Related Party Transactions: Effects of the 2014 PCAOB Auditing Standard No. 18. Abstract

Related Party Transactions: Effects of the 2014 PCAOB Auditing Standard No. 18 Abstract In 2014, the PCAOB adopted the Auditing Standards No. 18 (AS18) to improve auditors performance in auditing related party transactions (RPTs). Following the call from the PCAOB, the paper empirically exploits the economic consequences of the AS18, by using hand-collected RPT data of Russell 3000 companies from 2011 to 2016. Our results show that the AS18 is effective in deterring companies opportunistic RPT transactions and improving their RPT control policies, supporting the Board s position that RPTs may represent an audit risk that warrants enhanced auditing procedures. Consistent with Board s anticipation, we show that companies audited by non-big4 firms are affected by AS18 to a greater extent than those audited by Big4 firms. We also document an increase in operating efficiency and Tobin s Q in non-big4 companies, suggesting that the AS18 regulation brings in relatively larger benefits to investors in non-big4 companies than Big4 companies. Overall the findings in our study are more consistent with the conflict of interest theory than the efficient contracting theory related to RPT. The results are robust using different measures of RPTs or using non-pcaob companies as a control group. Our research is the first to document the impacts of external RPT auditing regulation on firms internal RPT practices. It extends the limited existing research on the relationship between RPTs and auditing, provides timely feedback on the effectiveness of the new PCAOB standard, and help both regulators and practitioners to better understand the costs and benefits of the Board s regulation. Keywords: Related Party Transactions, RPTs, Auditing Standards, Auditing Standard No. 18, Big4 Firms, Non-Big4 Firms 1

Related Party Transactions: Effects of the 2014 PCAOB Auditing Standard No. 18 1. Introduction Historically, RPTs have been contributing factors in numerous financial reporting frauds. Enron, Tyco International, and WorldCom are all notorious cases involving related party transactions (RPTs). Surveys based on the SEC fraudulent cases and PCAOB inspections also reveal RPTs as a key indicator of auditing deficiency. 1 Despite prominent corporate scandals, existing auditing requirements on RPTs had remained largely unchanged for over 30 years until 2014. On June 10, 2014, the PCAOB issued Auditing Standard No. 18 (AS18), Related Parties, superseding the AU Section 334 (AU334), Related Parties. The adoption of AS18 represents two major changes on the Board s positions to RPT auditing. First, it represents a paradigm shift from viewing RPT as an item in ordinary transactions, unless there is evidence to the contrary (AU334) to viewing RPT as a potential risk item that may involve increased risks of material misstatement in company financial statements and hence request conduction of enhanced audit procedures (PCAOB 2014). Second, the AS18 represents a switch from a principle-based approach, which mainly employs guidance and examples, to a rulebased approach, which requires specific auditing procedures, to address the Board s concern that the previous principle-based approach resulted in inadequate and inconsistent applications of the auditing standards (PCAOB 2014, p.178). The Board expects that the changes in the AS18 would 1 See Beasley, Carcello and Hermanson 2001, Top 10 Audit Deficiencies: Lessons from Fraud-Related SEC Cases, Journal of Accountancy. Also see PCAOB (2013), Report On 2007-2010 Inspections of Domestic Firms That Audit 100 or Fewer Public Companies, PCAOB Release No. 2013-001, February 25, 2013, accessible at https://pcaobus.org//inspections/documents/02252013_release_2013_001.pdf 2

deter companies opportunistic behaviors on RPT and hence benefit investors. While the PCAOB was particularly interested in obtaining empirical data regarding the effects of the AS18 (PCAOB, 2014), after three years of adoption, there is virtually no research providing quantitative analysis of the impacts of this new standard. In this paper, we take the first attempt to empirically assess the effects of the AS18 on companies RPT practices, by examining the following two research questions: (1) Does the AS18 have any effects on companies RPT practices? (2) Do the AS18 effects differ in companies audited by Big4 firms and those audited by non-big4 firms? Specifically, in the first research question, given that the PCAOB mandated specific steps for auditors to enhance RPT auditing, we are interested in assessing whether such enhanced external monitoring deters companies RPT activities and improve companies RPT control procedures. In the 2 nd research questions, we further assess whether the AS18 has different impacts on companies audited by Big4 and Non-Big4 firms, given that the PCAOB noted critical differences between the two groups (PCAOB, 2014). 2 Echoing the Board s observations, both theoretical literature (DeAngelo, 1981; Dopuch and Simunic, 1980) and empirical literature (Khurana and Raman, 2004, Behn et al., 2008) provide support that audit quality of Big4 firms is superior to that of non-big4 firms. Hence, we anticipate that different ex ante audit quality of Big4 and non-big4 firms may result in different impacts of the AS18 on ex post auditor and corporate actions. We use a group of Russell 3000 composite companies (excluding financial and utility 2 In its 2014 release document of the AS 18, the PCAOB made the following statement: (T)he Board has observed that the facts underlying a significant percentage of the Board's settled disciplinary actions to date have involved auditors' failures to perform sufficient procedures regarding related party transactions. Many of these cases involve smaller audit companies. Likewise, the Board's inspection program has identified a range of deficiencies in auditing related party transactions, particularly with respect to audits of smaller public companies that were conducted by smaller domestic audit companies. (PCAOB 2014, p.10) 3

