Relation between Auditors’ Risk-Preparedness and Audit Adjustments: Evidence from Professional Risk Fund and Professional Indemnity Insurance

Abstract

Using proprietary information about Chinese audit firms’ Professional Risk Fund (PRF) and Professional Indemnity Insurance (PII) and their publicly traded clients’ audit adjustments, we examine whether and how audit firms’ PRF and PII relate to audit adjustments. We find that audit firms’ PRF and PII have opposite effects on the probability of making audit adjustments to clients’ profits and the magnitude of the audit adjustments. In particular, audit firms with larger PRF provisions exhibit a higher probability and magnitude of audit adjustments, whereas audit firms that hold more PII exhibit a lower probability and magnitude of audit adjustments. Our findings are robust to multiple approaches for addressing potential endogeneity, including using a changes model, a fixed-effects model, and a difference-in-differences specification. The results call into question the use of one-size-fits-all regulations regarding specific risk-shielding methods.