Accounting Fraud, Auditing and the Role of Government Sanctions in China

We use the unique economic, legal, and political landscape of China to examine the impact of auditors on the incidence and consequences of accounting fraud. In particular, we examine whether large audit firms reduce the incidence of financial statement fraud in China, an emerging market in which auditors face strong government sanctions but low litigation risk associated with audit failures. We find companies audited by large audit firms are less likely to commit financial statement fraud. This effect is stronger for regulated industries, consistent with heavier government monitoring in such industries. This effect is also stronger for revenue-related frauds, consistent with heavier government sanctions for such frauds. After excluding firms cross-listing in other jurisdictions, our results remain robust. Our results are also robust to considering the severity of fraud, using alternative measures of fraud, accounting for the self-selection of auditors and controlling for other corporate governance mechanisms. Our results highlight the role of government sanctions in assuring audit quality and have important practical implications to help international audit firms – and businesses more generally – successfully compete in China