companies) as our sample and divide the sample into three sub-groups: non-big4 Small, Big4 Small, and Big4 Large companies. Non-Big4 Small represents small and medium-size companies that are audited by non-big4 firms, while Big4 Small represents companies that are audited by Big4 firms and that are matched with non-big4 Small companies by industry, size, profitability. 3 Big4 Large companies are the Standard & Poor 500 companies contained in Russell 3000 Index - these companies are all audited by Big4 firms. We manually collect RPT data from these companies annual proxy statements during fiscal years of 2011 to 2016. This time period allows us to assess changes three years before and after the adoption of the AS18. The financial and market performance data and auditors information are collected from the Wharton Research Data Services (WRDS). The governance data are obtained from Bloomberg. The results show some interesting findings. The PCAOB expects the AS18 to strengthen the auditing of RPTs. If the standard is effective, the enhanced external monitoring through auditing may constrain companies opportunistic RPTs and improve their RPT control procedures. Consistent with the PCAOB s anticipation, we observe companies disclose approximately 17% fewer RPTs following the adoption of the AS18, along with changes in RPT control procedures. Such reduction of RPTs, however, is only concentrated on Big4 Small and Non-Big4 Small companies, rather than Big4 Large companies, and is more salient for the Non-Big4 Small companies, suggesting that companies have poorer ex ante monitoring are affected to a greater extent by the AS18 adoption. To sort out if the reduction of RPTs involves benign or opportunistic RPTs, following Kohlbeck and Mayhew (2017), we divide companies RPTs into business RPTs (RPT_BUS) and 3 For the convenience of writing, throughout the text we refer to small and medium size companies as small companies. 4

tone RPTs (RPT_Tone). 4 We find a reduction of tone RPTs for all three sub-groups. The reduction of tone RPTs is most significant for Non-Big4 Small, followed by Big4 Small and then by Big4 Large companies. These findings support the argument that AS18 significantly reduce the opportunistic RPTs and the reduction is most announced for smaller companies audited by non- Big4 firms. For Non-Big4 Small and Big4 Small companies, we find that business RPTs are significantly reduced as well. This may represent an unintended consequence of the PCAOB regulation for smaller companies. The AS18 is expected to deter companies use of opportunistic RPTs; however, due to the increased workload for the firm to deal with auditors inquiries on RPTs, managers may choose to reduce the use of business RPTs as well. Such unintended consequence appears to affect smaller companies only, probably because Big4 Large companies already have related mechanism in place to account for auditor inquiries, and hence result in no substantial increase in workload. To further assess if the reduction of RPT benefits the companies investors, we conduct two additional tests by investing if companies operating efficiency and Tobin s Q have improved following the RPT reduction. We find a significant improvement of the operating efficiency and Tobin s Q only for Non-Big4 Small companies, again supporting the observation that investors from smaller companies audited by non-big4 firms benefit most from the Board s new regulation. In the additional analysis, we also use RPT amount ($RPT) and RPT dummy (D_RPT) to proxy for companies RPT activities, and the results are qualitatively the same. We also use a group of Canadian companies to proxy for non-pcoab companies and do not find a significant reduction of RPTs in this control group, suggesting that the reduction of RPT is a result of PCAOB 4 Kohlbeck and Mayhew (2017) find tone RPTs, rather than business RPTs, are related to material misstatements, suggesting that tone RPTs are opportunistic in nature. 5

regulation. With respect to the effect of AS18 on RPT control procedures, we find companies are more likely to adopt a formal written RPT policy and assign the Audit Committee as the authoritative body to review and approve RPTs, in response to the AS18 s mandatory requirements for auditors to communicate with companies audit committee and conduct enhanced auditing procedures on companies RPTs. Among the three sub-groups, the AS18 effect on written policy adoption is observed for Non-Big4 Small companies and Big4 Small companies, while the AS18 effect on Audit Committee designation is only observed for Non-Big4 Small companies, 5 consistent with the PCAOB s observations that smaller companies and companies using non-big4 auditors suffer more ex ante auditing and corporate deficiencies in monitoring RPTs and hence are affected more by the AS18. 6 This study contributes to accounting communities in several ways. From a practical perspective, it is a timely study to assess the AS18 s impact on companies RPT practices. Our study provides empirical evidence on whether and what changes were taking place following the AS18 adoption, which may help accounting practitioners and capital market investors gain better insight into RPT-related issues. In particular, we provide evidence of the role of regulation and auditors in shaping companies real world RPT activities and their RPT control procedures. To our knowledge, this is the first study to document such association. Our study also helps real world practitioners and investors to understand if the mandatory regulation helps deter management s opportunistic behaviors, and if the effect differs in companies audited by Big4 and non-big4 firms. From a policy-making perspective, the PCAOB s authority over the accounting profession 5 Big4 Small companies also marginally increase their delegation of audit committee as P=0.103 6 PCAOB (2014): the Board's inspection program has identified a range of deficiencies in auditing related party transactions, particularly with respect to audits of smaller public companies that were conducted by smaller domestic audit firms.25 (p.10) 6

