Legal Liability, Government Intervention, and Auditor Behaviour: Evidence from Structural Reform of Audit Firms in China

Abstract

This paper investigates how legal liability influences audit quality and audit fees, particularly in the presence of government intervention. Since 2010, all Chinese audit firms were required to transform from a structure of limited liability company (LLC) to limited liability partnership (LLP), which removes the cap on the liability exposure of negligent auditors. By adopting this natural experiment, we document the following findings: First, after audit firms reorganize as LLPs, auditors are more likely to (1) issue modified audit opinions and going concern opinions, (2) constrain clients’ earnings management, and (3) charge a premium in audit fees, which suggest that exerting unlimited legal liability on negligent auditors improves both audit quality and audit fees. Secondly, the effect of the LLP adoption is more pronounced when auditors are from local audit firms, and clients are controlled by local governments. Further analyses suggest that the stock prices of clients react positively to the reform event, which indicates that LLP adoption improves the overall value of audits. In summary, our empirical findings are consistent with the argument that legal liability is able to effectively shape auditor behaviour in emerging markets where the other institutional mechanisms are relatively weaker and government intervention is heavy.

Keywords: Audit quality; Audit fees; Chinese audit firm structural reform; LLP adoption

JEL Classification: L22, M42