MANAGEMENT OWNERSHIP STRUCTURE, AUDIT QUALITY AND
IMPAIRMENT OF ASSETS - EVIDENCE FROM CHINA
by
Wong Wai Yee, Pauline
A thesis
submitted in partial fulfillment
of the requirements for the Degree of
Doctor of Philosophy
School of Accounting and Finance
The Hong Kong Polytechnic University
December 2007
UMI Number: 3313064
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sensitive to economic losses, as compared to companies dominated by holders of
non-state shares. In addition, I also find that local auditors support managerial
decisions on asset write-down.
Chinese regulators realize that companies may use provision for asset
write-down and its reversal to build up big-bath and to smooth reported income.
Therefore, the 2006 Accounting Standards forbid the reversal of recognized asset
impairment provision on long-term investments, fixed assets, construction in
progress, and intangible assets, effective from 2007. I examine whether incentives
including controlling ownership by state and audit quality of small domestic
auditors located in the region of their clients will affect reversal of recognized
provision for asset write-down during the transition period. My empirical findings
show that state controlled companies tend to have weak incentive in reporting asset
impairment reversal, conditional on positive stock returns or positive cash flows.
Companies controlled by state tend to reverse more impairment provisions, as
compared to companies dominated by holders of non-state shares. Furthermore,
ocal small auditors are more likely to agree with the aggressive accounting
treatment on impairment reversal of their clients.
ACKNOWLEDGEMENTS
My ultimate appreciation must go to my supervisors, Dr. Jiang Li, Professor
Phyllis L. L. Mo, and Dr. Donghui Wu, for their thorough guidance on my
dissertation. I would not be able to reach this stage without their talents, patience
and continuous encouragement. I appreciate the financial support provided by the
School of Accounting and Finance of the Hong Kong Polytechnic University, which
makes it possible for me to complete my studies. I cannot thank them all in this
limited space, but I would like to express my gratitude to the following academic
professionals, Professor Ferdinand Gul, Professor Jeong Bong Kim, Professor Bin
Srinidi, Professor T.J. Wong, Dr. Shimin Chen, Dr. Peter Cheng, Dr. Agnes Lo, Dr.
Raymond Wong, Dr. Xiaodong Xu and other academic colleagues and professionals
for their advices on my thesis. Thanks are due to Kevin Ding, Joseph Mak, Roger
Lui,

so I do not lose them in the return."
Management Ownership Structure, Audit Quality and Impairment of Assets
- Evidence from China
Certificate of Originality
Abstract
Acknowledgements
Table of Contents i
List of Figure vi
List of Tables vi
Chapter 1 Introduction
1.1 Motivation for the Research 1
1.1.1 The Role of Accounting Standards in Conservative
Financial Reporting 1
1.1.2 The Role of Accounting Standards in Conservative
Financial Reporting in China 1
1.1.3 Significance of State Ownership 4
1.1.4 Significance of State Ownership in China 5
1.1.5 Significance of Audit Quality 6
1.1.6 Significance of Audit Quality in China 7
1.2 Objectives of the Thesis 9
1.3 Contributions of the Thesis 10
1.4 Organization of the Thesis 11
Chapter 2 State Ownership, Audit Quality and Earnings
Management in China
2.1 Ownership Structure of Listed Companies in China 13
2.2 Audit Quality in China 15
I
2.3 Profitability Requirement for Listed Companies 21
2.3.1 Maintenance of Listing Status 21
2.3.2 Regulations on Rights Issues 23

