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.