Journal of Business Research 68 (2015) 11861195

Contents lists available at ScienceDirect

Journal of Business Research

Accounting fraud, auditing, and the role of government sanctions

in China
Ling Lei Lisic a, Sabatino (Dino) Silveri b, Yanheng Song c, Kun Wang d,
a

School of Business, George Mason University, Fairfax, VA 02030, United States

School of Management, Binghamton University (SUNY), Binghamton, NY 13902, United States
School of Management, Zhejiang University, Hangzhou, Zhejiang 310027, China
d
Department of Accounting, School of Economics & Management, Tsinghua University, Beijing 100084, China
b
c

a r t i c l e

i n f o

Available online 3 December 2014

Keywords:
Auditor size
Financial statement fraud
Government sanction
Corporate governance

a b s t r a c t
We use the unique economic, legal, and political landscape of China to examine the impact of auditors on the incidence of accounting fraud. In particular, we examine whether large audit rms reduce the incidence of nancial
statement fraud in China, an emerging market in which auditors face strong government sanctions but low litigation risk associated with audit failures. We nd that companies audited by large audit rms are less likely to
commit nancial statement fraud. This effect is stronger for regulated industries and for revenue-related frauds.
Our results are robust to considering the severity of fraud, excluding rms cross-listing in other jurisdictions,
using alternative measures of fraud, accounting for the self-selection of auditors, and controlling for other corporate governance mechanisms. Our results highlight the role of government sanctions in assuring audit quality and
have important practical implications to help international audit rms and businesses more generally successfully compete in China.
2014 Elsevier Inc. All rights reserved.

1. Introduction
China is now the world's second largest economy and growing at a
faster rate than most western countries. The size and growth of
China's economy present many business opportunities. However,
understanding China's unique economic, legal, and political landscape
is imperative for any rm to successfully compete in China. One of the
prominent differences from the west is the direct role the government
plays in detecting and dealing with accounting fraud. We focus on the
relation between auditor size and the incidence and consequences of
nancial statement fraud in China, an environment where auditors
face negligible litigation risk but severe government sanctions for
audit failures.
The goal of an independent audit is to provide reasonable assurance
that nancial statements are free from fraud or material error. Auditing
is thus essential in ensuring the proper functioning of the nancial
reporting system. Some studies nd that large audit rms provide

We thank three anonymous reviewers, Robert Grosse (the Guest Editor), Zhaoyang Gu,
Tom Omer, Roger Simnett, TJ Wong, Arch Woodside (The Editor in Chief), Xing Xiao, and participants at the George Mason University Competing in China Conference for their helpful
comments and suggestions. Song and Wang gratefully acknowledge research funding from
the National Natural Science Foundation of China (Project 70902004, Project 71372048,
and Project 71072116).
Corresponding author.
E-mail addresses: llisic@gmu.edu (L.L. Lisic), ssilveri@binghamton.edu (S.(D.) Silveri),
songyh@zju.edu.cn (Y. Song), wangk@sem.tsinghua.edu.cn (K. Wang).

http://dx.doi.org/10.1016/j.jbusres.2014.11.013
0148-2963/ 2014 Elsevier Inc. All rights reserved.

higher quality audits using data from countries where auditors face signicant litigation risk (Francis & Krishnan, 1999; Khurana & Raman,
2004; Lennox & Pittman, 2010). In contrast, other studies nd no
difference in audit quality between large and small audit rms in
countries with a relatively low level of legal protection for claimholders
(Hope & Langli, 2010; Jeong & Rho, 2004).
Using China as a setting, where auditors face negligible litigation risk
but harsh sanctions from government agencies for providing low
quality audits, we examine whether large audit rms reduce the
incidence of nancial statement fraud. On the one hand, litigation
against auditors in China is very rare. The court only accepts fraud
case allegations after the government has already sanctioned the
auditor for fraud (see Several Regulations about Fake Statement Litigation in Security Market (2003) enacted by the Supreme People's
Court). Although few cases have been brought to court, there has
never been a successful case of shareholder litigation against an auditor
due to low audit quality. Given this legal environment, it is not clear
whether auditors in general and large auditors in particular have
sufcient incentives to provide high quality audit services.
On the other hand, government agencies such as the Chinese
Security Regulatory Committee (CSRC) and the Ministry of Finance
sanction audit rms that fail to detect and report fraud in clients'
nancial statements (Firth, Mo, & Wong, 2005). The Chinese government is motivated to improve nancial statement quality in order to
attract foreign investment. Depending on the severity of the fraud, the
penalties for audit rms range from nes, to reprimands, to suspension
of audit work, to revoking licenses.

L.L. Lisic et al. / Journal of Business Research 68 (2015) 11861195

We seek to shed light on whether government sanctions can substitute for claimholder litigation in ensuring audit quality. Using all government enforcement actions against companies in China whose nancial
statements are challenged by government agencies for accounting
malfeasance, we identify 270 nancial statement frauds committed
during 19992005. We nd that the incidence of fraud declines over
our sample period. We also nd that, despite a very different legal
landscape, government sanctions in China appear to have a similar effect
on audit quality as litigation does in the U.S. Importantly, we show that
clients audited by large accounting rms are less likely to commit nancial statement fraud.
Certain industries are more heavily regulated and monitored by the
CSRC due to strategic considerations (Tian & Estrin, 2008; Wei, Xie, &
Zhang, 2005). These industries include energy, iron and steel, oil renery and petrochemicals, communications, and heavy machinery. Since
these industries potentially pose a higher risk of government sanctions
for nancial fraud, we expect and nd a more negative relation between
audit rm size and nancial statement fraud in these industries.
In China, revenue-related fraud is more consequential than assetrelated fraud because income performance is an important criterion
for initial public offerings, rights offerings and maintaining exchangetrading status (Aharony, Lee, & Wong, 2000; Chen & Yuan, 2004). In
addition, investors rely on accounting earnings to evaluate a company's
performance. Firth et al. (2005) nd that auditors are more likely to be
sanctioned when they fail to detect and report revenue-related fraud
compared with asset-related fraud. Accordingly, we partition the
sample into revenue-related and asset-related fraud. We nd that the
negative association between fraud and auditor size is stronger for
revenue-related fraud than for asset-related fraud.
Some rms in our sample are cross-listed in other countries and
regions such as the U.S. or Hong Kong, or have B-shares. As a result,
such rms are potentially subject to both government sanctions and
litigation risk. In order to provide a cleaner sample of rms that are
subject to government sanctions only, we drop these cross-listed rms
and nd that our results remain robust.
Our results are also robust to considering the severity of fraud as
measured by the punishment imposed after the fraud is discovered.
Our inference regarding the relation between auditor size and the
incidence of fraud remains robust to accounting for the self-selection
of auditors and controlling for corporate governance mechanisms that
potentially reduce the incidence of fraud. Finally, we examine alternative measures of fraud by investigating high abnormal accruals and
nd similar results.
Our study contributes to the academic literature on three levels and
has important implications for rms looking to compete in China. First,
our study furthers our understanding of China's unique economic environment. As a developing country with a very different legal landscape
to the U.S., China presents a low litigation risk environment for businesses including audit rms. However, the Chinese government is
motivated to improve nancial statement quality in order to attract
foreign investment. For example, the former Chinese Premier Zhu
Rongji set No Fictitious Records as a motto for the Shanghai National
Accounting Institute at its Inauguration Ceremony in 2001. Thus, the
government uses an alternative mechanism to litigation, namely government sanctions, to ensure high quality audits. Understanding this
feature is important for international audit rms who intend to successfully compete in China. For example, if an audit rm draws from its
experience in the U.S. where the threat of litigation is a key driver
of audit quality, the rm might erroneously conclude that it can get
away with lower quality audits in China absent such litigation risk.
However, our ndings suggest that government sanctions in China
substitute for litigation risk to ensure audit quality.
Second, our paper also has implications for client companies
successfully competing in China's capital markets. We document that
rms using larger audit rms are less likely to be sanctioned by the
Chinese government. The accounting literature generally suggests that

