Auditors’ Organizational Form, Legal Liability, and Reporting Conservatism: Evidence from China* MICHAEL FIRTH, Lingnan University PHYLLIS L. L. MO, City University of Hong Kong RAYMOND M. K. WONG, City University of Hong Kong 1. Introduction Limiting the legal liability of auditors can alleviate their exposure to financial loss. However, theoretical studies suggest that limiting auditor liability can also pose a threat to audit qual- ity (Dye 1993, 1995; Chan and Pae 1998). In contrast, many CPA firms argue that limiting their legal liability will not adversely affect audit quality (London Economics 2006; Napier 1998). Given these contrasting views, the issue of whether limiting the legal liability of audi- tors adversely affects audit quality is an important issue for the accounting profession, the academic community, regulators, and policy makers. Previous research focuses on deriving theoretical models of the association between the limited liability of auditors and audit qual- ity (e.g., Chan and Pae 1998), but the empirical evidence to support these arguments has been restricted to examinations of how different litigation regimes affect auditor behavior (e.g., Choi, Kim, Liu, and Simunic 2008; Francis and Wang 2008). The objective of this paper is to investigate empirically the association between the organizational form of certified public accountant (CPA) firms and an auditor’s reporting conservatism in China. 1 We study the issue in the Chinese setting because of the unique institutional environment there. The disaffiliation exercise for CPA firms that took place in 1998–1999 requires all state-owned CPA firms in China to separate from their govern- ment-affiliated parent organizations and form independent CPA firms (Yi 2003). In the restructuring process, subject to approval by the regulatory authorities, CPA firms could choose to take an unlimited liability partnership form of organization or a limited liability form. As all state-owned CPA firms have changed from being government-supported agents to separate legal entities, their risk exposures substantially increase, and their liabili- ties are no longer covered or protected by the government (Yang, Tang, Kilgore, and Jiang 2001). This change in risk exposure becomes an important concern that has an impact on an auditor’s reporting behavior. Therefore, the reform of the CPA profession in * Accepted by Michael Willenborg. We thank Associate Editor Michael Willenborg and two anonymous ref- erees for their constructive comments. We also thank K. Hung Chan, Charles Chen, Gongmeng Chen, Helen Choi, Joseph Fan, Jere Francis, Jeong-Bon Kim, Kenny Lin, Agnes Lo, Chung-ki Min, Oliver Rui, William Shafer, T. J. Wong, Donghui Wu, Xi Wu, and George Yang for their helpful comments, discus- sions, and suggestions on earlier drafts of the paper. In addition, we acknowledge the constructive feedback received from workshop participants at The Chinese University of Hong Kong, City University of Hong Kong, The Hong Kong Polytechnic University, The University of Hong Kong, the China Research Confer- ence 2006 at The Chinese University of Hong Kong, and the American Accounting Association Auditing Section 2006 Midyear Conference, Los Angeles. Michael Firth acknowledges financial support from a grant from the Government of the HKSAR (GRF 340408). 1. We use the term ‘‘auditor’s reporting conservatism’’ (decision) to reflect the threshold required to give a clean audit opinion. Therefore, an auditor’s reporting conservatism is not the same as a company’s report- ing conservatism (e.g., in the sense of the Basu model and its derivatives). Contemporary Accounting Research Vol. 29 No. 1 (Spring 2012) pp. 57–93 Ó CAAA doi:10.1111/j.1911-3846.2011.01081.x