auditor choice in politically connected firms

DOI: 10.1111/1475-679X.12032Journal of Accounting Research

Vol. 52 No. 1 March 2014Printed in U.S.A.

Auditor Choice in PoliticallyConnected Firms

O M R A N E G U E D H A M I ,∗, † J E F F R E Y A . P I T T M A N ,‡A N D W A L I D S A F F A R§

Received 26 April 2011; accepted 15 September 2013

ABSTRACT

We extend recent research on the links between political connections andfinancial reporting by examining the role of auditor choice. Our evidencethat public firms with political connections are more likely to appoint a Big4 auditor supports the intuition that insiders in these firms are eager to im-prove accounting transparency to convince outside investors that they refrainfrom exploiting their connections to divert corporate resources. In evidenceconsistent with another prediction, we find that this link is stronger for con-nected firms with ownership structures conducive to insiders seizing privatebenefits at the expense of minority investors. We also find that the relationbetween political connections and auditor choice is stronger for firms operat-ing in countries with relatively poor institutional infrastructure, implying that

∗Moore School of Business, University of South Carolina; †SKKU Business School,Sungkyunkwan University (Seoul, Republic of Korea); ‡Memorial University of Newfound-land; §School of Accounting and Finance, The Hong Kong Polytechnic University.

Accepted by Philip Berger. We thank Najah Attig, Narjess Boubakri, Jean-Claude Cosset,Sadok El Ghoul, Mara Faccio, Clive Lennox, Pete Lisowsky, Stefan Sundgren, and especiallyan anonymous referee for their insights on an earlier version of this paper. Our paper has alsobenefited from comments from participants at the 2012 European Accounting AssociationConference, the 2011 Global Finance Conference, and seminars at various universities. Weappreciate financial support from Canada’s Social Sciences and Humanities Research Councilas well as excellent research assistance from Nabhomani Aggarwal, David Godsell, and ZeinaMehdi. Omrane Guedhami and Jeffrey Pittman gratefully acknowledge funding from the Cen-ter for International Business Education and Research at the University of South Carolina andthe CMA Professorship/Chair in Corporate Governance and Transparency at Memorial Uni-versity, respectively.

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Copyright C©, University of Chicago on behalf of the Accounting Research Center, 2013

108 O. GUEDHAMI, J. A. PITTMAN, AND W. SAFFAR

tough external monitoring by Big 4 auditors becomes more valuable for pre-venting diversion in these situations. Finally, we report that connected firmswith Big 4 auditors exhibit less earnings management and enjoy greater trans-parency, higher valuations, and cheaper equity financing.

1. Introduction

In response to calls for research on this issue (e.g., Wang, Wong, and Xia[2008]), we estimate the importance of corporate insiders’ political con-nections to auditor choice.1 Our analysis contributes to extant researchby isolating whether political connections affect the likelihood that publicfirms rely on Big 4 auditors that tightly constrain insiders’ discretion overfinancial reporting.2 Moreover, we examine three other research questions:(1) Are connected firms with ownership structures that leave minority in-vestors more vulnerable to expropriation by insiders more likely to appointBig 4 auditors?, (2) Are connected firms in countries with relatively weakgovernance institutions more eager to engage a Big 4 auditor?, and (3) Doconnected firms benefit from hiring a Big 4 auditor?

Political connections heighten the tension that insiders in public firmsexperience in their financial reporting incentives. These insiders could ex-ploit their position to deny outside investors by siphoning corporate re-sources that they later conceal by distorting the financial statements (e.g.,Shleifer and Vishny [1994], La Porta et al. [1998]). In other words, theymay manipulate accounting numbers to suppress information on actualeconomic performance in order to ensure that their diversionary practices,largely stemming from political cronyism and corruption, are kept hidden.In fact, Chaney, Faccio, and Parsley [2011] find that earnings quality islower in politically connected firms. Rendering the financial statements lessinformative to provide cover for expropriation activities would be evidentin the absence of a Big 4 auditor.

However, there are countervailing incentives pushing politically con-nected firms to improve disclosure. In particular, connected insiders whorefrain from self-dealing would prefer higher-quality financial reportingto ensure that outside investors realize this. It follows that such politicallyconnected firms would be more likely to appoint Big 4 auditors since in-vestors value accounting transparency for protecting their interests (e.g.,Watts and Zimmerman [1983], Dyck and Zingales [2004]). This argumentreflects that more reliable financial reporting helps prevent expropriationby dominant insiders and their political patrons.

1 Reinforcing the significance of our research, politically connected firms account for al-most 8% of the world’s stock market capitalization (Faccio [2006]).

2 Although Arthur Andersen dissolved during our study period, we follow convention bylabeling the large brandname public accounting firms and their predecessors as the Big 4.Choi and Wong [2007] review worldwide evidence implying that the Big 4 supply higher-quality audits, reinforcing the U.S. evidence that Francis [2004] comprehensively surveys.

AUDITOR CHOICE IN POLITICALLY CONNECTED FIRMS 109

We evaluate which of these financial reporting incentives dominates byexamining whether auditor choice varies systematically with political ties.Given that recent evidence implies that connected firms suffer uniqueagency problems that may magnify the demand for external monitoring—for example, Qian, Hongbo Pan, and Yeung [2011] find that insiders’ ex-propriation of minority investors in China is more severe in politically con-nected firms—we extend research on political connectivity and financialreporting outcomes to include the role of auditor choice.

Our analysis leads to four primary insights. First, we provide evidence thatthe demand for Big 4 auditors is greater for politically connected publicfirms relative to their nonconnected counterparts matched, using alterna-tive techniques, on country, industry, size, ownership structure, and othercharacteristics. In various specifications, our coefficient estimates translateinto political affiliations materially increasing the likelihood that firms willappoint a Big 4 auditor by a range of 5–8%, with all other variables assignedtheir mean values.3 Second, we report that connected firms with ownershipstructures that intensify insiders’ incentives to divert corporate resourcesare even more likely to appoint Big 4 auditors. Third, we find that the linkbetween auditor choice and political ties is stronger in firms operating incountries with relatively poor governance institutions, implying that Big 4audits become more valuable for disciplining connected insiders in thesecountries. Finally, our results suggest that connected firms with Big 4 au-ditors exhibit lower earnings management and enjoy greater transparency,higher valuations, and cheaper equity financing.

Although our core results are robust to confronting this issue variousways (e.g., alternative matching procedures, controlling for firm hetero-geneity as well as an extensive set of country-level variables, and restrictingthe sample to firms with long auditor tenure), the potential endogeneitybetween auditor choice and political connections means that we cannotinfer causality from this analysis. We address another important issue by iso-lating the incremental role that connections play in auditor choice beyondownership characteristics, including large ultimate shareholding (e.g., Fanand Wong [2005]). In developing our predictions, we rely on prior re-search to motivate that political connections exacerbate agency conflictsbetween dominant large shareholders and outside investors (e.g., Morck,Stangeland, and Yeung [2000], Faccio [2006], Berkman, Cole, and Fu[2010], Qian, Hongbo Pan, and Yeung [2011]). Empirically, we employseveral strategies to better identify the link between connections and au-ditor choice. First, we separately control in all regressions for the equitystakes held by the ultimate shareholder and the state, which have beenshown to influence auditor choice (e.g., Fan and Wong [2005], Guedhami

3 To provide some perspective on the economic magnitude of our evidence, Fan and Wong[2005] estimate that raising the fraction of voting (cash flow) rights belonging to the ultimateowner one standard deviation from its mean value leads to hiring a Big 4 auditor becoming5% (2%) more likely.


Pittman, and Saffar [2009]). Second, we apply several matching techniquesto assemble a benchmark group of nonconnected firms against which weevaluate auditor choice in politically connected firms. Third, we conductcross-sectional analysis to examine whether the link between political con-nections and auditor choice varies with corporate ownership characteris-tics. In all of these estimations, we find that connections affect auditorchoice beyond the ownership effects.

The rest of this paper is organized as follows. Section 2 reviews priorresearch to develop the testable hypotheses. Section 3 outlines our data andreports descriptive statistics on the regression variables. Section 4 covers theempirical evidence and section 5 concludes.

2. Motivation

2.1 THE IMPACT OF POLITICAL CONNECTIONS ON AUDITOR CHOICE

Political connections can benefit firms in many ways.4 However, anotherperspective holds that they can also lead to value-destroying tunneling bydominant insiders eager to at least recover the costs incurred in develop-ing these ties (e.g., Morck, Stangeland, and Yeung [2000]). In fact, Qian,Hongbo Pan, and Yeung [2011] report that the share of earnings that in-siders expropriate from outside investors in China exceeds the collectivevalue that political connections generate for the firm. Controlling share-holders in connected firms may have more opportunity to divert corpo-rate resources since they tend to be subject to fewer disciplinary constraintsfrom regulators. For example, Berkman, Cole, and Fu [2010] find evidencefrom stock market returns in China implying that minority investors per-ceive that regulators will fail to protect their interests by strictly enforc-ing new governance standards when the firm has a controlling owner withpolitical connections.5 Similarly, recent U.S. research suggests that politi-cally connected firms that fraudulently exaggerate their earnings experi-ence more lenient monitoring from regulators relative to fraudulent firmswithout political connections (e.g., Correia [2010], Yu and Yu [2011]).

Our research is grounded in prior research implying that Big 4 audi-tors supply better monitoring than non–Big 4 auditors. However, a natural

4 These political benefits include preferential treatment in the form of access to credit fromstate-owned banks (e.g., Dinc [2005]); the receipt of government contracts (e.g., Agrawal andKnoeber [2001]); corporate bailouts in the event of financial distress (e.g., Faccio, Masulis,and McConnell [2006]); lower tax burdens (e.g., Adhikari, Derashid, and Zhang [2006]);lax regulatory enforcement (e.g., Berkman, Cole, and Fu [2010]); and greater allocation ofgovernment investment during financial crises (e.g., Duchin and Sosyura [2012]).

5 However, evidence from a single country may not generalize elsewhere. For example, al-though there is extensive research on political connections in Indonesia, Faccio, Lang, andYoung [2001] caution against extrapolating inferences from there given its weak capital mar-ket institutions and poor corporate transparency. Rather than the unique conditions in playwhen focusing on a single country, we analyze the importance of connections worldwide toauditor choice to justify more general insights.


question is whether the Big 4 outperform other auditors outside the UnitedStates where legal institutions governing investor protection are more be-nign. Some equity pricing evidence suggests that the severe exposure tocivil lawsuits confronting auditors in the United States is responsible fora major fault line that separates this country from the rest of the worldon differential audit quality (e.g., Khurana and Raman [2004], El Ghoul,Guedhami, and Pittman [2012]). Although both reputation incentives andlitigation shape Big 4 audit quality in the United States (e.g., Baber, Kumar,and Verghese [1995], Mansi, Maxwell, and Miller [2004]), the Big 4’s inter-est in protecting their reputations is largely behind their audits becomingeconomically distinct in other countries where it is harder for investors torecover damages when audit failure occurs.

