Are state ownership and auditors' locality determinants of asset write-downs? Evidence from China

Wong, Pauline W. Y. Article Are state ownership and auditors' locality determinants of asset write-downs? Evidence from China China Journal of Accounting Research Provided in Cooperation with: Sun Yat-sen University Suggested Citation: Wong, Pauline W. Y. (2018) : Are state ownership and auditors' locality determinants of asset write-downs? Evidence from China, China Journal of Accounting Research, ISSN 1755-3091, Elsevier, Amsterdam, Vol. 11, Iss. 4, pp. 385-405, https://doi.org/10.1016/j.cjar.2018.07.002 This Version is available at: https://hdl.handle.net/10419/241786 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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Wong Department of Accountancy, Hang Seng Management College, Hong Kong, China ARTICLE INFO Article history: Received 1 October 2017 Accepted 9 July 2018 Available online 5 September 2018 JEL classifications: G18 M41 M42 Keywords: Earnings management Impairments State ownership Auditor locality Political influence ABSTRACT After issuing the 1998 Accounting Standards, Chinese regulators implemented additional regulations in 2001 governing write-downs of impaired assets and required assessment of recoverable amounts for four additional asset categories. As the recoverable value cannot be obtained objectively, management can discretionally assess the magnitude of write-downs to affect bottom-line profit. This study used 7258 firm-year observations in China from 1998 to 2005 to examine whether the percentage of asset write-downs by statecontrolled firms differs from non-state-controlled firms, conditional upon more conservative financial reporting rules, and investigate whether local auditors support managerial decisions on asset write-downs. The empirical findings support the tendency of state-controlled ownerships to have lower asset write-downs. Local auditors also support managerial decisions on asset write-downs, especially when the companies are controlled by local governments. Ó2018 Sun Yat-sen University. Production and hosting by Elsevier B.V. This is an open access article under the CC BY-NC-ND license (http://creativecommons.org/licenses/by-nc-nd/4.0/). 1. Introduction Recent studies emphasize that accounting standards only partially influence accounting properties, and it is the preparer’s incentives that determine the quality of accounting information (Ball et al., 2003; Ball and https://doi.org/10.1016/j.cjar.2018.07.002 1755-3091/Ó2018 Sun Yat-sen University. Production and hosting by Elsevier B.V. This is an open access article under the CC BY-NC-ND license (http://creativecommons.org/licenses/by-nc-nd/4.0/). E-mail address: [email protected]k q This paper was funded by grants from the Hong Kong Polytechnic University, Lingnan University, Hang Seng Management College and the Research Grants Council of the Hong Kong Special Administrative Region, China (Project No. UGC/IDS14/15). I appreciate the helpful comments from an anonymous referee, Shimin Chen, In-Mu Haw, Li Jiang, Jeong-Bon Kim, Zhijun Lin, Phyllis L.L. Mo, Donghui Wu, Xijia Xu and the participants at the workshop of the Hong Kong Polytechnic University. All errors are my own. China Journal of Accounting Research 11 (2018) 385–405 HOSTED BY Contents lists available at ScienceDirect China Journal of Accounting Research journal homepage: www.elsevier.com/locate/cjar Shivakumar, 2005). In fact, institutional features of a country influence the ownership and governance of enterprises, which shape the preparer’s incentives to report accounting information. Market forces and government involvement play important roles in determining the institutional features. In other words, the demand for financial reporting by the public and the government’s participation in setting and enforcing the rules and standards affect the ownership structure of enterprises and in turn their incentives for reporting. This study investigates whether different ownership structures of A-share listed companies in China will differ in the policy of impairment provision and have different levels of earnings management. I choose China to examine the write-down provisions because it provides a unique institutional setting. First, the Chinese government retains significant ownership and control of listed enterprises. Before the introduction of the shareholding system by the State Council in July 1992, China is a centrally planned economy and all enterprises are state-owned. Therefore, there is little demand for public financial information as the dominating shareholder is the state or its agents. Following the establishment of the Shanghai and Shenzhen stock exchanges in the early 1990s, the Ministry of Finance (MOF) is responsible for releasing accounting standards, and the China Securities Regulatory Commission (CSRC) is established to monitor and regulate the Chinese stock market. However, the government is still exercising significant control over listed companies by holding state shares and state-owned legal person shares. The dual roles played by the government as both investor and regulator provide a unique setting for this study. Second, with China’s accession to the World Trade Organization (WTO), the MOF issued accounting standards in 1998, 1999 and 2001 and specified rules for asset write-downs. This is a unique opportunity to investigate whether ownership structure will affect the incentives of preparers of accounting information and in turn influence the write-down magnitude in response to the change in accounting standards. Third, the CSRC is monitoring the listing status of companies on the two exchanges according to the reported Return on Equity (ROE) levels. Companies continuing to report losses over a three-year period will be delisted. However, the CSRC also assesses the applications for raising additional capital with reference to the ROE levels. If an enterprise can maintain the required ROE levels over three consecutive years, it can apply for rights issues. Therefore, the reported profit levels of companies in China play extra roles as compared with other institutional settings. To improve the quality of accounting information to attract more investors in local enterprises, Chinese authorities issue accounting regulations and 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 to write down the value of assets and the magnitude of the write-downs allow management of listed companies to exercise discretion in determining the recoverable value of relevant assets and provide a good chance for management to opportunistically manage the reported earnings. Li (2001) shows that when the policy of asset write-downs is compulsory, listed companies with loss aversion, rights issues and threshold motivations tend to increase (or, not to decrease) the current earnings. In China, there are three categories of ownership of A-shares, namely, state shares, legal person shares, and tradable shares. 