The effect of enforcement action on audit fees and the audit reporting lag

Abstract

We study the effect of audit market regulation on auditor contracting by examining a sample of enforcement actions on engagement auditors by the China Securities Regulatory Commission (CSRC). We conjecture that sanctions change auditor behaviour through increased effort and diligence. Specifically, we hypothesise that sanctioned auditors would (a) increase audit fees and (b) increase reporting lag. We find results consistent with these hypotheses. We also provide supporting evidence using a battery of output measures of audit quality including abnormal accruals (various kinds), modified audit opinion, F-score, and restatements. Thus, both input-based and output-based indicators show that sanctioned auditors improve audit quality. Additionally, in nuanced tests, we present evidence on other aspects of auditor behaviour: we find that audit firms combine sanctioned auditors with more seasoned co-partners and assign a lighter workload. By far, this is the most direct and compelling evidence that auditors respond to sanctions. Overall, sanctions appear to encourage sanctioned auditors as well as their firms to take a concerted and strategic approach to improve audit quality.