In short, prior research suggests that reputation incentives are sufficientto generate an audit quality differential in countries with mild private en-forcement against auditors. Consistent with theory (e.g., DeAngelo [1981],Rogerson [1983]), this evidence implies that large auditors with valuablereputations at stake provide stricter monitoring. For example, recent re-search on German (Weber, Willenborg, and Zhang [2008]) and Japanese(e.g., Skinner and Srinivasan [2012]) firms supports the reputation expla-nation for audit quality in countries that impose minimal discipline onauditors in the form of holding them liable for violating securities laws.6

Moreover, Big 4 auditors with global practices may provide uniformly high-quality assurance services worldwide to avoid undermining their reputa-tions (e.g., Humphrey, Loft, and Woods [2009]). Altogether, this researchhelps justify our focus on the importance of Big 4 auditors to constrain-ing insiders in politically connected firms against distorting their financialstatements.

Politically connected firms may be reluctant to appoint Big 4 auditorsto improve accounting transparency since prior research suggests thatthey have access to cheap loans from state-owned banks anyway (e.g.,Dinc [2005], Claessens, Feijen, and Laeven [2008]). Moreover, Leuz andOberholzer-Gee [2006] find that Indonesian firms with close connectionsto the state avoid raising capital from arm’s length sources that insist onmore transparency since they are eager to conceal transactions benefit-ing controlling insiders and their political backers. In motivating their re-search on the impact of politically charged events on the release of negativefinancial news by Chinese state-owned enterprises, Piotroski, Wong, andZhang [2008, p. 3] explain that: “transparency will limit the ability of politi-cians and managers to consume their private benefits of control by expos-ing poor governance . . . ” They find that connected firms heavily suppress

6 Additionally, Fan and Wong (2005) find that Big 4 auditors improve corporate gover-nance in East Asia, a region where there is hardly any implicit insurance coverage availableto investors in the event of audit failure. In another study on this low-litigation region, Mit-ton [2002] finds evidence corroborating that investors perceive that Big 4 auditors improveaccounting transparency in East Asian firms.


information, which Piotroski, Wong, and Zhang [2008] partly attribute tothese firms’ incentives to hide from minority shareholders’ expropriation-related activities stemming from political cronyism and corruption.

Similarly, Stulz [2005] concludes that the threat of public exposure has asobering impact on whether politicians and insiders collude to extract pri-vate benefits. In evidence implying that smaller investors are marginalizedin these situations, Fan, Wong, and Zhang [2007] find that Chinese firmswith politically connected CEOs seldom appoint directors representing mi-nority shareholders, which stands in sharp contrast to the large fractionof their directors who are affiliated with the largest shareholder or gov-ernments. Faccio [2006] reports some cross-country evidence from stockprice reactions to announcements that politicians were joining the boardsof firms in which outside investors perceived that controlling sharehold-ers and their political allies would exploit these connections to expropriatethem. Her evidence reconciles with prior research implying that politiciansextract rents from the firms that they manage (e.g., Shleifer and Vishny[1994]). Politically connected firms in Canada tend to have concentratedownership (e.g., Morck, Stangeland, and Yeung [2000]), reinforcing thatoutside investors have valid concerns that insiders in these firms may con-sume private benefits to their detriment. Accordingly, although prior re-search supports that political connections can add value to all sharehold-ers, they can also engender agency conflicts between dominant insiders andoutside investors.

Given their diverging accounting transparency incentives, it remains un-clear whether insiders in politically connected firms turn to Big 4 auditorsto lower information asymmetry. In one direction, the stricter monitoringimposed by a higher-quality auditor would reduce insiders’ discretion todistort financial reporting. Consequently, financing costs (valuations) forconnected firms with Big 4 auditors will fall (rise) under this argumentsince accounting transparency helps outside investors identify any expro-priation. In the other direction, connected insiders extracting private ben-efits may choose a non–Big 4 auditor to hide that they are depriving out-side investors. Accompanying political ties according to this argument arestrong incentives for insiders to deliberately render the financial statementsless informative by hiring a lower-quality auditor to help cover their tracks.

This underlying tension in insiders’ financial reporting incentives moti-vates our analysis (Fan and Wong [2005]). We focus on how firms with polit-ical connections weigh the marginal benefits of appointing a Big 4 auditor(e.g., cheaper equity pricing and higher firm value) against its marginalcosts (e.g., narrower scope to expropriate). Big 4 audits are a two-edgedsword from the standpoint of insiders: negative when they are extractingprivate benefits and positive when they internalize outside investors’ bestinterests. The importance of political connections to the demand for Big 4audits remains an empirical question that hinges on which financial report-ing incentive dominates. We, largely for expositional convenience, predictthat firms with political ties tend to hire higher-quality auditors to credibly


commit to refrain from diverting corporate resources (all hypotheses arestated in the alternative):

H1: In comparison to other public firms, politically connected firms aremore likely to appoint Big 4 auditors.

2.2 THE MEDIATING ROLE OF FIRMS’ OWNERSHIP STRUCTURES

Ownership characteristics may shape the role that political connectionsplay in auditor choice. La Porta et al. [2002] report that ownership struc-tures in which dominant shareholders exercise control despite owning onlya small fraction of the firm’s cash flow are widespread around the world.7

Mapping into our research questions, Fan and Wong [2005] find that thedemand for external monitoring by a high-quality auditor in East Asianfirms rises when the controlling shareholder’s voting rights exceed her cashflow rights. Given that minority investors become more susceptible to ex-propriation as the ownership-control gap widens (e.g., Shleifer and Vishny[1997], Joh [2003], Faccio [2006]), we expect to observe that such con-nected firms are even more likely to appoint Big 4 auditors to reduce infor-mation asymmetry.

Similarly, firms with a single large shareholder suffer worse agency con-flicts with outside investors. Pagano and Roell [1998] model that firms withmultiple large shareholders—with both the ability (via their voting rights)and the incentive (via their cash flow rights) to actively cross-monitor eachother—prevent insiders from accruing private benefits. In contrast, ratherthan requiring the consent of a coalition of large shareholders, a singledominant shareholder can unilaterally dictate corporate policy, includingdiversionary activities (Bennedsen and Wolfenzon [2000]). It follows thatstrict external monitoring by Big 4 auditors is more valuable to outside in-vestors in connected firms when they cannot rely on committed internalmonitoring by multiple major shareholders to protect their interests.

Finally, large shareholders in business groups can exploit, for example,pyramidal ownership to secure control rights that far exceed their equity

7 The collapse of Parmalat, the Italian dairy-and-food conglomerate, in 2003 illustrates theinterplay between ownership structure, political connections, and insiders disguising their di-version of corporate resources by manipulating financial reporting. The company, which re-mained closely controlled by the Tanzi family through a pyramidal ownership structure afterit went public in 1990, was accused of deliberately exaggerating its earnings. The company’sfounder and CEO, Calisto Tanzi, who admitted to diverting about $640 million from Parmalatto his family’s companies (Sylvers [2004]), was eventually convicted and sentenced. Other in-siders later confessed to depriving outside investors by tunneling “commissions” to offshorecompanies that they controlled (e.g., Gumbel [2004]). After recounting how Mr Tanzi devel-oped connections with politicians, Ferrarini and Giudici [2005, p. 12] argue that, “Parmalatreveals some features common to firms that have faced catastrophic financial failures: mas-sive growth, questionable accounting and accountants, poor underlying performance, polit-ical connections, a dominating shareholder, complex corporate structures and operationalmystery.”


stakes, providing them with greater incentives and means to siphon corpo-rate resources than their counterparts in independent firms (e.g., La Porta,Lopez-de-Silanes, and Shleifer [1999], Claessens et al. [2000], Bae, Kang,and Kim [2002]). Firms belonging to business groups may be more likelyto appoint a Big 4 auditor to provide outside investors with more assurancethat they abstain from extracting private benefits. Since the separation ofcash flow rights from voting rights in firms affiliated with a business groupmagnifies agency costs, minority investors will particularly value the pres-ence of a Big 4 auditor in this situation. In our second prediction, we ex-amine whether the importance of political connections to auditor choicevaries with firms’ ownership structures:

H2: In comparison to other connected firms, politically connected firmswith ownership characteristics that worsen agency conflicts with out-side investors are even more likely to appoint Big 4 auditors.

2.3 THE MEDIATING ROLE OF COUNTRY-LEVEL INSTITUTIONS

Next, we evaluate whether country-level governance institutions mediatethe relation between auditor choice and political connections. Recent ev-idence implies that political connections are prevalent in countries withunderdeveloped legal institutions and pervasive corruption (e.g., Faccio[2006, 2010]). Reflecting the importance of transparency, Djankov et al.[2010] report that public disclosure of politicians’ finances and businessactivities correlates with lower perceived corruption. Similarly, Johnsonet al. [2000] document that the risk of insider diversion is increasing incountries’ corruption. More recently, Boubakri et al. [2012] find that po-litical connections are more valuable in countries with weak institutionalenvironments. Consequently, we expect that operating in countries withworse institutional infrastructure intensifies connected firms’ incentives toengage a Big 4 auditor to lend more credibility to their financial statements.In our third prediction, we isolate whether the role that political ties playin auditor choice hinges on the quality of countries’ governance institu-tions:

H3: In comparison to other public firms, politically connected firms incountries with relatively poor governance institutions are even morelikely to appoint Big 4 auditors.

2.4 ECONOMIC IMPLICATIONS OF AUDITOR CHOICE IN POLITICALLYCONNECTED FIRMS

Finally, we examine several economic outcomes to help empirically clar-ify what is behind any evidence that political connections elicit greater de-mand for Big 4 auditors. Since exploiting connections to orchestrate thediversion of corporate resources requires hiding, credible financial report-ing plays a natural role in protecting outside investors by lowering infor-mation asymmetry. Accordingly, we predict that connected firms intent onreducing agency costs by appointing a Big 4 auditor exhibit less earnings


T A B L E 1Politically Connected Firms’ Distribution by Country

Country N % Country N %

Austria 5 0.36 Italy 37 2.70Belgium 20 1.46 Japan 100 7.29Canada 5 0.36 Korea, South 25 1.82Chile 10 0.73 Malaysia 268 19.55Denmark 10 0.73 Mexico 20 1.46Finland 10 0.73 Philippines 18 1.31France 51 3.72 Singapore 54 3.94Germany 28 2.04 Spain 10 0.73Greece 5 0.36 Sweden 10 0.73Hong Kong 22 1.60 Switzerland 15 1.09India 5 0.36 Taiwan 5 0.36Indonesia 105 7.66 Thailand 93 6.78Ireland 10 0.73 United Kingdom 395 28.81Israel 10 0.73 United States 25 1.82

Total 1,371 100

This table reports the country and industry distribution for the sample of 1,371 politically connectedfirms from 28 countries.

management, enabling them to enjoy greater transparency, lower equityfinancing costs, and higher valuations:

H4: In comparison to other politically connected firms, politically con-nected firms with Big 4 auditors benefit from lesser earnings man-agement, greater transparency, higher valuations, and cheaper equityfinancing.

