switching behaviour,” says Koo Minjae, an Assistant Professor of Accounting at the Chinese University of Hong Kong (CUHK) Business School.

“There might be some opportunism going on when switching the pricing sources to get a more favourable estimate that is more consistent with what the insurers want: boosting their assets. After looking at certain instances where different sources generate conflicting estimates, we found that the opinion shopping motive dominates.”

Opinion shopping could impair financial reporting transparency and lead to mistrust among investors and policyholders. Policyholders may also misallocate and make inefficient investment decisions if the financial statements are misstated or inflated.

Opinion shopping vs. objective valuation

In the research paper titled Third-party source switches: Objective valuation or fair value opinion shopping? Professor Koo, along with Konduru Sivaramakrishnan of Rice University and Zhao Yuping of the University of Houston, analysed documents submitted to the NAIC by US insurers on their investments in bonds and other securities. The researchers obtained a sample comprised of 662,528 security-insurer-year observations from 1,852 unique insurer-years from 2014 to 2017.

The result confirmed that insurers strategically switch between third-party sources to either provide objective valuations or inflate fair value estimates by opinion shopping. While both motives exist, opinion shopping tends to be prevalent. The study highlights that opinion shopping is more widespread among financially weaker insurers with lower risk-based capital ratios. Opinion shopping is also more common among illiquid bonds or securities that are not traded frequently.

Furthermore, the researchers found that insurers engage in block-switching behaviour, where they strategically switch the price source for groups of securities rather than individual ones to make it less obvious to the regulators or the auditors. This can result in changes in fair value estimates for multiple securities within a block.

“We found evidence of opportunistic opinion shopping among insurers, even when they are regulated to disclose the source and pricing vendors at the security level.”

Professor Koo Minjae

As US insurers are regulated at the state level, with each state having its own regulations, Professor Koo and the team further interviewed several regulators. Many admitted that some insurers may opportunistically inflate their value estimates.

“What the regulators typically do is compare the same securities owned by an insurer with those of other insurers,” says Professor Koo. “If they think that the price is deviating quite a lot from other insurance companies, the regulators would advise or recommend the relevant insurers to readjust their financial statements.”

This comparison method is quite normal for valuing level-two assets that have no regular market pricing, such as bonds that are traded in not very active markets. Companies usually infer bonds at this level with other bonds that have similar interest rates or maturities.

Meanwhile, level-one assets are the easiest to value for their readily observable and transparent prices, such as listed stocks. On the other side of the spectrum, level-three assets have no observable market prices and can only be valued based on internal models or “guesstimates”.

Indicative signs of opinion shopping

In an additional analysis of 280 unique price sources, Professor Koo and her team found that the “Big Five” external price sources accounted for 63.2 per cent of the market share during the sample period, dominated by Intercontinental Exchange and followed by Bloomberg, Thomson Reuters, S&P, and Markit. These top players have more capital and the ability to better estimate the value of the securities.

Surprisingly, after re-estimating the effect of switches to Big Five and non-Big Five sources, the researchers found that switches to non-Big Five are associated with a greater deterioration in fair value estimate quality than switches to Big Five price sources. This result is consistent with opinion shopping.

“If we see some cases where the securities had been measured by Big Five but not anymore, there is a likelihood of manipulation ongoing,” says Professor Koo. “In such cases, the insurers might have switched to a vendor that can give them more favourable estimates.”

Enhancing fair value estimates

There is much literature on a fair valuation, and according to Professor Koo, the general view is that companies manipulate or engage in opportunistic inflation of the fair valuation to boost their assets. For example, opinion shopping can also be found among hedge funds, which are not mandated to disclose their security holdings, giving them incentives to inflate their value estimates.

Although insurers need to maintain their risk-based capital in a highly regulated industry, this does not apply to the less-regulated mutual fund industry.

“We found evidence of opportunistic opinion shopping among insurers, even when they are regulated to disclose the source and pricing vendors at the security level,” says Professor Koo. “Public companies are not mandated to disclose at the security level, so in that case, we are suggesting that there can be more opportunistic opinion shopping going on.”

To enhance the fair value estimates, Professor Koo recommends using multiple pricing sources for the same securities, instead of relying on only a single source. Regulators could also help by carrying out cross-validation and verification. For instance, state regulators can observe in real-time how the same security is valued by different states or different insurers in different states.

“The disclosure itself should be more transparent, in the sense that there may be something going on when insurance companies switch from a certain source to another,” she says. “Therefore, there should be more mandatory disclosure on why insurers are switching to another source.”

Lastly, more frequent external auditory reviews and regulatory reviews may be necessary. Currently, regulators only review an insurance company once every three to five years. “This frequency should be increased to verify and cross-validate the insurers’ estimates,” Professor Koo adds.

