The unintended consequence of local government debt: Evidence from auditors' risk perception

This paper examines whether the rapid expansion of local government debt (LGD) in China produces unintended consequences by influencing auditors' risk perception. Using a comprehensive dataset of Chinese A-share listed companies, we find a robust positive association between regional local government debt and corporate audit fees, suggesting that auditors perceive heightened risk in high-debt jurisdictions and adjust their pricing accordingly. We identify three channels through which auditors perceive local government debt-related risk: financial constraints, government procurement contracts, and tax avoidance. Moreover, the effect is more pronounced for firms with certain characteristics—specifically, non-state-owned enterprises, high levels of earnings management or leverage manipulation, and those located in regions with weaker business environments, lower fiscal freedom or non-coastal geographic locations. Importantly, we show that the audit fee premium reflects auditors' perceived risk, rather than a substantiated increase in firms' substantive risk. Additionally, we find that higher local government debt is associated with a higher likelihood of auditor changes and higher audit fees after the change. Our findings offer novel insights into the determinants of audit pricing, and contribute to the broader literature on the economic implications of local debt in emerging markets.