1187

larger auditors provide higher quality audits and this brings economic
benets to client rms in the capital markets. For example, clients of
larger auditors exhibit higher earnings quality (Teoh & Wong, 1993)
and lower underpricing when they undertake an initial public offering
(Hogan, 1997). In addition, rms switching from small auditors to
large auditors tend to experience a positive stock market reaction
(Knechel, Naiker, & Pacheco, 2007). Thus, a key implication of our
results is that hiring a large audit rm in China ensures higher audit
quality (i.e., lower fraud rate), which translates into economic benets
for client rms in the capital markets. Hiring a large audit rm in
China helps client rms successfully compete in China.
Third, we add to the audit literature by suggesting that government
discipline potentially serves as an alternative mechanism to litigation to
ensure high quality audits. As Allen, Qian, and Zhang (2011) argue, the
alternative mechanisms found in many fast-growing economies can be
superior to using the law as the basis for nance and commerce. Our
ndings thus have potential policy implications for other countries
with a less litigious environment. Public enforcement (government
sanctions) may be able to substitute for private enforcement (class
action law suits) to ensure high quality audits in these countries.
Our paper proceeds as follows. In Section 2, we discuss the institutional background of the audit market in China and review the relevant
literature. In Section 3, we develop our main hypothesis and specify
the research design. Section 4 presents the sample selection process
and the descriptive statistics. Section 5 reports the empirical results
and additional analyses and Section 6 concludes.
2. Institutional background and literature review
Since the 1978 economic reforms, interest in business practices in
China has grown substantially. China's fast growing economy presents
numerous opportunities for rms in China as well as for foreign rms
considering entering China's capital markets. The subsequent rapid
development of China's capital market has created a demand for high
quality external audits. Chinese regulators have also taken steps to
improve audit quality in order to attract foreign investment and to
restructure state-owned enterprises. For example, the Chinese Institute
of Certied Public Accountants was established in 1988 to regulate
Certied Public Accountants (CPAs). The CPA Act, which mandates
that auditors be indicted for ctitious audit reports, was enacted in
1993. In 1995, the Ministry of Finance adopted a new set of auditing
standards that are closely modeled after the International Auditing
Standards. The China Securities Regulatory Commission (CSRC) and
the Ministry of Finance introduced the Audit Firm Disafliation program
in 1997 to sever ties between CPA rms and government agencies. The
CSRC has also issued several regulations since 2000 to encourage the
mergers of small- and medium-sized audit rms into larger rms.
Despite signicant regulatory reforms, however, the role of the auditor in assuring accounting information quality in China's capital markets
is still unclear. The major concern is derived from the legal landscape in
China. Litigation risk is a major factor ensuring high quality audits in
developed countries such as the U.S. In contrast, suing auditors in
China is rare and to date there has not been a successful case of
shareholder litigation against auditors.
Although litigation risk is negligible, auditors who provide low
quality audit services in China do bear other risks, namely government
penalties. Both the CSRC and the Ministry of Finance have authority to
monitor and sanction audit rms that fail to detect and report nancial
statement fraud such as misreporting income, misreporting assets and
liabilities and facilitating ctitious transactions. Chapter 10 of The Security Law delegates the CSRC as the main regulator of security markets in
China, which has authority to investigate and sanction listed companies
and market intermediates (including auditors) involved in securities
fraud and malpractice. The CSRC regularly reviews and randomly
inspects listed companies, especially when they receive complaints
from investors or the media. Once a nancial statement fraud is

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L.L. Lisic et al. / Journal of Business Research 68 (2015) 11861195

discovered, the CSRC issues an enforcement action to sanction the listed

company and its management. The auditor will also be sanctioned if the
CSRC believes that the fraudulent nancial reporting should have been
detected by the auditor (Firth et al., 2005). Among all fraudulent companies, 77% of the corresponding auditors are sanctioned for audit failures
(Wu, 2007).
The Ministry of Finance has jurisdiction over the nancial reporting
of all Chinese companies (both listed and unlisted) and jurisdiction over
accounting professionals such as auditors. Beginning in 1997, the Ministry of Finance randomly inspects 20% of accounting rms annually, with
this proportion increasing to one third after 2004. For auditing rms
found to have provided substandard audit services, penalties range
from nes, to reprimands, to suspension of audit work, to revoking
licenses. For auditors who have a license to audit listed companies,
the CSRC and the Ministry of Finance work together to supervise and
enforce punishment. For example, a large scale accounting scandal
involving YinGuangXia emerged in August 2001. Its auditor, then the
largest audit rm in China, ZhongTianQin, was heavily criticized for its
failure to detect the fraud. This audit failure led to the Ministry of
Finance and the CSRC's revocation of ZhongTianQin's license in early
2002 and the eventual demise of the rm.
Whether government sanctions can substitute for litigation in assuring audit quality is an open question. Glaeser, Johnson, and Shleifer
(2001) show that government regulation of nancial markets is useful
when court enforcement of private contracts or laws cannot be relied
upon. In the absence of an effective legal environment, other forms of
protecting property rights, such as government-enforced regulations
can be more efcient (La Porta, Lopez-de-Silanes, Shleifer, & Vishny,
2000).
Previous studies on audit quality in China provide mixed results.
Some studies nd that audit failures are not unusual, especially in the
early stages of the development of the audit market. For example,
Chen, Su, and Zhao (2000) document the existence of acquiescent auditors that allow clients to manipulate earnings without issuing modied
opinions. In addition, some studies document that large auditors do not
provide higher quality audit services in China (Liu, Xie, & Huang, 2009;
Liu & Zhou, 2007). However, other studies nd that larger auditors
begin to provide higher quality audits after recent government regulations. For example, DeFond, Wong, and Li (1999) show that larger auditors are more likely to issue modied reports than smaller auditors.
3. Hypothesis development and research design
3.1. Hypothesis development
The role of government regulation can be crucial for transitioning
economies. As pointed out earlier, Glaeser et al. (2001) show both
theoretically and empirically that government regulation of nancial
markets is useful when court enforcement of private contracts or laws
cannot be relied upon. In China, lawyers represent only 10 to 25% of
clients in civil and business cases and only one-fth of lawyers (and
even a lower fraction of judges) have law degrees or have formally
studied law at a university or college (Allen, Qian, & Qian, 2005). As a
result, the legal redress available to individual investors in China is not
efcient. In the absence of an efcient legal environment, other forms
of protecting property rights, such as government-enforced regulations
can be more efcient (La Porta et al., 2000). Consequently, government
sanctions assume a more important role in policing and curbing fraud.
As La Porta et al. (2000) point out, the successful regulations of markets
share a common element: the extensive and mandatory disclosure of
nancial information by the issuers, the accuracy of which is enforced
by tightly regulated nancial intermediaries (auditors). The quality of
auditors thus plays an important role in helping safeguard the assets
of investors (Fan & Wong, 2005).
Compared to other measures of accounting quality such as discretionary accruals, earnings persistence, or earnings informativeness,