3. Data Description

3.1 THE SAMPLE

To analyze the impact of political connections on auditor choice, wehand-match data from two sources: political connections data from Faccio[2006] and auditor identity, financial statement, and ownership data fromWorldscope. We confine the analysis to countries with connected firms ac-cording to Faccio [2006], which yields a sample of 1,371 (30,181) firm-yearobservations with (without) political connections from 28 countries cover-ing the period from 2001 to 2005.8 Table 1 presents sample characteristicsfor the politically connected firms by country. It is evident from the countrydistribution that the sample exhibits good diversification across geograph-ical regions, including Asia, Europe, Latin America, and North America,

8 However, all of our inferences hold when we extend our analysis to cover the entire setof 47 countries studied in Faccio [2006]. In this expanded sample, politically connected firmsrepresent almost 2% of the total firm-year observations, which is comparable to the 2.7%reported in Faccio’s [2006] full data set.


which is important when examining the interplay between political connec-tivity and country-level governance institutions. The United Kingdom andMalaysia contribute the largest share of the sample at 28.8% and 19.6%,respectively, followed by Indonesia (7.7%), Japan (7.3%), and Thailand(6.8%). All other countries comprise less than 4% of the sample.

3.2 VARIABLES AND DESCRIPTIVE STATISTICS

3.2.1. Measuring Auditor Quality. We follow extensive prior research bygauging auditor quality with a dummy variable labeled BIG 4 that takes thevalue of one for firms with Big 4 auditors (and their predecessors), andzero otherwise.9 Given that the Worldscope database does not provide au-ditor history details, we ensure accuracy in coding BIG 4 by identifying audi-tors with five (2001–2005) of its compact discs. The descriptive statistics intable 2 reveal that connected firms rely more on Big 4 auditors compared tononconnected firms; the 82–77% difference in market share is statisticallysignificant at the 1% level. The Big 4 market share in our sample is slightlyhigher than the 71% reported in Choi and Wong [2007] for a sample ofpublic firms from 39 countries for the period 1993–1998 and the 74% re-ported in Francis and Wang [2008] for a sample of firms from 42 countriesfor the period 1994–2004. Table A1 summarizes all variables used in theanalysis, including the data sources.

3.2.2. Measuring Political Connections. We rely on Faccio’s [2006] data-base to measure political connections. Faccio [2006, p. 369] explains thata firm is considered politically connected if “at least one of its large share-holders (anyone controlling at least 10% of voting shares) or one of itstop officers (CEO, president, vice-president, chairman, or secretary) is amember of parliament, a minister, or is closely related to a top politician orparty.” Apart from its extensive country coverage, an important upside ofthis database is its considerable detail on the type of connection (i.e., con-nection with members of parliament, a minister or the head of state, and

9 After prior cross-country research analyzing years surrounding its collapse (e.g., Francisand Wang [2008]), we include Arthur Andersen in our main specification of the Big 4 audi-tors. However, our core results remain when we remove all Andersen clients from the estima-tions. Similarly, none of our inferences are sensitive to also excluding the successor auditors(whether Big 4 or non–Big 4) to Andersen after its dissolution in 2002. Another issue is the im-pact on our evidence of potential Worldscope auditor coding errors, which might be evidentin low Big 4 audit market shares in some of the countries represented in our sample. We helpmitigate this concern by removing in successive regressions firms from countries in which theBig 4 market share is below 25% (this involves excluding firms from India and Greece) and50% (this involves excluding firms from India, Greece, France, and Mexico). Our evidencesupporting the prediction in H1 holds at the 5% level or better in these smaller samples. Also,we perform spot checks on 10% of the Indian, Greek, French, and Mexican firms in our sam-ple, which confirms without exception that auditor identity in Worldscope matches that infirms’ annual reports. In any event, auditor coding errors, which inject noise into the analysis,would likely work against our tests rejecting the null hypotheses.


T A B L E 2Descriptive Statistics for the Politically Connected Firms

Means Medians

Connected Nonconnected Connected NonconnectedFirms Firms t-statistics Firms Firms z-statistics

BIG 4 0.82 0.77 3.39∗∗∗

LARGEOWN 0.27 0.26 0.57 0.20 0.17 0.89COMPLEXITY 2.74 2.60 3.08∗∗∗ 3.00 2.00 2.68∗∗∗

FOREIGNSALES 20.46 18.06 2.22∗∗ 0.00 0.00 2.05∗∗

FINANCING 0.07 0.08 –0.99CROSS-LISTING 0.10 0.05 5.48∗∗∗

SIZE 15.68 15.42 2.18∗∗ 15.15 15.50 2.25∗∗

STATEOWN 0.26 0.06 2.06∗∗ 0.00 0.00 1.94∗

ROA 0.03 0.03 1.21 0.04 0.03 0.89LEVERAGE 0.59 0.44 6.59∗∗∗ 0.34 0.18 7.31∗∗∗

GROWTH 4.85 6.30 –2.36∗∗ 3.25 2.88 1.34INV 0.09 0.10 –4.91∗∗∗ 0.06 0.08 –5.36∗∗∗

MTB 1.70 1.61 1.93∗ 1.27 1.20 1.53ACCURACY −0.01 −0.01 0.52 0.00 0.00 0.70IAS 0.18 0.16 1.67∗

ANALYSTS 10.91 8.33 5.63∗∗∗ 10.00 6.00 6.62∗∗∗

EM 0.04 0.08 −4.20∗∗∗ 0.04 0.05 −3.84∗∗∗

KMED 11.15 11.76 −0.76 10.34 10.83 −0.38

This table reports measures of central tendency for all explanatory variables according to political con-nection. The full sample includes 1,371 politically connected firms and 1,911 nonconnected firms. ∗∗∗, ∗∗,and ∗ denote statistical significance at the 1%, 5%, and 10% levels, respectively. Definitions and data sourcesfor the variables are provided in table A1.

close relationship to a top official). Faccio [2006] classifies a firm as con-nected through a minister or head of state when the politician or a close rel-ative (son or daughter) holds this office and is a large shareholder or top of-ficer. In her analysis, a firm is connected with a member of parliament whenthe large shareholder or the top director is a member of parliament. Rela-tives are not included in this classification. Close connections in the formof well-known friendships and connections are identified by several sources(The Economist, Forbes, or Fortune) and prior studies (e.g., Backman [1999],Agrawal and Knoeber [2001], Fisman [2001]). The names of top officersand shareholders are drawn from Worldscope, Extel, Lexis-Nexis, and com-pany Web sites. Shareholder information is also collected from Claessens etal. [2000], Faccio and Lang [2002], and various stock exchanges Web sites.Applying these definitions, Faccio [2006] identifies 541 firms with politicalconnections. We follow recent research by specifying our main test variableas a dummy variable (CONNECTED) that takes the value of one if a companyis identified as politically connected in Faccio’s [2006] database, and zerootherwise (e.g., Faccio, Masulis, and McConnell [2001], Boubakri, Cosset,and Saffar [2008], Boubakri et al. [2012], Faccio [2010], Chaney, Faccio,and Parsley [2011]).

3.2.3. Measuring Country-Level Governance Institutions. We rely on fourwidely used proxies to calibrate the quality of countries’ governance


institutions. The first variable is Faccio’s [2006, p. 373] regulatory score(RESTRICTIONS), which is an assessment of the stringency of “regulationsthat prohibit or set limits on the business activities of public officials.” Thisregulatory score varies from zero to six with high values indicating majorrestrictions on public officials. The second variable is La Porta et al.’s [1998,p. 1125] measure of the risk of expropriation (EXPROPRIATION), which isan assessment of the “risk of a modification in a contract taking the formof a repudiation, postponement, or scaling down” due to “budget cutbacks,indigenization pressure, a change in government, or a change in govern-ment economic and social priorities.” We recode the index from 0 to 10with higher values reflecting greater risk of expropriation. The third vari-able is Djankov et al.’s [2008] anti-self-dealing index (ANTISELF), whichfocuses on the regulation of corporate self-dealing transactions in 72 coun-tries along three dimensions: disclosure, approval procedures for transac-tions, and facilitation of private litigation when self-dealing is suspected.The fourth proxy is La Porta, Lopez-de-Silanes, and Shleifer’s [2006] mea-sure of investor protection (PROTECTION), which is equal to the princi-pal component of the anti-director rights, disclosure requirements, and li-ability standards indices described in their database. Table A2 reports themeans of these variables by country.

3.2.4. Control Variables. In our multivariate regression analysis, we at-tempt to isolate the role that political connections play by comprehen-sively controlling for two sets of variables known to affect auditor choiceaccording to prior research (e.g., Mansi, Maxwell, and Miller [2004], Fanand Wong [2005], Lennox [2005], Choi and Wong [2007], Fortin andPittman [2007], Wang, Wong, and Xia [2008], Guedhami, Pittman, andSaffar [2009]). The first set includes the following firm-level characteristics:firm size (SIZE), which we measure with the natural logarithm of total as-sets expressed in U.S. dollars;10 asset structure (INV), which we capture withthe ratio of inventory to total assets; leverage (LEVERAGE), which we codeas the ratio of long-term debt to total equity; growth (GROWTH), whichamounts to the asset growth ratio in the past year; ownership structure vari-ables: the equity stakes held by the largest shareholder (LARGEOWN) andthe government (STATEOWN), and the percentage of voting rights belong-ing to the ultimate owner (CONTROLRIGHTS) obtained from Claessens,Djankov, and Lang [2000] and Faccio and Lang [2002]; complexity

10 None of our core results are materially sensitive to replacing SIZE with the natural loga-rithm of sales or market capitalization. Given that both BIG 4 and POLITICAL are positivelycorrelated with SIZE according to table A3, we help reduce the concern that firm size is spu-riously responsible for our evidence as follows. After Feltham, Hughes, and Simunic [1991]and Pittman and Fortin [2004], we re-estimate our regressions after isolating a size-truncatedsample comprised of all firms ranging between the smallest Big 4 client according to assetsand the largest non–Big 4 client. In this restricted sample, which helps address whether ourresults reflect pervasive economic phenomena rather than very large firms dominating theanalysis, the evidence on our predictions persists at the 5% level or better.


(COMPLEXITY), which we measure with the number of business segmentsbased on two-digit SIC codes; foreign sales (FOREIGNSALES), which is theportion of sales from foreign operations; level of financing activities, whichwe capture with two variables: a dummy variable that takes the value of oneif the sum of new long-term debt plus new equity exceeds 20% of total as-sets (FINANCING) and cross-listing in foreign markets (CROSS-LISTING);and profitability (ROA), which is the return on assets ratio. The second setof controls includes two macroeconomic variables, namely the logarithmof GDP per capita (LGDPC) and a country’s foreign direct investment as afraction of GDP (FDI), and a proxy for a country’s auditor discipline infras-tructure, which reflects the intensity of civil litigation against auditors (SUEAUDITOR) according to La Porta, Lopez-de-Silanes, and Shleifer [2006].Prior evidence suggests a high correlation between the level of economicdevelopment and the demand for transparency, including auditor choice(e.g., Leuz, Nanda, and Wysocki [2003], Guedhami, Pittman, and Saffar[2009]).

Table 2 presents descriptive statistics for the regression variables. Theaverage politically connected firm in our sample is relatively large accord-ing to its assets (SIZE = 15.7; $553 million before logarithmic transforma-tion) and valuable (MTB = 1.7), with considerable long-term debt to equity(LEVERAGE = 59%) and moderate asset growth (GROWTH = 5%) and for-eign operations (FOREIGNSALES = 20%). In comparison to nonconnectedfirms, we find that connected firms, on average, are larger, more leveraged,more complex, and more likely to cross-list in foreign markets. Althoughconnected firms have a higher fraction of state ownership and foreign salesthan nonconnected firms, their growth rates and inventory levels tend to belower. These differences are consistent with prior research (e.g., Boubakri,Cosset, and Saffar [2008], Boubakri et al. [2012], Faccio [2010]).

