The Contagion of Caution: How Environmental Penalties Induce Auditor Conservatism Through Shared Audit Relationships

ABSTRACT This study investigates how the disciplinary effects of China's environmental regulations spill over through the shared auditor network. We argue that when a Chinese firm is penalized for an environmental violation, its auditor learns from the event and subsequently enhances audit scrutiny for other, non‐sanctioned Chinese clients within the same audit portfolio. Using a company‐pair design based on Chinese listed firms, our findings show this spillover effect leads to significantly higher audit fees and a greater likelihood of receiving a modified audit opinion for the non‐sanctioned Chinese client firms. This effect is more pronounced in environments with high investor attention in China, when the auditor has weaker capabilities, or when a related‐party transaction exists between the Chinese clients. Conversely, the spillover effect is weakened for Chinese clients that have obtained independent assurance for their ESG reports or hold ISO certifications. Further analysis reveals that this heightened scrutiny improves Chinese clients' financial reporting quality and environmental disclosures. Our research highlights the critical role of auditors in transmitting non‐financial risk and amplifying regulatory discipline within the Chinese institutional context, providing new evidence on the auditor's evolving role in China.