Economic Consequences of Abolishing Mandatory Dual Audit System: A Study Based on Cost of Equity and Spillover Effect

雙重審計管制取消的經濟後果: 基於權益成本和溢出效應的研究

Student thesis: Doctoral Thesis

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Award date21 Apr 2020

Abstract

China abolished the mandatory dual-audit and dual-reporting system (DADRS) for mainland Chinese companies cross-listed in Hong Kong (AH companies) in 2010. At the end of 2018, over 62% of AH companies continued to use the dual audit system. Arguably, the DADRS contributes to ensuring auditor independence and improving corporate governance. This audit system also helps provide investors accurate and complete financial information and facilitates mainland local audit firms to accumulate international business experience. The impacts of the deregulation of the mandatory DADRS greatly concern investors (Sun, 2014). The DADRS and its change have drawn persistent attention from researchers. A comprehensive investigation on the consequences of the deregulation of the mandatory DADRS can enhance understanding of the influences of the DADRS on financial reporting quality, audit quality, and investor protection. Such an investigation can also provide important implications for future audit regime arrangements. However, existing studies are limited to investigating the audit-related consequences of this deregulation, with little attention paid to its economic consequences on the capital market. Moreover, prior studies generally assume the existence of a spillover effect that drives audit quality of the dual audits (or DADRS) and examine the audit-related consequences. The presence of the spillover effect has not been thoroughly and empirically verified. Aiming to fill these gaps, this study investigates the impacts of the deregulation of the mandatory DADRS by analyzing clients’ cost of equity (capital market analysis) and auditors’ spillover effect (audit market analysis).

Using a sample of Chinese listed companies from 2007 to 2015, this study obtains the following findings. In the capital market, companies have a lower cost of equity when they mandatorily have the dual audit before the deregulation than when they voluntarily use the dual audit after the deregulation. Companies voluntarily using the dual audit after the deregulation have a lower cost of equity than companies using only the single audit in the same period. Furthermore, the effects of mandatory dual audit and voluntary dual audit in reducing the cost of equity are greater in companies with higher equity financing demand and agency costs, and the effect of mandatory (voluntary) dual audit in reducing the cost of equity is irreplaceable (substitutable) by alternative voluntary audit mechanisms. In the audit market, I provide empirical evidence that a positive spillover effect, from Hong Kong- to mainland-based auditors, is present during the dual audit process. Therefore, companies keeping the dual audit have higher audit quality when they are subject to a more positive spillover effect from Hong Kong-based auditors. A positive association is observed between the loss of the positive spillover effect from Hong Kong-based auditors and the decrease in audit quality after companies cancel the dual audit. Overall, the empirical findings demonstrate that the deregulation of the mandatory DADRS exerts an adverse impact on the capital market and audit market.

This study makes the following contributions to the literature.

First, this study elaborates and empirically verifies that different ways through which companies conduct the dual audit significantly affect the cost of equity. It provides empirical evidence for the economic consequences of the deregulation of the mandatory DADRS on the capital market. Previous studies focus on the audit-related consequences of the deregulation of the mandatory DADRS. These studies only compare companies that have the dual audit with those that do not or companies in the regulated period with those in the period after the deregulation. To the contrary, this study classifies dual audits into mandatory dual audit (before the deregulation) and voluntary dual audit (after the deregulation) and analyzes how both separately affect the cost of equity. The theory of commitment effect of complying with mandatory requirements and the theory of signaling effect of making voluntary choices are used as bases. This study argues that after the deregulation, voluntarily choosing the dual audit can help companies maintain a lower cost of equity than using only the single audit by potentially sending a positive signal to investors. However, voluntarily choosing the dual audit is unlikely to totally make up for the loss of the important role that complying with the mandatory dual audit requirement plays in mitigating investors’ suspicions on management’s self-serving behavior and reducing agency conflicts and information asymmetry. Based on the cost-of-equity measure derived from the GLS model (Gebhardt et al., 2001), this study finds that the cost of equity for mandatory dual audit is lower than that for voluntary dual audit and that for the latter is lower than that for single audit in the same period. The aforementioned arguments of this study are confirmed by these findings, which suggest that the deregulation of the mandatory DADRS affects investors’ perceptions and decisions. Such effects yield significant economic consequences on the capital market. These results not only enrich the research on the dual audit system and that on the cost of equity, but also enhance understanding of the differential albeit important roles that mandatory and voluntary dual audits separately play in the cost of equity.

Second, this study verifies that the loss of the positive spillover effect from Hong Kong-based auditors is the main driver of the declining audit quality of companies canceling the dual audit. Hong Kong-based auditors are faced with a more stringent institutional environment, and thus, have higher independence and audit quality than mainland-based auditors. Moreover, the A-share and H-share financial statements of a company should be substantially consistent with each other according to the rules and regulations. This implies a potential positive spillover effect from the Hong Kong-based auditor to the mainland-based auditor of a company through the dual audit process. As a result, audit quality is likely to be guaranteed when companies keeping the dual audit. By contrast, canceling the dual audit is likely to forego the positive spillover effect from Hong Kong-based auditors and impair audit quality. On the basis of change analyses, this study provides initial evidence confirming that the positive spillover effect from Hong Kong-based auditors helps ensure the higher audit quality of companies keeping the dual audit, whereas the loss of this effect is primarily responsible for the decline in the audit quality of companies canceling the dual audit. Compared with previous studies, the analyses of this study effectively rule out the potential impacts of cross-listing, accounting standards convergence, auditors’ concern regarding shared reputational risk, and unobserved confounding factors. These analyses help to reach rigorous and robust conclusions. Extending the research on the dual audit system and that on audit quality, the results of this study contribute to further understanding of the indispensable role played by the positive spillover effect from Hong Kong-based auditors in the dual audit regime.

Third, this study constructs a measurement of the spillover effect from Hong Kong-based auditors in the dual audit process. Previous studies leave a gap between theoretical argument and empirical test in terms of this spillover effect. Although the literature elaborates on this effect, it has no direct and valid measurement. A company’s A-share and H-share financial statements should be supported by accounting assumptions that are inseparably connected with each other according to relevant rules. Meanwhile, the company may choose different accounting policies for its A-share and H-share financial statements. Reconciling the company’s A-share and H-share financial statements and elaborating the differences in accounting policy in its annual reports are compulsory. The engaged auditors are required to keep a close eye on an authentic and complete reconciliation (CSRC, 2001). With these constraints, the stricter H-share audits of a company performed by a Hong Kong-based auditor can help prevent earnings management in the company’s A-share financial statements, and thereby have a positive spillover effect on the company’s A-share audits performed by a mainland-based auditor (Ke et al., 2015). Accordingly, this study assumes that a closer gap (shorter distance) between a company’s H-share and A-share audit quality represents a larger constraint effect of the H-share audits performed by its Hong Kong-based auditor on the A-share audits performed by its mainland-based auditor, that is, a more effective positive spillover effect from the Hong Kong-based auditor. Following this rationale, this study uses absolute abnormal accruals to measure audit quality, and creates a measurement of the spillover effect from Hong Kong-based auditors based on the calculation of the distance between the H-share’s and A-share’s absolute abnormal accruals of a company keeping the dual audit. This study takes an initial step toward empirically measuring the spillover effect from a high-quality auditor to a low-quality auditor using the institutional setting of the DADRS. It promotes the development of research on the dual audit system and that on audit quality.

    Research areas

  • Dual audit, Economic consequences, Cost of equity, Spillover effect, Audit quality