1 Provincial governments are managing listed companies, whether controlled by state shares or stateowned legal person shares (China Industrial and Commercial Times, 2003) and are unwilling to have companies under their provincial supervision be delisted. If these companies suffer from continuous loss, local governments will try to adopt all administrative measures to protect their listing status (Legaldaily.com.cn., 2001). As asset write-downs 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 1 State shares are held by the central government, provincial governments or wholly owned government enterprises. Legal person shares are held by domestic institutions, including securities firms and non-bank financial institutions. Most of the legal person shares are partially owned by the central or provincial governments (Jia et al., 2005). Neither state shares nor legal person shares are allowed to trade via the Shanghai and Shenzhen stock exchanges in China, and they are only transferable to domestic institutions within the same category upon the CSRC’s approval (Cooper, 2003; Jiang, 2004). 386 P.W.Y. Wong / China Journal of Accounting Research 11 (2018) 385–405 to the management of listed companies to manage earnings. The objective of this study is to examine whether the companies controlled by local governments, through state shares and state-owned legal person shares, will affect the magnitude of asset write-downs. Prior studies suggest 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 that the Big Six audit clients use more conservative accounting methods (Basu et al., 2002; Chung et al., 2003). In China, the audit market is still dominated by small-scale domestic certified public accounting (CPA) firms and is not fully opened to international accounting firms. Chan et al. (2006) find that local auditors have greater economic dependence on local clients and tend to issue clean auditor opinions to companies owned by local government. Hence, I further examine whether audit firms with operations in the same provincial region as their clients will tend to follow the management decision on asset impairment to keep their listed clients. In this study, I examine all companies listed on the Shanghai and Shenzhen stock exchanges from 1998 to 2005. From a sample of 7258 observations, I find that local government-controlled companies tend to write down fewer assets, even though more conservative financial reporting regulations are introduced. I also find that audit firms with operations in the same provincial region as their clients tend to follow management’s decision on asset impairment when the clients are controlled by local governments. The results of this study contribute to the literature in several aspects. First, this study contributes to understanding the unique characteristics of the Chinese capital market. One of the most important objectives of the management of listed firms is to maintain the required ROE level and thus to safeguard their listing status and meet the rights issue requirements. With the intention to achieve the target, companies are likely to adopt an aggressive asset write-downs policy to report the required ROE level. Second, this paper shows the impacts of ownership structures on earnings management. The Chinese government is not only the majority shareholder but also the regulator of companies listed in China. Unlike that in marketoriented economies, management of listed companies in China is not appointed by shareholders but by the central or local governments. Managers of local government-controlled companies in China are more likely to have political connections with the government (Fan et al., 2007). These managers are seldom rewarded in line with their performance as incentive-based compensation schemes are not widely launched in China. Managers do not worry about financing because the banking industry in China is not well developed, and funding is mainly provided by the government through financing from other StateOwned Enterprises (SOEs) and the raising of capital. In other words, listed companies in China are seldom monitored by financial institutions or lenders. They have fewer stakeholders than their companions in the western market. To strive for political promotion and to indicate their superior performance in the competition with managers of non-listed SOEs, managers of local government-controlled companies have strong incentives to be aggressive in reporting. Third, Chan et al. (2006) find that local auditors have greater economic dependence on local clients and tend to issue clean auditor opinions to companies owned by local governments. The present study provides further evidence that the locality of audit firms and their clients can impact the impairment decision. To build a credible independent auditing profession and to compete with international audit firms after China’s accession to the WTO, Chinese regulatory bodies should evaluate the effectiveness of the policies relating to the improvement of auditor quality and independence. Fourth, Chen and Wu (2007) find that accounting standards are a necessary ingredient but are not sufficient in conservative financial reporting. The present results further show that companies controlled by local governments have fewer incentives to recognize asset impairments despite the availability of conservative rules. The remainder of the paper is organized as follows. The next section provides an analysis of the institutional background of the study. The third section reviews previous literature and develops the hypothesis. The fourth section presents the research methodology. The fifth section discusses the empirical results. The sixth section summarizes the robustness checks, and the final section concludes the paper. P.W.Y. Wong / China Journal of Accounting Research 11 (2018) 385–405 387 2. Institutional background 2.1. Accounting regulations on asset write-downs In 1998, the MOF issued the 1998 Accounting Standards and allowed companies to provide for bad and doubtful debts 2 according to management’s judgment (Chen et al., 2004). Under the new standards, all listed companies with shares issued to investors outside China (B-shares) and shares issued on the Hong Kong Exchange (H-shares), New York Stock Exchange (N-shares) and London Stock Exchange (L-shares) were required to adopt the rules and to write down values of inventories and shortand long-term investments. However, except for the provision for bad debts, the rules on asset write-downs were not mandatory for A-share listed