Auditing Standards, Increased Accounting Disclosure, and
Information Asymmetry: Evidence from an Emerging Market
Auditing Standards, Increased Accounting Disclosure
and Information Asymmetry : Evidence from an Emerging Market
The interest in accounting disclosure and audit quality by academics, practitioners, and regulators heightened following the various financial reporting scandals, and subsequent legislative and professional response to these scandals (e.g., ASX Corporate Governance Guide 2003; Sarbanes-Oxley Act 2002). An important question that has been on the minds of many is whether the implementation of stricter auditing standards such as those mandated by the U.S. Sarbanes-Oxley 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 bid-ask spread, and increased accounting disclosures following the adoption of new auditing standards in China—an environment in which disclosure hitherto was relatively low.1 Lev (1988) asserts that accounting regulation should reduce information asymmetry among investors and increase liquidity in the markets. Leuz and Verrecchia (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 Palepu 2001; Core 2001; Leuz and Verrecchia 2000).3 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 of increased disclosure on market liquidity (Verrecchia 2001). Unlike developed capital markets, accounting disclosures in Chinese capital markets have been characterized as low in quantity and quality (Xiao et al. 2004; Abdel-Khalik et al. 1999; Liu and Zhang 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.4 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 (CRSC) and the Chinese Institute of Certified Public Accountants (CICPA) are required to impose costly penalties on auditors who fail to comply with the new auditing standards (DeFond et al. 2000). For example, the Qiongmingyuan 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 (Gul et al. 2003). 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 Lev (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...
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