nancial statement fraud raises a larger concern to regulatory authorities due to its substantial negative impact on the development of
China's capital market. Regulators in China believe that auditors are
responsible for detecting and reporting fraud and therefore should be
heavily sanctioned for their failures (Firth et al., 2005). Auditors'
concerns about regulatory sanctions can dominate their economic
incentives (Chen, Sun, & Wu, 2010). Large auditors in particular are
more prominent and therefore more likely to be monitored by the
CSRC and the Ministry of Finance. They also have more to lose once
their licenses are revoked due to their larger client base (DeAngelo,
1981). In addition, the Ministry of Finance requires peer reviews as
part of its annual inspection of auditors. Large auditors draw substantially more competition from their peer rms and therefore, ceteris paribus,
are more likely to receive an unfavorable peer review. Consistent with
these arguments, Zheng and Xu (2011) nd that CSRC sanctions have
a larger negative impact on larger accounting rms ex-post. In particular, larger accounting rms suffer a larger loss of market share and a
greater reduction in audit fees after they are sanctioned by the CSRC.
Therefore, ex-ante, we expect larger accounting rms in China to have
stronger incentives to provide high quality audits relative to smaller
accounting rms. Our main hypothesis appears in its alternative form.
H1. Ceteris paribus, companies audited by larger accounting rms are
less likely to engage in nancial statement fraud.
3.2. Model specications
We use the following probit model to examine H1:


Fraudi;t 0 1 Ln AuditorSizei;t 2 Auditor Tenurei;t
3 ROE Dummyi;t 4 StateOwnedi;t




5 Ln CompanyAgei;t 6 Ln CompanySizei;t
7 Leveragei;t 8 ROAi;t 9 Book toMarket i;t
10 Lossi;t1 i;t

where Fraudi,t is a dummy variable that equals one if company i

commits a nancial statement fraud during year t and zero otherwise.
Auditor Sizei,t is a continuous variable dened as the total client assets
of rm i's auditor in year t. As an alternative, we also measure auditor
size as a dummy variable, Top 10i,t, which is set to 1 if rm i's auditor
is among the 10 largest auditing rms in year t and 0 otherwise
(Chen, Firth, Gao, & Rui, 2006; DeFond et al., 1999). Our main hypothesis
predicts that 1 is negative.
We include control variables prior studies on nancial statement
fraud nd important (Chen et al., 2006; Lennox & Pittman, 2010).
Auditor Tenurei,t is the number of years, as of year t, rm i has been
audited by the same auditing rm. There are two conicting predictions
on how auditor tenure impacts the incidence of nancial statement
fraud. Some studies nd a positive relation between auditor tenure
and earnings quality (Carcello & Nagy, 2004; Geiger & Raghunandan,
2002; Ghosh & Moon, 2005; Myers, Myers, & Omer, 2003), suggesting
a negative relation between auditor tenure and the incidence of fraud.
Other studies argue that an auditor's independence from the client
likely declines in time as it builds a long-term relationship with the
client (Davis, Soo, & Trometer, 2009). This argument predicts a positive
relation between accounting malfeasance and auditor tenure. With little
evidence from emerging markets, it is an empirical question how
auditor tenure is related to the likelihood of nancial statement fraud.
The CSRC requires a minimum return on equity (ROE) greater than
0% for a rm to maintain trading status. It also requires at least 6% and
an average of 10% over three consecutive years during 1999 to 2002,
and an average of 6% over three consecutive years after 2002 for the
company to raise additional capital from the stock market. Prior studies
nd that rms with ROE slightly above 0%, 6% and 10% are rms that
have likely managed earnings (Chen & Yuan, 2004; Jiang & Wang,

L.L. Lisic et al. / Journal of Business Research 68 (2015) 11861195

2008). As such, we include a dummy variable ROE Dummyi,t that takes the
value one if rm i's ROE in year t is between 0 and 1%, 6 and 7% or 10 and
11%. Ding, Zhang, and Zhang (2007) and Chen, Chen, Lobo, and Wang
(2011) suggest that state-owned companies manage earnings less so we
include an indicator variable, State-Ownedi,t, which equals 1 for stateowned companies and 0 otherwise. We note that it is also possible that
the Chinese government might be less likely to sanction state-owned
companies, again predicting a negative sign on State-Ownedi,t. We follow
Lennox and Pittman (2010) to control for company age and size. Company
Agei,t is the number of years that the company is listed on a stock
exchange. We use total assets to measure Company Sizei,t. As debt holders
have incentive to monitor management and obtain high quality accounting information, it is more difcult for rms to manage earnings if they
have high leverage (Frankel, Johnson, & Nelson, 2002). On the other
hand, highly levered rms face larger expected costs of nancial distress.
As a result they may be more likely to misreport (Burns & Kedia, 2006)
or even commit fraud (Erickson, Hanlon, & Maydew, 2006). We thus
include Leveragei,t, dened as total debt divided by total assets for rm i
in year t, as a control variable but do not predict the sign.
To control for rm performance, we include Return on Assetsi,t (ROAi,t)
which is dened as net income divided by total assets for rm i in year t.
Some studies nd that rms with rapid growth are more likely to commit
fraud (e.g., Loebbecke, Eining, & Willingham, 1989) although other papers
fail to nd a signicant association between growth and misreporting/
fraud (Burns & Kedia, 2006; Erickson et al., 2006). We use the Book-toMarketi,t ratio, dened as the book value of equity divided by the market
value of equity for rm i in year t, to proxy for growth opportunities.
Since Chinese rms are marked as Special Treatment by stock exchanges
if they incur losses in two consecutive years, rms have strong incentives
to avoid a loss in the current year if they also incur a loss in the prior year.
As such, we include Lossi,t 1, a dummy variable that equals 1 if rm i
incurs a loss during year t 1 and 0 otherwise.
4. Sample and descriptive statistics
To identify rms that have committed accounting fraud, we search
the China Stock Market and Accounting Research Database (CSMAR)
for enforcement reports issued by government agencies including the
CSRC, the Ministry of Finance, and the Shanghai and Shenzhen stock
exchanges. On average, there is a four-year gap between the fraud commitment date and the government report date. Thus, we identify frauds
committed during the period 1999 to 2005 as our sample is based on
enforcement reports up to 2009.
CSMAR identies four types of fraudulent activities: nancial statement frauds, delayed or fake announcements, shareholders' violation
of fund provisions or other expropriation activities and illegal share
purchases or stock price manipulations. We focus on the rst type,
which is often perceived as the auditor's responsibility to detect and
report. We exclude nancial rms following Khurana and Raman
(2004) and Ettredge, Sun, Lee, and Anandarajan (2008). A total of 270
fraud-year observations during 1999 to 2005 are identied. As an
example of our classication scheme, Shenxin Taifeng Group Co.
received an enforcement report from the CSRC on October 9, 2007.
The report stated that the company had fabricated nancial numbers
in its 2003 annual report. Specically, the company inated inventory
by 20 million Yuan and inated prepaid accounts by 6.5 million Yuan.
Thus, we identify 2003 for this company as a fraud-year observation.
It is further dened as an asset-related fraud since the misstatement
affects only assets but not revenue (or income). If the accounting
fraud was committed in more than one year, we identify each year as
a fraud-year observation. Our results, however, are robust to examining
only the rst year of consecutive frauds.
Table 1 summarizes the sample distribution. Panel A breaks down
the number of frauds by year. The frequency of accounting frauds in
China is higher than the U.S. (see Lennox and Pittman (2010) for U.S.
data). For example, in 1999 the frequency of accounting frauds is 3.9%

