1.2 Research Questions and Research Significance

1.2.1 Research Questions

Based on the discussions in Section 1.1, the H-share market acts as an important channel for the mainland Chinese companies to become internationalized, and the number of AH-share cross-listings keeps increasing. In addition, the abolition of the mandatory dual audit system for AH companies does not mean that the dual audit system has disappeared since then. After the deregulation, changes in AH companies' audit systems and in audit quality are of investors' major concern (Sun, 2014) ^[1] . Academics constantly pay attention to this audit system and its change after the deregulation. A comprehensive investigation on the dual audit system can deepen understanding of this audit system's influences on financial reporting quality, audit quality and investor protection. Such an investigation can provide also helpful references for subsequent audit system arrangements. However, existing studies are limited to investigating the audit-related consequences of this deregulation, with little attention paid to other economic consequences, such as those on the Chinese capital market. Moreover, studies focusing on the audit quality-related issues have not deeply explored, through the empirical process, a mechanism whose existence (loss) may be the main driver of the higher (decreased) audit quality when companies keep (cancel) the dual audit system. Given these potential limitations of the previous literature, this study investigates the economic consequences of the deregulation of the mandatory dual audit system on the capital market and audit market. In particular, this study proposes the following main research questions:

First, in terms of the consequences of the deregulation on the capital market, do companies have a lower cost of equity when they mandatorily have the dual audit before the deregulation than when they voluntarily use the dual audit after the deregulation?

As mentioned in Section 1.1.2, existing studies focus mainly on the audit-related consequences of the deregulation of the mandatory dual audit system. However, does this deregulation have effects on the capital market by affecting the cost of equity? In addition, researchers generally compare companies having the dual audit with those not doing so or compare companies in the regulated period with companies in the period after the deregulation. Little research has considered dividing companies having the dual audit into those that are required to use the dual audit before the deregulation and those that choose to use the dual audit after the deregulation. Lacking this consideration, researchers make few comparisons between them or between the latter and companies not having the dual audit in the same period. Do the dual audit in the regulated period and the dual audit after the deregulation have differential impacts on the cost of equity? Rock (2002) ^[217] , Stulz (2009) ^[218] , and Cheng et al.(2013) ^[219] note that a company's compliance with a mandatory requirement with a powerful enforcement system is regarded by investors as a promise that is made on an ex-ante basis and hard to reverse. As a consequence, investors' concerns on management's self-serving behavior that would damage shareholders' interests can be relieved by such a perceived commitment. This commitment device role of complying with mandatory requirements can reduce agency costs, information asymmetry, and thereby the cost of equity (Monahan, 2006; Hail, 2011) ^[220,221] . Based on this argument, compliance with the mandatory dual audit requirement can serve as a mechanism for companies to credibly commit, on an ex-ante basis, to be under the monitoring of two audit firms and disclose two sets of audited financial statements. As a result, companies' compliance with the mandatory dual audit requirement can relieve investors' concerns on management's self-serving behavior. Moreover, it is costly for companies that are required to use the dual audit to breach this requirement, given the powerful enforcement systems, especially those in the Hong Kong market. Contrary to complying with the mandatory dual audit requirement, voluntarily choosing the dual audit after the deregulation is self-serving because this choice allows companies to evaluate the possible consequences before making a dual audit decision. Moreover, for companies choosing to keep the dual audit, whether their use of this audit system will be sustained in the future is questionable because they can freely opt out without any threat of punishment from regulators. Therefore, I expect that the role of complying with the mandatory dual audit requirement in maintaining a lower cost of equity cannot be completely replaced by voluntarily choosing the dual audit. Based on this expectation, this study first investigates the economic consequences of the deregulation on the capital market by analyzing whether the cost of equity for complying with the mandatory dual audit requirement before the deregulation is lower than that for voluntarily choosing the dual audit after the deregulation.

Second, in terms of the consequences of the deregulation on the capital market, do companies that voluntarily choose the dual audit after the deregulation have a lower cost of equity than companies that use only the single audit in the same period?