enterprises. In other words, A-share listed companies were only encouraged to voluntarily write down the asset value on their inventories and shortand long-term investments. Moreover, the 1998 Accounting Standards did not specify how to take up the impairment losses and therefore, firms could have accounting choices. First, management could choose whether to adopt the write-down policy. Second, if firms adopted the policy, they could charge the impairment expenses wholly to the income statement and reduce the current year’s reported income level, or they could discretionally charge the portion relating to the current reporting year to the income statement and the remainder to retained earnings if it related to operations in previous years. However, it is hard to assess, and also difficult for auditors to verify, the amount related to the current year and previous years. As the 1998 Accounting Standards were only optional for A-shares listed companies, these companies seldom adopted the new approach (Chen et al., 2004). The MOF then amended the regulations in 1999 by introducing Supplementary Provisions on Accounting Treatment in the Accounting System for Shareholding Companies (‘‘1999 Supplementary Provisions”) to compulsorily require all listed and non-listed companies to set up provisions for the write-downs of four types of their assets, namely accounts receivable, inventories, short-term investments and long-term investments. In addition, the new provisions incorporated other receivables into accounts receivable and required a corresponding provision for bad debts to be made, as the situation required. The 1999 Supplementary Provisions also required companies to charge the unrealized loss incurred in 1999 to the income statement and record the portion related to prior years to equity (Li, 2001; Chen et al., 2004). Therefore, the impact of adopting the accounting standards would not fall wholly on net income in 1999. All asset impairment provisions made after 1999 will be reflected in the income statement of the relevant year. In 2000, the Chinese authority issued the 2001 Accounting Standards to enforce all listed companies to provide for impairment in value of an additional four types of assets, effective from 2001. These additional assets include intangible assets, fixed assets, construction in progress and commission loans. 3 Unlike the four asset categories specified in the 1998 Accounting Standards, the market values of the four new assets are more difficult to assess objectively. Hence, the 2001 Accounting Standards required that such assets be written down to their recoverable amounts, i.e., the higher of net selling price and the value in use. However, recoverable amounts are not easily available from the market. Furthermore, commission loans are always treated by companies as off-balance-sheet items, and it is even more difficult to provide for any impairment of an asset that is not recognized on the books (see Table 1). 2 Before 1998, listed companies could only provide for bad debt allowances according to approved percentages of 0.3–0.5% on the outstanding accounts receivable balances. There were several reasons for prohibiting write-downs on other assets. First, assets in Chinese SOEs were not likely to be impaired during the central planning economy era. Second, China adopted tax-based accounting until the early 1990s, and accounting income differed little from taxable income (Chan et al., 2007). Therefore, write-downs of assets would reduce the reported income and might affect the income tax revenues of the state. Third, assessing assets for write-downs required market values. However, certain SOEs were monopolies in their industries (e.g., national defense, power generation and coal mining or oil and gas extraction), and market values of their assets were not always available in China. 3 Commission loans are loans made to investment companies in return for compromised returns. This was a common practice during the period of the booming security market. However, when a bear market was experienced, the principal, together with the promised returns, might not be recoverable. Before the release of the 2001 Accounting Standards, listed companies were not required to disclose commission loans separately. Instead, the commission loans were sometimes incorporated into shortor long-term investments. 388 P.W.Y. Wong / China Journal of Accounting Research 11 (2018) 385–405 2.2. Profitability requirement for listed companies The establishment of the Shanghai and the Shenzhen stock exchanges in 1990 and 1991, respectively, provided platforms for companies to raise capital. Initially, the People’s Bank of China supervised the local governments of Shanghai and Shenzhen and other governmental bodies to monitor the capital market in China. The CSRC was established pursuant to the State Council Directive in July 1992 to monitor and regulate the Chinese stock market. In 1998, the CSRC set up the Special Treatment (ST) and Particular Treatment (PT) system to improve the quality of listed companies and to protect the rights of investors. Companies continuously suffering losses will be labeled to remind investors of the additional risks incurred when investing in their shares. When a listed company suffers losses for two consecutive years, the shares will be labeled as ST, and the CSRC will impose reporting and trading restrictions on its shares. 4 If the ST firm has a turnaround in the following year, the ST label will be lifted. However, if the ST company continues to incur losses in the third year, its shares will be classified as PT and can only be traded on Fridays. 5 If the PT company suffers further losses, its shares will be suspended from trading, and the company will be delisted from the stock exchange. By labeling the firms with ST or PT, companies with poor management can be easily identified by investors. Local governments are unwilling to have companies under their provincial supervision be delisted. Hence, speculators push the share prices upwards as they expect the local governments to step into bail the PT companies out (Wall Street Journal, 2001). To convey correct information to the public, the CSRC strengthened the regulatory procedure and effective 1 January 2002, it abolished the PT category. According to the new rules, all companies suffering losses for three consecutive years are suspended from trading. If an ST company, after incurring losses for three consecutive years, continues to report losses in the following quarter, the CSRC will label it with an asterisk before ST. If an * ST company again reports losses in the following quarter, it will be delisted from the exchange (Hong Kong Commercial News, 2003). Raising equity in China, including initial public offerings (IPOs) and re-issuance of securities, also requires the CSRC’s approval. According to the ‘‘Relevant Questions Concerning Rights Issue by Listed Companies” issued by the CSRC in March 1999, to qualify for rights issues for years 1999 and 2000, listed companies have to attain a minimum annual ROE of 6% for each of the previous three years and maintain an average ROE of 10% for the three years. 