Auditing Related Party Transactions: Evidence from Audit Fees and Audit Opinions

• In Event: Continental Breakfast and Research & Education Forum
  In Roundtable Session: Table 6: Business Structure and Audit Fees

Abstract

Two competing views explain the widespread existence of related party transactions (RPTs). Under the efficient contracting perspective, RPTs enable firms to cut down transaction costs and reduce transaction uncertainty and do not necessarily pose additional financial reporting risk. Under the expropriation/earnings management perspective, RPTs allow managers to conveniently expropriate company resources and/or manage earnings and poses incremental financial reporting and auditing risk. Using the Chinese market data, we examine how the independent auditor responds to the presumably heightened risk of RPTs. We find that RPTs are not associated with audit fees, but are positively associated with the receipt of modified audit opinions (MAO). The positive association between RPTs and MAO is more pronounced for RPTs with nonmarket-based or undisclosed pricing policy, for significant RPTs outside the ordinary course of business, and for abnormal RPTs. Furthermore, firm valuation decreases in RPTs in the presence of MAO. Taken together, the results support the interpretation that because of the lower auditability of RPTs, auditors resort to MAO as a cost-effective alternative to compensate for the higher risk of RPTs and the value relevance of RPTs depends on audit opinions.

Authors

• Junxiong Fang, Fudan University

• Yinqi Zhang, American University

• Yuping Zhao, University of Houston