After investigating the effect of mandatory dual audit relative to voluntary dual audit on the cost of equity, this study then analyzes the effect of voluntary dual audit relative to single audit on the cost of equity. Melumad and Thoman (1990) ^[222] and Lennox and Pittman (2011) ^[223] posit that a company can voluntarily incur audit costs to exploit a signaling mechanism in the absence of mandatory audit requirements. Based on this signaling theory, voluntarily choosing the dual audit, which incurs higher audit and disclosure costs than using only the single audit, can convey incremental information about a company's good properties over and above the audited financial information. Such properties include high quality, low risk and profitable prospects. As a result, voluntarily choosing the dual audit can generate a positive signal to distinguish companies doing so from those using only the single audit. This signal can help companies that voluntarily choose the dual audit win investors' preference and raise external equity capital at lower costs. Accordingly, after the deregulation of the mandatory dual audit system, I expect that voluntarily choosing the dual audit is more effective than using only the single audit in reducing the cost of equity. Based on this expectation, this study then investigates the economic consequences of the deregulation on the capital market by analyzing whether the cost of equity for voluntarily choosing the dual audit after the deregulation is lower than that for using only the single audit in the same period.

Third, in terms of the consequences of the deregulation on the audit market, is the audit quality decline following companies' cancelation of the dual audit mainly driven by the loss of a positive spillover effect from Hong Kong-to mainland-based auditors?

After understanding the consequences of the deregulation on the capital market, this study analyzes the consequences on the audit market by focusing on companies canceling the dual audit and their comparison with those keeping the dual audit after the deregulation. As mentioned in Section 1.1.2, the existing literature concurs that the audit quality of companies not having the dual audit is lower than that of companies having the dual audit. It can be inferred from this consensus that canceling the dual audit possibly causes an audit quality deterioration for companies. Based on Ke et al.(2015) ^[5] , the loss of a positive spillover effect from Hong Kong-to mainland-based auditors through the dual audit process is likely to be a reasonable explanation for this audit quality deterioration. In particular, the institutional environment in Hong Kong is stronger than that in mainland China, resulting in higher independence and audit quality of Hong Kong-based auditors than that of mainland-based auditors. Moreover, the A-share and H-share financial statements of a company should be substantially consistent with each other according to the rules and regulations. With these situations and requirements, an indirect positive spillover effect may exist from the Hong Kong-based auditor to the mainland-based auditor of a company through the dual process. That is, the exemplary audit work, outcomes, and potential monitoring of the Hong Kong-based auditor can positively influence the mainland-based auditor and make it more difficult for the latter to compromise on audit quality. As a result, audit quality is likely to be guaranteed when companies keep the dual audit, whereas canceling the dual audit is likely to forego the positive spillover effect from Hong Kong-based auditors and impair audit quality. The above elaboration about the potential positive spillover effect from Hong Kong-based auditors in the dual audit process is theoretically comprehensible. However, how should this mechanism be measured empirically? Do companies that keep the dual audit have higher audit quality when they are subject to a more positive spillover effect? Does the loss of this positive spillover effect drive the decline in audit quality of companies that cancel the dual audit? Based on these unresolved issues, this study investigates the economic consequences of the deregulation of the mandatory dual audit system on the audit market by constructing a novel measure of the positive spillover effect from Hong Kong-based auditors and deeply exploring the role that the loss of this effect plays in the audit quality deterioration following companies' cancelation of the dual audit.

1.2.2 Research Significance

1.2.2.1 Theoretical Significance

First, this study adds to the literature on the dual audit system by taking into account the economic consequences of the deregulation of the mandatory dual audit system on the Chinese capital market. While previous research focuses on the audit-related consequences of the deregulation of the mandatory dual audit system, this study pays attention to the consequences of this policy change on the capital market and considers the impact of mandatory dual audit and that of voluntary dual audit separately. By investigating their impacts on the cost of equity, this study contributes to developing comprehensive understanding of the economic consequences of the deregulation of the mandatory dual audit system. This study also enriches the perspectives and contents of research on the dual audit system. The results suggest that in addition to the audit-relevant outcomes studied by previous research, the deregulation of the mandatory dual audit system affects investors' perceptions and decisions, and thereby yields significant economic consequences on the Chinese capital market.

