Does regulator designation of auditors improve independence? The moderating effects of litigation risk

Abstract

Purpose

The practice of management having control over auditor appointment and compensation is believed to be a fundamental cause for the lack of auditor independence. While researchers propose alternative auditor appointment procedures to improve auditor independence, there are a few settings that allow researchers to examine alternative auditor appointment procedures such as regulator designation of auditors. This research aims to investigate the effects of regulator designation of auditors and litigation risk on auditor independence in a Chinese setting

Design/methodology/approach

This study adopts a 2 × 2 between-subjects experimental design. A total of 110 surveys were sent out and 81 were collected from eastern China.

Findings

The results of an experiment with 81 Chinese auditors indicate that regulator designation of auditors improves auditor independence. In particular, auditors designated by the regulator feel less pressure from the audited company, perceive themselves to be more independent and are more willing to challenge the audited company’s aggressive financial reporting compared with those directly hired by the company. In addition, litigation risk moderates the effect of regulator designation of auditors on auditor independence such that regulator designation of auditors has a stronger impact on auditor independence when the litigation risk is low.

Research limitations/implications

This study is also subject to limitations. First, regulator designation of auditors in China was examined. While regulator designation of auditors seems to improve auditor independence in the Chinese context, it is unclear if the same results will be observed in other economies, as China is a unique setting. For example, the majority of listed companies in China are under the control of government-related agencies. Consequently, the government has significant power in influencing auditor appointment policy. In contrast, the majority of other economies are more market-oriented with less government influence. Future studies in other markets will further enrich the understanding on regulator designation of auditors. Second, only regulator designation of auditors for state-owned enterprises was examined. It is unclear how regulator designation of auditors would affect non-state-owned enterprises. Moreover, future research could investigate the designation of auditors in other forms such as the designation of auditors by investors. Third, auditor appointment procedure may affect perceived risk of loss of client which in turn influences auditor independence. Future research could further investigate the mechanism through which regulator designation of auditors affect auditor independence.

Originality/value

Results of an experiment with 81 Chinese auditors show that regulator designation of auditors can improve auditor independence. In a decision context where auditors must provide judgments relating to a proposed audit adjustment that is quantitatively material and will affect the client’s ability to meet debt covenants, auditors designated by the State-Owned Assets Management Bureaus are more resistant to management pressure and are less willing to accept the management’s aggressive financial reporting practice than those directly hired by the company.

Citation

Tang, F., Ruan, L. and Yang, L. (2017), "Does regulator designation of auditors improve independence? The moderating effects of litigation risk", Managerial Auditing Journal, Vol. 32 No. 1, pp. 2-18. https://doi.org/10.1108/MAJ-03-2016-1334