Cash flow manipulation, audit opinion and internal control: evidence from China

This study examines whether there is an association between cash flow management and the likelihood of auditors issuing modified audit opinions, and whether this association is conditional upon the strength of a firm’s internal control. Using a large sample of Chinese listed firms for the years 2007 to 2015, we find that the association between auditors’ modified opinions and cash flow management (CFM hereafter) is conditional on the strength of firms’ internal control. Auditors are more likely to issue modified audit opinions (MAOs hereafter) on cash flow irregularities in clients firms with weak internal controls. The sub-sample analysis provides corroborative evidence that CFM is only positively related to MAOs in firms with weak internal controls. The results also show that in client firms with weak internal controls, top ten auditors identified based on audit revenues are more likely to issue MAOs on clients suspected of CFM when compared to non-top ten auditors. In addition, in firms with weak internal controls, auditors are more likely to issue MAOs for cash flow irregularity in State-owned enterprises (SOEs) than they do in non-SOEs. Our findings lend strong support to the effect of auditor monitoring on CFM in China where government has undertaken significant reforms to improve audit quality.