1189

Table 1
Financial statement frauds by year and industry.
Panel A: Frauds by year
Years

Entire sample

Frauds (proportion (%))

Total
1999
2000
2001
2002
2003
2004
2005

7843
862
1000
1076
1146
1211
1273
1275

270 (3.44)
34 (3.94)
36 (3.60)
38 (3.53)
42 (3.66)
45 (3.72)
47 (3.69)
28 (2.20)

Panel B: Frauds by industry

Agriculture
Exploring
Manufacturing
Utilities
Construction
Transportation
Technology
Commerce
Properties
Services
Media
Conglomerate

Entire sample

Frauds

Proportion (%)

180
96
4530
331
132
321
435
625
312
267
77
537

22
2
171
3
1
6
15
8
12
3
8
19

12.22
2.08
3.77
0.91
0.76
1.87
3.45
1.28
3.85
1.12
10.39
3.54

in China and 1.1% in the U.S. There is a decreasing trend in the frequency
of frauds over the years, from 3.9% in 1999 to 2.2% in 2005. This pattern
is partially due to more stringent government scrutiny on listed companies and auditors in recent years. Panel B of Table 1 reports the distribution of frauds across industries. The industry classication follows the
CSRC guidelines. The distribution of fraud is in general similar across
industries, except for the agriculture industry and the media industry.
These industries are more difcult to audit due to the nature of the
products (Ding, 2013; Si, 2012). This potentially explains why these
industries have the highest incidence of accounting fraud (12.22% and
10.39%, respectively).
Table 2 presents the ranking and the market share of the Top 10
auditors where market share is dened as the combined client total
assets of the audit rm divided by the combined total assets of all listed
companies. The total number of auditors on the list is more than ten
because the composition of the Top 10 auditors changes over time. In
terms of market share, large auditors dominate China's market. For
example, as of 2005 the Top 10 auditors as a group account for more
than 50% of the market. We dene a company as being audited by a
Top 10 auditor only if the auditor is among the largest 10 auditors in
the corresponding scal year.
Table 3 compares the number and the frequency of nancial statement fraud among companies audited by the Top 10 auditors versus
non-Top 10 auditors. For our sample period, the average frequency of
accounting fraud is 1.8% in companies audited by the Top 10 auditors
compared to 3.7% for non-Top 10 auditors. The difference is statistically
signicant at the 1% level (t = 3.43). When we break down the
sample by year, the difference is negative in each year and is signicant
in four out of seven years. This preliminary evidence supports our main
hypothesis that companies audited by Top 10 auditors are less likely to
commit accounting fraud.
Table 4 presents the descriptive statistics for the fraud versus the
non-fraud sub-samples. The number of observations is slightly reduced
due to missing nancial information for the ROA computation. Altogether, 8% of the fraud rm-years are audited by the Top 10 auditors while
15% of the non-fraud rm-years are audited by Top 10 auditors. Auditor
Size is also greater in the non-fraud sample. The differences in the means
and medians of Top 10 and Auditor Size between the fraud and nonfraud samples are both statistically signicant at the 1% level. These

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L.L. Lisic et al. / Journal of Business Research 68 (2015) 11861195

Table 2
Ranking and market share of top 10 auditors.

Anderson HuaQiang
BeiJing Jingdu
Deloitte Hu Jiang/HuaYong
E&Y DaHua
E&Y HuaMing
Grant Thornton ZhongHua
HeBei Huaan
KPMG HuaZhen
PWC DaHua/ZhongTian
ShangHai
ShangHai Lixin
ShenZhen ZhongTian
Shinewing
SiChuan JunHe
TianQin
ZhongTianQin
ZheJiang TianJian

1999

2000

2001

2002

2003

2004

2005

Ranking
(Share %)

Ranking
(Share %)

Ranking
(Share %)

Ranking
(Share %)

Ranking
(Share %)

Ranking
(Share %)

Ranking
(Share %)

12 (2.57)
8 (2.98)
34 (0.98)
1 (6.19)
15 (2.06)
3 (4.08)
6 (3.37)
2 (4.22)
19 (1.74)
4 (3.95)
9 (2.81)
5 (3.70)
22 (1.63)
10 (2.77)
7 (3.31)

8 (3.04)
5 (3.73)
46 (0.83)
2 (5.64)
3 (3.77)
7 (3.36)
12 (2.34)
9 (2.88)
32 (1.22)
6 (3.42)
4 (3.75)

2 (4.95)
6 (3.23)
32 (1.08)
3 (4.60)
5 (3.35)
8 (2.26)
13 (1.97)
1 (17.05)
9 (2.25)
12 (2.13)
4 (3.97)

6 (2.92)
14 (1.77)
3 (4.21)
5 (3.09)
8 (2.37)
10 (1.99)
1 (14.80)
2 (11.54)
13 (1.78)
4 (3.56)

7 (2.57)
11 (2.11)
4 (3.75)
5 (2.95)
8 (2.39)
10 (2.13)
1 (14.39)
2 (9.96)
14 (1.86)
3 (3.94)

7 (2.68)
10 (2.29)
5 (2.78)
4 (4.11)
11 (2.11)
9 (2.33)
1 (14.57)
2 (9.19)
15 (1.66)
3 (4.98)

7 (2.53)
5 (3.78)
8 (2.44)
3 (6.06)
9 (2.38)
11 (2.28)
1 (15.74)
2 (8.77)
19 (1.38)
4 (4.27)

19 (1.49)
13 (2.26)

10 (2.18)
17 (1.56)

7 (2.60)
19 (1.40)

6 (2.61)
21 (1.34)

6 (2.75)
32 (1.05)

6 (2.73)
35 (0.88)

