Public Communication of Audit Risks and Related-Party Transactions: Evidence from China

Abstract

This paper examines whether and how firms’ engagement in related-party transactions (RPTs) is shaped by public communication of audit risks as required by the expanded audit report. Using the phased regulatory changes in China and a difference-in-differences design with firm fixed effects and matching, we find that firms significantly reduce their RPTs after the adoption of expanded audit reports (EARs). To investigate potential mechanisms, we find that (1) investor scrutiny increases after the adoption of EARs, (2) the reduction of RPTs is more pronounced when EARs are more likely to attract investor attention, and (3) the reduction of RPTs is weaker when firms are less concerned about investor scrutiny. The results suggest that EARs can attract investor scrutiny and increase the possible penalty associated with self-dealing, thus motivating firms to reduce RPTs.