Financial Misrepresentation,Auditor Behavior And Regulatory Punishment

Independent auditing has always been highly valued for its governance role of protecting the quality of corporate financial information.However,financial statement fraud has never stopped since the establishment of China's stock market,making investors more and more questionable about the governance role of independent auditing for financial information quality.On the one hand,the relationship between auditors and clients is essentially an employment relationship that will result in auditors' economic dependence on clients,which makes it difficult for auditors to remain completely independent,thereby providing low quality audit service.On the other hand,the accountability mechanism for auditors who experience the audit failure mainly depends on the administrative punishment with weak deterrence,leading to auditor's fearless attitude.As a result,auditors may not be diligent in performing the audit business,or even collude with clients,resulting in misstatement of financial statement information.Whether the auditors do not keep the professional prudence as the investors have suspected,so that they can not identify or reveal the financial statement misrepresentation of the listed companies? Or in other words,can auditors identify or reveal the financial statement misrepresentation when the listed companies implement the fraud,that is when corparate fraud has not been exposed by the outside(media and regularory authority,etc.),and pass it to the external information users through specific auditor behavior? This paper discusses the above issues by analyzing auditor behavior(audit opinion,auditor switch,and audit fees)during the occurrence of financial misrepresentation.Using 146 penalty cases(involving 307 fraud-year samples)of non-financial listed companies for financial statement misrepresentation between 2001 and 2017 carried out by the China Securities Regulatory Commission(CSRC),the Shanghai Stock Exchange,the Shenzhen Stock Exchange and the Ministry of Finance,we find that,firstly,compared with the control samples(pre-fraud-period samples and paired non-financial fraud samples),auditors are more likely to issue modified audit opinions(MAOs)during the occurrence of financial statement misrepresentation.In particular,compared to the pre-fraud-period samples and paired non-financial fraud samples,the probability of auditors issuing MAOs during fraud increases by 5.23-7.25% and 5.54-6.65%,respectively.Further,57.38% MAOs are unqualified opinions with paragraphs,and86.89% MAOs fail to effectively reveal companies' financial statement misrepresentation.Secondly,the rate of auditor switch during fraud is no higher than that of control samples,and the accounting firms do not assign more experienced CPAs in the absence of auditor switch.Finally,auditors do not charge higher audit fees during fraud compared to the control samples.These findings indicate that auditors are able to identify the listed companies' financial statement misrepresentation for issuing more MAOs to financial fraud firms,but suggest that auditors are unable to effectively reveal companies' financial statement misrepresentation for pressure from clients may cause auditors to modify audit opinions and disclose unrelated or minor financial fraud matter in the audit reports.In addition,from the foregoing results it can also be concluded that auditors tend to retain clients in the face of financial fraud,and except for issuing more MAOs,auditors do not increase audit effort or audit fees to reduce risk induced by financial fraud.Overall,these results suggest that auditors do not issue high-quality audit reports for clients who are implementing financial fraud.Moreover,auditors do not take other risk management strategies such as resignation,increasing audit effort and audit fees.This shows that in Chinese audit markets,independent auditing has limited governance role for corporate financial information,and auditors' risk awareness is weak.The reasons behind this may be due to the imperfect law environment and auditors' lack of independence.Based on the perspective of accounting firms and CPAs,combined with the CSRC punishment for auditors,this paper also examines whether the different behaviors of auditors involved in misrepresentation cases during the period of misrepresentation and before the regulatory punishment will result in different regulatory punishment,including lower(higher)punishment probability or lower(higher)punishment level.For the accounting firms,using 126 penalty cases(involving 307 fraud-year samples)of listed companies for financial statement fraud carried out by CSRC and 54 penalty cases of accounting firms that were punished by CSRC for listed companies' financial fraud,this paper investigates the impact of audit opinions and early departure on the regulatory punishment of accounting firms.Firstly,we find that MAOs can protect accounting firms from regulatory punishment or mitigate the extent of punishment,as evidenced by the fact that if accounting firms issue MAOs during fraud,the probability and extent of punishment in the future will drop by 15.31% and 42.25%respectively compared to the accounting firms that issue clean opinions.However,the protection role of MAOs only reflects in qualified opinion and disclaimer of opinion.Secondly,accounting firms that leave its clients before punishment have a 20.95%lower probability of being punished in the future compared to the accounting firms that do not leave the clients before punishment,but the extent of punishment will not be reduced.Further,resignation of accounting firms during the occurrence of financial fraud can reduce the likelihood and extent of punishment by 29.11% and 59.75%,respectively.These findings indicate that MAOs and early departure can protect accounting firms from regulatory punishment or mitigate the extent of regulatory punishment.For the individual auditors,using 580 fraud-year-CPA samples and 109 CPAs' penalty samples,this paper examines the impact of audit opinions and early departure on the regulatory punishment of CPAs.Firstly,we find that MAOs can protect CPAs from regulatory punishment or mitigate the extent of punishment,as evidenced by the fact that if CPAs issue MAOs during fraud,compared to the CPAs who issue clean opinions,the probability and extent of punishment in the future for CPAs will drop by15.27-16.09% and 20.63-26.29%,respectively.However,compared with the unqualified opinions with paragraphs,qualified opinions and disclaimer of opinions play a more protective role for CPAs.Secondly,early departures of CPAs will not reduce their possibility and extent of punishment.On the contray,if CPAs resign after the end of financial fraud and before the punishment,the possibility and extent of their being punished will be higher with the consideration of auditors' personal characteristics.These findings indicate that MAOs can protect CPAs from regulatory punishment and mitigate the extent of regulatory punishment,but early departure does not have the role of protection.This study makes three contributions to the literature.Firstly,each misrepresentation case can be roughly divided into the period of occurrence for misrepresentation and the period of regulatory for misrepresentation(Karpoff et al,2008;Karpoff et al,2017),but extant literature mainly analyses the auditor behavior during the period of regulatory for misrepresentation,that is,the changes of auditor behavior after the reveal of financial fraud,lacking analysis of auditor behavior during the occurrence of financial fraud.This paper fills this gap by analyzing auditor behavior during the occurrence of misrepresentation.Secondly,different from previous literature mainly uses indirect indicator such as earnings management to measure financial statement misrepresentation to examine whether auditors can identify corporates' financial statement fraud,this paper directly measures financial statement misrepresentation through the actual occurance year of financial fraud disclosed by the CSRC,the Stock Exchanges and the Ministry of Finance,which partly alleviates the measurement error.Thirdly,the exsiting literature about the influencing factors of auditors' regulatory punishment is limited and mainly focuses on the accounting firms,lacking literature about the influencing factors of CPAs' regulatory punishment.To this end,by incorporating accounting firms and CPAs into the analytical framework and analyzing the auditors' regulatory punishment from multiple dimensions,such as audit opinion,audit resignation,this paper enriches the research of the influencing factors of auditors' regulatory punishment.