The post How insurers inflate bond values to mask underperformance first appeared on China Business Knowledge.

By Pete Sabine

Decentralised finance, or DeFi, emerged more than a decade ago alongside the rapid growth of cryptocurrencies as alternative investments. With no central authority, DeFi disrupts traditional financial systems and is a conduit for innovation. At the core of its disruptive power lie smart contracts on self-executing blockchains.

Similar to other financial products, DeFi is not immune to theft, which is caused by programming errors and incomplete contracts. In April 2023, for example, blockchain-based lending protocol 0VIX lost approximately US$2 million after hackers exploited technical faults to manipulate its token prices. To mitigate this risk, smart contract audits became popular.

Unlike standard financial audits for public firms, smart contract audits focus on the integrity and completeness of a piece of computer code as opposed to financial statements. A new study by Janja Brendel, Assistant Professor of the School of Accountancy at the Chinese University of Hong Kong (CUHK) Business School, found that the smart contract audit market is thriving.

The study titled Decentralised finance (DeFi) asssurance: Early evidence, which was conducted in collaboration with Professor Thomas Bourveau at Columbia University and Professor Jordan Schoenfeld at the University of Utah, provides valuable insights into the smart contract audit market and the role of auditors in ensuring the security and reliability of DeFi ecosystems.

“We provide some of the first evidence showing that these audits are pervasive, with the audit firm market composed of new technical audit firms. The scope of these audits can span a variety of contract features, and the audit inputs and outputs differ substantively from those of conventional financial audits,” says Professor Brendel. “The market reacts positively to the release of these audit reports, suggesting that these reports are value-relevant.”

DeFi making deft inroads

For this seminal study, Professor Brendel and the team gathered a comprehensive sample of smart contract reports from January 2017 to the end of June 2023 from a smart contract scanner, De.Fi. The data showed that new blockchain assurance services have become a force to reckon with in the market in the past few years, as can be seen in the table. The “full sample” consists of 8,531 unique audit reports that delve into specific details. The “market sample” comprises 303 audit-venture events focusing on each DeFi project.

The audit market for smart contracts is composed of many new entrants. TechRate, the largest audit firm established in 2017, accounts for around 20 percent of the market share, followed by InterFi, founded in 2021, with more than 11 per cent and Certik, which was set up in 2018, with six per cent.

In terms of cost, the audit fee mostly depends on the length and complexity of the code. Audit firms with more expertise and experience can also charge more. TechRate and InterFi are widely considered to be low-cost, charging from US$250 and US$300 respectively, for a standard audit. As a comparison, Quantstamp, OpenZeppelin, and Trail of Bits label their services from US$5,000, and Hacken starts its fee at US$9,000.

These prices are justified for various reasons. The largest audit firms have conducted audits for more than thousands of projects with household names in the crypto world. Top-quality audit firms are found to provide more detailed reports, comprising team size, methods used, and days spent on the audit. These firms are also more likely to deploy audit teams of five or fewer, use a combination of manual and automatic processes about 88 per cent of the time, and conduct longer audits, as measured in days.

While these audits can identify vulnerabilities, programming errors, and deviations, audit firms do not provide a guarantee against data breaches, thefts, and hacks. Many smart contract audit firms even put legal disclaimers in their reports and advise clients to obtain third-party opinions, leaving some space for insurance to grow. For instance, Certik introduced a plan in 2023 to compensate its clients for any hack-related losses incurred after one of its audits, up to US$2 million.

“Smart contract audit reports are used by DeFi service providers primarily to build trust with existing and prospective users of and investors in their services.”

Professor Brendel Janja

Users can look at several factors to assess how good an audit firm’s reputation is. This includes checking portfolios and tracking records. If they have worked on large and high-profile projects that have not been compromised, it is a sign of reliability. Those seeking a smart contract audit should look at the firm’s previous projects with specific blockchains, as they may be more relevant to the project they are currently pursuing. The smart contract audit firm’s previous reports can also be examined for their level of detail or comprehensiveness.

Keeping on the right track

“Smart contracts play an increasingly important role in structuring and executing common DeFi financial transactions, such as loans and venture capital funding, with more than US$200 billion now locked in such contracts,” Professor Brendel explains. “Smart contract audit reports are used by DeFi service providers primarily to build trust with existing and prospective users of and investors in their services.”

Such assurance is important, perhaps due to its decentralised nature, which means smart contract audits are not mandated by legislation. Besides, blockchain projects have a chequered history, so it is inevitable that investors need reassurance that the security protocols are up to scratch and that the underlying code works. This allows investors to assess the overall trustworthiness of blockchain projects while mitigating the risks that cause loss of income and irreversible damage.

