Labor protection is an important issue in labor economics. Labor protection regulations globally were originally established to protect the interests of workers and to mitigate inefficiencies caused by the inequities of the free market employment relationship. Labor protection regulations have a positive impact on the improvement of employee welfare in the labor market. Although labor protection increases employee welfare, it may also have a negative impact on the capital market. An increase in labor costs caused by labor protection policies may lead to a decrease in overall firm profitability, resulting in a decrease in firms’ capital expenditures and considerably slow sales growth. Labor protection increases firms’ financial risk, leading to increased debt default risk and earnings management.

Research on the capital market consequences of labor protection has focused on corporate risk-taking, mergers and acquisitions, corporate tax avoidance, corporate innovation, cash holdings, and corporate earnings management behavior. In particular, existing research has found that firms respond to cost pressures and profit shocks from labor protection policies through earnings management. However, to the best of my knowledge, few studies address the impact of labor protection on auditor behaviors, such as the role of labor protection policies among the factors influencing audit pricing and audit reporting conservatism. To fill in this gap in the literature, the main motivation of this thesis is to examine whether or not auditors can accurately identify labor protection as a risk factor and reflect it in audit pricing and audit reporting conservatism.

I use a sample of A-share listed companies in China from 2004 to 2012 and the implementation of the Labor Contract Law in 2008 as a shock to construct a difference-in-differences model to empirically test the impact of labor protection on auditor behaviors, including audit pricing and audit reporting conservatism. I find that after implementing the Labor Contract Law, auditors charge higher audit fees and report more conservatively for labor-intensive firms.

I find the financial distress risk and earnings management are two channels. Auditors charge higher audit fees and report more conservatively for labor-intensive firms because increased labor protection increases financial distress risk and earnings management of these firms. In addition, the effect of labor protection on audit fees is markedly significant for non-state-owned firms, firms in regions with poor legal environment, and firms audited by non-Big 4.

This study has important theoretical and practical implications. Theoretically, this study expands the research on accounting and the labor market and enriches the literature on the impact of labor protection and auditor behaviors. First, this study adds to the growing literature that examines the economic consequences of labor protection, such as capital structure, corporate financing decisions, corporate governance, mergers and acquisitions, and technological innovation.

Second, this study extends the research on the factors influencing auditor behaviors. Previous studies on factors affecting audit fees and audit reporting conservatism have not considered labor protection policies among the risk factors. This research finds that auditors can identify financial distress risk and earnings management motives arising from labor protection. Accordingly, the increase in financial distress risk and earnings management increase audit fees and audit reporting conservatism, confirming the effectiveness of auditing as an independent economic monitoring activity.

This study also has practical implications for regulators for enhancing capital market supervision, with a particular focus on monitoring accounting information quality in the year when new labor protection rules and regulations are implemented and in subsequent years as well (e.g., Labor Contract Law in 2008, Minimum Wage Regulation in 2004, or each year when the minimum wage is raised), to minimize corporate earnings manipulation.

Second, the findings of this study also remind the authorities that labor protection regulations should be taken cautiously in terms of their adverse effects on the capital market while increasing employee benefits. Labor protection regulations should be formulated and implemented gradually, so they may not cause a sudden increase in labor costs that lead to excessive profit shocks to enterprises. Compensation measures can be simultaneously considered for firms and implemented together with labor protection regulations in the year when they formulate labor protection policies. This strategy may be able to alleviate the negative impact of labor protection on firms. This study provides a decision-making reference for the implementation of labor protection regulations in China, which is consistent with building a moderately prosperous society in all aspects.

Third, this study reminds auditors to include the enactment and implementation of labor protection policies and regulations as an influencing factor of audit risk. In the year when labor protection policies are implemented and in subsequent years, particular attention must be given to whether or not auditors’ clients have engaged in earnings management to cope with sudden cost increases and profit shocks, to maintain professional skepticism, and to play the effective role of auditing as an independent economic monitoring mechanism.

Lastly, the current development of Environmental, Social and Governance (ESG) reporting emphasizes the workplace environment and labor protection. The objective of China’s LC Law is in line with the current development of ESG reporting. As fair labor practices and protection are a crucial social aspect of the ESG framework, the findings of this study have implications for regulators and other stakeholders to devise new labor protection regulations and the effect on financial reporting to foster long-term sustainability and growth.