Regression Model Data and Methodology

483 We examine the relation between earnings management, auditor choice and management demography through the following two-stage least-square regression models 1 and 2: AQD =  +  1 Title +  2 Gender +  3 Tenure +  4 Age +  5 Edu +  6 BoardSize +  7 IndDirRatio +  8 DirHolding +  9 EPS +  10 DA +  11 MB +  12 LnAsset +  13 ForeignD +  14 NonSOED +  15 Develop +  t  t Year t +  j  j Industry j 1 EM =  +  1 FVAQD +  2 Title +  3 Gender +  4 Tenure +  5 Age +  6 Edu +  7 BoardSize +  8 IndDirRatio +  9 DirHolding +  10 EPS +  11 DA +  12 MB +  13 LnAsset +  14 NonSOED +  t  t Year t +  j  j Industry j 2

3.2 Measurement of Auditor Quality

In the audit literature, market share in terms of revenue or audited assets of an audit firm is used to measure audit quality e.g., Becker, DeFond, Jiambalvo and Subramanyam 1998. Thus international Big-N CPA firms previously Big 8, then Big 6, and then Big 5, and now Big 4 are used as a proxy for higher quality DeAngelo 1981; Gul and Tsui 1998. Studies using Chinese firms also use total audited assets of clients to rank auditors to proxy audit quality DeFond, Wong and Li 2000. DeFond et al show that firms audited by Top 10 auditors have better audit quality than firms audited by non-Top 10 auditors. However, in developing markets such as China, the audit market is still mainly dominated by the government-affiliated or domestic CPA firms in terms of the number of clients. For instance, in terms of revenue, the international Big-4 firms do rank the highest four audit firms between 2002 and 2005 in China 60 . However, in terms of 60 Based on the information of www.esnai.com , the total revenues earned by the Big-4 CPA 484 audited assets, one of the Big-4 international CPA firm cannot make it to the top 10 during the same period. Recently, Wang, Wong and Xia 2008 provide three reasons why local and smaller auditors in China are actually preferred by local and central SOEs 61 . Based on the methodology of DeFond, Wong and Li 2000, we use the market share in terms of audited assets of an audit firm as a proxy of auditor quality. First we construct an annual list of auditor by market share. Basically, we compute the total audited assets for each auditor per year. Based on this list, we can rank the auditors by market share, which proxies their quality. Our proxy of auditor quality is the traditional measure of a dummy variable AQD. We construct three versions of AQD AQD1 for Top 5, AQD2 for Top 10, and AQD3 for Top 15. For instance, AQD1 is coded 1 if the audit firm is in the Top-5 category and 0 otherwise.

3.3 Measurement of Earnings Management EM

Large audit firms have more reputation capital at stake and hence should be more resistant to management pressure not to report contract breach DeAngelo 1981. firms between 2002 and 2005 are RMB4,718,368,200 for PriceWaterhouse and Coopers, RMB2,462,856,400 for Ernst and Young HuaMing and DaHua, RMB2,234,605,300 for Deloitte and RMB2,396,702,400 for KPMG. 61 Wang, Wong and Xia 2008 mention several reasons why the local and central SOEs prefer small local auditors rather than Top 10 or non-local auditors. One reason is the preferential treatments given to the local and central SOEs in the product and capital markets by the stock market regulators and the government‘s or state‘s banks Brandt and δi β00γ. In addition, as the outside shareholders expect the government to provide bailout to the SOEs in times of financial problems, the SOEs have a weaker demand for Top 10 auditors to provide financial insurance or to mitigate the agency problems. Another reason for the preference to the small local audit firms by the SOEs is that the small local auditors have specialized knowledge of the local government and of the SOEs which are in the same regions.