Smart contracts that are audited are often audited again when there is a significant update to the contract, not periodically every fiscal year like financial audits. There is no formal education or certification required to be an auditor, and the audits also do not need to follow a universal standard or guideline, which means that the audit process and output can differ significantly based on the auditors’ approach and methodologies in ways that financial auditors typically cannot.

In general, smart contract auditors normally apply automated bug detection software to scan smart contracts for potential vulnerabilities, then augment the procedures with line-by-line manual code review to ensure a thorough assessment. Furthermore, stress testing is also conducted to emulate different attacks that could threaten the system.

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Blockchain and crypto companies can decide whether to release the audit result after weighing the costs and benefits. However, the release of a smart contract audit report is found to result in a positive and statistically significant market-adjusted return of about a 10 per cent increase within the two days after the release. This is consistent with the longstanding proposition in accounting that audits serve as a mechanism to reduce information asymmetry and improve the functioning of capital markets.

With the proliferation of DeFi, assurance services within these new fields are becoming crucial to all fields of business for a number of reasons. Auditing is essential for adding credibility to information that is disclosed, which in turn helps increase trust with users and investors and ultimately helps to raise the number of transactions.

The post A deep look into burgeoning blockchain audit first appeared on China Business Knowledge.

By Jaymee Ng, Principal Writer, China Business Knowledge@CUHK

Employing More Conservative Accounting

To do this, the researchers looked at a large sample of firms listed on Shanghai and Shenzhen stock exchanges from 2002 to 2016. They measured the level of political corruption in a region by calculating the number of political corruption cases investigated by the authorities to the total population of the region. They also measured the degree to which companies within that same region were likely to employ conservative accounting strategies by looking at how quickly these companies choose to recognise losses relative to gains.

According to the results, companies located in regions with a higher level of corruption tend to be more prudent when they release their earnings reports. To put things into perspective, a firm with corruption risk at the top quartile of the sample distribution exhibited earnings reporting habits that were 14.4% more conservative than an average firm in the sample.

“We find that firms in more corrupt regions do indeed tend to adopt more conservative accounting, which leads to systematic and persistent understatement of earnings and asset values. This is a strategy that firms employ to reduce their expropriation cost,” says Prof. Zhang.

“To put it plainly, what we’re seeing is that companies in regions with higher levels of corruption are playing possum. They are intentionally casting themselves to look ‘weak’ financially and making themselves look less capable of paying bribes,” he says.

Conditional Conservative Accounting and its Advantages

In disguising their true financial picture, the companies that operate in more corrupt regions have a number of choices. One route is they would delay the recognition of positive news (such as profits) while speeding the recognition of news that portrays the company in a negative light (such as losses). This method is called conditional conservative accounting.

Meanwhile, firms in regions with more corruption cases may choose other means to achieve the same purpose, such as balance sheet management, cash flow management and earnings management. For example, previous research has shown that companies can defend against local corrupt officials by reducing the availability of liquid assets and borrowing more debt. They can also choose to pay more dividends to shareholders and engage in more acquisitions to reduce financial resources for expropriation by corrupt officials. However, compared to conservative accounting, these strategies incur much higher costs, because companies have to adjust their real business activities to achieve the goal. In addition, companies might reduce expropriation cost by manipulating earnings downwards, but this approach is usually illegal and such reporting opportunism could lead to higher cost of capital.

Another accounting strategy that companies can adopt is to report low earnings and book value regardless of their business outlook. This is known as unconditional conservative accounting. Companies taking this route may choose to immediately recognise the expenditure of all research and development costs, adopt accelerated depreciation for fixed assets, and use last-in-first-out inventory accounting, meaning the most recent products purchased or produced are the first to be expensed.

According to the study, the second strategy (unconditional conservatism) can be more costly and less flexible in shielding companies’ earnings and assets from expropriation. The researchers explain that unconditional conservative accounting is usually predetermined by companies, but companies’ political environments are changing over time. Therefore, companies adjusting unconditional conservative accounting in response to their political costs face large costs. In addition, unconditional conservative accounting, once set, does not allow companies to shift income to future periods when they expect the political costs to be low.

“Conditional conservatism, when company earnings reflect bad news more quickly than the good news, is more flexible and less costly when compared to other strategies. This is because the very nature of this accounting strategy means a firm which practices it tends to be able to legally understate earnings and asset value according to its political environments without changing its real business activities,” Prof. Zhang says.

Are All Companies Susceptible to Bribe-Taking?

The researchers also note that not all companies are equally susceptible to bribe-taking. According to the study, companies with weaker ability to pay bribes and those with stronger refusal power may be less incentivised to shield their earnings from bribe-soliciting in the first place.