6 Table 1 Accounting treatment on asset impairment. (Source: Yang et al. (2005)) Category of Assets Governed by Accounting Standard Specification of Fair Value Impairment Loss Charged to Income Statement Under 1998 2001 Accounts Receivable (incl. Other Accounts Receivable) UURecoverable Amount Administration Expenses Inventories UUNet Selling Price Administration Expenses Short-Term Investments UUMarket Value Gain or Loss on Investments Long-Term Investments UURecoverable Amount Gain or Loss on Investments Intangible Assets – URecoverable Amount Non-Operating Expenses Fixed Assets – URecoverable Amount Non-Operating Expenses Construction in Progress – URecoverable Amount Non-Operating Expenses Commission Loans – URecoverable Amount Gain or Loss on Investments 4 Apart from providing an audited interim report to the CSRC, the daily fluctuation of the stock price of an ST company should not exceed 5%. As the daily stock price variation for normal listed companies is restricted at 10%, the reduction in price variation on ST firms has further reduced the attractiveness to investors of trading their shares. 5 The share price of a PT company can continue to fall but is not allowed to rise over 5% for any trading day to avoid any manipulation from related parties. 6 ‘‘Notice about Doing Well in the Issuance of New Shares by Listed Companies”released by the CSRC on 15 March 2001 amended the requirement by allowing listed companies, from 2001 onwards, to apply for rights issues if they attained a minimum level of 6% of the weighted average yield rates of net assets, being the lower of the net income before extraordinary items and the net income, for the latest 3 years. P.W.Y. Wong / China Journal of Accounting Research 11 (2018) 385–405 389 2.3. Earnings management incentives The central regulators set up a quota system for listing Chinese companies, and each province was given a number of SOEs to be listed (Leung et al., 2002). Provincial governments can determine which firms could list. However, the best SOEs may not be able to be listed because the provincial governments would use the scarce quotas for those firms that needed money the most (Leung et al., 2002). Local governments are managing the listed companies, no matter whether they are controlled by state shares or state-owned legal person shares (China Industrial and Commercial Times, 2003). Hence, local governments are unwilling to have companies under their provincial supervision be delisted. 7 For those companies suffering continuous losses, local governments will adopt all available administrative measures to maintain their listing status (Legaldaily.com.cn., 2001). Therefore, as long as the companies are controlled by state shares or state-owned legal person shares, local governments can exercise control over them. According to Becker et al. (1998), managers may be motivated to ‘‘manage”earnings by incentives such as management compensation plans, debt covenants, import relief negotiations, management buyouts and proxy contests. In China, reported earnings play an additional role of retaining listing status. As loss-producing companies will immediately attract the attention of the CSRC, one of the most important targets for management is to avoid reporting losses on the financial statements. To save from being labeled as ST, * ST or PT, a listed company must avoid losses for two to three consecutive years. The CSRC identifies loss-producing companies irrespective of the magnitude of their loss. Thus, a company incurring a loss of RMB1 will be treated by the CSRC in the same way as those suffering a loss of RMB100 million. Hence, management may intend to adopt the ‘‘big bath”approach, i.e., making adjustments to shift losses for two consecutive years into one, or to reduce losses for three consecutive years into two. Li (2001) shows that to minimize any further negative impact, management will incorporate future expenses by writing off assets in the current period so that they can increase future earnings. Similarly, management may intend to shift profits from one period to another to fulfill the requirement to raise additional share capital. The listing rules of both exchanges require the firm applying for rights issue to attain a minimum ROE level of 6% for each of the three years prior to offering additional capital and to maintain an average ROE level of 10% for the three years. To secure the right to raise further capital, a firm with an ROE level above 6% in the previous year will tend to want to attain an ROE level of 6% in the current year. A firm with ROE levels above 6% in each of the two previous years may be more eager to achieve a higher ROE level in the current year to maintain the average ROE level for the three years at 10% and to utilize the right to raise additional capital. In addition, unlike the case in market-oriented economies, management of local government-controlled listed companies in China is not appointed by shareholders but by the central or local governments. Thus, it is common that senior executives of listed enterprises are seconded from local government and will return to the government after the secondment period. Hence, managers of these firms are more likely to have political connections with the government (Fan et al., 2007) and are therefore more likely to be promoted as government officers. With the higher earnings of the listed companies indicating superior performance and better administrative abilities of the management, managers of state-controlled firms have stronger incentives to be aggressive in financial reporting to secure their future political career. However, managers of listed state-controlled firms are also competing with managers of non-listed SOEs for political promotion. Nonlisted SOEs are not required to adopt the accounting standards. 8 They are less visible to the public, and thus their accounting information is less exposed to public scrutiny. Hence, managers of listed state-controlled firms will have greater incentive to manage earnings to enhance their performance relative to managers of non-listed SOEs. 7 In the context of China’s quota system, delisting means the retroactive reduction of an allotted quota, and no other company can use the quota of the delisted firm to issue its shares (Pistor and Xu, 2005). 