The Influence of Qualified Foreign Institutional Investors on the Association between Default Risk and Audit Opinions: Evidence from the Chinese Stock Market

Abstract

ABSTRACTManuscript Type: EmpiricalResearch Question/Issue: Numerous studies demonstrate that audit opinions provide strong signals to investors/debt holders warning of firms’ default probability. When foreign investors were allowed to enter the Chinese stock market, the role of audit opinions grew in importance. In this study, we examine the relationships between audit opinions and default probability within the Chinese stock market, and explore whether there was any significant shift in this relationship following the entry of Qualified Foreign Institutional Investors (QFIIs).Research Findings/Insights: We find that audit opinions began providing signals of potential default risk only after QFIIs entered the market; suggesting that in the post‐December 2002 period, auditors’ decisions in China became more conservative, and that institutional investors began to play a monitoring role.Theoretical/Academic Implications: This study provides support for institutional theory through the provision of empirical evidence showing that audit opinions, as signals of potential default risk, may actually be less efficient in immature markets than in more mature markets. Furthermore, the role of audit opinions in providing such signals to outside investors can clearly be affected by the introduction of new monitoring mechanisms. The results imply that market maturity could prompt firms to provide more accurate information.Practitioner/Policy Implications: The strengthening of security laws could increase confidence among investors in China, thereby providing evidence to market participants showing that the more accurate information and greater efficiency of audit opinions, arising as a direct result of the entry of QFIIs, could lead to expansion of the Chinese investment environment.