These may include small and financially unstable companies that have fewer financial resources to pay bribes anyway. State-owned enterprises (SOEs), companies that operate in multiple regions, and companies with more shares held by the largest shareholders would have stronger ability and incentives to reject bribe requests, the study notes. SOEs have a strong relationship with the government so they typically have better access to state-controlled resources anyway. On a geographical level, firms which limit their operations within a specific region are typically more exposed to bribery because, unlike firms with multiple bases, it would be more costly for them to move their corporate headquarters to avoid corruption. Thirdly, controlling shareholders holding a large stake in a company have stronger incentives to deter expropriation as their wealth is tied to the value of the company and they have greater power to influence its corporate policies.

Furthermore, the study shows that companies in more corrupt regions may have weak incentives to adopt conservative accounting when they can pay bribes in exchange for economic benefits, for example, when they are more dependent on government procurement and when they have connections with the local government. In addition, under certain circumstances, managers may have their own incentives to reduce companies’ use of conservative accounting in corrupt environments. For example, younger managers, who just begin to establish their reputation, tend to signal their ability by showing better firm performance. Managers holding a larger stake in companies also have stronger incentives to report positive earnings to boost share price.

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The study also points out that strong legal enforcement on corruption can reduce companies’ use of conservative accounting strategies to protect themselves from being solicited for bribes. The researchers investigated the effect of the nationwide anti-corruption campaign in China that started in November 2012. The high-profile campaign led to the prosecution of numerous officials, including some in prominent positions. The researchers found that on average, companies displayed a significant decline in taking a more conservative approach in their accounting strategies since the start of the anti-corruption campaign. To get a more accurate reading of the effect of the anti-corruption campaign on firm behaviours, the researchers separated their sampled companies into two groups: those located in regions with more corruption cases and those located in less corrupt regions. The results showed that companies in more corrupt regions displayed a larger decrease in taking conservative accounting strategies than those in less corrupt regions.

“When companies see that the campaign has cleared up the regions that they operate in, they don’t have to understate their earnings and asset values anymore. In other words, the anti-corruption campaign has reduced the need of firms to shield themselves by adopting conservative accounting,” Prof. Zhang says.

The post Escaping from the Dilemma of Corporate Bribery first appeared on China Business Knowledge.

By Ella Chen

Guanxi Ensures Smoother Transitions

The researchers found substantial evidence that auditors who shared more teamwork experience with their predecessors were more likely to be selected when the engagements are rotated. In other words, audit firms prefer to consider auditors with professional guanxi (the Chinese concept of social networks) with the outgoing auditors rather than auditors without such connections.

Why do audit firms tend to assign the rotated engagements to auditors who are familiar with the outgoing audit partners? Prof. Wu explains that this preference is rooted in audit firms’ pragmatic approach to the transitions between the outgoing and incoming auditors.

“An auditor who has worked at a client company for five years is someone who has accumulated quite a lot of knowledge about that particular company. This kind of company-specific knowledge is complex and sometimes tacit and subtle. If this auditor has an existing interpersonal relationship with the incoming auditor, the process of knowledge transfer can be a lot smoother than if a stranger comes onboard,” says Prof Wu.

“Client companies appreciate that smooth transition because first of all, they don’t have to risk the loss of knowledge after the transition. Second, they don’t need to pay for a tonne of extra billable hours for the incoming auditor to learn the ropes.”

The research found that auditors with an established guanxi with the incumbent auditors are more likely to be assigned to rotations where the companies have more complex accounting needs. In addition, when none of the incoming auditors has any knowledge about the company, candidates who are connected with the incumbent were favored.

Guanxi among Auditors May Affect Objectivity

While choosing an auditor who is familiar with the outgoing one can be beneficial for companies, this practice raises the questions: Would the guanxi between the pair of auditors make the audit less objective? Wouldn’t this defeat the original intension of the SOX and its application in China? Prof. Wu admits that these were the concerns of his research team and they decided to find out through their study.

“Yes, it’s true that a friendly successor may not closely scrutinize the predecessor’s work and is less likely to catch and correct problems in the auditing process. When the two auditors are closely connected, the audit firms may not be able to benefit from the supposed ‘fresh-eye effect’ of rotating out an auditor after five years, thus potentially defeating the purpose of the partner rotation practice,” he admits.

In addition, Prof. Wu points out that the practice of hiring a familiar auditor can be regarded as an act of “favoritism.” This may discourage the incoming audit partner from challenging the outgoing one’s work, thus potentially weakening the objectivity or independence of having a new auditor on the job.

According to Prof. Wu, an audit firm may also overlook an incoming auditor’s competence level in the quest to ensure a smooth transition between the outgoing and incoming auditors. This may influence the quality of audits.

Better Transitions without Sacrificing Audit Quality

The above concerns were put to rest after the research team found that a high level of mutual trust between the auditing pairs not only enhanced the transfer of client-specific knowledge and expertise, but also improved the accuracy of audit reports and client satisfaction after the rotation took place.