Table A3 reports correlation coefficients between the regression variableswhile allowing for country and firm level clustering. Consistent with theprediction in H1, we observe a positive correlation between CONNECTEDand BIG 4 that is significantly different from zero at the 1% level. In thenext section, we consider whether this preliminary evidence that politicallyconnected firms are more likely to appoint Big 4 auditors persists in a seriesof multivariate regressions. Finally, we find that the correlations betweenthe controls are generally small, reducing concerns that multicollinearity isspuriously responsible for our evidence on the predictions.

4. Empirical Results

In a multivariate regression framework, we estimate the impact of polit-ical connections on the likelihood that firms will hire a Big 4 auditor toexamine the prediction in H1. Next, we analyze the prediction in H2 thatagency problems embedded in firms’ ownership structures strengthen thelink between political connections and auditor choice. For the predictionin H3, we isolate whether the importance of political connections to auditor


choice hinges on the quality of a country’s governance institutions. Finally,we examine whether politically connected firms with Big 4 auditors benefitfrom lower earnings management, greater transparency, higher valuations,and cheaper financing under the prediction in H4.

4.1 POLITICAL CONNECTIONS AND AUDITOR CHOICE

4.1.1. Main Evidence. To evaluate the link between political connectionsand auditor choice, we focus on the sample of connected firms describedin section 3.1 and a set of peer firms without political connections. In or-der to improve identification by confronting the threat that differences infirm characteristics, such as their ownership structures and size, are spu-riously responsible for any evidence supporting our predictions, we em-ploy two separate matching techniques to specify the benchmark group ofnonconnected firms.11 The first peer group consists of nonconnected firmsmatched to connected firms based on country, industry, year, and decile oftotal assets. The second group comprises firms matched on various observ-able characteristics according to a propensity score matching procedurethat we outline below.

Table 3 presents the results from estimating several pooled multivariatelogistic regressions to analyze the impact of political connections on au-ditor choice worldwide. All standard errors are clustered at the firm andcountry level, and adjusted for heteroskedasticity. We rely on two-sidedtests to gauge statistical significance in all estimations. To better assess theeconomic impact of the key test variable (CONNECTED), we also reportmarginal effects in square brackets. In these regressions, we control forownership structure in alternative ways. In models 1 and 2, we control forthe equity stake of the largest shareholder (LARGEOWN), rather than theirultimate ownership (CONTROLRIGHTS), to reduce data attrition. For ex-ample, narrowing our focus to firms with ultimate ownership data wouldlower the countries under study from 28 to 19, preventing us from exam-ining firms from countries such as the United States and Mexico that havea considerable number of political connections according to table 1. How-ever, we replace LARGEOWN with CONTROLRIGHTS in models 3 and 4and with both CONTROLRIGHTS and CASHFLOWRIGHTS in models 5 and6 to better isolate the incremental importance of political connections toauditor choice beyond the ultimate ownership effects that Fan and Wong[2005] document.

Model 1 reveals that the coefficient for the dummy variable identifyingpolitically connected firms (CONNECTED) loads positively at the 5% level,implying that these firms are more likely to hire Big 4 auditors relative tononconnected peers in the same country, industry, year, and decile of total

11 In another strategy for isolating the importance of political connections to auditorchoice, we assemble a third peer group consisting of nonconnected peers matched to con-nected firms based on country, industry, and year. In unreported estimations, we find evidenceat the 1% level supporting the prediction in H1 when we apply this matching technique.


TA

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assets.12 Reflecting its material economic impact, the coefficient estimatefor CONNECTED translates into political affiliations increasing the likeli-hood of appointing a Big 4 auditor by 6%, with all other variables assignedtheir mean values. This result is consistent with the prediction in H1 thatpolitically connected firms are associated with greater demand for Big 4auditors.13

Next, we examine the demand for a Big 4 auditor between connectedfirms and nonconnected peers matched according to propensity scores de-rived as follows (e.g., Boubakri et al. [2012]). First, we require that thecandidate firm for the matching share the same country, year, and indus-try class as the connected firm. Second, among the potential control samplefirms, we select the optimal match based on the nearest neighbor techniqueof the propensity score matching procedure. We follow Rosenbaum andRubin [1983] and Heckman, Ichimura, and Todd [1997, 1998] in relyingon this procedure in an attempt to control for differences in characteristicsbetween connected and nonconnected firms. To calculate the propensityscore, we analyze a comprehensive set of firm characteristics that shouldcapture the likelihood that a given firm will be politically connected ac-cording to prior research. More specifically, we consider size, leverage, thelargest shareholder’s ownership stake, state ownership, and cross-listing asconnected firms are likely to be different from nonconnected peers alongthese characteristics (see, e.g., Faccio [2006, 2010], Leuz and Oberholzer-Gee [2006], Boubakri, Cosset, and Saffar [2008], and Bunkanwanicha andWiwattanakantang [2009]).

This matching procedure translates into a sample of 2,742 firm-year ob-servations equally distributed by country, industry, and year between polit-ically connected and nonconnected firms. Despite the major data attritionthat accompanies constructing a matched sample using propensity scores inour setting, an upside of applying this technique here is the large numberof potential matches (30,181 nonconnected observations), ensuring thatthe connected and nonconnected samples have extremely close propen-sity scores. In model 2, we find that connected firms are significantly more

12 Reflecting the importance of political connections to auditor choice, the incremental R 2

for CONNECTED is 0.037 relative to 0.027 for SIZE.13 Although we follow extensive prior research in primarily specifying auditor quality with

the presence or absence of a Big 4 auditor, we also examine whether our results are mate-rially sensitive to replacing BIG 4 with firms’ audit fees. Extant research implies that auditfees are higher when auditors expend more effort on an engagement, translating into bet-ter audits (e.g., Dye [1993], Davis, Ricchiute, and Trompeter [1993], Whisenant, Sankaragu-ruswamy, and Raghunandan [2003], Caramanis and Lennox [2008]). Consequently, politi-cally connected firms will incur higher audit fees under the intuition for the prediction inH1. However, given poor audit fee data availability in Worldscope, the sample shrinks to 1,756firm-year observations compared to the 3,282 observations under study in model 1 in table 3.Nevertheless, we find in unreported results that CONNECTED continues to load positively atthe 1% level despite the loss in power in this smaller sample, suggesting that connected firmspay higher audit fees than their nonconnected peers matched by country, industry, year, andsize.


likely to appoint a Big 4 auditor than their propensity score matched peers.The coefficient estimate for CONNECTED in model 2 implies that a 5%increase in the probability of engaging a Big 4 auditor accompanies a polit-ical connection. In unreported tests, we exploit the large number of closematches available in our data set by implementing one-to-five and one-to-ten matching, and find that CONNECTED loads positively at the 5% and 1%levels, respectively, in these larger samples.

To better isolate the impact of political connections on auditor choice,we replace in models 3 and 4 the variable LARGEOWN with the ultimateownership variable CONTROLRIGHTS after Fan and Wong [2005]. In bothregressions, we continue to estimate a positive and statistically significant(at the 5% level) coefficient on CONNECTED. Corroborating our earlierevidence, these results imply that connected firms are more likely to en-gage a Big 4 auditor compared to their peer group of nonconnected firms.Economically, the coefficient estimates for CONNECTED suggest that firmsbecome 8% (model 3) and 6% (model 4) more likely to hire a Big 4 audi-tor in the presence of a political connection, with all other variables set totheir mean values. We complement the propensity score matching evidencein model 4 by conducting one-to-five and one-to-ten matching to take ad-vantage of the deep pool of control observations available in our data set.In these unreported estimations, we find that CONNECTED is positive andstatistically significant at the 1% level in both cases. In models 5 and 6, wecontinue to find that CONNECTED loads positively at the 5% level when weadd the cash flow rights of the ultimate owner to models 3 and 4. Consistentwith Fan and Wong [2005], CASHFLOWRIGHTS is statistically insignificantin these regression models, while CONTROLRIGHTS only enters negativelyin model 5. It is important to note that these ownership variables are highlycorrelated in our data (ρ = 0.77, p < 0.001).

In other unreported analysis, we follow Fan and Wong [2005] by speci-fying control concentration with a dummy variable (CONTROLRIGHTS ≥30%) assigned the value one if CONTROLRIGHTS is at least 30%, and zerootherwise. Additionally, in successive regressions, we replace CONTROL-RIGHTS with the separation between the voting and cash-flow rights be-longing to the ultimate owner (WEDGE), and a dummy variable set equalto one if WEDGE is at least 20%, and zero otherwise. We find that ourcore evidence on CONNECTED holds at the 5% level or better in thesere-estimations, reinforcing that the importance of political connections toauditor choice is incremental to the impact of the ultimate ownership char-acteristics that Fan and Wong [2005] examine.14

14 Our empirical design primarily diverges from Fan and Wong’s [2005] in two ways. First,we control for a larger set of firm-level determinants of auditor choice. In fact, the 14 controlsfor firm characteristics in our models include the four in their main specifications. Second, weapply various matching techniques to improve identification in our setting. After restrictingour sample to the eight Asian countries analyzed in Fan and Wong [2005] and no longerexamining matched samples, we find a positive and statistically significant coefficient on


Collectively, the results in table 3 using different matching techniquessuggest that the demand for a Big 4 auditor is higher in politically con-nected firms relative to their nonconnected peers. Importantly, our ev-idence persists after controlling for a comprehensive set of firm-leveldeterminants of auditor choice. In particular, we find that the role thatpolitical connections play in auditor choice extends beyond the impact ofthe ownership variables capturing the equity stakes held by the ultimateshareholder and the state. Interestingly, the coefficient for state ownership(STATEOWN) is generally negative and statistically significant in table 3.This result suggests that the demand for Big 4 auditors is decreasing instate ownership, supporting that the evidence in Guedhami, Pittman, andSaffar [2009] for the specific case of newly privatized firms generalizes topublic firms worldwide. More generally, this evidence squares with prior re-search on the political economy and financial reporting transparency (e.g.,Bushman, Piotroski, and Smith [2004], Bushman and Piotroski [2006]).Among the other firm-level determinants, we find that firm size, profitabil-ity, and foreign sales are positively related to auditor choice; only FINANC-ING and LEVERAGE have no perceptible impact on this decision in any ofthe table 3 regressions. Additionally, the three country-level controls (FDI,LGDPC, and SUE AUDITOR) generally enter positively and significantly atthe 5% level or better, implying that the demand for high-quality auditorsis higher in countries with more foreign investor involvement, more devel-oped economies, and more discipline imposed on auditors through civillitigation institutions.

4.1.2. Sensitivity Analyses. In this section, we evaluate whether our ear-lier evidence on the importance of political connections to auditor choicepersists when we tackle potential omitted variables bias and endogeneity,re-estimate our regressions on alternative matched samples, and respecifyauditor quality. To preview, the results that we report in table 4 lend ad-ditional support to the prediction in H1 that public firms with politicalconnections are more likely to appoint high-quality auditors. Except whenexamining whether our evidence holds when we apply alternative matchingapproaches, we rely on the sample of connected firms and nonconnectedpeers matched based on country, industry, year, and decile of total assets(model 3 in table 3) as our baseline in these sensitivity tests.