1 (6.89)
10 (2.75)

7 (2.30)

9 (2.30)

9 (2.27)

8 (2.36)

10 (2.32)

11 (2.71)

The market share of each audit rm is dened as the total assets of the audit rm's client base divided by the combined total assets of all listed companies on the stock market.

results are consistent with our hypothesis that frauds are less likely to
be committed by companies audited by larger auditors.
Variables associated with nancial statement fraud at the 5% signicance level include Auditor Tenure, State-Owned, Company Size, Leverage,
ROA and the Book-to-Market ratio. For example, Auditor Tenure is on average 3.9 years in the fraud sub-sample, and 4.7 years in the non-fraud subsample, which supports the view that longer auditor tenure is associated
with a lower likelihood of nancial statement fraud. Firms that commit
fraud are generally smaller than non-fraud rms. The mean of Company
Size is 1.5 billion Yuan (median 1.0 billion Yuan) for the fraud sample
compared with 2.7 billion Yuan (median 1.3 billion Yuan) for the nonfraud sample. We also nd that fraud-sample rms have lower ROA,
which suggests that rms are more likely to manipulate accounting
numbers when their performance is relatively poor. In addition, the
Book-to-Market ratio is lower for fraud rms when compared to nonfraud rms. Our ndings are, in general, consistent with the results of
Lennox and Pittman (2010) who use U.S. data. Thus, despite a very different legal landscape, it appears that government sanctions in China have a
similar effect on audit quality as litigation does in the U.S.

on Top 10 is 0.2598 (t = 1.96), suggesting that clients audited by

a Top 10 auditor are less likely to commit nancial statement fraud. To
calibrate the economic signicance of this association, we predict the
probabilities of accounting fraud for Top 10 auditors versus non-Top 10
auditors when other control variables are evaluated at their respective
sample means. When the company is audited by a Top 10 auditor, the
estimated fraud probability is 1.8% whereas the probability is 3.7%
when it is audited by a non-Top 10 auditor. In other words, our results
translate into fraudulent nancial reporting being twice as likely for a
non-Top 10 auditor's client as for a Top 10 auditor's client.
Consistent with the univariate results presented in Table 4, we nd
that Auditor Tenure is negatively associated with the likelihood of nancial statement fraud, suggesting that auditor tenure is positively associated with accounting quality. The State-Owned coefcients are negative
and statistically signicant at the 1% level. In addition, ROA is negatively
associated with the incidence of accounting fraud, implying that poor
operating performance is one of the driving forces behind nancial
statement fraud.

5.2. Regulated versus unregulated industries

5. Empirical results
5.1. Main results
Table 5 reports the main regression results on whether auditor size
is associated with the likelihood of nancial statement fraud. Since the
results are very similar whether we use Auditor Size or Top 10 to proxy
for auditor size, we focus on the results using Top 10. The coefcient

Table 6 reports the regression results on whether auditor size is

associated with the likelihood of nancial fraud for regulated versus
unregulated industries. We follow Wei et al. (2005) and Tian and
Estrin (2008) to dene regulated industries as energy, iron and steel,
oil renery and petrochemicals, communications and heavy machinery
industries. Since all regulated rms audited by Top 10 auditors do not
have any incidence of fraud, we cannot perform subsample analysis

Table 3
Comparison of nancial statement frauds in companies audited by top 10 versus non-top 10 auditors.
Years

Total sample
1999
2000
2001
2002
2003
2004
2005

Top 10 auditors

Non-top 10 auditors

Obs.

Frauds

Obs.

Frauds

1169
46
112
152
198
205
235
221

21
1
2
1
4
5
6
2

1.80
2.17
1.79
0.66
2.02
2.44
2.55
0.90

6674
816
888
924
948
1006
1038
1054

249
33
34
37
38
40
41
26

3.73
4.04
3.83
4.00
4.01
3.98
3.95
2.47

***, ** and * denote signicance at the 1%, 5% and 10% level, respectively.

Difference in fraud proportions

t-Statistic

1.93
1.87
2.04
3.34
1.99
1.54
1.40
1.57

3.43***
4.64***
1.77*
1.73*
1.18
0.34
0.83
2.24**

L.L. Lisic et al. / Journal of Business Research 68 (2015) 11861195

1191

Table 4
Descriptive statistics for the fraud versus non-fraud samples.
Variable

Fraud sample

Top 10
Auditor Size (billion Yuan)
Auditor Tenure (years)
ROE Dummy
State-Owned
Company Age (years)
Company Size (billion Yuan)
Leverage
ROA
Book-to-Market
Losst 1

Non-fraud sample

Obs.

Mean

Median

Obs.

Mean

Median

270
270
270
270
270
270
270
270
270
270
270

0.08
44.04
3.85
0.84
0.68
6.14
1.53
0.51
0.02
0.34
0.20

0
32.90
3
1
1
6
1.02
0.49
0.02
0.29
0

7573
7573
7573
7573
7545
7573
7570
7569
7569
7546
7569

0.15
57.39
4.66
0.82
0.83
6.19
2.68
0.48
0.02
0.41
0.17

0
39.47
4
1
1
6
1.30
0.47
0.03
0.35
0

t-Statistic

z-Statistic

4.38***
4.01***
5.38***
1.06
5.35***
0.31
6.88***
2.29**
5.72***
3.94***
1.44

3.35***
4.29***
4.00***
1.00
6.60***
0.13
4.17***
2.11**
6.95***
3.76***
1.55*

Note. Variables used in this table are dened as follows: Top 10 is a dummy variable that equals 1 if the auditing rm is among the 10 largest in terms of the total assets of the auditing rm's
client base in a given year and 0 otherwise. Auditor Size is the combined total assets of the auditor's client base measured in billion Yuan. Auditor Tenure is the number of years that the
company has been audited by the same auditing rm. ROE Dummy takes the value one if the listed company's ROE is between 0 and 1%, 6 and 7% or 10 and 11% and zero otherwise.
State-Owned equals 1 for state-owned companies and 0 otherwise. Company Age is the number of years that the company is listed on a stock exchange. Company Size is the year-end
total assets of the company. Leverage is a company's total debt divided by total assets. ROA (Return On Assets) is a company's net income divided by total assets. Book-to-Market is the
ratio of a company's book value of equity to the market value of equity. Losst 1 equals 1 if the company had a loss in year t 1 and 0 otherwise. The t-statistic tests for whether
there is a difference in means across the two samples. The z-statistic tests for whether there is a difference in medians across the two samples. ***, ** and * denote signicance at the
1%, 5% and 10% level, respectively.

with the Top 10 variable as a proxy for auditor size. We thus report in
Table 6 the results using Auditor Size. For regulated industries, the coefcient on Auditor Size is signicantly negative (0.2701, t = 2.70),
suggesting that clients in regulated industries audited by a larger
auditor are less likely to commit nancial statement fraud. For unregulated industries, although the coefcient on Auditor Size is signicantly
negative (0.1196, t = 2.45), its economic signicance is less than
half of that for regulated industries. These results are consistent with
the effect of auditor size on nancial statement fraud being larger in
regulated industries due to more severe government monitoring.
5.3. Revenue- versus asset-related fraud
We classify frauds into two types; revenue-related frauds that
include revenue (or expenses) misstatement, and asset-related frauds
that only affect assets (or liabilities). In China, revenue-related fraud is
more consequential than asset-related fraud because income performance is an important criterion for initial public offerings, rights
offerings and maintaining exchange-trading status (Aharony et al.,

Table 6
Probit regression of the incidence of fraud on auditor size for regulated versus unregulated
industries.

