Do professional risk funds affect audit quality?

Abstract

In China, audit firms are required to maintain ‘professional risk funds’. These funds can be used only to pay civil compensation caused by deliberate or gross negligence in auditing activities. Using Chinese data from this peculiar regulatory characteristic, we investigate the impact of audit firms’ professional risk funds on audit quality. We find that the higher the audit firms’ professional risk funds, the lower the discretionary accruals. This finding is more pronounced for client firms with higher information asymmetry or weaker corporate governance. Further tests indicate that the higher the professional risk funds, the greater the audit effort invested in the auditing process, while audit fees do not change significantly. Our results suggest that higher professional risk funds ultimately improve audit quality by increasing audit effort.

Keywords:

• professional risk funds
• audit quality
• audit effort
• risk awareness

Disclosure statement

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

Notes

1 In article 3 of the Regulation of Audit Firms’ Professional Risk Funds, purchases of professional liability insurance can be used to offset professional risk funds and the deductible amount equals 15 times the amount insured.

2 Such as warning, confiscation of audit revenue, fines, or market banning.

3 The latest case is that of China's largest domestic audit firm, LiXin, which was sentenced to assume joint liability because of an audit failure in July 2018, the compensation amount being estimated to exceed CNY 100 million, or one tenth of its audit revenue. Other examples are show in Appendix Table A1.

4 The document is titled ‘Several Provisions of the Supreme People's Court on the Trial of Compensation Cases for Civil Tort Involving Accounting Firms Engaging in the Audit Business’.

5 Dechow et al. (1995) propose this modified Jones model.

Additional information

Funding

This work was supported by National Natural Science Foundation of China: [Grant Number 71302037,71602171,71740019,71740023,71932001,72072090]; Natural Science Foundation of Zhejiang Province: [Grant Number LQ16G020002].