has far-reaching implications for business communities and could be a double-edged sword. On the one hand, it may help improve firm reporting quality and auditing practices; on the other hand, it could add undue burdens to accounting practitioners without well-justified benefits. A better understanding of the costs and benefits of a PCAOB auditing standard not only helps the PCAOB to assess the effectiveness of the new standard, but also helps policymakers to consider whether a similar standard should be adopted in other countries. Our findings show the PCAOB s regulation on RPT auditing does have real world effects, as reflected by the significant reduction of RPTs for smaller companies in our sample. The reduction of tone RPTs for all three sub-groups, along with the finding of improved operating efficiency and Tobin Q for Non-Big4 Small companies, indicates the effectives of AS18 is deterring RPTs that may be detrimental to investors. The findings consistently show that the AS18 has more pronounced impacts on companies audited by non-big4 firms than those audited by Big4 firms, suggesting these non-big4 companies suffer more ex-ante RPT deficiencies and their investors may benefit most from the AS18 adoption, among the three sub-groups. The AS18 has less impacts on Big4 Large companies, suggesting that large firms are usually better governed than smaller firms. The reduction of tone RPTs for Big4 Large companies reveals that the AS18 s ability to deter opportunistic RPTs is not limited to smaller companies. The significantly different impacts we observe in this study between companies audited by Big4 and non-big4 firms suggest that future auditing standard setting should put more weight in considering possible different implications for small vs. big audit firms and their respective clients. Within the companies audited by Big4 firms, our findings also show that the reduction of total RPTs and business RPTs and the adoption of written RPT policies post AS18 only concentrate on Big4 Small companies but not on Big4 Large companies. These findings 7

suggest that future Board regulations should not only put into consideration the disproportionate impacts on companies audited by Big4 vs. non-big4 firms, but also the disproportionate impacts on small and large companies that are both audited by Big4 firms. From an academic perspective, it contributes to research on RPTs by studying the relationship between auditing and companies RPT practices. Although RPTs have been potentially considered as red flags by the PCAOB, they have not yet received ample attention from academia. Studies on RPTs, especially studies on the relationship between RPTs and auditing, are limited (see more discussion in Section 2). The findings of our study add insight to existing limited studies on companies RPT behaviors by showing the inter-relationship between external RPT auditing and internal RPT activities and control procedures, as well as the differences of RPT behaviors between companies audited by Big4 and non-big4 firms. Moreover, one difficulty in conducting RPT research is the substantial time spent on manually collecting RPT data, which normally result in a small set of sample companies. Our study involves three sub-groups, six years (2011-2016), and 588 companies, consisting of a relatively large sample in RPT studies. Another difficulty in conducting RPT research is the differentiation between benign and opportunistic RPTs. Ryngaert and Thomas (2012) and Kohlbeck and Mayhew (2017) have conducted some pioneer work in this field. Although RPTs have been deemed as a potential risk factor, not all RPTs are bad RPTs, and how to differentiate RPTs during the normal course of business from RPTs involving firm managers opportunistic behaviors is a big challenge. Our study provided evidence supporting Kohlbeck and Mayhew (2017) findings by showing a significant reduction of tone RPTs in all three groups. Besides, our study also extends these studies by using the number of RPTs, the amount of RPTs, and the dummy RPT as testing variables. Finally, our study provides a natural experimental setting to examine 8

factors affecting RPTs for the same firm before and after the AS18 regulation. The study also adds to research on the effects of PCAOB regulations. 7 As pointed out in Defond and Zhang (2014), While there is evidence that some changes brought about by regulatory intervention have improved audit quality, there is also evidence that the costs of these changes are high and it is not clear if there are net benefits (p.312). They call more future research to understand the nature and extent of regulatory intervention in improving audit and corporate practices in the new regime, and our study is a timely answer to this call. The study is organized as below. Section 2 reviews related literature and develops our hypothesis; Section 3 describes our sample selection procedure and research design; Section 4 reports empirical finding on our main hypothesis; Section 5 provides robustness test and additional analysis; Section 6 concludes the paper. 2. Related Literature and Hypothesis Development Given the scale of the fraudulent cases detected in real world related to RPT, studies on RPTs are relatively limited. Existing studies have found certain RPTs have damaging impacts on companies because these transactions are often associated with high restatement risks (Kohlbeck and Mayhew, 2017), high likelihood of fraudulent behaviors (Henry, Gordon, Reed, and Louwers, 2012), decreased firm value (Jiang, Lee, and Yue, 2010; Kohlbeck and Mayhew, 2010; Cheung et al., 2006) and increased likelihood of financial distress (Ryngaert and Thomas, 2012). 7 Studies on the effects of PCAOB regulation represents an emerging body of research, since the PCAOB was only created in 2002. Abernathy et al. (2013) provide a synthesis of papers examining the economic consequences of the PCAOB activities. The paper documents that 70% of such research are after 2010, showing a growing trend of PCAOB research in more recent years. In the papers examined in this synthesis, only about a few papers directly address the consequences of PCAOB auditing standards on auditors and their clients. The study concludes that [a]s we learn more about the influence of the PCAOB, many prior views in academic research about the roles of auditors and regulators may warrant reinvestigation or further exploration. 9

