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    Do Political Connections Add Value to Audit Firms? Evidence...
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 04.0 Independence and Ethics, 04.05 Ethics and Consultation 
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    Title:
    Do Political Connections Add Value to Audit Firms? Evidence from IPO Audits in China.
    Practical Implications:

    To the extent that political connections bring significant economic benefits, non-top-tier firms may be induced to spend scarce resources in competing for such connections while reducing the amount of resources directed towards improving audit quality. Audit clients may also be attracted to audit firms with political connections rather than to those providing high-quality audit services. Auditors in China play a role in reducing the risk of an IPO application being rejected. Because the Chinese IPO market has become the largest in the world in recent years, this finding should be of interest to academics, practitioners, and regulators.

    Citation:

    Yang, Z. 2013. Do Political Connections Add Value to Audit Firms? Evidence from IPO Audits in China. Contemporary Accounting Research 30 (3): 891-921.

    Keywords:
    initial public offerings, resource allocation, political connections, ethics, audit fees
    Purpose of the Study:

    Political connections have been shown to play an important role in economic activities around the world. Both audit quality and auditor independence are relatively low in economies with pervasive government intervention such as China. Examining the role played by political connections in audit firms will enhance the understanding of these findings. This study extends the literature by investigating whether political connections bring benefits to audit firms, and if so, in which forms. The author investigates how political connections benefit audit firms in a highly regulated capital market. Audit firms are considered politically connected after their partners are appointed to the IPO regulatory Committee. Audit firms’ connections with regulators may reduce the IPO rejection rate for their clients in two ways. First, such connections enable them to obtain specialized knowledge of the regulatory process and thus help their clients better prepare IPO applications. Second, they can gain access to key officials and Committee members and thus lobby for favorable regulatory decisions on their clients behalf.

    Design/Method/ Approach:

    This study focuses on IPO cases examined by the CSRC between January 1, 2002 and April 30, 2010. Committee members who served between January 1, 2004 and April 30, 2010 include 42 auditors from 19 audit firms. The empirical tests conducted in this study are based on two samples. One sample comprises successful IPO companies, and the other sample comprises all prospective IPO companies.

    Findings:
    • After their partners are appointed to the Committee, non-top-tier audit firms significantly increase their IPO audit fees and market share, and significantly reduce the IPO rejection risk for their clients, whereas the same is not the case for top-tier audit firms.
    • The average quality of non-top-tier audit firms’ clients approved to conduct IPOs declines significantly after these firms become connected to regulators.
    • Non-top-tier audit firms’ clients are more likely to experience an earnings decline immediately after the IPO if they are approved in connection periods rather than in pre-connection periods. This suggests that the quality of non-top-tier audit firms’ IPO clients declines after partners of such firms are appointed to the Committee.
    • Audit firms risk reputational loss if they participate in lobbying activities or their clients approved to conduct IPOs perform poorly after the IPO. The potential reputational loss is much greater for reputable audit firms, which may discourage them from helping their clients raise the probability of passing the IPO screening process to a level higher than that implied by their clients’ quality.
    • Top tier audit firms are less likely to benefit from Committee appointments than are nontop-tier firms.
    Category:
    Client Acceptance and Continuance, Independence & Ethics
    Sub-category:
    Audit Fee Decisions, Ethics & Consultation