“Based on our audit-quality analysis, we found no evidence that audit quality suffers when the incoming partners are closely connected to the rotated-off partners,” remarks Prof. Wu. In fact, Prof. Wu says, the study provides evidence that prior teamwork experience with the incumbent auditors actually increases the successors’ tendency to issue Modified Audit Opinions (MAOs). MAOs are usually issued when there are ongoing accounting or disclosure issues. So when the study found that successors actually issued more MAOs, it implies that the act of hiring “familiar” auditors does not compromise the neutrality and quality of the audits performed by the new auditor.

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“Our MAO analysis suggests that when the succeeding auditors have a professional guanxi with the incumbent, they actually can provide more accurate warning signals about their clients’ looming financial or accounting problems to the market,” says Prof. Wu.

This study contributes to a new, more positive view than existing literature on the subject of mandatory auditor rotation. It has found new evidence that companies do prefer to hire auditors who have an established guanxi with the outgoing auditor. It also provides assurance for audit firms to design their auditor rotation policies in an optimal way so that they can reap the benefits while ensuring a high audit quality.

The post Does Guanxi Among Auditors Defeat the Purpose of Auditor Rotation? first appeared on China Business Knowledge.

By Raymond Ma, Managing Editor, China Business Knowledge @ CUHK

More than a century ago, the American philosopher and psychologist William James first coined the term the “bitch goddess” in reference to the downsides of material success. In modern China, fame can be a lot of things but a new study has found it could lead to higher fees or a more severe audit opinion for the companies of their newly-famous and newly-wealthy owners.

Conducted by Prof. Donghui Wu of The Chinese University of Hong Kong Business School’s School of Accountancy and Prof. Qing Ye of Nanjing University, the study, entitled Public Attention and Auditor Behavior: The Case of Hurun Rich List in China, looked at how auditing firms reacted when the controlling owners of their clients make it to the Hurun Report’s China Rich List, a ranking of the wealthiest individuals in the country launched in 1999.

Analysing 126 public companies in China between 1999 and 2012, the study found auditors were estimated to charge around 8 percent higher in fees to compensate for the higher audit risk after an entrepreneur associated with a company becomes listed on the China Rich List.

“Auditors respond to an increase in public scrutiny by becoming less acquiescent about clients’ irregularities. They issue more severe audit opinions or charge clients higher audit fees if their controlling owners get listed on the China Rich List.”

Prof. Donghui Wu

It also found the level of severity in modified audit opinions – which are issued if auditors find questionable practices in a company’s accounting books – increased by 6.3 percent for firms whose bosses appear for the first time on what the local media have dubbed the “slaughter list” in reference to a tendency for misfortune to befall those who appear in it.

Increased Public Scrutiny

Prof. Wu explains that while China has experienced phenomenal economic growth on the back of decades of economic reform, creating a new class of wealthy entrepreneurs in the process, its values have remained egalitarian in nature, with the rich generally reluctant to disclose their wealth to the public.

By publishing the names of billionaires in China, Hurun subjects the newly minted wealthy and the firms they control to public scrutiny. It also doesn’t help that many ordinary Chinese believe businesspeople have amassed their wealth through political connections, favoritism, and corruption. “The Chinese public hold the belief that billionaires and their firms must have committed some ‘original sin’,” says Prof. Wu.

This is happening against backdrop of increasingly severe regulatory consequences for audit failures – witness the demise of “big five” Arthur Andersen shortly after being enveloped by the Enron fraud scandal, as well as a similar fate which befell ZhongTianQin, once the largest audit firm in China, around the same time over an accounting scandal surrounding client YinGuangXia, a conglomerate dubbed the “Chinese Enron”.

The study found that firms controlled by billionaires that appear for the first time on the top 200 rich list experience a sharp increase in negative press coverage and regulatory enforcements. However, there was no evidence for such changes for firms linked to billionaires who appear for the first time on the list but with lower rankings and are thus less conspicuous and news-worthy.

“The predominantly negative publicity generated by rich owners’ presence on Hurun can entail greater regulatory scrutiny, exposing auditors to a higher risk of audit failures,” says Prof. Wu. This higher visibility thus means higher risks for auditors. In response, Chinese auditors have adopted strategies that shield them against potential and very public audit failures.

“Auditors respond to an increase in public scrutiny by becoming less acquiescent about clients’ irregularities. They issue more severe audit opinions after rich-listing events,” Prof. Wu adds. “To keep overall audit risk at an acceptable level or alleviate the impact of future losses, auditors also charge clients higher audit fees during the post-listing period.”

Higher Fees Versus Stricter Audit Opinion

The study also found that auditing firms were more likely to issue a more severe audit opinion when the way an entrepreneur generated their wealth is associated with dubious transactions or practices, such as privatisation of state assets, involvement in tax evasion, opaque information disclosure, or the prevalence of corruption in the region where the company is located. For these clients, auditors do not significantly increase audit fees, implying that even opinion shopping is not an option for auditors to protect themselves against higher risks.