Because of their potential negative consequences, almost in all countries, RPTs have been subject to major changes in their reporting and detection rules. Generally, these rules are aimed at making the use of RPTs more transparent for outsiders. Internal corporate governance mechanisms have been widely used for this purpose. For example, in the 2006 SEC regulation, companies are asked to disclose more RPT-related information and Lu (2017) finds that this regulation results in fewer harmful RPT transactions. However, Gordon et al. (2007) argue that internal control has difficulty tracking related-party transactions because of the complexity of these transactions. As a result, external auditing is used as an alternative to corporate governance devices for reducing the occurrence of RPTs. External auditors are considered by investors as the first line of defense against fraud (La Porta, Lopez-de-Salinas, and Shleifer, 2006). They can monitor and discipline managers (Francis and Wang, 2008) and enhance investor protection (Newman, Patterson, and Smith, 2005). Nevertheless, evidence on the impact of auditors on companies RPT practices is very limited in the literature, 8 and there is hardly any evidence regarding the impact of auditing standards on corporate RPT practices. Our study furthers these existing studies by assessing if an auditing regulation results in a change in the number of RPT and control procedures on RPTs, and if the regulation has different effects on companies audited by Big4 vs. Non-Big4 firms. Lawrence et al. (2011) point out that correct inferences on Big4 vs Non-Big4 differences are important because it may impose undue economic consequences on these two distinct groups and their clients. Existing studies argue that Big4 are less likely than Non-Big4 to compromise their independence, as no single client could dominate larger accounting companies. 9 In addition, 8 See Gordon et al. (2007) for a synthesis of literature examining the relationship between auditing and RPT. More recently, Bennouri et al. (2015) use a sample of 85 French companies over the period of 2002-2008 and find companies audited by Big4 firms report fewer RPTs. 9 See DeFond and Zhang (2014) for a review of these studies. 10

Big4 firms have stronger incentives to protect their reputations and can provide more robust training programs and standardized audit methodologies. 10 Hence, we anticipate that different ex ante audit quality of Big4 and Non-Big4 companies may result in different impacts of the AS18 on ex post auditor and corporate actions, and we project that the AS18 adoption may have more pronounced economic impacts on Non-Big4 companies than Non-Big4 companies. Development of H1 Given that the AS18 was only recently issued, to date, there has been no empirical studies directly assessing the effect of the AS18 on corporate RPT practices. We anticipate that the AS18 would affect companies real RPT activities (H1) and their RPT control procedures on RPTs (H2). In this section, we examine the possible effect of the AS18 on companies real RPT activities (H1). Previous studies provide strong evidence that effective regulations could play a valid role in restricting opportunistic activities in companies (Ashbaugh-Skaife et al. 2008; Cohen et al., 2013; Iliev, 2010). The AS18 requires auditors to obtain written representations from management assuring that there are no side agreements or other arrangements undisclosed to the auditor, that the management has made available to the auditor the names of all related parties and RPTs, and that an assertion is included in the financial statements that RPTs are conducted on terms equivalent to those prevailing in an arm s length transactions (PCAOB 2014). Auditors are also required to perform sufficient procedures to obtain relevant evidence and actively communications with companies Audit Committees while performing the RPT auditing procedures. These improved external monitoring requirements could strengthen the systems and procedures the 10 There exist a few studies that provide counter evidence to these assertions. These studies argue that Non-Big4 auditors may not be inferior to Big4 auditors in providing quality audit reports (Chaney et al. 2004, Beyer and Sridhar 2006, Bar-Yosef and Sarath 2005). However, the mixed results may arise from research design deficiencies such as self-selection bias (DeFond and Zhang 2014). 11

auditors use to identify and account for RPTs, which constrain managements ability to use RPTs as a tool of opportunistic transactions, leading to the less frequent use of harmful RPTs by management. Meanwhile, the additional requirements from the auditor and the enhanced communications between the auditor and the company s Audit Committee could increase the management s workload to provide the necessary evidence to justify their involvements in RPT. The Board recognizes that such audit-related costs may outweigh any cost advantage a company may have from engaging in related party transactions during its normal course of operation and hence serve as a deterrent against their use [of related party transactions] (p.183). As a result, the management may avoid the use of RPTs even though these RPTs could meet the best interests of the companies. In such case, we argue that both harmful and benign RPTs may be reduced. Arguably it could also be possible that the AS18 may result in increased RPTs, if previously undisclosed RPTs become disclosed under more stringent auditing procedures, or no change of RPTs at all, if enhanced auditing procedures required in AS18 have already been voluntarily taken by auditors before the AS18 adoption. We do not rule out these possibilities; however, given that the Board expects the regulation may deter companies use of RPT, we predict a reduction of RPTs post the AS18. H1: Companies involve in less frequent use of RPTs following the AS18 adoption. Because of the Big4 s superior audit quality, Big4 clients could be less likely to be involved in harmful RPTs ex ante. Therefore, an increased scrutiny of auditors following the AS18 may not decrease Big4 clients opportunistic RPTs to the same extent for Big4 and non-big4 clients. Furthermore, Big4 clients may have fewer harmful RPTs ex ante as a result of their superior firm characteristics, given that they are usually larger, more profitable and better governed than non- 12

Big4 clients. Taken together, we project that the regulation effect of the AS18 is more salient in reducing RPTs for non-big4 clients than Big4 clients, due to lower auditor quality and poorer firm characteristics before the regulation for non-big4 clients. As mentioned previously in footnote 6 the PCAOB expects AS18 may impact large companies and small companies differently. Many small companies are audited by non-big4 companies, which lack the proper RPT audit procedures ex ante. In addition, they don t have as much media attention or analyst following as large companies do, resulting in a less stringent monitoring from the public. Therefore, quality of smaller companies RPTs could be worse than that of large companies on average ex ante. The risk of RPTs to shareholders could be severer in small companies than in large companies. Development of H2 Previous literature shows that audit scrutiny can increase companies corporate governance and enhance monitoring procedures (McConomy, 1998; Manry et al., 2003; Carcello and Li, 2013). We expect the AS18 would have similar effects and develop H2 accordingly. H2: Companies RPT control procedures improved following the AS18 adoption. Specifically, we expect two effects. First, the new standard requires auditors to understand and evaluate the company s RPT control procedure policies. This external monitoring on RPT is expected to promote the initiation of a formal written RPT policy. The PCAOB projects that management may be more attentive to written procedures and responsibilities for RPTs as a result of the AS18. Hence, we develop H2a as below. 13

