An important question hat has been on the minds of many is whether the implementation of stricter auditing standards such as those mandated by the U. S. Serbians-Solely Act would improve the Information environment of firms whose shares are publicly traded. In this paper, I Investigate the link between Information asymmetry, measured by bold- ask spread, and Increased accounting disclosures following the adoption of new auditing standards In China-?an environment In which disclosure hitherto was relatively low. Level (1988) asserts that accounting regulation should reduce and Overreached (2000) argue that increased accounting disclosures should reduce information asymmetry not only between firms and stockholders but also among investors. 2 Currently, most empirical results on the economic link between increased disclosure and information asymmetry are based on samples of U. S. Firms. However, these firms have a rich information environment, making it difficult to observe economic consequences of increased disclosures (Callahan et al. 1997, Healy and Appeal 2001; Core 2001; Else and Overreached 2000). An emerging market environment, which is characterized by higher level of ex ante information asymmetry, may provide a potentially more powerful setting for detecting the effects f increased disclosure on market liquidity (Overreached 2001). Unlike developed capital markets, accounting disclosures in Chinese capital markets have been characterized as low in quantity and quality (Ixia et al. 2004; Abdul-Chalk et al. 1999; Lieu and Ghana 1996). Over the period 1996 to 1997, accounting regulators and professionals in China implemented a series of auditing standards, modeled after the International Auditing Standards.
The new auditing standards address a wide range of issues, such as audits of financial statements, audit evidence, audit reports, fraud and errors, internal controls, and audit risk. All domestic auditors are required to comply with the new standards in the conduct of financial statement audits. In addition, the Chinese Securities Regulatory Commission (CARS) and the Chinese Institute of Certified Public Accountants (CIVIC) are required to impose costly penalties on auditors who fail to comply with the new auditing standards (Defend et al. 2000).
For example, the Augmentation scandal in 1996 resulted in the suspension of the CPA firm from practice for six months. Further, the Chinese High Court issued Document No. 56 in 1996 emphasizing auditor’s legal liabilities at the national level (Gull et al. 003). The intent of the changes in auditing standardization, government enforcement, and litigation environment is to make auditors more independent than they used to be. If that is so, then disclosure behavior of firms should receive more supervision and control, yielding significant increases in the quantity and quality of firms’ disclosures and decreases in information asymmetry.
Thus, after adopting these standards, Chinese firms should expect narrower bid-ask spreads, an economic benefit from increased disclosure suggested by Level (1988). In this paper, I extend prior research in several ways. First, I examine the role of auditing regulations in reducing information asymmetry. Only few studies have directly investigated whether audit quality enhances disclosure quality, reducing both information asymmetry and cost of capital in the U. S. (see Chaser 2003). 5 A plausible reason for the paucity of research in this area might be that the rich disclosure environment of U.
S. Firms limits the incremental impact of audit quality on accounting disclosure quality (Healy and Appeal 2001). In contrast, the disclosure level in the Chinese emerging market is relatively low, thus audit opinions could envoy useful information to the market about the quality of a firm’s accounting information. Empirical studies on Chinese capital markets have documented links between auditing regulations and audit qualifications (Defend et al. 2000), and between audit qualifications and market return (Gull et al. 2003).
I extend this line of research by investigating the impact of increased auditing regulation on firm’s accounting disclosure on information asymmetry (e. G. , see Yon 1998). As noted by Callahan et al. (1997), these studies focus only on the short-run information symmetry risk faced by dealers and investors rather than the long-run information asymmetry risk, which is of much concern to policy-makers and regulators. 6 In this study, I examine the long-term information asymmetry “between the informed and uninformed traders caused by the structural differences in the access to information” (Callahan et al. 997, 57). Finally, the Chinese emerging market implemented a series of auditing standards within a short period. The incremental effects of increased accounting disclosure on information asymmetry in such an environment should be much more significant than in a rich disclosure environment f developed markets (Overreached 2001). In addition, this study is also the first to explicitly study economic link between increased accounting disclosures on information asymmetry in an emerging market.
I compare an experimental group of firms not previously audited under any auditing standards to a control group of firms previously audited under the international auditing standards. 7 1 will investigate whether the experimental firms’ bid-ask spreads declined significantly subsequent to the adoption of the new auditing standards (controlling for other known bid-ask spreads determinants). Further, I will conduct time-series intervention analyses to examine the experimental group’s spread reductions are significant and permanent and whether there is a significant decline in control group’s bid-ask spread.
The results of this paper could have implications for policy-makers and regulators, and in particular, those in emerging economies. Policy-makers and regulators usually state that high quality accounting and/or auditing standards “result in greater investor confidence, which improves liquidity, reduces capital cost, and makes market prices possible” (Levity 1998, 81). A good effort on accounting/auditing policy-making and regulation should help the emerging economies improve information environment and market liquidity.
The results suggest that auditing standards enhance disclosure quality, and that regulators in emerging economies should focus on auditing regulations to enhance audit quality in addition to their efforts to improve corporate accounting disclosure. 8 The remainder of the paper will be organized as follows. Section two will present the motivations for the study and the institutional settings of the Chinese emerging market. Overviews of prior research and hypothesis placement are to be presented in section three. Section four will describe the research design, and section five will present the empirical results.