An interesting academic paper was recently published concerning auditor independence in China. Among other things, the paper reported an experiment as to the effect of guanxi on auditor independence. They study found that auditors with a close bond (guanxi) with managers were less likely to recommend adjustments to stop earnings management.
Guanxi refers to the network(s) of existing informal relationships and favor exchanges that dominate all business and social activity in China. While the social capital created from reciprocal relationships is common in all societies, the Chinese really take it to an art form, and many Chinese seem to spend their entire lives building a guanxi network that they can call on when they need to get something done.
Auditors are not immune to the pressures of culture. The authors observe that “Chinese auditors are entrenched in the guanxi culture and psychologically bonded to their clients. This psychological tie created by guanxi leads auditors to trust their clients and act as advocates for the client.” That is not the way auditors are supposed to behave. Auditors are supposed to be independent of management. The presence of guanxi undermines independence and destroys the credibility of audits. The authors say “the strong psychological bond makes it difficult for Chinese auditors to distance themselves from managers and maintain independence in mind during the audit work."
The authors argue that “many problems relating to Chinese auditing practice can be attributed to the guanxi network where auditors act as an advocate for the manager and even collaborate with the manager in illegal or unethical acts.” In other words, guanxi can lead to an audit failures and we have certainly seen plenty of them in China.
The Chinese Institute of CPAs is well aware of the practice of guanxi, and its code of ethics, Article 165, specifically forbids auditors from accepting gifts from clients. I don’t know the extent to which that is followed in practice.
Audit committees should take responsibility for evaluating the independence of auditors. Required rotation of audit partners is helpful, but periodic rotation of firms might also be a prudent step. I would also recommend that audit committees ask difficult questions about personal relationships between company managers and the audit team. As an audit committee member, I would be very skeptical when a new CFO wants to onboard a new CPA firm. Often the CFO has a guanxi relationship with the new CPA firm that makes them part of his team. You don’t want the auditor to be on the CFOs team.
Ning Du, Joshua Ronen, and Jianfang Ye (2015). Auditors’ Role in China: The Joint Effects of Guanxi and Regulatory Sanctions on Earnings Management. Journal of Accounting, Auditing & Finance, Vol. 30(4) 461–483.