Auditing Related Party Transactions: Evidence from Audit Opinions

Abstract

Two competing views explain the widespread existence of related party transactions (RPTs). Under the efficient contracting perspective, RPTs enable firms to reduce transaction costs and transaction uncertainty and do not necessarily pose additional financial reporting risk. Under the expropriation/earnings management perspective, RPTs allow managers to conveniently expropriate company resources and/or manage earnings, and consequently increase financial reporting and auditing risk. Using data from the Chinese market, we examine how the independent auditor responds to the potentially heightened risk of RPTs. We find that firms engaging in RPTs are more likely to receive a modified audit opinion (MAO), and this probability is higher for RPTs with non-market-based or undisclosed pricing policy, for significant RPTs outside the ordinary course of business, and for abnormal RPTs. We also find that a firm’s equity market value decreases with RPTs, but only when it receives a MAO. Taken together, our results suggest that in a low litigation risk environment, auditors resort to MAO to signal the higher risk associated with RPTs, and that the market responds negatively to RPTs when the auditor issues a MAO.

Keywords: Related party transactions; audit risk; audit opinion

JEL Classification: M49