Auditing Related Party Transactions: Evidence from Audit Opinions

52 Pages Posted: 4 Jan 2014

See all articles by Junxiong Fang

Junxiong Fang

Fudan University - School of Management

Gerald J. Lobo

University of Houston - C.T. Bauer College of Business

Yinqi Zhang

American University

Yuping Zhao

University of Houston

Date Written: December 3, 2013

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

Suggested Citation

Fang, Junxiong and Lobo, Gerald J. and Zhang, Yinqi and Zhao, Yuping, Auditing Related Party Transactions: Evidence from Audit Opinions (December 3, 2013). Available at SSRN: https://ssrn.com/abstract=2374598

Junxiong Fang

Fudan University - School of Management ( email )

No. 670, Guoshun Road
No.670 Guoshun Road
Shanghai, 200433
China

Gerald J. Lobo

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States
713-743-4838 (Phone)
713-743-4828 (Fax)

HOME PAGE: http://www.bauer.uh.edu/acct/acctprofile.asp?search=Gerald%20Lobo

Yinqi Zhang

American University ( email )

4400 Massachusetts Ave NW
Washington, DC 20016
United States

Yuping Zhao (Contact Author)

University of Houston ( email )

334 Melcher Hall
Houston, TX 77204
United States
713-743-2166 (Phone)
713-743-4828 (Fax)

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