Political Connection And Audit Quality

The question of how the political environment influences the business environment is essential for public welfare because improper regulations can lead to corruption.Meanwhile,overregulation can also eliminate a firm’s value-generating potential.Researchers have studied the connection between politics and business for decades and so a meaningful amount of data exists,especially regarding the corporate valuegenerating potential of political connections and the finance-related questions.However,some areas of research are still incomplete: for instance,political connections and innovation,and such connections and audit.The following dissertation explains the interrelationship between political connections and the quality of audit,namely: How do political connections influence audit quality? The thesis completes a detailed literature review to identify the channels through which political connections can influence corporations and,hence,affect audit work.According to the literature review,the actual empirical results show controversial outcomes.Furthermore,the current dominant resource-based theory barely to explain several phenomena,and this implies a second research question: Why does a significant amount of seemingly controversial results exist? The thesis provides “political monitoring” as an alternative explanation.Proposed theory: When the political connections possess a large amount of political power then,because of riskaversion,the political environment seeks for higher audit quality to prevent future scandals which can destroy the existing political power.Political monitoring theory predicts that the more influential a company’s political connectedness is,the higher the audit quality is.This is because,according to the loss-aversion theory of cognitive psychology and decision theory,people prefer to avoid losses as opposed to acquire equivalent gains with increasing wealth.We may assume that the more wellconnected a politician is,the more political power he/she possesses.Also,a corporate scandal can destroy political power.Thus,the more power a politician holds,the more they prefer to avoid any corporate scandal.Concerning audit theory,this forces the politician to be interested in maintaining an efficient audit environment.This paper employs panel regression analysis,supported by two-stage linear regression.The study has applied the concept of group network centrality from network theory and,according to sociology literature,this indicator is capable of measuring the power of political connections,while the ordinary dummy variable represents only the existence of the connection.The model estimates the importance of the related politicians in the whole social network.Audit fees,Big 4 selection,audit report delay,audit failure,and earnings management represent audit quality.The calculation uses the sample of Chinese listed companies,2008-2017,containing 24187 firm-year observations.The study involves six main parts.First,a comprehensive collection and theoretical analysis of the existing literature.The second part proposes a theory that describes when a political connection behaves more like a monitoring function,instead of a resource provider.The third section develops the hypothesis.The fourth part implements the existing network analysis methodology to define the empirical model.The fifth part presents the observed results.Finally,the sixth part provides a summary of the thesis and policy implications.According to the literature review,the results are controversial.This research provides two answers.First,the measurement of political connectedness lacks enough sophistication;for instance,it is often oversimplified,combines conflicting interests and ignores the institutional peculiarity of the analysed country.Second,a theoretical gap exists,the current theories,such as resources-based theory,greasy money,the inefficiency of state-owned enterprises（SOEs）,are unable to explain some phenomena.Empirical tests reveal that politically-connected firms pay significantly lower audit fees,more often hiring Big 4 auditors.Contrary to the literature,other measurements of audit quality do not show negative associations.The results show that higher network centrality is associated with better audit quality.These results suggest to us that we should move away from the simplified narrative,which automatically identifies the presence of politicians in companies as an element of corruption.Instead,the authorities should implement new regulations that take into account the discussed mechanism.They should establish an environment that forces the politicians to concentrate more on the political monitoring function,replacing the resource provider function.The empirical results suggest that the proposed political monitoring theory should have some explanatory power.The current thesis provides the following main contributions and innovations:1)The paper proposes a supplementary theory in order to explain when and why the political connections monitoring function has become more substantial compared to the resource provider.The model implements the existing loss-aversion,political visibility,political cost and resource provider theory.2)The thesis reviews the generally-used methodology and provides an argument concerning its advantages and disadvantages;this reasoning defines why the currently used measurements lead to contradictory results.3)The empirical analysis implements network theory and provides an alternative approach to analysing political connections.As compared to the existing approaches,network centrality measures the political connections’ strength and existence.The empirical model also uses audit failure to measure audit quality;this indicator is based on a hand-selected database of companies’ enforcement actions.