Research On The Self-enforcing Mechanism Of Auditing Contracts

Auditing has played an tremendous and indispensable role to identify the corporation financial information in more than 10 years'history of China's capital market. But at the same time, a series of financial fraud and audit failure cases extremely disappointed the investors, and the audit quality and the auditor reputation are seriously doubted.Auditing is a kind of mechanism which ensures the effective performance of accountability, involving the confirmation and release of accountability fulfilling. It is an institutional arrangement which can rise enterprise value through reducing agency costs. Auditing is valuable only when the investors expect that auditors would report violations of managers that have been found. The value of auditing increases as the probability of reproting the founded default behavior increases.What's the key factor to determine the audit quality? Macaulay (1963) stated that"The comparative informal and non-legal coercive contractual arrangements dominates commercial relationships in the market, and it's extremely rare to rely on the explicit legal sanctions" So the self-enforcing mechanism is the determining factor for successful completion of transactions. The legal system and regulations will ultimately work through the market mechanism itself. China's capital market was born out of the planned economic system, but it is gradually moving towards to the market economy after a number of reformations during the recent years. This trend is inevitable. As a kind of service traded in the capital market, does the current market institutional background show some self-enforcing function for audit contracts? To hw much extent it can play its role? Has it already incented and restrained auditors to automatically perform audit contracts and provide high-quality service? This study constructs a self-enforcing mechanism theory of audit contracts according to the self-enforcing mechanism theory of normal products transaction contracts and verifies the effectiveness of the relevant topics in China's capital market. And on this basis it gives some summarized evaluation and corresponding policy recommendations. This study is divided into eight chapters of five parts, namely, introduction, theoretical analysis, and system background analysis, empirical tests and conclusions.Part I: Chapter 1, Introduction. This chapter introduces the background and purposes of the research, as well as the relevant core concepts, basic theories, literature review and the perspective, significance, structure, methods, innovation and inadequacy of this study.Part II: Theoretical analysis. This part includes self-enforcing mechanism theory of transaction contract and self-enforcing mechanism theory of audit contacts.Chapter 2, self-enforcing mechanism theory of audit contacts. This chapter is based on transaction cost economics and systematically goes through the self-enforcing mechanism theory of general product and service transaction contract. Firstly, for the specific investment contract, once the investment is in place, default behavior of appropriable quasi-rents may happen. This problem is solved by private punishment of the market, that is, on one hand, trading partners will terminate the contractual relationship with the violators, on the other hand, the private punishment will led to greater loss than benefits on the violators to prevent violations from occurring.In order to prevent the violation of the transaction, in addition to the private punishment after violation, the market tends to give a "quality premium" to the high-quality products providers in order to increase the personal private contractual enforcement capital. This mechanism will not only effectively prevent violations, but also enable traders consciously provide high-quality products.In the market where we are unable to distinguish the identity of the product providers, enterprises will invest in the reputation to separate their products from other providers'in order to receive premium. This investment will be recovered in the form of a premium in latter period and in the event of default, it can be a security of product quality, once non-compliance will not be able to recover. This investment can stop competitors to enter the market in the equilibrium state of a competitive market. The chapter also analysis and illustrates self-enforcing mechanism theory of audit contracts using self-enforcing mechanism theory of transaction cost economics. Firstly, it begins with the construction of audit relationship contract, analyzing the characteristics of implicit and explicit accountability audit contracts separately and the obstacles of audit contracts self-enforcing.Secondly, it constructs the theoretical framework of audit contracts self-enforcing mechanism theory, and analyzes the penalties mechanism, premium incentive mechanism and the reputation specific investment collateral mechanism of audit contracts market through the model.Finally, it studies the self-enforcing mechanism theory of audit contracts from a historical perspective. Auditor was produced in the initial form of corporation and becomes universal in joint-stock companies. Auditor is produce inside the market and its independence is maintained by constraints of contract parties. So the quality problem of the audit industry major problem can be solved mainly by own strength of the market.Part III: Chapter 3, the system background. This chapter analyses the market-oriented reforms and the results of audit contracts relations in China's capital market. The conclusion are as follows: China's current capital market is on transition to market-oriented, however, there are obstacles on market mechanism for the self-enforcing mechanism of audit contracts due to the incompleteness of market-oriented system and some excessive supervision measures.Part