8 The 1998 Accounting Standards do not apply to non-listed SOEs. The 2001 Accounting Standards are also not mandatory for non-listed SOEs. If they decide to adopt the new standards, they are required to apply to the local Bureau of Finance for permission. 390 P.W.Y. Wong / China Journal of Accounting Research 11 (2018) 385–405 2.4. Ownership structure of listed companies in China Economic reforms have transformed China from a centrally planned economy and have brought out restructuring of the ownership structure in enterprises from contractual leasing and collectively owned Township-Village Enterprises to investor-owned public enterprises (Zhang, 2001). In July 1992, the State Council issued the Regulations on Transforming the Management Mechanism of State-Owned Industrial Enterprises and introduced the shareholding system. Currently, China’s listed companies are classified into A-shares, B-shares, H-shares, N-shares and L-shares according to the holders’ residency. A-shares are listed on the Shanghai or the Shenzhen stock exchanges, are held by domestic shareholders and are denominated in RMB. 9 B-shares are also listed on the two exchanges in China, but only to foreign shareholders, and are denominated in Hong Kong or US dollars. 10 H-shares, N-shares and L-shares are Chinese enterprises listing on the Hong Kong Exchange, New York Stock Exchange and London Stock Exchange, respectively. A-shares, B-shares and the overseas-listed shares carry the same ownership rights. The ownership of A-shares is mainly divided into three different categories: state shares, legal person shares and tradable shares. State shares are issued to the central government, local governments or wholly owned government enterprises. Legal person shares are further divided into two categories: state-owned legal shares and ordinary legal shares. Ordinary legal shares are issued to domestic institutions such as securities companies and non-bank financial institutions. 11 Tradable shares, which amount to only 35% of the total shares of the enterprises, are issued to the public, and most of them are held in the hands of small individual investors (Wang, 2004). Non-tradable shareholders control the enterprises. As shown in Panel C of Table 2, the portion of nontradable shares was reduced from 71.9% in 1993 to 64.5% in 1995 and remained at a very steady level after that. State shares represent the largest portion within the non-tradable shares. In 1992, the total number of state shares was 2.9 billion, representing 42.0% of the total issued number of shares and 60.3% of the number of non-tradable shares. After the 15th National Congress of the China Communist Party held in September 1997, more state-owned enterprises were allowed to be listed on the exchanges. During 1998–2001, 327.5 billion additional shares were raised, a number 1.69 times that of the total number of shares listed on the exchanges at the end of 1997. With the total non-tradable shares remaining at 65% of the total issued share capital, the portion of state shares has increased from 31.5% in 1997 to 45.0% in 2005, indicating that the controlling power of state shareholders over the market is increasing. 2.5. Audit quality in China Prior studies have noted that conservatism is one of the most important characteristics of financial statements (Pope and Walker, 1999; Ball et al., 2000; Chung et al., 2003) and that the Big Six audit clients adopt more conservative accounting methods (Basu et al., 2002; Chung et al., 2003). DeAngelo (1981) finds that Big Six auditors are of higher quality than non-Big Six auditors, and Chung et al. (2002) find that when management has preferences for income-increasing accounting choices, Big Six auditors are more effective than nonBig Six auditors in monitoring and deterring opportunistic accounting choices. The audit market in China is still dominated by small-scale domestic CPA firms and is not yet fully opened to international accounting 9 In 2002, Qualified Foreign Institutional Investors (QFIIs) were allowed to participate in the A-share market with the approval of the CSRC. 10 Starting from June 2001 onwards, the restriction on B-shares to be traded by foreign investors using foreign currencies was lifted. 11 Before 2005, both state shares and legal person shares could not be traded on the Shanghai and the Shenzhen stock exchanges but could be transferred to domestic institutions within the same category, subject to CSRC approval (Cooper, 2003; Jiang, 2004). State shares can only be transferred to another state shareholder and legal person shares are restricted to transfer to another legal person shareholder. The transfer price is set at the net assets value per share plus a margin through negotiation and is also subject to CSRC approval (Wei and Xiao, 2005). This restriction is imposed to retain significant ownership and control of the enterprises and the industries by the state and to eliminate any chance of diluting the state control over listed companies without prior approval (Walter and Howie, 2001). Under the ‘‘Administrative Measures on the Share Segregation Reform of Listed Companies”and the ‘‘Guidelines on Practice and Operation of Share Segregation Reform of Listed Companies,”state and legal person shares can now be traded after the proposal for disposal of these shares are approved by the state-owned assets regulatory authorities. P.W.Y. Wong / China Journal of Accounting Research 11 (2018) 385–405 391 firms. Chan et al. (2006) find that political and economic influences from local government will outweigh the effect of high-quality auditors, and local auditors have greater economic dependence on local clients and thus are more likely to issue clean auditor opinions compared to companies owned by local governments. The CPA profession was established in China in the 1910s along with the development of shareholding enterprises. International CPA firms began to practice in China, and by 1947, there were 3356 registered CPAs in China. The revolution in 1949 diminished the role of auditing in China. In 1962, the economy was Table 2 Stock market in China. (Source: CSRC, China Securities and Futures Statistical Yearbook (2006)) 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Panel A: Summary Statistics of the Shanghai and Shenzhen Stock Exchanges No. of Listed Companies 53 183 291 323 530 745 851 949 1088 1160 1224 1287 1377 1381 Only A-shares a – – 227 242 431 627 727 822 955 1025 1085 1146 1236 1240 Amount of Capital Raised from A-shares (RMB, billion) 5.0 19.5 5.0 2.3 22.4 65.5 40.9 49.8 81.2 53.4 51.7 45.4 35.3 5.7 Market Capitalization (RMB, billion) 105 353 369 347 984 1753 1952 2647 4809 4352 3833 4246 3706 3243 No. of Investors (million) 2.2 8.4 11.1 12.9 24.2 34.8 42.60 48.1 61.2 69.0 68.4 69.8 72.2 73.4 Panel B: Share Structure of China’s Listed Companies (No. of Total Shares, in