Beg your pardon? The effect of communication costs on audit quality

Abstract

We examine how language-induced communication costs affect audit quality by utilising unique data of signing auditors’ native dialects and audit adjustments in China during 2006–2011. The results show that greater language-induced communication costs lead to lower audit quality. We further find that the negative effect of communication costs on audit quality is mitigated by extended audit tenure. Our study introduces linguistics theory into auditing and is the first to investigate the empirical impact of language-related communication costs in the audit context.

Keywords:

• audit adjustments
• audit quality
• communication costs
• dialects

Subject classification code:

• M42

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 People's Daily, ‘There are still 30% of the population in China who do not speak Mandarin.’ September 24, 2014.

2 For more details about the survey, see Section 7.

3 Auditors collect information about clients through audit inquiry, which auditors often use to investigate potential audit issues (Trompeter and Wright 2010). Negotiations with management are pervasive in auditing, especially in the resolution of proposed audit adjustments and disagreements between auditors and clients (Wright and Wright 1997, Trotman et al. 2005).

4 We greatly appreciate a reviewer's insightful comment on this issue. It is costly for audit firms to make such adjustment in the context of the Chinese audit market for two main reasons. First, only around 40 audit firms are qualified to audit listed firms, while there were more than 2,300 listed firms in 2011. That means each audit firm has to meet the demands of many clients and each signing auditor has to deal with several auditing projects. It is difficult to take every client's dialect into account and arrange auditors who are familiar with the client's dialect. Second, there is inadequate cooperation among different audit offices and audit teams in China. Although the Ministry of Finance has stressed the importance of integrating the headquarters and offices of audit firms, it is still difficult for audit firms to allocate resources flexibly among different offices and different audit teams.

5 We do not focus on the dialectal distance between a specific person in the client company (e.g. CEO or CFO) and the auditor due to the fact that communication between auditors and clients takes place throughout the audit engagement: planning/risk assessment, evaluation of internal controls, substantive testing, and reporting, etc. Thus, considering the difficulty of specifying who in the client company is communicating with the auditors, we take the nearest dialectal distance between the client's dialect and the two signing auditors’ dialects as the dialectal distance between the client and auditors. The results indicate that both the engagement and the review partners play an important role in the communication with clients.

6 Altman's Z-score (Z_Score) is a summary measure of bankruptcy risk, which combines accounting measures of working capital, retained earnings, earnings before interest and tax, sales, total liabilities, and total assets, as well as market value of equity (Altman 1983). Following Choi et al. (2004), we take Z_Score as a proxy for clients’ risk and calculate it as follows: Z-score=1.2*(working capital/total assets) + 1.4*(retained earnings/total assets) + 3.3*(earnings before interest and tax/total assets) + 0.6*(market value of equity/total liabilities) + 0.999*(sales/total assets).

7 Following Coles et al. (2006), we take stock return volatility (Return_volatility) as a proxy for clients’ risk and define it as the logarithm of the variance of daily stock returns.

8 Website: https://www.wjx.cn/.

Additional information

Funding

This work was supported by National Natural Science Foundation of China: [Grant Number 71672188, 71902071, 71432008].