Table 5
Probit regression of the incidence of fraud on auditor size.
Fraud

Top 10
Ln(Auditor Size)
Auditor Tenure
ROE Dummy
State-Owned
Ln(Company Age)
Ln(Company Size)
Leverage
ROA
Book-to-Market
Losst 1
Intercept
Year xed effects
Industry xed effects
N
Pseudo R2

2000; Chen & Yuan, 2004). For example, during the 1990s the CSRC
required a minimum ROE of no less than 10% for a company to apply
for a rights offering (at present, this ROE requirement is no less than
6% on average for three years). Consequently, Chinese listed companies
have strong incentives to manipulate income numbers in order to raise
capital and to maintain listing status (Aharony et al., 2000; Chen & Yuan,
2004; Jian & Wong, 2010). In addition, investors rely on accounting
earnings to evaluate a company's performance. Due to the protability
regulations and the prominent nature of accounting earnings in the
capital markets, regulators perceive revenue-related fraud as more
devastating than those solely related to assets. Consistent with this,
Firth et al. (2005) nd that auditors are more likely to be sanctioned
when they fail to detect and report revenue-related fraud compared
with asset-related fraud. As a result, we expect the negative association
between auditor size and the incidence of nancial fraud to be stronger
for revenue-related fraud than for asset-related fraud.
To investigate this, we split the fraud sample into revenue- and
asset-related fraud. Untabulated statistics show that revenue-related

Fraud

Coefcient

t-Statistic

0.2598**

(1.96)

0.0537***
0.0899
0.3888***
0.1418
0.0089
0.2202
2.2199***
0.1012
0.0468
0.7612
Included
Included
7809
0.0879

(2.91)
(1.22)
(3.09)
(1.57)
(0.15)
(0.85)
(5.14)
(0.43)
(0.56)
(0.63)

Coefcient

t-Statistic

0.1078**
0.0473***
0.0876
0.3938***
0.1408
0.0173
0.2185
2.2250***
0.1186
0.0487
1.5423
Included
Included
7809
0.0854

(2.36)
(2.63)
(1.19)
(3.15)
(1.57)
(0.29)
(0.84)
(5.19)
(0.51)
(0.58)
(1.02)

Noe. This table reports the results of probit regressions investigating the association between
nancial statement fraud and auditor size. The dependent variable is Fraud, which equals 1 if
the rm committed nancial statement fraud in year t and 0 otherwise. See Table 4 for all
other variable descriptions. t-statistics clustered by rm are presented in parentheses. ***,
** and * denote signicance at the 1%, 5% and 10% level, respectively.

Ln(Auditor Size)
Auditor Tenure
ROE Dummy
State-Owned
Ln(Company Age)
Ln(Company Size)
Leverage
ROA
Book-to-Market
Losst 1
Intercept
Year xed effects
Industry xed effects
N
Pseudo R2

Regulated industries

Unregulated industries

Coefcient

t-Statistic

Coefcient

t-Statistic

0.2701***
0.2203***
0.3292
0.3292
0.3213
0.5439***
0.9951
3.1604**
1.7830
0.1638
15.9239***
Included
Included
885
0.25

(2.70)
(2.73)
(1.52)
(0.08)
(1.15)
(3.00)
(1.47)
(1.97)
(1.43)
(0.88)
(4.12)

0.1196**
0.0453**
0.1319*
0.3900***
0.0959
0.0552
0.2536
2.2990***
0.2017
0.0774
0.4585
Included
Included
6924
0.06

(2.45)
(2.49)
(1.76)
(3.14)
(1.02)
(0.86)
(0.93)
(5.24)
(0.87)
(0.91)
(0.28)

Note. This table reports the results of probit regressions investigating the association between
nancial statement fraud and auditor size for regulated versus nonregulated industries.
Regulated industries are dened as energy, iron and steel, oil renery and petrochemicals,
communications and heavy machinery industries. The dependent variable is Fraud, which
equals 1 if the rm committed nancial statement fraud in year t and 0 otherwise. See
Table 4 for all other variable descriptions. t-Statistics clustered by rm are presented in
parentheses. ***, ** and * denote signicance at the 1%, 5% and 10% level, respectively.

1192

L.L. Lisic et al. / Journal of Business Research 68 (2015) 11861195

Table 7
Probit regression of fraud type on auditor size.
Revenue-related fraud

Asset-related fraud

(1)

(2)

(3)

0.3532**
(2.29)

Top 10

0.1665***
(2.74)
0.0600**
(2.54)
0.1025
(1.16)
0.3655**
(2.12)
0.1010
(0.89)
0.0097
(0.12)
0.1011
(0.29)
1.9150***
(3.73)
0.0121
(0.04)
0.1850*
(1.73)
2.6796
(1.30)
Included
Included
7328
0.0964

Ln(Auditor Size)
0.0620***
(2.62)
0.1169
(1.33)
0.3665**
(2.11)
0.1035
(0.89)
0.0009
(0.01)
0.0970
(0.28)
1.8827***
(3.59)
0.0080
(0.03)
0.1836*
(1.75)
0.9321
(0.56)
Included
Included
7328
0.0926

Auditor Tenure
ROE Dummy
State-Owned
Ln(Company Age)
Ln(Company Size)
Leverage
ROA
Book-to-Market
Losst 1
Intercept
Year xed effects
Industry xed effects
N
Pseudo R2

(4)

0.2381*
(1.86)

0.0222
(1.01)
0.0660
(0.66)
0.3234**
(2.45)
0.1419
(1.21)
0.0467
(0.64)
0.3279
(1.07)
1.9500***
(3.75)
0.2805
(0.94)
0.0850
(0.84)
2.1004
(1.42)
Included
Included
7214
0.0716

0.0031
(0.07)
0.0244
(1.13)
0.0605
(0.61)
0.3216**
(2.44)
0.1360
(1.18)
0.0150
(0.21)
0.2874
(0.95)
1.9663***
(3.75)
0.1980
(0.67)
0.0840
(0.82)
1.4226
(0.86)
Included
Included
7214
0.0666

Note. This table reports the results of probit regressions investigating the association between revenue-related fraud and auditor size and between asset-related fraud and auditor size. The
dependent variable in regressions (1) and (2) is revenue-related fraud, which equals 1 if the fraud is related to revenues in year t and 0 otherwise. The dependent variable in regressions
(3) and (4) is asset-related fraud, which equals 1 if the fraud is related to assets in year t and 0 otherwise. See Table 4 for all other variable descriptions. t-Statistics clustered by rm are
presented in parentheses. ***, ** and * denote signicance at the 1%, 5% and 10% level, respectively.