4.1.2.1. Omitted Variables Bias and Endogeneity. We begin the sensitivityanalysis by confronting whether endogeneity or omitted variables bias ex-plains the evidence in table 3. Although our research design mitigatesthese issues since we control for an extensive set of firm- and country-level

CONTROLRIGHTS, helping to reconcile our evidence to theirs. More generally, our resultsare consistent with El Ghoul et al. [2013], who find that Fan and Wong’s [2005] evidencefor East Asia does not extend to Western Europe where investor protection institutions aretypically better.

126 O. GUEDHAMI, J. A. PITTMAN, AND W. SAFFART

AB

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AUDITOR CHOICE IN POLITICALLY CONNECTED FIRMS 127T

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variables and implement various matching procedures, we address linger-ing concerns with three techniques.

First, in unreported analysis, we estimate a treatment effects model sinceit is plausible that some unobserved determinants of auditor choice mayalso affect political connections, causing our reported results to be bi-ased and inconsistent. After Chaney, Faccio, and Parsley [2011] and Chen,Chen, and Wei [2011], we rely on CAPITAL—a dummy variable set equalto one if the firm is located in the capital city, and zero otherwise—as aninstrument for political connectivity given prior evidence on its role in facil-itating the formation of political connections (e.g., Roberts [1990], Agrawaland Knoeber [2001], Bertrand et al. [2007]). Importantly, the correlationbetween CAPITAL and BIG 4 is small in our data set (ρ = 0.05), helping tojustify the validity of this exclusion restriction (e.g., Larcker and Rusticus[2010], Lennox, Francis, and Wang [2012]). In the first stage, we performa logit regression of political ties on the dummy variable CAPITAL and theset of independent variables included in model 3 of table 3. The first stagefitted values for political connections are then used in the second stagelogit regression explaining auditor choice. Similar to Boubakri, Cosset, andSaffar [2008] and Chaney, Faccio, and Parsley [2011], the first stage regres-sion results include that the firm’s location is a good predictor of politicalconnections: the coefficient for CAPITAL loads positively at the 1% level,implying that the incidence of connections is higher for firms located inthe capital. Consistent with the prediction in H1, we find in the secondstage logit estimation that the coefficient of the (predicted) political con-nection variable is positive and statistically significant at the 1% level.15

Second, we exploit the panel nature of our data by estimating a randomeffects model. In the results reported in model 1 of table 4, we continue tofind that appointing a Big 4 auditor becomes more likely in the presenceof a political connection. This is constructive for mitigating the concernthat omitted variables are spuriously behind the evidence supporting theprediction in H1. Third, we control for several additional country-level fac-tors that capture: openness to international trade (OPENNESS); the level offreedom of the press (NEWSPAPER), which measures the extent of publicopinion pressure according to Dyck and Zingales [2004]; the risk of state

15 Although the treatment effects model has the advantage of analyzing the entire sample(e.g., Chaney, Faccio, and Parsley [2011]), an alternative approach to addressing endogeneityin order to improve identification is to analyze political connection formation over time andobserve the ensuing effects on auditor choice. However, Chaney, Faccio, and Parsley [2011]stress that a major limitation of this approach is the small sample of firms for which the dateof political connection formation can be determined, preventing researchers from using for-mation dates to draw meaningful inferences. In our setting, we could only pinpoint the dateof formation of the political connection for 44% of our sample. Regrettably, the vast majorityof these connections were forged before 2001 when our sample period begins, precludingus from reliably examining the link between changes in political connections and auditorchoice. Moreover, Faccio’s [2006] database does not disclose the connected member, whichcomplicates tracking shifts in political affiliations over our 2001–2005 sample period.


expropriation (PREDATION) using Durnev and Fauver’s [2009] predationindex; and three proxies for the quality of legal institutions derived from LaPorta, Lopez-de-Silanes, and Shleifer [2006], namely, accounting standards(DISCLOSE), the efficiency of the judicial system (JUDICIAL), and the ruleof law (RULEOFLAW). Prior research implies that these country-level vari-ables matter to the demand for accounting transparency as well as the pres-ence and value of political connections (e.g., Faccio [2006], Choi and Wong[2007], Guedhami, Pittman, and Saffar [2009], Boubakri et al. [2012]).Besides these country-level variables, we control for business group mem-bership (BUSINESSGROUP), which may affect group-wide auditor choice.Despite that adding these controls leads to some sample attrition, we findin model 2 that the positive relation between CONNECTED and auditorchoice remains in this regression. Although these additional tests providesome assurance that endogeneity is not responsible for the link that we ob-serve between political connections and auditor choice, we stress that westill cannot infer causality from the analysis.

It also would be premature to conclude that our evidence reflects thatpolitically connected firms are more likely to appoint a Big 4 auditor toprovide stricter monitoring of the financial reporting process unless weconsider two other competing explanations for our evidence. First, a Big 4auditor can protect its valuable reputation and avoid litigation by refusingto accept engagements from clients that are more apt to resort to manip-ulating their financial statements to hide underlying performance, or re-sign from engagements when the ensuing risk reaches an intolerable level(e.g., DeFond, Ettredge, and Smith [1997], Shu [2000], Johnstone and Be-dard [2004]). Second, insiders intending to materially distort their firms’financial statements by, for example, overstating earnings to conceal theirdiversionary activities may prefer to hire a non–Big 4 auditor in order to flyunder the radar when they begin accumulating private benefits at the ex-pense of outside investors (e.g., Fan and Wong [2005], Guedhami, Pittman,and Saffar [2009]).

We follow Lennox and Pittman [2010] in considering the potential rolesthat screening by auditors and selection by their clients play by evaluat-ing whether our core results hold when we isolate firms with long auditortenure. The intuition for this analysis is that endogeneity is worse when theduration between auditor choice and the decision to deliberately exagger-ate earnings is shorter since a firm planning to misreport would requireless lead time to cover its tracks by switching to a non–Big 4 auditor, whileits Big 4 auditor may shed clients that have become riskier (e.g., Jones andRaghunandan [1998], Johnstone and Bedard [2004]).16 Consequently, werestrict the sample to firms that neither upgrade from a non–Big 4 to a Big 4

16 Consistent with Bockus and Gigler’s [1998] theory, Shu [2000] reports that riskier clientsare less likely to retain another large auditor when their incumbent auditor resigns from theengagement. Although prior research implies that large audit firms in the United States aremore eager to avoid riskier clients since they have more to lose in the form of reputational and


auditor nor downgrade from a Big 4 to a non–Big 4 auditor between 1998and 2005—this timeframe covers the five years (2001–2005) under studyin the rest of our analysis and the three preceding years—since we are onmore solid ground in treating BIG 4 as predetermined when auditor tenureis longer (Myers, Myers, and Omer [2003], Caramanis and Lennox [2008],Chang, Dasgupta, and Hilary [2009]). In this smaller sample, we find sup-port at the 1% level in model 3 for the prediction in H1, reducing concernthat screening or selection phenomena are spuriously responsible for ourearlier evidence. Our results are almost identical when we apply the samefive-year tenure breakpoint as Lennox and Pittman [2010].

4.1.2.2. Alternative Samples. In recent cross-country research, Guedhami,Pittman, and Saffar [2009] examine auditor choice in state-owned enter-prises and during their transition to private ownership. In particular, theyreport a negative relation between the extent of government ownership andthe likelihood of selecting a Big 4 auditor. They also find that privatizationcorrects the distortions in auditor choice that Wang, Wong, and Xia [2008]stress, although continued government ownership lowers the probability ofappointing a Big 4 auditor after privatization. To alleviate the concern thatour evidence on the role that political connections play in auditor choicereflects the government’s ownership, we control for its equity stake in allregressions. In unreported analysis, we better isolate the importance of po-litical connections to this decision by excluding privatized firms. The pos-itive and statistically significant relation at the 1% level between politicalconnections and auditor choice persists in this regression.

Our empirical strategy in table 3 involves applying two forms of match-ing to improve identification. Next, we expand this analysis to considerwhether our core evidence is robust to implementing alternative match-ing techniques. First, in model 4, we compare connected firms to theirnonconnected peers matched based on country, industry, year, and decileof the largest shareholder’s voting rights. Second, in model 5, we selectnonconnected firms based on country, industry, year, and the largest share-holder’s identity—the specific types reflect ownership by widely held non-financial institutions, widely held financial institutions, families, the state,and dispersed shareholders according to data available from Claessens et al.[2000] and Faccio and Lang [2002]. Most relevant to our purposes, CON-NECTED remains positive and statistically significant at the 5% level in bothregressions, reinforcing our earlier evidence on the link between politicalconnection and auditor choice.

4.1.2.3. Alternative Dependent Variables. There are reasons to doubt thatBIG 4 is the relevant construct for all of the countries represented in our

litigation costs in the event of audit failure, this evidence is sensitive to shifts in the auditorlitigation liability landscape there (e.g., Jones and Raghunandan [1998], Francis and Reynolds[2003], Choi, Doogar, and Ganguly [2004]).


sample. For example, although table 2 reports that the Big 4 audit nearly82% of the politically connected firms in our sample, data inspection re-veals wide variation in their market shares across countries. Consequently,we respecify auditor choice by coding a dummy variable, LARGEST FIVE,one when the auditor is among the five largest in the country accordingto client assets, and zero otherwise. In unreported analysis, we find thatCONNECTED remains positive and statistically significant at the 5% levelwhen we replace BIG 4 with this alternate dependent variable. We find al-most identical evidence when we calibrate market share with the numberof clients rather than their assets (e.g., Wang, Wong, and Xia [2008]), oridentify large auditors as those that hold at least a 5% market share in thecountry (e.g., DeFond, Wong, and Li [2000]).17

4.2 POLITICAL CONNECTIONS AND AUDITOR CHOICE: THE MEDIATINGROLE OF FIRMS’ OWNERSHIP STRUCTURES

In table 5, we examine in panel A whether the importance of politi-cal connections to auditor choice varies systematically with the extent ofagency costs embedded in firms’ ownership structures. Initially, we estimatewhether the relation between auditor choice and political ties is sensitiveto the presence of any wedge between the controlling shareholder’s vot-ing rights and cash flow rights. To ensure that we draw valid inferencesconcerning the interaction, we also report the corrected mean interac-tive effect of the interaction terms using the methodology proposed byAi and Norton [2003] for nonlinear models. In model 1, we find that theOWNERSHIPWEDGE∗CONNECTED interaction has no perceptible impacton auditor choice, inconsistent with the prediction in H2 that control di-verging from ownership explains demand for high-quality auditors in con-nected firms. Next, we analyze in model 2 whether connected firms aremore likely to hire a Big 4 auditor when the control rights of the ultimateowner exceed 50% and find supportive results.

Consistent with the prediction in H2, we find evidence in model 3 thatconnected firms with a single large shareholder are more likely to appoint aBig 4 auditor, implying that they rely more heavily on external monitoringby high-quality auditors in the absence of internal monitoring by multi-ple large shareholders. This evidence persists in model 4 when we replacethe dummy variable representing the absence of multiple major sharehold-ers with a continuous version of this conditioning variable, NUMBER OF

17 Another issue is that the Big 4 are prohibited from operating in some countries unlessthey form affiliations with local auditors. It follows that audit quality falls when the country re-quires the Big 4 to arrange these local affiliations to access the market. After identifying thesecases using Worldscope data, we narrow our BIG 4 specification to strictly firms from coun-tries that do not require local affiliations; that is, we treat Big 4 auditors with local affiliationsas equivalent to non–Big 4 auditors. In this re-specification, we continue to find evidence atthe 5% level supporting the prediction in H1 that connected firms are more likely to preferhigher-quality auditors.