Second, this study enriches the literature on the cost of equity by taking the variation in audit systems into consideration as a determinant of the cost of equity in the Chinese setting. While previous studies conclude that financial statements audit contributes to lowering the cost of equity for companies, audit is usually valued for its role in providing independent assurance of financial information reliability (DeFond and Zhang, 2014; Clatworthy and Peel, 2013; Hay and Cordery, 2018) ^[96,224,225] . Limited attention has been paid to whether the variation in audit system affects the cost of equity, regardless of the assurance levels provided by the engaged auditors. With the assurance value of audits effectively controlled in the empirical process, this study compares mandatory dual audit before the deregulation with voluntary dual audit after the deregulation, and it compares the latter with single audit in the same period. By doing so, this study shows the differential effects of mandatory and voluntary dual audits on the cost of equity, thereby broadening the system of determinants of the cost of equity in the Chinese capital market.

Third, this study extends the literature on audit quality by constructing a novel measure to represent a spillover effect from a high-quality auditor (i. e., Hong Kong-based auditor) to a low-quality auditor (i. e., mainland-based auditor) and highlighting the role that this positive spillover plays in audit quality. Previous studies leave a gap between theoretical argument and empirical test in terms of this spillover effect. Although the literature elaborates on this effect, the literature does not present any valid measurement or examination in this regard. To fill this gap, this study takes an initial step toward promoting the empirical work by deriving a measure to capture this spillover effect based on the regulatory rules and Ke et al. 's (2015) ^[5] argument. Then, this study examines the impact of the existence of the positive spillover effect from Hong Kong-based auditors on the audit quality of companies keeping the dual audit, and it examines the impact of the loss of this positive spillover effect on the audit quality decline of companies canceling the dual audit. By doing so, this study sheds light on an important determinant of audit quality in the Chinese setting.

1.2.2.2 Practical Significance

First, this study provides a new reference for policy-makers and regulators to re-access the costs and consequences of the policy change—the deregulation of the mandatory dual audit system. Overall, this study indicates adverse impacts of this policy change, that is, increasing the cost of equity and decreasing audit quality. The former reflects an increase in investors' suspicions after the deregulation of the mandatory dual audit system about companies' self-serving behavior that may harm their interests. The latter confirms practitioners' concern that companies' audit quality would be impaired if they do not engage Hong Kong-based auditors. The findings suggest that the decision to opt out of the dual audit system is unlikely to help a company achieve cost savings without increasing investors' suspicions or sacrificing audit quality. This study, to a certain degree, demonstrates why few AH companies have responded to regulators' call to cancel the dual audit system, and thus, questions the value of this policy change.

Second, this study serves as an important caution that becoming truly big and strong could be a long and arduous task for mainland local audit firms. Since the reform and opening-up, China's economy develops fast, and scales of companies are expanding constantly. Under this background, the call for bigger and stronger local audit firms becomes louder. In recent years, the Chinese government and Chinese Institute of Certified Public Accountants (CICPA) have made much effort, such as encouraging audit firm mergers, to develop large-scale audit firms. By doing so, regulators are in the hope of bringing up local audit firms with brand reputation. Continuous audit firm mergers during these years have increased the market concentration of the Chinese audit market. So far, a few large mainland local audit firms have earned revenue quite close to that of top international audit firms. However, this growth in revenue is only a result of local audit firms becoming bigger. In other words, it is the increase in business brought about by large audit firms merging small audit firms that leads to the growth in revenue. The market performance of these merged large audit firms is not satisfactory. For example, frequent audit failure cases in recent years have labeled local audit firms as "big but not strong" and "low quality" . Consistent with this reality, the findings of this study suggest a significant decline in the A-share audit quality of companies canceling the dual audit system, which is largely driven by the loss of a positive spillover effect from Hong Kong-to mainland-based auditors. Therefore, although regulators have provided considerable policy support for the development of the mainland audit profession, becoming truly high-quality alternatives to top international audit firms could remain a long way to go for mainland local auditors.