The Impact of Improved Auditor Independence on Audit Market Concentration in China

Abstract

In an effort to increase the credibility of financial information in its emerging capital markets, China recently adopted rigorous new auditing standards designed to increase auditor independence. Consistent with increased auditor independence, we find that the frequency of modified opinions increases nine-fold subsequent to the adoption of the new standards. However, the increase in modified reports is immediately followed by a large decline in audit market share among the largest auditors -- those with the greatest propensity to issue modified reports. We conjecture that this flight from audit quality results from the absence of market-based incentives for Chinese managers to demand independent auditors. Our findings suggest that government regulation alone is not sufficient to create financial markets that foster auditor independence.