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LARGE OWNERS, which is the natural logarithm of one plus the numberof shareholders holding at least a 10% equity stake. These results reinforcethat committed monitoring by several large shareholders obviates the disci-plinary role that Big 4 audits play in connected firms.

Similarly, the interaction between BUSINESSGROUP and CONNECTEDloads positively in model 5, implying that Big 4 appointments become morelikely when connected firms belong to a business group. We also estimatea positive and significant mean interactive effect (reported at the bottomof model 5). Our results square with Faccio’s [2006] evidence that cumu-lative abnormal returns surrounding politicians joining firms’ boards arenegative when the connected firm has a pyramidal ownership structurethat increases agency costs since expropriation becomes more lucrative forthe controlling shareholder as the gap between their voting and cash flowrights widens (e.g., Johnson et al. [2000], La Porta et al. [2002], Fan andWong [2005]).

Collectively, the evidence in panel A of table 5 generally supports the in-tuition that connected firms are even more eager to engage high-qualityauditors when their ownership structures leave minority investors morevulnerable to expropriation by dominant shareholders. Economically, ourcoefficient estimates translate into connected firms (i) with the ultimateowner’s control rights exceeding 50%; (ii) with a single large shareholder;and (iii) affiliated with a business group becoming 12%, 15%, and 15%more likely to appoint a Big 4 auditor, respectively, with the rest of the re-gression variables set to their mean values.

In panel B of table 5, we complement the cross-sectional results involv-ing ownership structure by analyzing whether the link between politicalconnections and auditor choice hinges on other firm-level characteristics.More specifically, we follow prior research by examining the role that clientsize, profitability, complexity, financial constraints, and risk play in shapingconnected firms’ demand for Big 4 auditors (e.g., Fan and Wong [2005],Hay, Knechel, and Wong [2006], Chang, Dasgupta, and Hilary [2009],Sankaraguruswamy, Whisenant, and Willenborg [2013]). Consistent withexpectations, we report in models 1–6 evidence that connected firms thatare larger have positive earnings in the past year, have larger capital ex-penditures, are more complex according to the presence of extraordinaryitems or discontinued operations, exhibit a greater change in bankruptcyprobability, and have more current assets—firms with higher levels of inven-tory and receivables are harder to audit—are more likely to rely on a Big 4auditor.18 Except for models 1 and 5, the mean interactive effects reported

18 We continue to find supportive evidence when we replace the dummy variable forwhether the firm has incurred a loss in a prior year with its return on equity to capture prof-itability. Similarly, our results in table 5 are robust to measuring client size with revenues ratherthan assets. We resort to alternative proxies for some constructs when poor data availabilitymeans that we cannot examine more standard measures. For example, we follow Whisenant,Sankaraguruswamy, and Raghunandan [2003] and Sankaraguruswamy, Whisenant, and


at the bottom of panel B are statistically significant. In contrast, we find noevidence in model 7 supporting that connected firms that are cross-listedtend to prefer higher-quality auditors. Similarly, in untabulated results thatshift the focus from foreign financing to foreign operations, this interac-tion remains statistically insignificant when we replace cross-listing with theamount of foreign sales to gauge firms’ international orientation. In mod-els 8 and 9, we also fail to find that connected firms with more debt in theircapital structures or requiring more external financing exhibit greater de-mand for Big 4 auditors; both LEVERAGE and FINANCING are irrelevant toauditor choice according to table 3.

In the first three regressions in panel C of table 5, we examine therole of public scrutiny in shaping auditor choice in politically connectedfirms. This analysis is rooted in the intuition that connections increasethe exposure of insiders to public scrutiny from the press and politicalopponents, reducing their ability and incentives to extract private bene-fits (Stulz [2005]). In short, subjecting connected firms to tough publicscrutiny constrains their diversionary instincts. Consequently, these firmswill prefer to appoint Big 4 auditors since they have nothing to hide whenthey refrain from self-dealing. In successive regressions, we interact CON-NECTED with three variables reflecting the extent of media and politicaloversight, namely the circulation of daily newspapers divided by popula-tion (NEWSPAPER) from Dyck and Zingales [2004], the strength of polit-ical opposition (POLITICALOPP) obtained from the Database of PoliticalInstitutions (Beck et al. [2001]), and a dummy variable indicating whetherit is a national election year (ELECTION) from the Database of PoliticalInstitutions. The results generally indicate that these variables conditionthe link between political connections and auditor choice in the predicteddirections. More specifically, the interaction terms between CONNECTEDand the variables measuring the strength of political opposition (model 2)and the presence of an election year (model 3) load positively, althoughwe fail to find supportive results when we focus on the role of the press inmodel 1. The positive mean interactive effects reported in models 2 and 3reinforce our conclusions. Next, we evaluate whether the countries’ debtmarket development mediates the link between political ties and auditorchoice given Chaney, Faccio, and Parsley’s [2011] evidence on the impor-tance of political connections to firms’ borrowing costs. We measure debtmarket development with the total value of bank (financial system) depositsto GDP in model 4 (model 5). In both regressions, we find evidence imply-ing that connected firms in countries with more developed debt markets

Willenborg [2013] in gauging firm complexity with the presence of extraordinary items ordiscontinued operations, rather than the number of subsidiaries, the audit report lag, orthe presence of pension or other postretirement plans. However, the interaction with CON-NECTED becomes statistically insignificant when we measure client complexity with the num-ber of business segments.


are less likely to hire Big 4 auditors; the mean interactive effects are alsonegative and statistically significant.

4.3 DOES COUNTRY-LEVEL GOVERNANCE AFFECT THE LINK BETWEENPOLITICAL CONNECTION AND AUDITOR CHOICE?

Given prior research that the value of political connections is higherin weaker institutional environments, it follows that insiders resisting thetemptation to expropriate outside investors will have even more incentiveto improve external monitoring by hiring a Big 4 auditor in these countries.Consequently, we examine the prediction in H3 that the relation betweenpolitical connections and auditor choice is stronger in countries with rela-tively lax governance institutions by re-estimating the regression in model 3in table 3 after bisecting the sample into countries with weak versus stronggovernance according to the median rating of the various proxies describedin section 3.2.19

Table 6 presents the results after dividing the sample using the four prox-ies for country-level governance, RESTRICTIONS, EXPROPRIATION, ANTI-SELF, and PROTECTION. We find across all proxies that the coefficienton CONNECTED is positive and statistically significant in the subsample offirms located in countries with weak governance institutions (models 1, 3, 5,and 7), suggesting that political connections magnify the demand for high-quality audits in these situations.20 However, in stark contrast, we find thatthe coefficient on CONNECTED is statistically indistinguishable from zeroin the subsample of countries with strong governance institutions (models2, 4, 6, and 8). The difference in the CONNECTED coefficients between thesamples of weak and strong institutional environments is statistically signif-icant for two out of the four country-level governance variables; the excep-tions are the comparisons involving RESTRICTIONS and EXPROPRIATION.In unreported regressions, we control for the largest shareholder’s equitystake (LARGEOWN) rather than their control rights (CONTROLRIGHTS) inorder to recover observations by improving the country coverage in table 6to 28 from 19, and find that the CONNECTED coefficients are significantlydifferent between the countries with weak and strong governance institu-tions in all four comparisons. These results lend support to the intuition

19 This split sample design with respect to country-level variables follows extensive prior re-search (e.g., Lang, Lins, and Miller [2004], Pinkowitz, Stulz, and Williamson [2006], Wang[2010]). In an important advantage, this approach avoids multicollinearity complications aris-ing from the high correlations between the test variables and their interaction terms, especiallywhen the interaction involves a dummy variable and country-level time invariant variables. In-deed, in our analysis, the Belsley collinearity test indicates a score above the threshold of 30when we include the interaction terms.

20 Economically, our evidence in this section implies that the importance of political con-nections to auditor choice is generally larger when we isolate firms from countries with rela-tively poor governance institutions. For the full sample, the regression in model 3 in table 3suggests that the probability of hiring a Big 4 auditor rises 8% in the presence of a politicalconnection. In comparison, the coefficient estimates for CONNECTED translate into an 8%impact in model 1 in table 6, 9% in model 3, 13% in model 5, and 14% in model 7.


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A1.


that the incentives of politically connected firms to appoint a Big 4 auditorare stronger in countries with relatively poor governance institutions.

4.4 ECONOMIC OUTCOMES STEMMING FROM AUDITOR CHOICEIN POLITICALLY CONNECTED FIRMS

The analysis above suggests that politically connected firms are morelikely to engage a Big 4 auditor, especially when they suffer more severeagency problems and operate in countries with relatively lax country-levelgovernance institutions. This evidence naturally raises another question:why are these firms more eager to engage a Big 4 auditor? Extant researchdetects that firms with better auditors enjoy higher-quality earnings (e.g.,Becker et al. [1998]), higher valuations (e.g., Fan and Wong [2005]), andlower cost of capital (e.g., Mansi, Maxwell, and Miller [2004]). However,there is evidence that connected firms have preferential access to credit(e.g., Khwaja and Mian [2005]) and are more likely to be bailed out by gov-ernments (Faccio, Masulis, and McConnell [2006]). In other words, someresearch implies that the upside of tough external monitoring by Big 4auditors may be minimal for connected firms. In the other direction, thepresence of a Big 4 auditor protects outside investors by constraining in-siders’ discretion over the financial reporting process, which may translateinto connected firms benefiting from lower information asymmetry. In thissection, we contribute to empirically settling this issue by testing the predic-tion in H4 that politically connected firms appointing a Big 4 auditor prac-tice less earnings management, enjoy greater transparency, exhibit highervaluations, and attract cheaper financing.

In table 7, we report the results of this analysis, which involves interactingauditor choice with the variable CONNECTED to isolate whether politicallyconnected firms benefit more from becoming better known by hiring a Big4 auditor. In focusing on the interaction term between CONNECTED andauditor choice, we examine an extensive set of firm-level outcome variablesmotivated by prior research, namely earnings management (e.g., Beckeret al. [1998], Chaney, Faccio, and Parsley [2011]); analyst forecast coverageand accuracy (e.g., Lang, Lins, and Miller [2004], Lang, Lins, and Maffett[2012], Chen, Ding, Kim [2010]); accounting standard choice (e.g., Langand Maffett [2011], Lang, Lins, and Maffett [2012]); valuation (e.g., Fanand Wong [2005]); and equity pricing (e.g., Khurana and Raman [2004]).