fraud is more prevalent than asset-related fraud (54% versus 46%,

respectively). We compare each type of fraud to the non-fraud companies, respectively, using Eq. (1). Specically, we drop asset-related
frauds from the original sample to test the impact of larger auditors on
the incidence of revenue-related frauds. Similarly, we drop revenuerelated frauds from the original sample to test the impact of larger
auditors on the incidence of asset-related frauds. We predict that the

Table 8
Probit regression of the incidence of fraud on auditor size after excluding rms listing in
other countries or listing B-shares.
Fraud

Top 10
Ln(Auditor Size)
Auditor Tenure
ROE Dummy
State-Owned
Ln(Company Age)
Ln(Company Size)
Leverage
ROA
Book-to-Market
Losst 1
Intercept
Year xed effects
Industry xed effects
N
Pseudo R2

Fraud

Coefcient

t-Statistic

0.4226***

(2.85)

0.0480**
0.0777
0.3100**
0.1612
0.0094
0.2885
2.2039***
0.1859
0.0535
0.4528
Included
Included
7042
0.09

(2.36)
(1.00)
(2.35)
(1.63)
(0.14)
(1.05)
(4.76)
(0.74)
(0.58)
(0.33)

Coefcient

t-Statistic

0.1212**
0.0404**
0.0761
0.3198**
0.1564
0.0043
0.2714
2.2001***
0.1903
0.0559
2.2137
Included
Included
7042
0.09

(2.57)
(2.04)
(0.98)
(2.45)
(1.62)
(0.06)
(0.99)
(4.80)
(0.76)
(0.61)
(1.33)

Note. This table reports the results of probit regressions investigating the association between
nancial statement fraud and auditor size after excluding rms listing in other jurisdictions
or listing B-shares. The dependent variable is Fraud, which equals 1 if the rm committed
nancial statement fraud in year t and 0 otherwise. See Table 4 for all other variable
descriptions. t-Statistics clustered by rm are presented in parentheses. ***, ** and * denote
signicance at the 1%, 5% and 10% level, respectively.

differential impact of large auditors versus small auditors is signicantly

more pronounced in revenue-related fraud than in asset-related fraud.
We present these results in Table 7.
Regression models (1) and (2) present the results examining the
auditor's role in reducing revenue-related fraud. Consistent with our
expectations, the revenue-related fraud results are stronger than those
using the entire fraud sample. The coefcient of Top 10 is more negative
both statistically and economically than the corresponding coefcient in
Table 5. In economic terms, the estimated probability of revenue-related
fraud is 0.8% when the company is audited by a Top 10 auditor compared to 2.4% when the company is audited by a non-Top 10 auditor.
Thus, revenue-related nancial fraud occurs three times as often for a
non-Top 10 auditor's client as for a Top 10 auditor's client.
In regression models (3) and (4), we include only asset-related fraud
and exclude revenue-related fraud. We nd evidence of higher audit
quality for larger auditors only when auditor size is measured by the
Top 10 dummy variable. Even though the coefcient of Top 10 is negative and marginally signicant, both the magnitude and statistical
signicance of the coefcient are smaller than those shown in regression model (1). Moreover, in regression model (4) where we use the
continuous measure of auditor size, the coefcient is no longer signicant. Taken together, these results are consistent with our expectation
that the effect of larger auditors in reducing nancial fraud is stronger
for revenue-related fraud than for asset-related fraud.
5.4. Cross-listed rms and rms listing B-shares
Approximately 10% of our sample are cross-listed in other jurisdictions or have B-shares. Such rms could potentially be subject to both
government sanctions and litigation risk. In order to see whether
these rms drive our results, we drop rms with cross-listings or Bshares. Table 8 reports the regression results. After excluding these
rms, we continue to nd that the coefcients on Top 10 ( 0.4226,

L.L. Lisic et al. / Journal of Business Research 68 (2015) 11861195

t = 2.85) and Auditor Size ( 0.1212, t = 2.57) are signicantly

negative. These results present clearer evidence that it is government
sanctions that drive the difference in audit quality between large and
small audit rms in China.
5.5. Additional analyses
5.5.1. Severity of fraud
Since nancial statement frauds vary in severity, we test whether
auditor size is associated with the severity of fraud. We measure the
severity of fraud by the severity of punishments after the fraud is
discovered. Specically, punishments are classied into two categories:
public criticism and public punishment. The rst category includes
public condemnation or criticism of the fraud rm and ofcial warning
without monetary nes being levied. The second type imposes monetary nes as an additional punishment. Thus, frauds that are sanctioned
by public punishment are more severe than frauds sanctioned by public
criticism. In our sample, 38% of fraud rms receive public criticism and
62% receive public punishment.
We modify Eq. (1) as an ordered probit regression to reect the
severity of fraud. Specically, the dependent variable takes the value 0
when there is no fraud, 1 when there is fraud and punishment is public
criticism (but not monetary nes), and 2 when there is fraud and
punishment includes monetary nes. As shown in Table 9, the results
are very similar to the probit model results in Table 5. Both Top 10 and
Auditor Size have a negative impact on the severity of fraud. Thus, larger
auditors not only reduce the likelihood of fraud but also reduce the
severity of accounting irregularities.
5.5.2. An alternative measure of fraud
Our Fraud variable in the above analyses is dened as an ex-post
sanction by the CSRC, which could be confounded by the incentives of
CSRC to detect and impose sanctions. Thus, we explore an alternative
proxy for nancial statement fraud using high abnormal accruals,
which is free of the self-selection issue pertaining to CSRC sanctions.
We dene high abnormal accruals as above the 90th percentile of
the distribution of the performance-adjusted modied Jones model
(Kothari, Leone, & Wasley, 2005) for abnormal accruals. We replace
the Fraud variable in Eq. (1) with this alternative measure and report
the results in Table 10.
Consistent with our main results in Table 5, we nd negative and
signicant coefcients on both Top 10 (0.944, t = 2.02) and Auditor
Size ( 0.0787, t = 2.06), providing further support for our conclusion that clients of larger auditors are less likely to commit nancial
statement fraud in China. Our results are robust to using the 75th
percentile to dene high abnormal accruals.
5.5.3. Self-selection bias
A potential self-selection bias could confound our results. Auditees
that are less predisposed to committing nancial statement fraud may
hire large auditors to signal their type and enhance their reputation
in the stock market. In addition, large auditors may select less risky
audit clients to reduce their risk exposure. To address this concern, we
adopt a two-stage regression procedure. First, we model auditor selection (Top 10 versus non-Top 10) as a function of the company's risk
factors, where the explanatory variables are primarily based on Francis
and Krishnan (1999) and Fan and Wong (2005). We obtain the tted
values from this regression and calculate the inverse Mills ratio
(Heckman, 1979). In the second stage, the inverse Mills ratio is used as
an additional explanatory variable in Eq. (1) to correct for a potential
self-selection bias. The self-selection test results are untabulated. The
rst stage regression is signicant overall at explaining the selection of
large auditors. In the second stage analysis of Eq. (1), the coefcient on
Top 10 is 0.2238 and remains statistically signicant at the 10% level.
Thus, even after controlling for a potential self-selection bias, we still
nd that large auditors reduce the incidence of nancial statement fraud.