billions) Non-tradable Shares State Shares 2.9 19.0 29.7 32.9 43.2 61.2 86.6 111.6 147.5 241.1 277.3 304.7 334.4 343.3 Domestic Legal Person’s Shares 1.5 7.6 14.7 19.7 31.6 57.0 68.0 78.1 85.7 90.8 96.4 101.0 110.2 79.5 Foreign Legal Person’s Shares 0.3 0.4 0.8 1.2 1.5 2.6 3.6 4.1 4.6 4.6 5.3 5.9 7.0 22.6 Employee Shares 0.1 0.9 0.5 0.3 1.5 4.0 5.2 3.7 2.4 2.4 1.6 1.1 0.9 0.4 Others 0.0 0.0 0.1 0.6 1.2 2.3 3.1 3.4 3.5 1.6 3.2 3.4 4.6 25.7 Total Non-tradable Shares 4.8 27.9 45.8 54.7 79.0 127.1 166.5 200.9 243.7 340.5 383.8 416.1 457.1 471.5 Tradable Shares A-shares 1.1 6.2 14.4 18.0 26.7 44.3 60.8 81.3 107.8 131.8 150.9 171.5 199.3 228.1 B-shares 1.0 2.5 4.2 5.6 7.9 11.7 13.4 14.2 15.2 16.3 16.8 17.5 19.7 21.8 H-/N-/L-shares 0.0 2.2 4.1 6.5 8.4 11.2 12.0 12.5 12.5 33.2 36.0 37.7 38.8 41.6 Total Tradable Shares 2.1 10.9 22.7 30.1 43.0 67.2 86.2 108.0 135.5 181.3 203.7 226.7 257.8 291.5 Total No. of Shares issued 6.9 38.8 68.5 84.8 122.0 194.3 252.7 308.9 379.2 521.8 587.5 642.8 714.9 763.0 Panel C: Share Structure of China’s Listed Companies (% of Total Shares) Non-tradable Shares State Shares 42.0 49.0 43.4 38.8 35.4 31.5 34.3 36.1 38.9 46.2 47.2 47.4 46.8 45.0 Domestic Legal Person’s Shares 21.7 19.6 21.5 23.2 25.9 29.3 26.9 25.3 22.6 17.4 16.4 15.7 15.4 10.4 Foreign Legal Person Shares 4.4 1.0 1.2 1.4 1.2 1.3 1.4 1.3 1.2 0.9 0.9 0.9 1.0 2.9 Employee Shares 1.5 2.4 0.7 0.4 1.2 2.1 2.1 1.2 0.6 0.5 0.3 0.2 0.1 0.1 Others 0.0 0.0 0.2 0.7 1.0 1.2 1.2 1.1 0.9 0.3 0.5 0.5 0.6 3.4 Total Non-tradable Shares 69.6 71.9 66.9 64.5 64.8 65.4 65.9 65.0 64.3 65.3 65.3 64.7 63.9 61.8 Tradable Shares A-shares 15.9 16.0 21.0 21.2 21.9 22.8 24.1 26.3 28.4 25.3 25.7 26.7 27.9 29.9 B-shares 14.5 6.4 6.1 6.6 6.5 6.0 5.3 4.6 4.0 3.1 2.9 2.7 2.8 2.9 H-/N-/L-shares 0.0 5.7 6.0 7.7 6.9 5.8 4.8 4.1 3.3 6.4 6.1 5.9 5.4 5.4 Total Tradable Shares 30.4 28.1 33.1 35.5 35.3 34.6 34.1 35.0 35.7 34.7 34.7 35.3 36.1 38.2 Total Shares 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Notes: a Information is only available from 1994 onwards. 392 P.W.Y. Wong / China Journal of Accounting Research 11 (2018) 385–405 Table 4 Descriptive statistics on client firm characteristics and auditor locality. Mean Min. Median Max. Std. Dev. Skewness WD t 0.0311 0.5566 0.0130 0.6049 0.0743 7.0580 Conservatism Variables SS t 0.8328 0.0000 1.0000 1.0000 0.3732 1.7841 RET t 0.0059 0.6512 0.1165 1.9244 0.4081 1.3998 SS t RET t 0.0012 0.6512 0.0024 1.9244 0.3706 1.5234 Neg_RET t 0.6098 0.0000 1.0000 1.0000 0.4878 0.4501 SS t Neg_RET t 0.5013 0.0000 1.0000 1.0000 0.5000 0.0052 RET t Neg_RET t 0.1559 0.6512 0.1165 0.1251 0.1739 0.7161 SS t RET t Neg_RET t 0.1255 0.6512 0.0000 0.1251 0.1660 1.0284 Auditor Locality Variables Locality t 0.6863 0.0000 1.0000 1.0000 0.4640 0.8034 SS t Locality t 0.5779 0.0000 1.0000 1.0000 0.4939 0.3154 Big_4 t 0.0304 0.0000 0.0000 1.0000 0.1716 5.4758 SS t Big_4 t 0.0261 0.0000 0.0000 1.0000 0.1594 5.9478 Regulatory Incentives Variables LOSS t 0.1138 0.0000 0.0000 1.0000 0.3176 2.4327 SS t LOSS t 0.0876 0.0000 0.0000 1.0000 0.2827 2.9189 LOSS t1 0.0816 0.0000 0.0000 1.0000 0.2738 3.0570 SS t LOSS t1 0.0607 0.0000 0.0000 1.0000 0.2388 3.6798 LOSS t LOSS t1 0.0334 0.0000 0.0000 1.0000 0.1797 5.1941 SS t LOSS t LOSS t1 0.0244 0.0000 0.0000 1.0000 0.1543 6.1653 ROE00_01 t 0.0676 0.0000 0.0000 1.0000 0.2510 3.4460 SS t ROE00_01 t 0.0557 0.0000 0.0000 1.0000 0.2293 3.8762 ROE00_01 t LOSS t1 0.0124 0.0000 0.0000 1.0000 0.1105 8.8303 SS t ROE00_01 t LOSS t1 0.0093 0.0000 0.0000 1.0000 0.0960 10.2233 ROE06_07 t 0.1014 0.0000 0.0000 1.0000 0.3019 2.6407 SS t ROE06_07 t 0.0857 0.0000 0.0000 1.0000 0.2800 2.9600 ROE06_07 t1 0.1042 0.0000 0.0000 1.0000 0.3055 2.5917 SS t ROE06_07 t1 0.0882 0.0000 0.0000 1.0000 0.2836 2.9054 ROE06_07 t ROE06_07 t1 0.0270 0.0000 0.0000 1.0000 0.1621 5.8376 SS t ROE06_07 t ROE06_07 t1 0.0235 0.0000 0.0000 1.0000 0.1515 6.2934 Other Control Variables SIZE t1 20.8748 19.0263 20.8276 23.0173 0.7811 0.2401 DR t1 0.4405 0.0741 0.4360 1.0095 0.1714 0.1865 DSales t 0.1889 0.8066 0.1352 3.4441 0.4216 2.1587 DACC t 0.0996 0.3177 0.0922 0.6276 0.1291 0.3486 DOCF t 0.0057 0.3905 0.0076 0.3570 0.1003 0.2026 Notes: a. WD t = write-downs on asset impairment (reflected as a positive amount) in period t, divided by total assets at the end of period t 1; SS t = 1 if the largest shareholder holds 20% of the shares in the listed company, either in the form of state shares or state-owned legal person shares, and the holding percentage is greater than the sum of the holding percentage of the next four largest shareholders, 0 otherwise; and RET t = 12-month buy-and-hold annual stock returns from May in year tto April in year t+ 1; and Neg_RET t = 1 if the company generated negative annual stock returns, 0 otherwise; and Locality t = 1 if the company is audited by a local auditor, 0 otherwise; and Big_4 t = 1 if the company is audited by a Big 4 auditor, 0 otherwise; and SIZE t1 = natural logarithm of beginning total assets value; and DR t1 = beginning debt-to-asset ratio; and DSales t = percentage change in sales from period t 1 to period t; and DACC t = change in total accruals between period t and t 1, divided by total assets at period t 1; and DOCF t = change in operating cash flows between period t and t 1, divided by total assets at period t 1; and LOSS t = 1 for company reporting loss after write-downs in period t, 0 otherwise; and LOSS t1 = 1 for company reporting loss after write-downs in period t 1, 0 otherwise; and LOSS t LOSS t1 = interaction variable, 1 if the company reported loss after write-downs in period t 1 and in period t, 0 otherwise; and ROE00_01 t = 1 for 0.00 ROE 0.01 after write-downs, 0 otherwise; and P.W.Y. Wong / China Journal of Accounting Research 11 (2018) 385–405 399 on Locality t and SS_Locality t support Hypothesis 2b. The negative significant coefficient on SS_Locality t shows that local auditors tend to support a lower level of asset write-downs of A-share listed companies controlled by local governments. To control for the firm size effect on the write-downs, the logarithm of total assets at the beginning of the period (SIZE t1 ) is included in the model. Although previous studies find that larger companies are more likely to write down asset values (Francis et al., 1996), the results in the present analysis present a different finding. The write-down on asset impairment in China is significantly negatively associated with the size of the enterprises (t = 9.06) at the 1% level. This may be due to the reason that larger firms in China can afford higher-quality fixed assets, and thus the values of those assets are not impaired as much as those possessed by smaller firms. I expect high-leverage firms will be more interested in raising financing with lower cost and are more likely to