n
3.3.1.5 Audit Contract Type 56
3.3.1.6 Modified Audit Opinions 57
3.3.1.7 Non-Audit Service 57
3.3.1.8 Audit Failures 58
3.3.1.9 Political Influence from Audit Clients 59
3.3.2 Previous Research on Audit Quality in China 59
Chapter 4 Are State Ownership and Auditor Locality Determinants
of Asset Write-Down?
Chapter Summary 63
4.1 Introduction 65
4.2 Hypotheses Development 70
4.2.1 Economic Factors 70
4.2.1.1 Stock Returns 70
4.2.1.2 Cash Flows from Operations 73
4.2.2 Incentives Factors 74
4.2.2.1 State Controlled Firms 74
4.2.2.2 Audit Quality 76
4.2.3 Regulator y Factors 81
4.2.3.1 Delisting Avoiders 82
4.2.3.2 Rights Offering Qualifiers 83
4.2.3.3 Big Bath Takers 85
4.3 Research Methodology 88
4.3.1 Sample Selection 88
4.3.2 Empirical Models 90
4.3.2.1 Basu (1997) Model 91
4.3.2.2 Ball and Shivakumar (2005) Model 100
4.3.3 Descriptive Statistics 102
4.4 Empirical Results 103
4.4.1 Basu (1997) Model 103

5.4.2 Ball and Shivakumar (2005) Model 157
5.5 Robustness Tests 159
5.5.1 The Tobit Specifications 159
5.5.2 Alternative Definition of Controlling Ownership 160
5.5.3 Alternative Definition of Local Auditors 161
5.6 Chapter Conclusion 161
Chapter 6 Conclusion and Discussion
6.1 Summary of the Results 164
IV
6.2 Implications 166
6.3 Limitations 167
6.4 Future Extensions of this Research 168
Figure 170
Tables 171
References 231
v
LIST OF FIGURE
Figure 1-1 Audit Market in China 170
LIST OF TABLES
Table 1-1 Average Annual Percentage Growth of Real GDP 171
Table 2-1 Stock Market in China 172
Table 2-2 Licensed CPA Firms to Audit Listed Companies in China as at 175
December 31, 2005
Table 2-3 Licensed CPA Firms to Audit Listed Companies in China as at 177
December 31, 2006
Table 2-4 Top-100 Auditors - Ranked by Fee Income 179
For Years 2002-2005
Table 2-5 Top-100 Auditors - Ranked by Number of CPAs 180
For Years 2002-2005
Table 2-6 Analysis of Audit Opinions on Listed Companies in China 181

Table 5-4 Tobit Regression Results on Reversal of Recognized Asset 207
Impairment Provision (Basu Model) For Years from 2001 to
2005
vii
Table 5-5 Tobit Regression Results on Reversal of Recognized Asset 210
Impairment Provision (Ball and Shivakumar Model) For Years
from 2001 to 2005
Table 5-6 OLS Regression Results on Reversal of Recognized Asset 213
Impairment Provision (Basu Model) For Years from 2001 to
2005
Table 5-7 OLS Regression Results on Reversal of Recognized Asset 216
Impairment Provision (Ball and Shivakumar Model) For Years
from 2001 to 2005
Table 5-8 Tobit Regression Results on Reversal of Recognized Asset 219
Impairment Provision (Basu Model) - Alternative Definition of
Controlling Ownership
For Years from 2001 to 2005
Table 5-9 Tobit Regression Results on Reversal of Recognized Asset 222
Impairment Provision (Ball and Shivakumar Model) -
Alternative Definition of Controlling Ownership
For Years from 2001 to 2005
Table 5-10 Tobit Regression Results on Reversal of Recognized Asset 225
Impairment Provision (Basu Model) - Alternative Definition of
Top-10 Auditors (ranked by the number of audit clients)
For Years from 2001 to 2005
Table 5-11 Tobit Regression Results on Reversal of Recognized Asset 228
Impairment Provision (Ball and Shivakumar Model) -
Alternative Definition of Top-10 Auditors (ranked by the
number of audit clients)
For Years from 2001 to 2005

