Can Enforcement Actions on Engagement Auditors Improve Audit Quality?

Abstract

A unique feature of Chinese auditing and one under consideration for adoption in the U.S. is regulatory oversight of individual auditors. This paper analyzes enforcement actions by the China Securities Regulatory Commission (CSRC) against engagement auditors and investigates whether audit quality improves for sanctioned auditors. Our results indicate lower discretionary accruals for client firms following sanctions. Complementing this, and indicative of greater skepticism and independence by sanctioned auditors, we find that the probability of issuing a modified audit opinion increases following sanctions. We conjecture that audit quality increases because sanctions increases the likelihood of job loss and also damages reputations; consistent with this, we find evidence of job loss among some of the sanctioned auditors and of stock market losses for clients audited by sanctioned auditors. These adverse consequences appear to encourage sanctioned auditors to “clean up their act.” Finally, we examine one channel through which sanctions improve audit quality: we find evidence of a longer lag between fiscal year end and the date of the audit report, a metric interpreted in the literature as a measure of auditor effort. Thus, it appears that sanctions, by raising the specter of job and/or reputation loss, compel sanctioned auditors to increase effort in such a way that audit quality rises. Overall, our results indicate that governmental sanctions improve audit quality. This suggests that auditor incentives stemming from oversight mechanisms play a critical role in determining audit quality.