Auditor Independence, Audit Fee, and Regulatory Capture: An Examination of the Role of Auditors in the IPO Screening in China

Chinese firms must obtain approval from the regulator to do initial public offerings (IPOs). The regulator, the CSRC, set up a committee (the Committee thereafter) to screen IPO applicants. More than a quarter of IPO applications are rejected. Auditors are the single largest group in the 25-member screening committee in the CSRC.Our research will investigate the role of auditors in the screening of IPO applications. First, we will examine whether prospective IPOs have a better chance of obtaining approval when partners of their auditing firms are on the Committee. Second, we will examine whether auditing firms with partners on the Committee earn an audit fee premium from their IPO clients. Third, we will conduct several tests to compare the quality of the audits completed by auditing firms with partners serving on the Committee with the quality of the audits carried out by others and to compare the quality of IPO firms audited by those on the Committee with the quality of those firms audited by others. Results from these tests will help verify whether auditing firms with partners serving on the Committee assist relatively uncompetitive clients to pass the screening and whether they receive extra audit fees from their clients for this ‘nonaudit service’. To assess audit quality, we will compare the levels of IPO underpricing and abnormal accruals in IPO firms audited by those serving on the Committee with those audited by others. To assess the IPO quality, we will contrast the likelihood of being rebuked by the regulators in the year following the IPO between firms audited by auditing firms with partners on the Committee and others.This project is important for several reasons. First, it will provide new evidence to help determine if auditors compromise their independence in situations involving conflicts of interest. Second, our research will evaluate the supposition that an audit fee premium is always paid for audit quality. Third, the project is linked to literature concerning corruption activities during the IPO process. Lastly, our research findings will have important policy implications, most notably by ascertaining whether or not screening by regulators improves capital allocation efficiency.