Capital-Market Liberalization and Auditors' Accounting Adjustments: Evidence from a Quasi-Experiment

Abstract

Using a shock to the Chinese capital market and unique and detailed audit-adjustment data, this paper investigates the effect of a capital-market liberalization program on auditors’ adjustments to their clients’ financial reports. Employing difference-in-differences tests with propensity-score matching and firm fixed effects, we find that the capital-market liberalization induced by the implementation of the Shanghai - Hong Kong Stock Connect increases auditor prudence and leads to audit-adjustment changes stimulated by greater reputational and litigation risks for auditors. However, whereas the liberalization significantly decreases the frequency and magnitude of upward audit adjustments, its effect on the probability or magnitude of downward audit adjustments is largely conditional. Further evidence shows that the effect is more pronounced for companies with high trading volume from Hong Kong investors, audited by the largest audit firms, and with low financial transparency.