The opposite is true for firms without such associations, with auditors compensating for higher risks by increasing audit fees. This implies that the auditing firm is devoting more effort to addressing possible audit problems that may invite press scrutiny. This overall effect is more pronounced for the larger audit firms which are more concerned with their reputation or audit partners with more conservative auditing styles.

“The Chinese public hold the belief that billionaires and their firms must have committed some ‘original sin’.”

Prof. Donghui Wu

Finally, in rendering audit opinions, auditors tend to be more concerned about the risk of companies which are owned by entrepreneurs that may drop off the top 200, but they were indifferent for this group when it comes to pricing. Interestingly, not all companies are negatively affected after their entrepreneurs appear on the rich list: some do not experience an increase in negative press coverage likely because their entrepreneurs are seen as heroes by the public. For such firms, there is no evidence showing that auditors become tougher in rendering opinions or increase audit fees.

Prof. Wu says the study’s findings that auditors are concerned with the presence of the controlling owners of their clients on the Rich List may appear counter-intuitive. After all, earning a spot can advertise the entrepreneurs and their companies’ business success, generating benefits in the product and capital markets.

“We believe our evidence squares institutional features in China’s transitional economy, where getting rich can be associated with corruption and rent-seeking activities. As we illustrate, rich owners’ presence on the Hurun list draws negative media coverage and entails greater regulatory scrutiny over their firms. Like other rational economic agents who choose actions to maximise their utilities, Chinese auditors respond to rich listings by adapting strategies that shield themselves from potential backlash against publicised audit failures,” he says.

The post The Audit Cost of Being on China’s Hurun Rich List first appeared on China Business Knowledge.

By Huang Hong, PhD Candidate, School of Accountancy, CUHK Business School

Audit plays a significant role in the capital market. High-quality audit reduces the risks of inaccurate information, increases the transparency of the audited entities and thus facilitates financing and investment.

Because of such critical function of high-quality audit, many countries and jurisdictions around the world have established and enforced stringent regulations toward audit practice. One example of these regulations is imposing limitations on the length of audit partner tenure.

Regulators believe that forcing companies to change audit partner every few years can bring in fresh perspectives from new auditors who can be more independent and capable of discovering errors in financial reporting.

However, it is difficult to gather available data to test the efficiency of such approach due to the fact that most countries do not require audit partners’ names to be disclosed and so researchers are unable to identify any partner rotations – except in a few jurisdictions including China.

“In China, audit reports also need to disclose the names of both the review partner and engagement partner. Unless there is contrary evidence, the two partners sharing the same legal liability are subject to the same rules on mandatory rotation,” says Prof. Tianyu Zhang, Director of Center for Institutions and Governance at CUHK Business School.

In collaboration with Prof. Clive S. Lennox at Nanyang Technological University and Prof. Xi Wu at Central University of Finance and Economics, Prof. Zhang’s study entitled “Does Mandatory Rotation of Audit Partners Improve Audit Quality?” confirms that mandatory rotations of audit partners improve audit quality of the firm.

“Our result is significant as many countries rely on mandatory audit partner rotation rather than mandatory audit firm rotation to ensure high-quality audit,” says Prof. Zhang.

Unique Datasets in Chinese Audit Market

China is among the countries and jurisdictions which adopt a mandatory rotation of audit partners. Under Articles 3 and 5 issued by the China Securities Regulatory Commission (CSRC) and the Ministry of Finance dated October 8, 2003, the review and engagement partners have to be rotated every five years or in the case of newly listed companies, at the end of the second year following the initial public offering (IPO).

In China, audit reports also need to disclose the names of both the review partner and engagement partner. (Other jurisdictions currently requiring the disclosure of individual auditors include Australia, Taiwan, Germany, Sweden, Finland, Japan, and the UK.) Unless there is contrary evidence, the two partners sharing the same legal liability are subject to the same rules on mandatory rotation. Moreover, since 2006, for every public company audit in China, the audit firm is required to report the company’s pre-audit earnings to the Ministry of Finance. Using the pre-audit earnings number, the Inspection Bureau of the Ministry of Finance can identify whether a company had an audit adjustment to its earnings number.

“Audit adjustments are indications that an existing misstatement in financial reports is discovered and then corrected by the auditor. In other words, the existence of the audit adjustments in a certain audit engagement shows that auditors have delivered high-quality audit practice,” says Prof. Zhang.

“A newly appointed partner may have less client-specific knowledge and, therefore, be less likely to find financial reporting problems.”

Prof. Zhang Tianyu

How Does Mandatory Audit Partner Rotation Impact Audit Quality?