discretionarily write down asset values to increase the possibility of meeting the targets for raising further capital. The debt ratio (DR t1 , t = 9.59) is significantly positive, as predicted. In addition, the asset impairment decision is significantly associated with DSales t (t = 5.30), which means when its income level is high, a listed company is more willing to write down asset values. The write-down magnitude is negatively associated with DSales t , as expected, and is statistically significant. The signs of coefficients DACC t and DOCF t are inconsistent with the expectation but are not significant. LOSS t , LOSS t1 , LOSS t LOSS t1 ,ROE00_01 t and ROE00_01 t LOSS t1 are introduced into the model to test the impact of the CSRC’s regulations on the write-down magnitude (Li, 2001; Chen et al., 2004). As expected, LOSS t is significantly positively related to the magnitude of asset write-downs (t = 7.84). Because the CSRC only identifies firms with reported loss, the amount of the loss incurred in the period is not relevant to the ST or PT labels. Therefore, firms with loss incurred in the current period will take ‘‘big bath”charges and write down assets further to reduce future expenses. Similarly, when a firm has reported losses in both the current and the previous periods, it is at a very high risk of being delisted and is more likely to write down assets further in the current year. LOSS t LOSS t1 is significantly positive, as predicted (t = 6.87). Interestingly, SS_LOSS t and SS_LOSS t LOSS t1 are negatively correlated to the writedown magnitude, and the latter is significant at the 1% level. A possible explanation may be that consistent with speculators’ expectation, local governments are more likely to bail out PT companies (Wall Street Journal, 2001), and therefore management will try to save face by minimizing the amount of the loss reported. One way of reducing the loss magnitude is by making fewer allowances on asset write-down. However, if the firm has reported loss in the previous period, it will strive to reduce its expenses in the current period to save itself from being labeled as an ST firm. Hence, LOSS t1 and SS_LOSS t1 , consistent with expectations, are negatively related to the write-down magnitude in the regression results. Contrary to the expectation, the results of ROE00_01 t and SS_ROE00_01 t are positive but are insignificant. The coefficients on ROE00_01 t LOSS t1 and SS_ROE00_01 t LOSS t1 are negative as expected, although not significant. This shows that firms reporting a loss in period t 1 will tend to avoid being labeled as ST firms and are likely to avoid loss in the current year. ROE06_07 t1 and ROE06_07 t ROE06_07 t1 are negatively correlated with the write-down magnitude, and this result is consistent with the prediction. Firms surviving the 6% ROE level in the previous year may try to reduce assets write-down to fulfill the requirement of reporting the ROE level for rights issue. However, contrary to expectation, the coefficient on ROE06_07 t is positively related to the write-down magnitude. All of these variables, together with SS_ROE06_07 t1 , SS_ROE06_07 t1 and SS_ROE06_07 t ROE06_07 t1 , are insignificant. One possible reason is that firms are more likely to adjust their write-down magnitude when they report losses. ROE00_01 t LOSS t1 = interaction variable, 1 if the company reported loss after write-downs in period t 1 and is generating 0.00 ROE 0.01 after write-downs in period t, 0 otherwise; and ROE06_07 t = 1 for 0.06 ROE 0.07 after write-downs in period t, 0 otherwise; and ROE06_07 t1 = 1 for 0.06 ROE 0.07 after write-downs in period t 1, 0 otherwise; and ROE06_07t ROE06_07t 1 = interaction variable, 1 if the company reported ROE 0.06 and 0.07 after write-downs in periods t 1 and t, 0 otherwise. b. The top and bottom 1% of the continuous variables of WD t , RET t ,SIZE t1 ,DR t1 ,DSales t ,DACC t and DOCF t , are truncated according to annual distributions of the respective variables. 400 P.W.Y. Wong / China Journal of Accounting Research 11 (2018) 385–405 Table 5 Regression results on asset write-downs for years from 1998 to 2005. WD t =a 0 +a 01 POST 99 +a 02 POST 01 +a 11 SS t +a 12 SS t  POST 99 +a 13 SS t POST 01 +a 21 RET t +a 22 RET t POST 99 +a 23 RET t POST 01 +a 31 SS t RET t +a 32 SS t RET t POST 99 + a 33 SS t RET t POST 01 +a 41 Neg_RET t +a 42 Neg_RET t POST 99 +a 43 Neg_RET t POST 01 +a 51 SS t Neg_RET t +a 52 SS t  Neg_RET t POST 99 +a 53 SS t Neg_RET t POST 01 +a 61 RET t Neg_RET t +a 62 RET t Neg_RET t POST 99 +a 63 RET t  Neg_RET t POST 01 +a 71 SS t RET t Neg_RET t +a 72 SS t RET t Neg_RET t POST 99 +a 73 SS t RET t Neg_RET t  POST 01 +b 01 Locality t +b 02 SS t Locality t +b 03 Big_4 t +b 04 SS t Big_4 t +b 05 SIZE t1 +b 06 DR t1 +b 07 DSales t +b 08 DACC t + b 09 DOCF t +b 10 LOSS t +b 11 SS t LOSS t +b 12 LOSS t1 +b 13 SS t LOSS t1 +b 14 LOSS t LOSS t1 +b 15 SS t LOSS t LOSS t1 + b 16 ROE00_01 t +b 17 SS t ROE00_01 t +b 18 ROE00_01 t LOSS t1 +b 19 SS t ROE00_01 t LOSS t1 +b 20 ROE06_07 t +b 21 SS t  ROE06_07 t +b 22 ROE06_07 t1 +b 23 SS t ROE06_07 t1 +b 24 ROE06_07 t ROE06_07 t1 +b 25 SS t ROE06_07 t ROE06_07 t1 + Industry Dummies + e t . Variable Predicted Sign Coefficient t-value Pr > |t| Intercept ? 0.184 6.64 0.000 *** Test Variables POST99 +/0.021 1.18 0.239 POST01 +/0.021 2.08 0.038 ** SS t +/0.012 0.71 0.476 SS t POST99 +/0.001 0.04 0.965 SS t POST01 +/0.006 0.56 0.577 RET t +/0.017 0.52 0.605 RET t POST99 +/0.024 0.70 0.487 RET t POST01 +/0.007 0.36 0.719 SS t RET t +/0.015 0.40 0.686 SS t RET t POST99 +/0.013 0.35 0.728 SS t RET t POST01 +/0.001 0.05 0.959 Neg_RET t + 0.014 0.54 0.589 Neg_RET t POST99 +0.066 1.89 0.058 * Neg_RET t POST01 + 0.056 2.31 0.021 ** SS t Neg_RET t 0.015 0.54 0.593 SS t Neg_RET t POST99 0.067 1.79 0.073 * SS t Neg_RET t POST01 0.063 2.43 0.015 ** RET t Neg_RET t 0.057 0.67 0.500 RET t Neg_RET t POST99 0.159 1.32 0.187 RET t Neg_RET t POST01 0.115 1.3 0.193 SS t RET t Neg_RET t +0.073 0.80 0.423 SS t RET t Neg_RET t POST99 + 0.219 1.65 0.099 * SS t RET t Neg_RET t POST01 +0.191 1.93 0.053 * Auditor Locality Variables Locality t 0.006 1.50 0.133 SS_Locality t 0.009 1.95 0.051 * Big_4 t + 0.002 0.18 0.854 SS_Big_4 t + 0.002 0.15 0.881 Other Control Variables SIZE t1 +0.011 9.06 0.000 *** DR t1 + 0.050 9.59 0.000 *** DSales t 0.011 5.30 0.000 *** DACC t +0.005 0.65 0.517 DOCF t 0.002 0.26 0.792 Regulatory Incentives Variables LOSS t + 0.053 7.84 0.000 *** SS_LOSS t 0.007 0.92 0.359 LOSS t1 +0.021 2.35 0.019 ** SS_LOSS t1 0.028 2.74 0.006 *** LOSS t LOSS t1 + 0.094 6.87 0.000 *** SS_LOSS t LOSS t1 0.046 2.94 0.003 *** ROE00_01 t 0.002 0.23 0.817 SS_ROE00_01 t 0.003 0.36 0.721 ROE00_01 t LOSS t1 0.004 0.20 0.839 (continued on next page) P.W.Y. Wong / China Journal of Accounting Research 11 (2018) 385–405 401 6. Robustness checks 6.1. Alternative definition of controlling ownership I rerun the regressions by treating the local governments as the largest shareholder when the shareholding of state shares or state-owned legal person shares reached 20% or above and the ownership percentage of the largest shareholder should be greater than the sum of the next nine largest shareholders. The results are similar to the main findings. 