Can audit fees inhibit accounting misstatements? Moderating effects of auditor reputation from Chinese experience*

Abstract

We examine the association between audit fees and accounting misstatements and test the moderating effect of auditor reputation on this association in China, where auditors’ legal liability is essentially weak. We find that current-year audit fees are negatively and significantly associated with the likelihood of the current-year financial statement being misstated. This result is consistent with prior work, which has indicated a negative relation between audit fees and future misstatements in a strong litigation environment such as in the United States. Our finding indicates that higher audit fees can reflect audit effort, even in a setting where litigation plays essentially no role. The prior literature suggests that audit firms have reputational incentives; thus, we use auditor irregularities and audit firm rank as proxies for auditor reputation and find that the negative relationship between misstatements and audit fees weakens as auditor reputation decreases.