Guanxi and Auditing

Auditors play an important role as gatekeepers who ensure the quality of financial reports, which represent a key information source on which many economic decisions are based. Because of the interactive nature of the audit negotiation and verification process, social ties with client executives or audit committee members are likely to influence the decisions of auditors.

In theory, social connections between auditors and clients could affect audit quality in one of two very different ways. In one direction, such connections stimulate information flow, which leads to higher quality audits. In the other direction, however, they discourage auditors from exercising due care and even cause auditors to inject unconscious bias in their work, thus impairing audit quality.

“Our findings suggest that trust derived from social ties facilitates collusion between auditors and audit firm executives, which eventually impairs audit independence and audit quality.”

Prof. Wu Donghui

Which direction is more aligned with reality in China, which is characterised by weak law enforcement and a guanxi-based economic environment? We tried to find the answer in two papers, Do social ties between external auditors and audit committee members affect audit quality? and Do school ties between auditors and client executives influence audit outcomes?

As school ties play a considerable role in the economic environment in China, we first identified the educational links between auditors and audit firm executives and examined how such connections influence audit process and quality. We then extend our enquiry to social ties between auditors and audit committee members.

Overall, the two studies consistently show that the negative implications of guanxi between auditors and executives or audit committee members outweigh their benefits. Specifically, auditors’ social ties with the client management or audit committee significantly reduce the likelihood that the auditors issue modified audit opinions (MAOs), a practice that implies an auditor is able to discover and report accounting irregularities. Even if connected auditors do issue MAOs, the modifications tend to be less severe. In addition, when education links exist between auditors and audit firm executives, the chances of favourable audit opinions are higher, even in cases of financially distressed firms.

Our studies also indicate that companies audited by connected auditors tend to inflate earnings in their financial report. As a result, companies audited by such auditors are more likely to restate earnings downward in the future, compared with firms audited by non-connected auditors. Despite the lower audit quality, connected auditors can earn higher audit fees, likely reflecting the favour returned by the connected executives or audit committee members.

Another finding is that the negative impact of guanxi is more pronounced under several circumstances: first, where there are salient social ties in a firm, such as a connected audit committee member chairing the committee, having an accounting background, or sharing local ties with an engagement auditor; second, where firm governance is poor; third, where there are severe agency conflicts. On the bright side, the impact of school ties on audit quality can be mitigated by two factors, namely audit firm size and geographic distance between auditors and client companies. These presumably have something to do with the higher reputational costs and better auditing technologies of big firms, and the weaker auditor-executive bonding when a non-local audit firm is hired.

Our findings suggest that trust derived from social ties facilitates collusion between auditors and audit firm executives, which eventually impairs audit independence and audit quality. Investors and regulators, therefore, should be aware of the potential threat to auditor independence arising from social ties. Company shareholders and boards of directors should be mindful of the potential adverse effect of hiring connected external auditors. As for financial report users such as investors, they would be in a better position to assess audit and financial reporting quality if the interpersonal links between the engagement auditor and corporate executives or audit committee members can be known.

To find out more about a specific topic, click on the links below to navigate to the relevant chapter:

INTRODUCTION – Where Guanxi Matters: The Modern Chinese Financial Sector

PART I – The Influence of Guanxi on the Fund Manager-Analyst Relationship

PART II – Does Guanxi Affect the IPO Process in China?

PART III – Guanxi and Auditing

PART IV – Can Guanxi Help Analysts to Uncover Bad News?

CONCLUSION – How to Counter Negative Effects of Guanxi Ties in Financial Sector?

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