Does Controlling Shareholders’ Financial Risk Affect Auditors’ Perceptions of Firms’ Financial Reporting Risk? Evidence from Share Pledging

Abstract

We examine whether controlling shareholders’ financial arrangements and financial risk affect auditors’ assessments and perceptions of firms’ financial reporting risk. Adopting a sample of Chinese firms covering the years 2003 to 2016, we find that audit fees are higher for firms where controlling shareholders have shares pledged as collateral to secure their private debt. This effect is more pronounced with Big Four auditors, newly assigned auditors, and firms with opaque information environment. We also find that firms with share pledges have more: earnings management, related-party guarantees and transactions, and a higher likelihood of irregularity. In addition, we do not find evidence that share pledging impairs auditor independence as proxied by the propensity to render modified audit opinions, which suggests that our results are inconsistent with the collusion hypothesis that auditors charge higher fees to tolerate firms’ aggressive behaviors. Our results are robust to endogenousity and measurement error concerns. Collectively, our results suggest that the uncertainty introduced by controlling shareholders’ pledging increases auditors’ assessments and their perceptions of firms’ financial reporting risk.