H2a: Companies are more likely to adopt a written RPT policy following the AS18 adoption. Second, auditors are required in the AS18 to make inquiries of the Audit Committee members about their understanding of and concerns about related party transactions and make an additional communication to audit committees about the auditors evaluation of the company s identification of, accounting for, and disclosure of RPTs. In addition, if the auditor learns a relatedparty relationship or transaction that management did not disclose to the auditor, the auditor must advise the audit committee. These improved external monitoring will make companies audit committee unavoidably involved in the RPT auditing, and could enhance the Audit Committee s oversight of management, and become better informed and thus better equipped to fulfill their respective roles (PCAOB 2014, p.180). If a company s board uses another committee to review and approve RPTs, then the overlapping of RPT assessment between the two committees may make the responsibility unclear, decreasing the efficiency of monitoring. As a result, we expect the auditors involvement with the audit committee as required by the AS18 increases the likelihood for companies to delegate the audit committee, instead of any other committees, as the responsible party of reviewing and approving RPTs, to promote more efficient and effective communications between the firm and auditors. We develop H2b accordingly. H2b: Companies are more likely to use an Audit Committee as an approval authority following the AS18 adoption. Cassell, Giroux, Myers, and Omer (2012) consider the quality of corporate governance as a component of risk assessment, and show that Big4 firms scrutinize their clients governance 14

mechanisms when they make client retention or acceptance decisions. We predict that clients of less reputable auditors usually have weaker corporate governance. Consequently, these newly required auditing procedures in the AS18 could have larger impacts on these companies, resulting in a more salient improvement in corporate RPT control procedures. 3. Sample Selection and Research Design 3.1 Sample Selection Because we need to evaluate the impact on Big4 and non-big4 clients separately, we start our sample from Russell 3000 companies. Among them, 483 companies are audited by non-big4 firms. After removing 210 financial and utility companies, the remaining sample consists of 273 companies. After further removing 140 companies that have incomplete RPT or governance data, 11 the remaining 133 companies are matched with 133 companies audited by Big4 firms by industry, size, and profitability. 12 Given that companies audited by non-big4 are generally small in size, the matched companies audited by Big4 are small in size as well, and do not represent large companies audited by Big4. As a result, we include the S&P500 companies in the Russell 3000 to represent our large size companies audited by Big4. After excluding 123 financial and utility companies, 22 companies missing RPT disclosures, and 33 companies missing governance data, we have 322 S&P 500 companies left representing our large companies audited by Big4 firms. Our final sample consists of 133 companies audited by non-big4 firms (i.e. Non-Big4 Small), 133 matched 11 Regardless of mandatory RPT disclosure by SEC, many smaller firms, especially those audited by non-big4 firms, did not disclose RPT information in their proxies before the AS18. We have to drop these firms from our sample due to the lack of ex ante RPT information. However, these firms can be considered to have a weaker RPT governance. According to our argument, AS 18 would have affected these non-big4 small firms without RPT disclosure to a greater extent. In such case, our inference would still hold. 12 Lawrence et al. (2011) argue that a matched sample could provide a natural framework to parse out the effects of auditor and client characteristics, avoid selection bias as a result of Heckman (1979) two stage model, and mitigate the potential impact of Non-Non-Non-linearity in estimating the treatment effects. 15

companies audited by Big4 firms (i.e. Big4 Small), and 322 S&P 500 companies (i.e. Big4 Large). Table 1, Panel A reports the above sample selection process. As a result of missing values, we lost 140 companies in Non-Big4 Small companies in the above sample selection process. In Panel B of Table 1, we compare descriptive statistics of Non- Big4 Small companies used in our final sample (133 companies) with the full sample that includes all 273 companies audited by non-big4 firms (excluding financial and utility companies), to determine if they are comparable. The statistics does not reveal significant differences between the two samples. 3.2 Data Source RPT and RPT control procedure information are hand collected for a sample of Russell 3000 companies from their proxy statements from 2011 to 2016. As the AS18 has been in effect since December 15, 2014, our sample includes three years prior to the effective date and three years post. The financial and market performance data and auditor information are collected from the Wharton Research Data Services (WRDS). The governance data are obtained from Bloomberg. 3.3 Research Design Test of H1 We test H1 using the following OLS model. RPT = β 1 Post + β 2 Size + β 3 ROA + β 4 PB +β 5 Leverage + β 6 R&D + β 7 R&D missing + β 8 Firm Age+β 9 % of Independent + β 10 % Institutional + β 11 Dual share + β 12 CEO Tenure+ β 13 CEO Duality + β 14 CGQ + Industry Fixed Effect + ε (1) 16