6.2. Alternative definition of local auditors In the main findings, I define a local auditor as one located in the same province as their audit clients. I further analyze whether the results will be different if auditors are located in the same city as their clients. The results are generally consistent with the main findings. Table 5 (continued) Variable Predicted Sign Coefficient t-value Pr > |t| SS_ROE00_01 t LOSS t1 0.031 1.44 0.150 ROE06_07 t 0.003 0.45 0.651 SS_ROE06_07 t 0.008 0.97 0.332 ROE06_07 t1 0.002 0.32 0.752 SS_ROE06_07 t1 0.002 0.28 0.782 ROE06_07 t ROE06_07 t1 0.008 0.45 0.653 SS_ROE06_07 t ROE06_07 t1 0.014 0.79 0.431 Adjusted R 2 0.254 N 7258 Notes: a. WD t = write-downs on asset impairment (reflected as a positive amount) in period t, divided by total assets at the end of period t 1; POST 99 = 1 if the observation is from post-1999 period, 0 otherwise; and POST 01 = 1 if the observation is from post-2001 period, 0 otherwise; and SS t = 1 if the largest shareholder holds 20% of the shares in the listed company, either in the form of state shares or state-owned legal person shares, and the holding percentage is greater than the sum of the holding percentage of the next four largest shareholders, 0 otherwise; and RET t = 12-month buy-and-hold annual stock returns from May in year tto April in year t+ 1; and Neg_RET t = 1 if the company generated negative annual stock returns, 0 otherwise; and Locality t = 1 if the company is audited by a local auditor, 0 otherwise; and Big_4 t = 1 if the company is audited by a Big 4 auditor, 0 otherwise; and SIZE t1 = natural logarithm of beginning total assets value; and DR t1 = beginning debt-to-asset ratio; and DSales t = percentage change in sales from period t 1 to period t; and DACC t = change in total accruals between period t and t 1, divided by total assets at period t 1; and DOCF t = change in operating cash flows between period t and t 1, divided by total assets at period t 1; and LOSS t = 1 for company reporting loss after write-downs in period t, 0 otherwise; and LOSS t1 = 1 for company reporting loss after write-downs in period t 1, 0 otherwise; and LOSS t LOSS t1 = interaction variable, 1 if the company reported loss after write-downs in period t 1 and in period t, 0 otherwise; and ROE00_01 t = 1 for 0.00 ROE 0.01 after write-downs, 0 otherwise; and ROE00_01 t LOSS t1 = interaction variable, 1 if the company reported loss after write-downs in period t 1 and is generating 0.00 ROE 0.01 after write-downs in period t, 0 otherwise; and ROE06_07 t = 1 for 0.06 ROE 0.07 after write-downs in period t, 0 otherwise; and ROE06_07 t1 = 1 for 0.06 ROE 0.07 after write-downs in period t 1, 0 otherwise; and ROE06_07t ROE06_07t 1 = interaction variable, 1 if the company reported ROE 0.06 and 0.07 after write-downs in periods t 1 and t, 0 otherwise. a. Industry dummies are not presented. b. *** , ** and * represent significance at the 1%, 5% and 10% levels, respectively. 402 P.W.Y. Wong / China Journal of Accounting Research 11 (2018) 385–405 7. Conclusions To improve the quality of accounting information, Chinese regulators issue more conservative accounting standards with reference to international standards and introduce asset write-down regulations in 1998 and 2001. This study examines the impact of state ownership of A-share listed companies in China on the magnitude of asset write-downs, with respect to the more conservative financial reporting requirements. However, the write-down decision allows management to discretionally determine the recoverable value of relevant assets and to opportunistically manage reported earnings. From a sample of 7258 observations for 1998 to 2005, the study finds that asset write-downs are affected by the nature of company ownership, especially when companies are controlled by local governments through state shares and state-owned legal person shares. Local government-controlled companies tend to write-down fewer assets, especially after the introduction of the more conservative accounting rules implemented by the 2001 Accounting Standards. One possible reason is that the inclusion of four additional asset categories, which are generally of larger size, allows these firms to reduce the asset write-downs (or reverse previous write-downs) to meet the target ROE level and to retain their listing status. When I examine the relationship of local auditors and the magnitude of asset impairment, I find that they tend to agree with management’s decision for a lower level of asset write-downs. I do not find similar results with the Big Four audit clients. The results of this study contribute to understanding the unique characteristics of the Chinese capital market. With the intention to achieve the target ROE level to safeguard their listing status and to meet the rights issue requirements, companies tend to adopt an aggressive asset write-down policy to report the required ROE level. Second, this paper shows the impacts of ownership structures on earnings management. Managers of local government-controlled companies in China are more politically connected to the government (Fan et al., 2007), but they are seldom rewarded in line with their performance. To strive for political promotion and to indicate their superior performance in the competition with managers of nonlisted SOEs, these managers have strong incentives to be aggressive in reporting. Third, prior literature finds that local auditors have greater economic dependence on local clients and tend to issue clean auditor opinions to companies owned by local government (Chan et al., 2006). The study provides further evidence that the locality of audit firms and their clients impact the impairment decision, especially when the audit clients are controlled by local governments. Policy makers should assess the effectiveness of regulations to improve the quality and independence of auditors in China. Fourth, Chen and Wu (2007) find that accounting standards alone are insufficient in conservative financial reporting. The present results further show that companies controlled by local governments have fewer incentives to recognize asset impairments despite the availability of conservative accounting rules. This paper examines the magnitude of asset write-downs in China. 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