Related Party Transactions and Audit Fees: Evidence from China

Abstract

This paper investigates the effect of related-party transactions (RPTs) on audit fees in China. RPTs may violate the arm’s-length assumption of regular market-based transactions, impairing the representational faithfulness and verifiability of accounting data and, as a consequence, increase clients’ auditor-assessed business risk. The presence and magnitude of such transactions are therefore likely to increase audit fees. On the other hand, audit fees could be lower for firms with RPTs because auditors face less difficulty in verifying them, as opposed to third-party transactions. We first consider the effect of RPTs on audit fees, and document relatively high audit fees associated with RPTs. This lends support to the conjecture that RPTs are seen as increasing audit risk. We then extend this baseline case by considering the effects on audit fees of different classes of RPTs, of the different parties involved in RPTs and, finally, of the interaction between product-market competition and RPTs. We first document a negative (positive) association between RPTs involving sales and purchase of goods and services (RPTs related to intercorporate loans). We also find that audit fees are relatively high for RPTs involving loans and capital transfers when listed parents transact with their subsidiaries. Finally, we find that audit fees are relatively low for RPTs within competitive industries.