IV, empirical testing. This part includes three chapters, and it tests the private punishment mechanism of audit contracts, incentive mechanism and specific investment collateral mechanism in China's capital market separately.Chapter 4, it studies the punishment mechanism for auditors in China's capital market. Based on the 2004-2005 bulletin of quality inspection to audit industry of the Finance Ministry, this chapter analyzes the impact of auditors reputation declining and the effectiveness of the market punishment mechanism after investor aware of the quality problem through testing the changes of corporation's market value whose auditor has been criticized, numbers of clients and audit fees. Evidences indicate that market punishment mechanism only have some negative effects on world reputation audit firms.Chapter 5, it tests the incentive mechanisms for auditors in China's capital market. Audit firms are divided into international, large domestic and local ones in accordance with the reputation hierarchy. We assume that the international and domestic large ones can increase customers'market value, and we analyze the relationship between the reputation of audit firms and corporations'market value using multiple regression analysis method. We find that large domestic audit firms don't increase corporations'market value but the reputation of international firms and corporations'market value have a significant positive correlation.Chapter 6, it test the collateral system of audit contracts, including auditors initial discount investments and the corporate premium motivation to auditors. The empirical testing of this chapter includes two elements, whether corporations pay premium costs to high reputation auditors and whether auditors have a discount investment in initial period. Though from Chapter 6 we don't get evidence that large domestic audit firms don't increase corporations'market value, the empirical results from this chapter show that most corporations pay premium to international firms and large domestic firms . At the same time we found that the international firms already establishing a reputation get less discount, but for large domestic and local firms which haven't established reputation, the competition is more severe and discount is the main mean of competition.Part V, Chapter 7, the main conclusions and policy recommendations. This chapter is a conclusion of series of empirical analysis .It brings forward that the three kinds of self-enforcing mechanisms theory of audit contracts in China's current capital market play an incentive and restrictive role for international audit firms and they are the guarantees of their high-quality audit services. But for local firms, regardless of their size, we find it difficult to find the mechanisms have been self-enforced. This conclusion shows that China's capital market system has some serious defects, hardly to give birth to high quality auditors, and the market itself is not perfect enough, the market-oriented reform have yet to be thoroughly and optimization. According to these, this research proposes two reform aspects on the proper relationship management between government and market, laws and market.The major innovations of this research:First, the paper systematically studies the constraints and incentive mechanism of audit industry in China's current capital market in perspective of the self-enforcing mechanism theory of audit contractsThere are several research aspects on audit quality, such as from the perspective of audit requirements, legal risks and imbalances of audit contractss, we analyze the problems of audit market and audit industry, giving different policy suggestions. But according to economic theories, the smooth progress of transaction contracts mainly depends on incentive and restraint mechanisms of market itself. So this study take it as a starting point to explore the incentive and restraint to audit industry by China's capital market and gives objective evaluation and policy recommendation for reformation about the operation of China's capital market.Secondly, this paper constructs a self-enforcing mechanism theory of audit contracts according to the self-enforcing mechanism theory of product market transaction contract. Based on accountability contract, audit contracts are divided into implicit contracts between investors and auditors and explicit contracts between enterprises and auditors. It analyzes the interest characters of each contractor and the obstacles to self-enforcing mechanism of audit contracts. It then gives forward a self-enforcing mechanism system including private punishment mechanism, quality premium incentive mechanism and specific investment collateral mechanism. The three mechanisms complete each other, consisting in logic, and constitute a restraining mechanism on auditors'contracts compliance and violations behaviors, in order to ensure the self-implementation of audit contracts.Thirdly, based on the market-oriented reform background and self-enforcing mechanism theory of audit contracts as the empirical proposition, this paper tests these three mechanisms. In the test of punishment mechanism in capital market, the A class share market data was first used to investigate the self-enforcing mechanism theory, providing new empirical evidence for the studies on the degrading of the auditor'reputation. Our country's auditors were divided into three classes based on their reputation. After an in-depth analysis, it was found that only the auditing firms with international reputation can add value to the enterprise. The investment specialized for auditing industry, the discount investment in initial period, was tested from the perspectives of the change of auditor and different levels. The results indicate that the discount of the international auditing firm was smaller, and the discount of the domestic auditing firm is more significant.