Companies in relational economies rely on locally-based social networks for contracting. This suggests that auditors with greater knowledge of their clients’ locally-based social networks are more competent in evaluating whether their clients’ financial statements are fairly presented. However, locality-specific knowledge can only be acquired through the development of personal ties with clients, which threatens auditor independence. Using Chinese data, we find that the clients of engagement auditors with greater locality-specific knowledge are less likely to report financial misstatements or engage in accounting-related fraud. Further, this result is stronger among clients that rely more heavily on social networks for contracting and clients with more external monitoring. We address endogeneity concerns by finding that our results are robust to the inclusion of engagement auditor and client company fixed effects and that audit quality declines following the departure of auditors with more locality-specific knowledge. In addition, auditors with locality-specific knowledge are more likely to issue modified audit opinions to clients that subsequently report financial reporting irregularities. Taken together, our findings are consistent with the improved competency that arises from locality-specific knowledge outweighing the potential costs of impaired auditor independence.
Prof. T.J. Wong
(University of Southern California)