1193

5.5.4. Corporate governance mechanisms

Chen et al. (2006) examine whether corporate governance mechanisms such as ownership structure, board characteristics and auditor
quality can reduce the likelihood of fraudulent activities of Chinese
listed companies. We add the corporate governance mechanisms documented in Chen et al. (2006) into Eq. (1). Generally consistent with
Chen et al. (2006), our untabulated results suggest that many corporate
governance mechanisms are not signicantly associated with the
incidence of nancial statement fraud. However, importantly, we nd
that Top 10 and Auditor Size continue to be signicantly negatively
associated with the incidence of fraud, suggesting that our inferences
are robust to controlling for other corporate governance mechanisms.
5.5.5. Auditor competition
Intense competition is a feature of China's audit market. The number
of listed companies in China is small relative to the number of qualied
auditors when compared with the U.S. Kallapur, Sankaraguruswamy,
and Zang (2010) suggest that audit market dispersion affects audit
quality. In untabulated results we augment Eq. (1) with an audit market
dispersion measure calculated as a HerndahlHirschman Index based
on each audit rm's audit fee market shares by industry and year. We
continue to nd that Top 10 and Auditor Size are signicantly negatively
associated with the incidence of fraud. Thus, our results are robust to
controlling for auditor competition.
6. Conclusion
We investigate the relation between auditor size and the incidence
and consequences of nancial statement fraud in an environment
where auditors face negligible litigation risk but severe government
sanctions on audit failures. Our study sheds light on whether government sanctions motivate auditors to provide high quality audits. We
also highlight the importance of understanding China's unique economic, legal and political landscape for rms looking to successfully compete
in China's capital markets.
Following prior studies, we identify a sample of rms that are
sanctioned by government agencies for accounting malfeasance. We
provide evidence that larger auditors are indeed associated with a
lower incidence of nancial statement fraud. We further nd that the
difference in audit quality between large and small auditors is more

Table 9
Ordered probit regression of fraud severity on auditor size.
Fraud

Top 10
Ln(Auditor Size)
Auditor Tenure
ROE Dummy
State-Owned
Ln(Company Age)
Ln(Company Size)
Leverage
ROA
Book-to-Market
Losst 1
Intercept 1
Intercept 2
Year xed effects
Industry xed effects
N
Pseudo R2

Fraud

Coefcient

t-Statistic

0.2461*

(1.88)

0.0504***
0.0894
0.4171***
0.1295
0.0062
0.2101
2.2376***
0.0689
0.0582
0.6522
0.8426
Included
Included
7809
0.0782

(2.72)
(1.20)
(3.40)
(1.43)
(0.10)
(0.81)
(5.30)
(0.29)
(0.74)
(0.54)
(0.70)

Coefcient

t-Statistic

0.1058**
0.0441**
0.0872
0.4217***
0.1286
0.0151
0.2100
2.2425***
0.0876
0.0597
1.5949
1.4042
Included
Included
7809
0.0763

(2.37)
(2.43)
(1.17)
(3.46)
(1.43)
(0.25)
(0.81)
(5.36)
(0.37)
(0.75)
(1.04)
(0.91)

Note. This table reports the results of ordered probit regressions investigating the association
between nancial statement fraud and auditor size. The dependent variable is Fraud, dened
as 0 when there is no fraud, 1 when there is fraud and punishment is public criticism (but not
monetary nes), and 2 when there is fraud and punishment includes monetary nes. See
Table 4 for all other variable descriptions. t-Statistics clustered by rm are presented in
parentheses. ***, ** and * denote signicance at the 1%, 5% and 10% level, respectively.

1194

L.L. Lisic et al. / Journal of Business Research 68 (2015) 11861195

Table 10
Probit regression of the incidence of fraud (as identied by high abnormal accruals) on auditor size.

Top 10

Abnormal accruals above 90th percentile as fraud

Abnormal accruals above 75th percentile as fraud

(1)

(3)

0.1944**
(2.02)

Ln(Auditor Size)
Auditor Tenure
ROE Dummy
State-Owned
Ln(Company Age)
Ln(Company Size)
Leverage
ROA
Book-to-Market
Losst 1
Intercept
Year xed effects
Industry xed effects
N
Pseudo R2

(2)

0.0107
(0.81)
0.2088***
(2.61)
0.1180
(1.39)
0.3588***
(4.62)
0.0040
(0.08)
1.5165***
(6.91)
8.0448***
(8.71)
0.7717***
(3.20)
0.1212
(1.13)
1.7667*
(1.71)
Included
Included
7299
0.23

(4)

0.1315**
(2.35)
0.0787**
(2.06)
0.0042
(0.32)
0.1870**
(2.34)
0.1299
(1.53)
0.3600***
(4.63)
0.0069
(0.13)
1.5338***
(6.91)
8.3854***
(9.38)
0.7500***
(3.15)
0.0728
(0.66)
0.2330
(0.20)
Included
Included
7299
0.23

0.0131
(1.54)
0.0116
(0.24)
0.1267**
(2.33)
0.2248***
(4.50)
0.0108
(0.35)
0.4267***
(3.27)
2.5361***
(7.93)
0.8680***
(7.21)
0.0225
(0.36)
0.2566
(0.42)
Included
Included
7299
0.10

0.0423*
(1.77)
0.0103
(1.14)
0.0371
(0.75)
0.1611***
(2.86)
0.2722***
(5.31)
0.0263
(0.78)
0.5409***
(3.80)
3.1145***
(8.99)
0.9408***
(7.12)
0.0018
(0.03)
1.6567**
(2.21)
Included
Included
7299
0.13

Note. This table reports the results of probit regressions investigating the association between nancial statement fraud (as identied by high abnormal accruals measured using the
performance-adjusted modied Jones model) and auditor size. The dependent variable is Fraud, which equals 1 if the rm committed nancial statement fraud in year t and 0 otherwise.
See Table 4 for all other variable descriptions. t-Statistics clustered by rm are presented in parentheses. ***, ** and * denote signicance at the 1%, 5% and 10% level, respectively.

prominent for rms in regulated industries and frauds related to

revenues, which are more heavily sanctioned by the government.
We nd robust results after excluding rms cross-listed in other
jurisdictions or having B-shares, providing clearer evidence that
our results are driven by government sanctions and not litigation
risk. Our results are also robust to considering the severity of
accounting fraud, accounting for the self-selection of auditors, controlling for other corporate governance mechanisms and using alternative measures of fraud. Our ndings suggest that government
monitoring can potentially substitute for litigation risk in ensuring
audit quality in an emerging market.
Our results have important practical implications for international
audit rms aiming to successfully compete in China. We highlight that
auditors have to pay special attention to the role of government
sanctions in ensuring high quality audits. We also provide evidence
that client rms using larger auditors are less likely to be sanctioned
in China, suggesting that using larger auditors can also help companies
successfully compete in China.

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