Where RPT is the number of RPTs disclosed in companies annual filing. Post equals one when the sample year is in 2014 or after, and zero otherwise. We expect the coefficient on Post is negative, meaning that companies number of RPTs decrease with the AS18 adoption. Following Ryngaert et al. (2012), Kohlbeck and Mayhew (2017), and Balsam et al (2017), we control the variables below. 13 Size is the logarithm of total assets. ROA is the return on assets, measured as net income before extraordinary items divided by total assets. PB is the ratio of market to book value of equity. Leverage is the ratio of total debts to total assets. R&D is the research and development expenses scaled by total assets. R&D Missing equals one if a firm does not report R&D expenses. Firm Age is the number of years the firm is in operation since IPO. % of Independent is the percentage of independent directors on board. % of Institutional is the percentage of shares held by institutional investors. Dual Share is an indicator which equals one if the firm has more than one class of shares outstanding. CEO Tenure is the number of years current CEO is in place. CEO Duality is an indicator which equals one if the CEO is also the Chairman of the board. On top of these variables, following Bernile et al. (2009) and Borisova et al. (2012), we use CGQ calculated by the Institutional Shareholder Services (ISS) as a control variable to capture general corporate governance quality. We also control for industry fixed effect and cluster errors on companies. To assess if the AS18 effects vary by auditor quality, we further run the model (1) in the three sub-samples, that is, Non-Big4 Small, Big4 Small, and Big4 Large companies. We expect that the coefficient on Non-Big4 Small companies is more pronounced than that on Big4 Small companies, and the coefficient on Big4 Small companies is more pronounced than that on Big4 13 Some governance variables included in these three studies such as executive salaries or ownership are not included in our model because our analysis involves smaller companies and hence the data are not available. 17

Large companies. Test of H2 We test H2 by using the following logit model for the full sample and the three sub-samples. Prob (Adoption of Control Procedures) = β 1 Post + β 2 RPT + β 3 Size + β 4 % of Independent + β 5 % of Institutional + β 6 Dual share + β 7 CEO Tenure + β 8 CEO Duality + β 9 CGQ + β 10 NASDAQ + β 11 Delaware + Industry Fixed Effect + ε (2) Where the Adoption of Control Procedures refers to dummy variables as defined below. In the test of H2a, the dummy variable equals one if the firm has a written RPT policy; in the test of H2b, the dummy variable equals one if the firm delegates the audit committee as the responsible party for reviewing and approving RPTs. We expect the coefficient on Post is positive, meaning that during the post-as18 period, companies are more likely to adopt a formal written RPT policy and to delegate audit committees as an RPT approval authority. Similar to H1, we expect that the coefficient on Non-Big4 Small companies is more pronounced than that on Big4 Small companies, and the coefficient on Big4 Small companies is more pronounced than that on Big4 Large companies. As RPT control procedure can be considered as a part of the corporate governance systems within the firm, we include all control variables in Model (1) that may affect or reflect companies general effectiveness of governance (i.e., Size, % of Independent, % of Institutional Holding, Dual Share, CEO Tenure, CEO Duality, and CGQ). We also control for an occurrence of RPTs (RPT), in the sense that adoption of certain RPT policy may be affected by the intensity of RPTs. In addition, we control for NASDAQ, which equals one if the firm is listed in NASDAQ and zero 18

otherwise, 14 and Delaware, which equals one if the firm is incorporated in Delaware. We include Industry Competition since Giround and Mueller (2011) point out that product competition may be associated with a firm s internal governance. Industry fixed effects are included in the model and standard errors are clustered at the firm level. A summary of variables discussed above and their definitions is provided in the Appendix. 4. Empirical Analysis 4.1 Descriptive Statistics Table 2, Panel A provides a summary of descriptive statistics of the variables under analysis. As shown in Table 2, the sample companies report an average of 0.89 RPTs. The average RPTs for Non-Big4 Small and Big4 Small are 1.00 and 0.63, respectively, suggesting that Non- Big4 Small companies report more RPTs than their matched Big4 companies, consistent with findings from prior literature that auditors reputations are associated with the occurrence of RPTs (Bennouri et al., 2015). The average RPTs for Big4 Small and Big4 Large companies are 0.63 and 0.96, respectively, suggesting companies with larger size having more RPTs. On average, 53% of observations have adopted a written RPT policy, and 47% of observations use audit committees to review and approve RPTs. For control variables, the descriptive statistics are mostly comparable between Non-Big4 Small and Big4 Small companies suggesting these two groups of observation are well matched. The average size, defined as the logarithm of total assets, is 6.02 and 9.71 for Big4 Small and Big4 Large companies, respectively, indicating big differences in firm size between the two groups. 14 The listing exchanges may affect firm governance because different exchanges have different listing requirements related to firm governance. It is usually believed that the NYSE companies have stricter governance than the NASDAQ companies. 19