Proponents of mandatory rotation of audit partners believe that it can enhance the audit quality by providing an effective peer review effect. For example, the American Institute of Certified Public Accountants (AICPA) in the US and the Cadbury Committee in the UK believe that a replacement partner could bring in a fresh perspective to the audit and is therefore more likely to detect and correct financial reporting problems.

If an incoming partner finds the audit in the prior year unsatisfactory, he may inform others in the audit firm and thus damage the reputation of the departing partner within the audit firm, thus creating pressure for the departing partner. The departing partner will make necessary adjustments in his final year of tenure because, otherwise, the replacement partner may find reporting problems carrying over from the previous year.

Some also believe that a newly appointed partner will be more independent of the client as he or she would have had time to develop a close personal relationship with the management after a prolong period and become unwilling to challenge its reporting, creating “a familiarity threat” as claimed by the Code of Ethics of the International Federation of Accountants (IFAC).

However, this independence effect could be compromised, thus weakening the beneficial impact of mandatory rotation of audit partner.

“A newly appointed partner may have less client-specific knowledge and, therefore, be less likely to find financial reporting problems,” says Prof. Zhang.

Findings

Using a final sample of 6341 company-year observations for the period of 2006-2010, the study indicates that mandatory rotation results in higher audit quality.

First, an engagement partner is more likely to require an audit adjustment when the partner is scheduled for mandatory rotation at the end of the year.

“This suggests that the departing engagement partner has the motivation to clean up the client’s financial statements before handling over the audit to the new partner. This is consistent with a positive peer review benefit, whereby engagement partners perform higher quality audits when they are scheduled for mandatory rotation,” says Prof. Zhang.

Secondly, the study shows that a newly appointed engagement partner is more likely to require an adjustment during the first year of tenure following mandatory rotation.

“This shows that newly appointed engagement partners do bring in a fresh perspective to the audit and identify more financial reporting problems.”

“Our findings have important implications for public policy because many countries rely on mandatory audit partner rotation rather than mandatory audit firm rotation to ensure high-quality audit,” he says.

The post Does Mandatory Rotation of Audit Partners Improve Audit Quality? first appeared on China Business Knowledge.

By Fang Ying, Senior Writer, China Business Knowledge @ CUHK

Despite the slowdown of China’s stock market in recent years, there are still plenty of opportunities for those looking to invest in the world’s second largest economy. To successfully invest in Chinese firms, the key is to fully assess the target firms and their state of corporate governance. This is the take-away message from a joint forum organized by China Business Knowledge @ CUHK, the Center for Institutions and Governance (CiG), and the School of Accountancy at CUHK Business School.

The Corporate Governance Forum, titled “What Do You Need to Know about Corporate Governance When Investing in Chinese Firms?”, was held earlier this year and was part of a two-day academic conference organized by CiG. More than 150 participants from the academia and the business community attended.

The forum was moderated by T.J. Wong, Choh-Ming Li Professor of Accountancy and Director of the CiG at CUHK Business School. The panelists included Albert Ng, Chairman, China and Managing Partner, Greater China, EY; Patrick Sun, Chairman of the Chamber of Hong Kong Listed Companies; Jie Lian, Partner of Primavera Capital Group; and Joseph Piotroski, Associate Professor of Accounting and Center for Global Business and the Economy Research Fellow, Stanford University.

Current State of China’s Corporate Governance

Albert Ng of EY started by sharing his opinion on corporate governance in Chinese-listed companies. He said, “Despite all the issues and concerns, the state of corporate governance in China has improved.”

According to Ng, there is a common perception among the general public that state-owned enterprises (SOEs) are better governed than privately owned enterprises (POEs) in China. However, he cited a study conducted by Nankai University, which shows that the level of corporate governance in POEs in China has been higher than that of state-owned enterprises SOEs since 2011. Nevertheless, it would be wrong to simply judge whether POEs are better-governed than SOEs or vice versa, according to Ng.

“Both POEs and SOEs have corporate governance challenges. It may be fair to say that different companies are faced with different corporate governance issues,” he explained. “It is not a matter of POE or SOE, but a matter of individual companies. As an investor, you should be aware of the fact that there are good and bad companies among both POEs and SOEs. Just try to get as much information as possible before you invest.”

At the same time, Ng pointed out that China has moved a big step forward in terms of the accounting statements prepared by its listed companies.

“When you look at the financial information of companies, they need to be comparable and prepared based on the same accounting standards as overseas companies,” said Ng. “Compared with the early days, nowadays the accounting statements of Chinese-listed firms are very much in line with IFRS (International Financial Reporting Standards). It probably is 98 percent similar…. This is a fundamental progress in corporate governance in China.”

https://www.youtube.com/watch?v=BOdR5HMGpGc

In the video, Albert Ng of EY and CUHK Business School alumnus, shares with the audience the issues regarding corporate governance among China’s listed companies

Best Practices in SOEs

Patrick Sun, who is serving as an independent non-executive director (INED) for several listed companies in Hong Kong, two of which are SOEs, shared his observations on corporate governance in SOEs.