We initially examine the impact of auditor choice on earnings manage-ment since providing evidence that the presence of a Big 4 auditor reducesinformation asymmetry evident in accounting transparency is arguably anecessary condition for proceeding to analyze, for example, whether Big 4clients enjoy higher valuations and lower equity financing costs. After Fanand Wong [2005], we implement a two-stage estimation procedure. In thefirst stage, we predict, for each firm-year, the probability of choosing a Big4 auditor using model 1 in table 3. In the second stage, we regress earningsmanagement (EM)—specified after Leuz, Nanda, and Wysocki [2003] asthe absolute value of accruals over total assets where accruals are calculated


TA

BL

E7

Ana

lysi

sof

the

Impo

rtan

ceof

Aud

itor

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ice

toEa

rnin

gsM

anag

emen

t,Tr

ansp

aren

cy,M

arke

tVal

uatio

n,an

dEq

uity

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ing

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nin

gsM

anag

emen

t(EM

)(2

)A

nal

ystF

ollo

win

g(A

NA

LYST

S)(3

)Fo

reca

stA

ccur

acy

(AC

CU

RA

CY)

Vari

able

Vari

able

Vari

able

PBIG

4∗C

ON

NEC

TED

−0.1

2∗∗∗

PBIG

4∗C

ON

NEC

TED

1.62

∗∗PB

IG4∗

CO

NN

ECT

ED0.

13∗∗

∗

(−2.

67)

(2.4

4)(3

.06)

PBIG

40.

05PB

IG4

1.04

PBIG

40.

01(1

.45)

(1.4

5)(0

.37)

CO

NN

ECT

ED0.

09∗∗

∗C

ON

NEC

TED

−1.4

2∗∗C

ON

NEC

TED

−0.1

1∗∗∗

(2.7

4)(−

2.52

)(−

2.98

)R

OA

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0∗∗∗

CR

OSS

-LIS

TIN

G0.

13C

RO

SS-L

IST

ING

−0.0

0(−

4.14

)(1

.37)

(−0.

85)

SIZE

−0.0

0SI

ZE0.

27∗∗

∗SI

ZE−0

.00∗

(−1.

46)

(10.

20)

(−1.

74)

GR

OW

TH

−0.0

0L

AR

GEO

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4A

NA

LYST

S0.

00(−

0.81

)(−

0.20

)(1

.20)

LEV

ERA

GE

0.01

STAT

EOW

N0.

02N

EGEA

RN

ING

S0.

08∗∗

(1.3

4)(1

.59)

(2.3

4)L

AR

GEO

WN

0.01

GR

OW

TH

0.00

CH

AN

GE

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GS

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(−0.

36)

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82)

(−0.

17)

LAW

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DER

0.00

Inte

rcep

t−3

.20∗∗

∗EA

RN

ING

SM

GN

−0.0

0(0

.17)

(−5.

88)

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SEC

REG

−0.0

0L

IST

EDFI

RM

S0.

00(−

0.34

)(0

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AN

TIS

ELF

−0.0

5∗∗∗

IDV

−0.0

0(−

2.96

)(−

0.41

)

(Con

tinue

d)


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BL

E7—

Con

tinue

d

(1)

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t(EM

)(2

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nal

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win

g(A

NA

LYST

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)Fo

reca

stA

ccur

acy

(AC

CU

RA

CY)

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able

Vari

able

Vari

able

STO

CK

TR

AD

−0.0

0U

AI

0.00

(−0.

42)

(1.0

5)In

terc

ept

0.14

∗∗∗

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rcep

t0.

04(5

.10)

(0.9

0)A

djus

ted

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tin

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alua

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(MT

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(6)

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tofE

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y(K

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)

Vari

able

Vari

able

Vari

able

PBIG

4×

CO

NN

ECT

ED5.

10∗∗

PBIG

4∗C

ON

NEC

TED

1.38

∗∗PB

IG4∗

CO

NN

ECT

ED−5

.97∗∗

∗

(2.4

0)(2

.23)

(−2.

73)

PBIG

40.

39PB

IG4

0.72

∗∗PB

IG4

3.15

∗

(0.2

2)(2

.26)

(1.8

3)C

ON

NEC

TED

−4.0

1∗∗C

ON

NEC

TED

−1.0

1∗∗C

ON

NEC

TED

4.77

∗∗∗

(−2.

25)

(−2.

05)

(2.5

9)L

AR

GEO

WN

0.53

SIZE

−0.0

3∗∗SI

ZE−0

.32∗∗

∗

(1.2

0)(−

2.14

)(−

6.41

)FO

REI

GN

SAL

ES0.

00G

RO

WT

H0.

02∗∗

∗VA

RIA

NC

E7.

33∗∗

∗

(1.1

4)(9

.00)

(10.

24)

CF

−0.0

0L

AR

GEO

WN

−0.1

9FB

IAIS

9.32

∗∗

(−0.

50)

(−1.

16)

(2.3

7)FI

NA

NC

ING

−0.0

5C

RO

SS-L

IST

ING

0.13

MT

B−0

.39∗∗

∗

(−0.

19)

(0.8

7)(−

8.37

)C

RO

SS-L

IST

ING

0.15

FOR

EIG

NSA

LES

0.00

∗∗D

ISC

LO

SE−1

.49∗

(0.4

5)(2

.22)

(−1.

82)

SIZE

−0.2

5∗∗∗

CA

PEX

−0.0

0M

AC

VAR

8.55

∗∗∗

(−4.

01)

(−0.

50)

(4.4

0)

(Con

tinue

d)


TA

BL

E7—

Con

tinue

d

(4)

Acc

oun

tin

gSt

anda

rdC

hoi

ce(I

AS)

(5)

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ketV

alua

tion

(MT

B)

(6)

Cos

tofE

quit

y(K

MED

)

Vari

able

Vari

able

Vari

able

LEV

ERA

GE

0.48

∗∗∗

AN

TIS

ELF

−0.1

2L

AWO

RD

ER−0

.22∗

(3.9

8)(−

0.70

)(−

1.69

)T

UR

NO

VER

−0.2

6∗In

terc

ept

2.08

∗∗∗

INFL

ATIO

N0.

45∗∗

∗

(−1.

82)

(5.8

8)(2

.97)

GR

OW

TH

0.01

∗In

terc

ept

11.5

4∗∗∗

(1.7

2)(4

.77)

LG

DPC

0.26

∗

(1.8

1)A

NT

ISEL

F−4

.50∗∗

∗

(−7.

71)

STO

CK

TR

AD

0.21

(0.8

2)C

IFA

R0.

07∗∗

∗

(3.4

7)In

terc

ept

−16.

46∗∗

∗

(−6.

87)

[Mar

gin

alef

fect

ofPB

IG4

×C

ON

NEC

TED

in%

][4

4.71

]

Mea

nin

tera

ctiv

eef

fect

of0.

53∗

PBIG

4×

CO

NN

ECT

ED(1

.80)

Pseu

doR

20.

25A

djus

ted

R2

0.13

Adj

uste

dR

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36N

2,99

3N

3,11

9N

1,12

4

Th

ista

ble

repo

rts

resu

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man

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(mod

el1)

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allo

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ofon

epl

usth

en

umbe

rof

anal

ysts

follo

win

gth

efi

rm(m

odel

2),

anal

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fore

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racy

(mod

el3)

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oun

tin

gst

anda

rdch

oice

(mod

el4)

,val

uati

on(m

odel

5),a

nd

equi

typr

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g(m

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6)on

firm

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esa

mpl

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clud

esco

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dn

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dfi

rms

anal

yzed

inta

ble

3.E

xcep

tfo

rm

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2,w

hic

hin

clud

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ar,i

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,an

dco

untr

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her

mod

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incl

ude

indu

stry

and

year

effe

cts.

Ben

eath

each

esti

mat

eis

repo

rted

the

robu

stt/

z-st

atis

tic

clus

tere

dat

both

the

coun

try

and

the

firm

leve

l.M

odel

4re

port

sth

em

argi

nal

effe

ctof

the

inte

ract

ion

term

and

the

mea

nin

tera

ctiv

eef

fect

usin

gth

em

eth

odol

ogy

prop

osed

byA

ian

dN

orto

n[2

003]

.∗∗

∗ ,∗∗

,an

d∗

den

ote

stat

isti

cal

sign

ifica

nce

atth

e1%

,5%

,an

d10

%le

vels

,re

spec

tive

ly,

base

don

two-

side

dte

sts.

Th

ede

fin

itio

ns

and

data

sour

ces

for

the

vari

able

sar

eou

tlin

edin

tabl

eA

1.


as: (�total current assets – �cash) – (�total current liabilities – �short-term debt –�taxes payable) – depreciation expense (see table A1 for more details)—on thepredicted probability of Big 4 auditors (PBIG4). Importantly, relying onLeuz, Nanda, and Wysocki [2003] specification minimizes data attritionin our sample. In addition to our test variables, we include several firm-and country-level controls in this regression: firm size (SIZE), cross-listing(CROSS-LISTING), profitability (ROA), firm growth (GROWTH), firm lever-age (LEVERAGE), the ownership stake of the largest shareholder (LARGE-OWN), state ownership (STATEOWN), a composite securities regulation in-dex (SECREG), law and order (LAWORDER), stock market development(STOCKTRAD), and investor protection (ANTISELF). All variables are de-fined in table A1. The results in model 1 include that the coefficient on theinteraction between PBIG4 and CONNECTED is negative and statisticallysignificant at the 1% level, implying that earnings management is lowerin politically connected firms with Big 4 auditors. In this regression, CON-NECTED is positive and statistically significant at the 1% level, suggestingthat earnings management is worse in politically connected firms. This re-sult reconciles with Chaney, Faccio, and Parsley’s [2011] evidence that po-litically connected firms exhibit lower earnings quality. Lending supportto the prediction in H4, our evidence implies that this effect is less pro-nounced in politically connected firms that appoint a Big 4 auditor.

We extend our analysis to consider three measures of firm-level trans-parency examined in recent research (e.g., Lang and Maffett [2011], Lang,Lins, and Maffett [2012]). This includes analyzing in model 2 the numberof analysts following a firm (ANALYSTS). Lang, Lins, and Maffett [2012]hold that greater analyst coverage and forecast accuracy are likely to reflectgreater transparency in the firm’s information environment. Besides ourtest variables, we include a set of controls motivated by prior research (e.g.,Lang, Lins, and Miller [2003, 2004]): firm size (SIZE); cross-listing (CROSS-LISTING); the ownership stake of the largest shareholder (LARGEOWN);state ownership (STATEOWN); firm growth (GROWTH); the standard devi-ation of monthly returns over the previous year (VARIANCE); earnings sur-prise (EARNINGS SURPRISE); as well as industry, year and country effects.We find a negative and statistically significant (at the 5% level) coefficienton CONNECTED, indicating that connected firms have lesser analyst cov-erage. In additional evidence supporting the prediction in H4, we provideevidence at the 5% level that this effect subsides for politically connectedfirms that are Big 4 clients.

In model 3, we complement the evidence in model 2 by analyzingforecast accuracy (ACCURACY), defined as the negative absolute value ofthe difference between the median forecast and the actual earnings pershare (EPS) deflated by the stock price after Lang and Lundholm [1996]and Hope [2003]. We follow Hope’s [2003] cross-country research by in-cluding these control variables in the regression: firm size (SIZE); analystfollowing (ANALYSTS); cross-listing (CROSS-LISTING); an indicator vari-able for loss firms (NEG EARNINGS); the absolute value of the change in


earnings over the previous year (CHANGE EARNINGS); as well as country-level measures for earnings management (EARNINGS MGN), the quality offinancial reporting (CIFAR), domestic listed firms (LISTED FIRMS), in-vestor protection (ANTISELF), Hofstede’s [2001] cultural dimensions un-certainty avoidance (UAI) and individualism (IDV), along with industry andyear effects. Consistent with Chen, Ding, and Kim. [2010], the results inmodel 3 suggest that political connections adversely affect analyst forecastaccuracy. Importantly for our purposes, we find that the coefficient on theinteraction term PBIG4∗CONNECTED is positive and statistically significantat the 1% level, suggesting that connected firms that appoint a Big 4 auditorbenefit from more accurate analyst earnings forecasts.

