The Effect of Related Party M&A Transactions on Audit Quality and Audit Fees: Evidence from China

Abstract

Over the last decade, the number of mergers and acquisitions (M&As) has increased dramatically. Companies in developing countries, in particular China, play an increasingly important role in this augmentation. M&As are transactions of great significance and have potential direct effects on financial statements. They also lead to a higher level of risk for acquirers, partly due to information asymmetry about targets. However, M&As with related-parties may reduce information asymmetry between acquirers and targets because compared with acquiring an independent target company, acquirers possess more information about the related-party target’s operations, financial conditions, and organization structure. However, related-party M&As (RPM&As) may encounter the usual problems of related-party transactions, such as agency problems and wealth transfer, which pose challenges for auditors.

Prior studies on the role of auditors in M&As mainly focus on their intermediary role in reducing information asymmetry between acquirers and targets. However, nearly no study examines how RPM&As affect audit quality and audit fees, when auditors play a monitoring role in financial statement audits. On the one hand, if RPM&As can reduce information asymmetry, acquirers will have a lower risk of material misstatements compared with acquiring a third-party target. On the other hand, as a type of related-party transaction, RPM&As may provide an opportunity for acquirers to transfer wealth or prop-up earnings. In this case, there will be a higher risk of material misstatements. Therefore, whether RPM&As have a positive or a negative effect on audit quality and audit fees constitutes an empirical question.

This study investigates how RPM&As affect audit quality (measured by restatement and discretionary accruals) and audit fees in financial statement audits of Chinese listed companies. The Chinese capital market setting is chosen because approximately half of the M&A transactions in China are related-party M&As (Li, Yu and Wang, 2005).

Using a sample of Chinese listed companies from 2008 to 2016, evidence suggests that companies with RPM&As have a lower audit quality than firms without M&As and non-RPM&As. This association is more pronounced for firms with concentrated ownership. Specifically, firms dominated by controlling shareholders and with insufficient checks and balances are more likely to have lower audit quality than their counterparts. These results suggest that auditors are not effective monitors when firms do not have high-quality corporate governance mechanisms. For audit fees, results demonstrate that firms with RPM&As have lower audit fees than firms with non- RPM&As, and these results are driven by firms with concentrated ownership. In summary, these findings suggest that firms dominated by controlling shareholders and engaged in RPM&As demand lower audit quality and pay lower audit fees than their counterparts.

The study contributes to both auditing and M&A literature. Although related-party M&A is an important type of M&A transactions in an emerging market, most studies exclude RPM&As from their samples. In addition, auditing studies on M&A transactions focus on the information intermediary role of auditors in reducing information asymmetry between acquirers and targets in M&A transactions. To the best of my knowledge, there is no study examining auditors’ monitoring role in firms engaged in M&A transactions in financial statement audits. Therefore, this study is the first to explore the linkage between RPM&As, audit quality, and audit fees simultaneously.