According to Sun, unlike in other markets, not only do SOEs in China have to maximize the shareholder value, they also need to advance the government’s policy targets. Through the State-Owned Assets Supervision and Administration Commission of the State Council (SASAC), the state, which is the major shareholder of China’s SOEs, can assert political influence in the management of SOEs.

However, when it comes to the role of INEDs in China’s listed SOEs, Sun said that it is rather similar to that in other markets. According to Sun, in Chinese-listed SOEs, it is legally required that more than a third of the board members are INEDs, with at least one accounting professional. Meanwhile, to qualify as an INED, one needs to attend a course and pass a certification exam. “No matter how senior the position you are holding, you have to take the exam,” Sun said, adding that in Chinese SOEs, INEDs can only serve two terms of three years each. He said this is a best practice that is not common in Hong Kong.

Another best practice among China’s SOEs is that they have a more stringent internal control system. “They even hire auditors to review their internal control procedure,” said Sun. “Actually, the level of corporate governance in SOEs is very high, and to some extent, it is even higher than some companies in Hong Kong.”

Avoiding the Risks of Scandals and Frauds

Following Sun’s presentation, Jie Lian, former Managing Director of Goldman Sachs Hong Kong, discussed the issue of fraud. Lian, who has rich experiences in the investment banking sector, pointed out that amid the slowdown of China’s macroeconomy, Chinese companies are currently facing an increasing exposure to various operational vulnerabilities. At the same time, he said, fraud has become a big issue for private equity investments in China.

Nepotism and guanxi are the two major factors that contribute to this issue, according to Lian. Why? First, as many of China’s companies are family-based, external members of the management team may find it hard to penetrate this family circle of trust and loyalty, making it challenging to monitor its decision-making process and enforce corporate decisions. Second, guanxi is a central theme in Chinese society, and relationships with the Chinese government exist in almost every aspect of business. For overseas companies, it is thus essential to understand whether their Chinese partners’ strong relationship with their government counterparts is an institutional alliance based on operational strength or based on bribery.

In light of this, Lian emphasized that corporate governance is of paramount importance to a company and can influence the performance of firms. “It is almost as important as a company’s primary business plan,” he said. When corporate governance is executed effectively, it can prevent corporate scandals, fraud and criminal liability of the company, while bad corporate governance hurts the interest of minority shareholders.

What are the best practices of corporate governance? “Make sure you have a diverse board composition; hiring “real” independent directors; and establishing professional committees controlled by independent professionals.” Lian said.

Investing in China

The last speaker, Joseph Piotroski, Associate Professor of Stanford University, shared his views on corporate governance in Chinese firms from an academic perspective.

Prof. Piotroski said that investing in China requires a more careful analysis of value-relevant information above and beyond the set of financial, economic and strategic factors considered in a “traditional analysis.” Because financial information about firms in China and other emerging economies is typically less reliable, investors need to exercise caution when interpreting financial reports. Additionally, the unique institutional environment of China means that shareholder value can be created or destroyed through numerous channels.

According to Prof. Piotroski, when considering an investment in a Chinese-listed firm, investors need to evaluate the company from the following five perspectives.

First, investors need to understand the ownership structure of the company and the prevailing incentives of the controlling shareholder. “You need to know who controls the firm. Is it the government, a family or an entrepreneur? In addition, you need to understand the incentives of the major shareholders,” said the professor.

Secondly, investors should analyze whether the company’s related party transactions add or destroy any value.

Thirdly, investors should assess the credibility of the company’s corporate governance practices to determine whether they are effective or window-dressing only. “Does the firm use a high-quality auditor and are the independent directors truly independent? Are there any conflicts of interest?” asked Prof. Piotroski.

Fourthly, investors should understand the company’s political connections and exposure to political factors. “This is an important issue in the China market,” he stressed. “Before you invest in Chinese firms, you should ask yourself if it’s a privately owned firm and to what extent the firm depends on the local government; and if it’s a state-owned firm, whether it is aiming to maximize profits.”

Lastly, he urged investors to understand the individual characteristics of different provincial and local institutions in China: “China is a collection of localities and each locality has a very different set of market institutions. For example, some provinces are deeper into reforms than others and some localities have more severe corruption problems. An investor needs to be aware of these differences.”

Prof. Piotroski concluded: “When you invest in Chinese-listed companies, you need to consider these issues. Nevertheless, China remains an exciting place to invest.”

The post Corporate Governance in China: Risks and Opportunities first appeared on China Business Knowledge.