The D_RPT, an RPT indicator, shows that there are approximately 47% of observations report at least one RPT. Among the sub-groups, about 52% of observations in Non-Big4 Small companies report at least one RPT, while 39% of observations in Big4 Small companies and 48% of observations in Big4 Large companies report at least one RPT. The patterns observed in D_RPT is consistent with what is observed in our main RPT variable, that is, the Non-Big4 Small companies tend to report more RPTs than Big4 Small companies, and the Big4 Large companies tend to report more RPTs than Big4 Small companies. The statistics for $RPT shows a similar pattern. For Business RPTs (RPT_BUS) and Tone RPTs (RPT_Tone), the statistics in $RPT or in D_RPT are comparable with those in #RPT, reflecting higher weight in business RPTs than tone RPTs. Panel B of Table 2 reports the differences before and after the AS18 regulation. As shown in Panel B, there appear to be significant differences between the pre- and post- periods for all three measures of RPTs and the two measures of RPT monitoring indicators. The Pearson correlations reported in Table 3 show that companies audited by non-big4 firms and companies with fewer independent directors, less institutional holdings, dual CEOs, long CEO tenure and lower governance index (CGQ) are more likely to disclose more RPTs, suggesting that firm with more RPTs are associated with weak external monitoring and internal governance. More importantly, Post is negatively correlated with the number of RPT, suggesting that companies may significantly reduce their RPT behaviors after the adoption of the AS18. We do not find high correlations between the explanatory variables, indicating multi-collinearity is not a serious concern in our analyses. 20

4.2 Main Analysis 4.2.1 RPT Activity Analysis In Table 4, we examine the AS18 effects on the occurrence of RPTs (H1) and the respective effects of the AS18 on Big4 and Non-Big4 companies by regressing RPT on post, controlling for other company characteristics. Consistent with H1, the coefficient on Post for the full sample is negative and significant (-0.154, p = 0.000), suggesting that after the adoption of the AS18, sample companies significantly reduce their RPT activities. In terms of economic significance, a 0.154 change is approximately 17% decrease given an average of 0.89 RPTs. We find that both Non-Big4 Small companies (-0.366, p=0.000) and Big4 Small companies (-0.154, p=0.025) reduced RPTs post the AS18. In addition, the Non-Big4 Small companies reduced more RPTs than Big4 Small companies. The difference is statistically significant at 10% level. In contrast, the results for Big4 Large companies show that the AS18 has no effect on these companies as the coefficient on Post is insignificant (-0.056, p=0.35). The results provide evidence that the reduction of RPTs in the full sample is driven by the reduction of RPTs in smaller companies, instead of the large companies. Results in the Table 4 imply several notable points. First, the AS 18 has greater impacts on companies audited by non-big4 firms, suggesting that auditor quality plays a role in reducing RPTs in the pre-as18 period. Second, the reduction concentrates on Non-Big4 Small and Big4 Small companies, suggesting that the effects of AS18 is more pronounced for smaller companies. These two findings are consistent with the PCAOB s expectation that the AS 18 may have a larger effect on smaller companies and companies audited by smaller firms. Finally, results on the Big4 Large variable suggest that the introduction of AS18 did not have a significant impact on existing related party transactions for S&P 500 companies, probably because S&P500 companies are usually 21

subject to better external monitoring and internal controls. These internal and external factors may cause S&P500 companies to better manage and control RPTs prior to the AS 18 than smaller companies. For control variables, consistent with what we observed in the correlation table (Table 3), we find companies with fewer independent directors on board, lower institutional holdings, non- Big4 auditors, and lower CGQ scores report more RPTs, suggesting that more RPTs are associated with weaker external monitoring and internal governance. 4.2.2 RPT Control Procedure Analysis In this section, we examine if companies RPT control procedures are enhanced following the enhanced scrutiny from external auditors (H2a and H2b) and the respective impacts on Big4 and non-big4 companies. In Table 5, we regress Adoption of Written RPT Policy on Post using the logit model (2). For the full sample, the coefficient on Post is positive and significant (0.139, p=0.005), showing that companies are more likely to adopt a written RPT policy in the post AS18 period, supporting H2a. The analysis of sub-samples shows that the coefficients on Post are positive but not significant for Big4 Large companies (0.043, p=0.582) while positive and significant for Big4 Small companies (0.319, p=0.008) and Non-Big4 Small companies (0.409, p=0.003). The coefficient difference between Big4 Small and Big4 Large is significant at 5% level, indicating that smaller companies are more likely to adopt a written RPT policy in the post AS18 period, although both are audited by Big4 firms. A comparison of coefficients on Post for Non-Non-Big4 Small companies (0.409, p=0.003) and Big4 Small companies (0.319, p=0.008) does not show significant differences between the two sub-samples (0.0090, p=0.668). 22

In Table 6, we regress the delegation of Audit Committee on Post using the logit model (2). We find that companies are more likely to delegate their audit committees to review and approve RPTs following the adoption of the AS18 (0.175, p=0.000), supporting H2b. The results on Non- Big4 Small (0.482, p=0.000), Big4 Small (0.175, p=0.103) and Big4 Large (-0.023, p=0.751) show that the post-as18 change of Audit Committee concentrates on Non-Big4 Small companies only, suggesting the Board s regulation encourage more non-big4 clients to amend their audit committee s responsibility in RPT ratifications. Taken together, we find that, consistent with the PCAOB s expectation, AS18 have greater impacts on smaller companies than large companies; furthermore, small companies audited by non-big4 firms are more likely to adopt a written RPT policy and designate audit committee to review and approve RPTs than small companies audited by Big4 firms, suggesting the Board s regulation encourages more non-big4 firms to establish better RPT control procedures. 5.1 Business RPTs vs. Tone RPTs 5. Robustness Tests and Additional Analysis There are two types of theories related to RPTs: the efficient contracting theory and the conflict of interest theory (Pizzo 2013). The former assumes RPTs are used for efficient contracting and hence are beneficial to the company, while the latter assumes RPTs are used by managers to exploit the benefits of investors and hence are detrimental to the company. In the primary analyses, we implicitly assume that all RPTs are homogeneous in nature. However, prior studies document that not all RPTs are the same (e.g., Ryngaert and Thomas 2012; Kohlbeck and Mayhew 2010, 2017). Building on these insights, we group RPTs based on business RPTs and tone RPTs following Kohlbeck and Mayhew (2017), to explore which types of RPTs are reduced 23

