Measurement of Auditor Quality

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. 485 Therefore, higher audit quality can help constraining the magnitude of earnings management. Becker, DeFond, Jiambalvo and Subramanyam 1998 find that there is a larger discretionary accrual reported by non-Big 6 auditors lower audit quality than by Big 6 auditors higher audit quality. As a result, we expect a negative relation between auditor quality and earnings management. We have two measures of EM. The first measure is the modified Jones model Dechow, Sloan and Sweeney 1995 MJAC. The second measure is the performance-matched discretionary accrual model PMAC of Kothari, Leone and Wasley 2005. 62 We use the absolute values of MJAC and PMAC to examine the magnitude of earnings management.

3.4 Measurement of Management Demography

Based on our hypothesis, the five personal attributes of chairpersons we examine are title, gender, tenure year of experience as chairperson, age, and education level. Title is a dummy variable for title, which is coded 1 if the chairperson holds a title academic title or professional title and 0 otherwise. We use Gender, which is a dummy variable coded 1 if the chairperson is a female and 0 otherwise to test if there is a difference in auditor choice and earnings management. Tenure is a measure of experience, which is the number of years the chairperson stays in office. Age is the age of chairperson. Edu is a dummy variable coded 1 if the chairperson has a four-year university degree or above and 0 otherwise.

3.5 Control Variables

Measurement of Board Governance Factors 62 We also use the performance-matched discretionary accrual model because this method controls for the effect of performance on discretionary accrual which improves the reliability of inferences from earnings management. We use the current year‘s return on assets ROA t as the additional performance matching variable in the modified Jones model Dechow, Sloan and Sweeney 1995 to estimate the performance matched discretionary accrual each year for each industry.