The impact of disclosure level and client incentive on auditors’ judgments of related party transactions

• Pages: 717-737
• DOI: https://doi.org/10.1108/IJAIM-02-2020-0016
• Published date: 19 June 2020
• Date: 19 June 2020
• Author: Ling Yang,Lijun Ruan,Fengchun Tang
• Subject Matter: Accounting methods/systems,Accounting & Finance

The impact of disclosure level and

client incentive on auditors’

judgments of related

party transactions

Ling Yang and Lijun Ruan

Department of Accounting, New Jersey City University, Jersey City, New Jersey,

USA, and

Fengchun Tang

Department of Business and Management, Virginia Commonwealth University,

Richmond, Virginia, USA

Abstract

Purpose –The purpose of this study is to presentthe results of an experiment that examines the effects of

client management’s increased disclosure of related party transactions (RPTs) on auditors’judgments of

f‌inancialreports that contain RPTs.

Design/methodology/approach –This study used a 2 2 between-subjects experimentto investigate

auditors’judgmentsin response to questionable RPTs in a Chinese context.

Findings –The results show that the auditor participants assessed a lower likelihood that the client’s

f‌inancial statementswere intentionally misstated and that theywere less likely to request additional evidence

when the client management chose to disclose more, as opposed to less, detailed RPT information in their

disclosure. Moreover, there was a signif‌icant interaction between disclosure level and client incentive to

manipulateearnings on the likelihood of the auditorrequesting additional evidence.

Practical implications –This study should be of interest to regulatory agencies that have expressed

concernsover auditing practices related to RPTs.

Originality/value –The f‌indings from this study help to provide a more in-depth understanding of

disclosure literatureby investigating voluntary RPT disclosure and the moderationrole of clients’incentives

to manipulateearnings.

Keywords Disclosure, China, Experiment, Related party transactions

Paper type Research paper

1. Introduction

Related party transactions (RPTs) have received considerable attention because of their

involvement in a series of high-prof‌ile frauds over the past decade (Gordon et al., 2007). RPTs

are transactions that take place betweena company and its related entities such as subsidiaries,

aff‌iliates or directors. Most RPTs involve normal business practices whose purpose is to reduce

transaction costs or to optimize internal resource allocation within corporate groups (Ge et al.,

2010). However, management can use a RPT as a means for opportunism (Gordon and Henry,

2005). For example, anecdotal evidence suggests that RPTs may be used to manage earnings.

Unlike other types of real-activity manipulations, such as providing deep discounts to boost

sales, accelerating sales through RPTs tends to be less expensive (Jian and Wong, 2010),

making them an ideal target for earnings manipulation.

Related party

transactions

717

Received3 February 2020

Revised5 May 2020

Accepted17 May 2020

InternationalJournal of

Accounting& Information

Management

Vol.28 No. 4, 2020

pp. 717-737

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-02-2020-0016

The current issue and full text archive of this journal is available on Emerald Insight at:

https://www.emerald.com/insight/1834-7649.htm

Many RPTs are inherently complex (Ariffand Hashim, 2014). The complicated nature of

RPTs makes it diff‌icult for auditorsto detect a material misstatement that is associated with

a RPT (Gordon et al., 2004;Habib et al., 2015). In particular, RPTs are not always easily

identif‌iable and auditors who are attempting to identify and evaluate RPTs primarily rely

on the information that the client management provides(AICPA, 2001). Thus, RPTs pose a

particular challenge to the auditing process (Kohlbeck and Mayhew, 2017). In fact, the

presence of RPTs has been cited as one of the top reasons for audit failure (Gordon et al.,

2007), and many Securities and Exchange Commission (SEC) enforcement actions are

related to RPTs (Louwers et al.,2008). Despite concerns about current audit practices

regarding RPTs, few studies have been conducted to understand how auditors deal with

these types of transactions(Gordon et al., 2007;Habib et al.,2015;Fang et al., 2018).

This research attempts to f‌illthis gap by investigating the effect of client management’s

increased disclosure of RPTs on auditors’RPT-related judgments and whether this

relationship is moderatedby clients’incentives to manipulate earnings. RPT disclosure is an

under-explored area in RPT research (Lo and Wong, 2011). In response to heightened

concerns about management’s use of RPTs for opportunism, regulators in many countries

have strengthened regulations by mandating public companies to disclose certain

information abouttheir RPTs (Bennouri et al., 2015).

Furthermore, some companies choose to voluntarily disclose more-detailed RPT

information for various purposes. While previous research suggests that increased

disclosure improves transparency and enhances investor trust in various contexts (Lo and

Wong, 2011), little is known about how auditorsreact to management’s voluntary disclosure

of additional RPT information (Fang et al., 2018). Unlike investors, auditors have better

access to companies’private information and are expected to be more vigilant in detecting

fraudulent f‌inancial reporting(Habib et al., 2015). Therefore, auditors should independently

form their judgments solely based on their own evaluation of the RPTs that their clients

report. In such cases, management’s voluntary disclosure of additional RPT information

should have no impact on auditors’judgments of these transactions. However, anecdotal

evidence suggests that auditors may lack awareness of the material risks associated with

RPTs and consequently may over-relyon the information that client management provides.

This increased RPT disclosure may function as a signal that speaks to auditor about the

client management’s supposed credibility, thus causing the auditor to lose their vigilance

and become less professionally skeptical. In either case, understanding how auditors make

judgments with regard to RPTs will help inform practitioners, regulators and standard-

setters of the underlyingfactors that affect an auditor’s evaluation of RPTs.

In this study, we conducted an experimentin which we manipulated the level of detail in

the RPT information disclosed by client management (disclosure level) and the client’s

incentives to manipulate earnings at twolevels (low versus high incentives). Auditors who

work for public f‌irms in China were chosen as participants. Because of the country’sweak

legal and market institutions, RPTs are extensively used in China to either expropriate

wealth from minority shareholders or to manipulate earnings for f‌inancial-reporting or tax

purposes (Lo and Wong, 2011)[1]. Moreover, similar to the Public Company Accounting

Oversight Board’s (PCAOB) AuditingStandard No. 18, Chinese Auditing Standards require

that auditors assess clients’misstatements related to their RPTs and provide assurance of

the proper disclosureof these RPTs (Habib et al., 2015;Fang et al.,2018).

RPTs pose signif‌icant challenges to Chinese auditors because of the unique political

relationships between state-owned enterprises (SOE), parent companies and publicly listed

f‌irms. Thus, China presents an ideal natural setting for investigating the effectiveness of

RPT auditing standards in a climate where there are ample incentives for companies to

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