following the AS18. According to Kohlbeck and Mayhew (2017), tone RPTs include transactions with loans from or to directors, executives or shareholders, donations to related charities, and consulting and legal services. Business RPTs include selling, buying, leasing, and M&A transactions, which are close to the firm s core business operation. 15 Table 7 presents results of tone RPTs (Panel A) and business RPTs, (Panel B), respectively. With respect to tone RPTs, the outcomes in Panel A show that the coefficients on Post are all negative and significant for the full sample (-0.050, p=0.000) and for all three sub-samples, that is, Non-Big4 Small companies (-0.092, p=0.000), Big4 Small companies (-0.044, p=0.014), and Big4 Large companies (-0.029, p=0.043). These results provide strong evidence of a significant reduction of tone RPTs following the adoption of AS18. Given that Kohlbeck and Mayhew (2017) find tone RPTs are more associated with material misstatements than business RPTs, the significant reduction of tone RPTs following AS18 suggests the effectiveness of PCAOB regulation to reduce the opportunistic behaviors for all three groups. A comparison of the coefficients shows that the reduction of tone RPTs are most salient for Non-Big4 Small companies, followed by Big4 Small companies, and then by Big4 Large companies. With respect to business RPTs, the outcomes in Panel B indicate that the coefficient on Post is negative and significant for the full sample (-0.088, p=0.002), suggesting a significant reduction following AS18. However, the breakdown analysis shows that such effect is concentrated on Non-Big4 Small companies (-0.208, p=0.009) and Big4 Small companies (-0.086, p=0.097), but not on Big4 Large companies (-0.044, p=0.289). The reduction of business RPTs could be a result of more rigorous auditing deterring harmful business RPTs, but it also could be a result of reducing benign RPTs due to concerns on increased justification workload for 15 This classification also considers identification of related parties. Please refer to Kohlbeck and Mayhew (2017) for detailed discussion. 24

companies. The fact that the AS18 effects are more salient for smaller firm suggest that large companies probably do not need to take extra efforts to justify business RPTs since a valid system may have already been created for auditors to assess the risks of such RPTs. 5.2 Operating Efficiency In the main analysis in Section 4 for the full sample, we find that companies significantly reduce RPTs after the AS18 adoption, but we don t know whether this reduction is beneficial to companies. If most RPTs reduced are harmful RPTs, we could expect an improvement of operating efficiency. In contrast, if most RPT reduced are beneficial RPTs, then reduction of these RPTs will impair a firm s operation. In this section, we examine whether companies operating efficiency is improved with the reduced occurrence of RPT using the following model. Operating Efficiency = β 1 RPT Post + β 2 RPT+ β 3 Post + β 4 Size + β 5 Market Share + β 6 Foreign Operation +β 7 Free Cash Flow + β 8 Firm Age+ β 9 Segment Concentration + ε Operating Efficiency is measured using Data Envelop Analysis. Specifically, we use sales as our output and seven other accounting inputs in the DEA analysis. These seven accounting inputs consist of cost of goods sold (COGS), selling, general and administrative expenses (SG&A), property, plant and equipment (PP&E), operating leases, research and development (R&D), goodwill, and other intangibles. We then solve the following optimization problem by industry year. 25

max θ = $ '()*' $ +,-./0$ 1 /.&30$ 4 55&60$ 7-8'9*('*0$ : ;&<0$ =.>>?@A))0$ B -CD*EAFC(FGAH)* θ is the measurement of companies operating efficiency. Following Demerjian et al. (2012), we control for factors that may affect companies operating efficiency. Size is the logarithm of total assets. Market Share is measured as the ratio of a companies revenue to total revenue in an industry. Foreign operation is an indicator which equals one if companies report a foreign income. Free Cash flow is an indicator which equals one if a firm has positive free cash flow in a given year. Firm Age is the number of years a firm has been listed. Segment Concentration is measured as the Herfindahl-Hirschman index of a company s segment revenue. The results in Table 8 show that, for the full sample, before the AS18 adoption, companies RPT occurrence is associated with lower operating efficiency (-1.436, p=0.033). The negative association is mitigated in the post-as18 period, as the coefficient on the RPT Post becomes significantly positive (2.024, p=0.014). The breakdown analysis of sub-samples shows that the results in the full sample are mainly driven by the RPT reduction of Non-Big4 Small companies (4.664, p=0.032), not by the Big4 Small companies (3.115, p=0.231) or Big4 Large companies (0.571, p=0.498). The results reveal two important implications. First, we find that in the pre-regulation period, RPTs are associated with lower operating efficiency for Non-Big4 Small companies only (-3.869, p=0.005). Such findings support the PCAOB and accounting literature s observation that non-big4 companies have lower auditing quality ex ante. Second, the adoption of the AS18 has significant positive impacts on Non-Big4 Small companies, as evidenced by the improved operating efficiency for these companies. For Big4 small and Big4 Large companies, the impact 26