2008 (projected) for China is 9.6 percent and 9.4 percent respectively, as compared
to 3.2 percent and 4.4 percent for the world average, and 3.0 percent and 2.8 percent
for the United States. In order to continue the growth and to attract foreign
investment, Chinese enterprises have to develop modern governance system and to
provide confidence to investors.
(Insert Table 1-1 about here)
To improve the quality of accounting information in order to attract more
investors in local enterprises, Chinese authorities issue accounting regulations and
2
accounting standards with reference to international standards. By introducing
asset write-down regulations in 1998 and 2001, the Chinese government aims at
enhancing the usefulness of the information reported on financial statements.
However, the decision of writing down the value of assets and the magnitude of
write-down allow management of listed companies to exercise discretion in
determining the recoverable value of relevant assets and provides a good chance for
management to opportunistically manage the reported earnings. Li (2001) shows
that, when the policy of asset write-down is compulsory, listed companies with loss
aversion, rights issues, and threshold motivations tend to increase (or, not to
decrease) the current earnings by lower asset write-down. Since asset write-down
will affect the reported profits and thus the listing status, the Accounting System for
Shareholding Companies of 1998
("1998
Accounting Standards") and the
Accounting System for Business Enterprises of
2001
("2001
Accounting Standards")
provide opportunities to management of listed companies to manage earnings. To
reduce firm's earnings management behaviors, Chinese regulators attempt to tighten
accounting standards. On February 15, 2006, the Ministry of Finance (MOF)

conclude that empirical work on this area faces the problem of selection bias, which
is arising from the factors affecting the enterprises to be state-owned or privately
owned and influencing the performance of the enterprise. Therefore, the
significance of state ownership remains an interesting area of research.
1.1.4 Significance of State Ownership in China
Economic reforms have transformed China from a centrally planned
economy and have brought out restructuring of ownership structure in enterprises
from contractual leasing, collectively-owned Township-Village Enterprises to
investor-owned public enterprises (Zhang, 2001). Enterprises controlled by
ministries or government agencies were transformed to become shareholding
5
companies. In July 1992, the State Council issued the Regulations on
Transforming the Management Mechanism of State-Owned Industrial Enterprises
and introduced the shareholding system. The establishment of the Shanghai Stock
Exchange (SHSE) in 1990 and the Shenzhen Stock Exchange (SZSE) in 1991
provided a platform for enterprises to list their shares.
Although shares of SOEs are allowed to be traded on the exchanges, the
state retains the ultimate control of the companies and reforming to market-oriented
economy according to the idea of "Socialism with Chinese characteristics".
Furthermore, the ministries and local governments transfer productive assets and
expertise from non-listed SOEs to establish a listed enterprise. In order to achieve
their social targets and to recover the cost of assets transferred, the state has to
retain control of the listed companies.
1.1.5 Significance of Audit Quality
Prior studies suggested that high quality auditors act as one of the effective
deterrents to earnings management by detecting and revealing misreporting by
management (Becker et al., 1998) and Big Six audit clients used more conservative
accounting methods (Chung et al.,
2003;
Basu et al., 2002). High quality auditors

audit services according to the accounting regulations in China, and to hire
international audit firms to provide supplementary audit services according to
international accounting standards
1
.
However, as compared to developed markets, the litigation risk for auditors
1
This regulation is abandoned after the Enron incidence (Liu and Zhou, 2006).
On February 28, 2002, the CSRC released the 'Wo. 10 Notice on Related Questions
Regarding Supplementary Audit on A-Share Companies" ("No. 10 Notice") and
restricted the scope of firms to (1) those offering more than 300,000,000 shares; or
(2) those specifically required by relevant ministries or the CSRC. In addition, the
No.
10 Notice also allowed licensed local audit firms to provide supplementary
audit services.
8
is low in China
2
. When Big Five audit firms can secure a substantial portion of
market share in China, the risk of losing quasi-rent is much reduced. Therefore, it
is interesting to examine if Big Five is providing higher quality services than local
audit firms in China.
1.2 OBJECTIVES OF THE THESIS
The primary objective of this thesis is to investigate the impact of state
ownership and auditors' locality on the magnitude of asset impairment and on the
reversal of asset write-down. First, with the introduction of the 2001 Accounting
Standards, I attempt to examine whether different ownership structures of A-share
listed companies in China will have different levels of earnings management and
2
In 1997, Chengdu Hong Guang Industrial Limited (Stock Code: 600083) reported a