In model 4, we develop another conditioning variable by identify-ing whether a firm adopts international accounting standards (IAS). Ac-counting quality is generally higher for these firms according to Barth,Landsman, and Lang [2008] and Lang and Maffett [2011]. In this re-gression, we follow prior research (e.g., Hope, Jin, and Kang [2006],Barth, Landsman, and Lang [2008], Kim and Shi [2012]) by control-ling for firm size (SIZE), the ownership stake of the largest shareholder(LARGEOWN), firm growth (GROWTH), firm leverage (LEVERAGE), cashflows from operating activities (CF), cross-listing (CROSS-LISTING), salesturnover (TURNOVER), level of financing activities (FINANCING), foreignsales (FOREIGNSALES), the logarithm of GDP per capita (LGDPC), investorprotection (ANTISELF), stock market development (STOCKTRAD), and acountry’s quality of financial reporting (CIFAR) as well as industry and yearfixed effects. Reinforcing our earlier evidence, the results indicate that thecoefficient on CONNECTED is significantly negative while the mean inter-active effect of PBIG4∗CONNECTED loads positively at the 5% level. Col-lectively, these results support that the presence of a high-quality auditormitigates the lower transparency of politically connected firms.

We consider in model 5 the role that auditor choice plays in shapingfirm value, measured by the market-to-book ratio (MTB). In this regression,we include other factors shown in prior research to affect firm value (e.g.,Durnev and Kim [2005]): firm size (SIZE), cross-listing (CROSS-LISTING),firm growth (GROWTH), the ownership stake of the largest shareholder(LARGEOWN), foreign sales to total assets (FOREIGNSALES), capital expen-ditures (CAPEX), and investor protection (ANTISELF) in addition to yearand industry fixed effects. We report that the coefficient on the interactionbetween PBIG4 and CONNECTED loads positively at the 5% level, implyingthat connected firms that appoint a Big 4 auditor are valued at a premium.This finding extends evidence in Fan and Wong [2005] that the economicconsequences of the presence of a high-quality auditor are larger for EastAsian firms with highly concentrated control.

Recent research suggests that accounting transparency at the country-(e.g., Hail and Leuz [2006]) and firm-level (e.g., El Ghoul, Guedhami,and Pittman [2012]) is associated with a lower cost of equity capital. Ac-cordingly, we extend our analysis in model 6 by gauging the links among


political connections, auditor choice, and equity pricing. We follow exten-sive prior research by using analysts’ earnings forecasts and stock pricesto derive the ex ante cost of equity (e.g., Hail and Leuz [2006], Dhaliwal,Heitzman, and Li [2006], Chen, Chen, and Wei [2011]). This approachconstitutes a useful alternative given the failure of asset pricing models toproxy for the cost of equity (e.g., Fama and French [1997], Pastor, Sinha,and Swaminathan [2008]). More specifically, we adopt four implied costof equity capital models, namely those developed by Gebhardt, Lee, andSwaminathan ([2001]; KGLS), Claus and Thomas ([2001]; KCT), Ohlsonand Juettner-Nauroth ([2005]; KOJN), and Easton ([2004]; KES). To reduceconcerns that the results are driven by the assumptions underpinning anyparticular model, we specify as the dependent variable the median impliedcost of equity obtained from the four models (KMED). Moreover, to allevi-ate the concern that optimism inherent in analysts’ earnings forecasts ad-mits bias that inflates the equity premium estimates, we follow Hail andLeuz [2006] by running a weighted least square regression that assignsless (more) weight to inaccurate (precise) forecasts. In this regression, theweight is equal to the forecast error (absolute value one-year ahead earn-ings forecast minus realized earnings deflated by assets per share).

In addition to our test variables, we include several control variables: thenatural logarithm of total assets (SIZE), the market value of common equityplus book value of debt scaled by total assets (MTB), forecast error definedas the difference between the one-year-ahead earnings forecast and real-ized earnings deflated by beginning of the period assets per share (FBAIS),the volatility of stock returns over the previous 12 months (VARIANCE),the realized inflation rate over the next year (INFLATION), disclosure stan-dards (DISCLOSE), law and order (LAWORDER), and macroeconomic vari-ability (MACVAR). In model 6, which also includes year and industry fixedeffects, we observe a negative and statistically significant (at the 1% level)coefficient on the interaction between PBIG4 and CONNECTED, implyingthat connected firms that appoint a Big 4 auditor attract cheaper equityfinancing.

Notwithstanding that the implied cost of capital approach has beenwidely used in the accounting and finance literature (see, e.g., Hail andLeuz [2006], Chen, Chen, and Wei [2011]), it is beset by another limita-tion apart from deviations between analysts’ and investors’ earnings expec-tations. This limitation relates to the sensitivity of the implied cost of equityestimates to the assumptions of long-term growth rates beyond analysts’forecast horizons (e.g., Easton [2004]). In particular, the cost of equity es-timates derived from the models of Claus and Thomas [2001] and Ohlsonand Juettner-Nauroth [2005] assume that the perpetual growth rate is equalto the future (realized) inflation rate. To verify that our findings in model6 are robust to addressing this concern, we follow Hail and Leuz [2006] byre-estimating the median cost of equity capital (KMED) after applying thesealternative growth assumptions for the models of Claus and Thomas [2001]and Ohlson and Juettner-Nauroth [2005]: (i) a constant long-run growth of


3% and (ii) a perpetual growth rate equal to the annual real GDP growthplus long-run inflation rate, respectively. The untabulated results includethat the PBIG4∗CONNECTED coefficient is negative and statistically signif-icant at the 5% level, corroborating our earlier evidence that politicallyconnected firms with Big 4 auditors enjoy equity financing costs that arecloser to the risk-free rate. Overall, the evidence reported in this sectionprovides empirical support for our fourth hypothesis that politically con-nected firms with Big 4 auditors exhibit lower earnings management andgreater transparency, and benefit from higher valuations as well as cheaperequity financing costs.

5. Conclusions

In response to calls for research on this issue (e.g., Wang, Wong, and Xia[2008]), we examine the importance of corporate insiders’ political con-nections, which exacerbate the expropriation of minority investors accord-ing to recent evidence (e.g., Faccio [2006], Qian, Hongbo Pan, and Yeung[2011]), to auditor choice in public firms worldwide. The tension that con-nected insiders experience in deciding whether to appoint a Big 4 auditorto constrain their discretion over financial reporting motivates our analysis.In one direction, insiders eager to persuade outside investors that they arenot exploiting their political connections to divert corporate resources mayrely on a Big 4 auditor to strengthen external monitoring. In the other di-rection, connected insiders depriving outside investors may prefer to hirea non–Big 4 auditor to help conceal their diversion by rendering the finan-cial statements less informative about underlying firm performance. Usinga unique data set on political connections around the world constructed byFaccio [2006], we analyze which financial reporting incentive dominates byestimating the role that political connections play in auditor choice. Ourevidence that public firms with political connections are more likely to ap-point a Big 4 auditor lends support to the intuition that these firms respondto the serious agency problems that connections engender by improving ac-counting transparency evident in auditor choice.

Next, we separately isolate whether connected firms with ownershipstructures conducive to self-dealing by insiders or operating in countrieswith relatively poor institutional infrastructure are even more eager to re-duce information asymmetry by engaging a Big 4 auditor. In a set of re-sults consistent with these predictions, we find that the link between au-ditor choice and political connections is stronger when firms’ ownershipcharacteristics lead to severe agency conflicts and country-level governanceinstitutions are worse. This evidence implies that Big 4 auditors in thesesituations are more valuable for protecting outside investors by disciplininginsiders against diverting corporate resources.

Finally, we consider some economic outcomes stemming from auditorchoice in politically connected firms. This analysis contributes to resolvingwhat is behind our evidence that connected firms have greater demand


for Big 4 auditors. We begin by documenting that connected firms thatappoint Big 4 auditors exhibit lower earnings management and greatertransparency evident in analyst coverage and forecast accuracy as well asthe adoption of international accounting standards. Additional evidenceimplies that the capital markets reward connected firms that are Big 4clients with higher valuations and cheaper equity financing costs. Impor-tantly, despite that our core results persist when we tackle this issue withseveral standard techniques—including various matching procedures, es-timating a treatment effects model, controlling for firm heterogeneity inrandom effects models, and narrowing our analysis to firms with long au-ditor tenure—we stress that we cannot dismiss endogeneity as a competingexplanation for our evidence.


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eate

dby

exam

inin

gan

dra

tin

gco

mpa

nie

s’19

95an

nua

lrep

orts

onth

eir

incl

usio

nor

omis

sion

of90

item

s.T

hes

eit

ems

fall

into

seve

nca

tego

ries

:gen

eral

info

rmat

ion

,in

com

est

atem

ents

,bal

ance

shee

ts,f

unds

flow

stat

emen

t,ac

coun

tin

gst

anda

rds,

stoc

kda

ta,a

nd

spec

iali

tem

s.A

min

imum

ofth

ree

com

pan

ies

inea

chco

untr

yw

ere

stud

ied.

See

Bus

hm

an,

Piot

rosk

i,an

dSm

ith

[200

4].

La

Port

a,L

opez

-de-

Sila

nes

,an

dSh

leif

er[2

006]

(Con

tinue

d)


TA

BL

EA

1—C

ontin

ued

Vari

able

Defi

nit

ion

Sour

ce

RU

LEO

FLAW

Mea

sure

sth

eex

ten

tto

wh

ich

agen

tsh

ave

con

fide

nce

inan

dab

ide

byth

eru

les

ofso

ciet

y.T

hes

ein

clud

epe

rcep

tion

sof

the

inci

den

ceof

both

viol

enta

nd

non

viol

entc

rim

e,th

eef

fect

iven

ess

and

pred

icta

bilit

yof

the

judi

ciar

y,an

dth

een

forc

eabi

lity

ofco

ntr

acts

.See

Kau

fman

n,K

raay

,an

dM

astr

uzzi

[200

8].

La

Port

aet

al.[

2006

]

LIS

TED

FIR

MS

Th

en

umbe

rof

dom

esti

clis

ted

firm

sdi

vide

dby

popu

lati

onin

2000

.Am

easu

reof

the

impo

rtan

ceof

the

stoc

km

arke

t.L

aPo

rta,

Lop

ez-d

e-Si

lan

es,a

nd

Shle

ifer

[200

6]M

AC

VAR

MA

CVA

Ris

the

firs

tpri

nci

palc

ompo

nen

toff

our

prox

ies

for

mac

roec

onom

icva

riab

ility

:(i)

the

coun

try-

year

med

ian

stan

dard

devi

atio

nof

ann

uale

arn

ings

per

shar

eov

erth

ela

stfi

veye

ars

scal

edby

tota

lass

ets

per

shar

e,(i

i)th

eco

untr

y-ye

arm

edia

nst

anda

rdde

viat

ion

ofac

coun

tin

gre

turn

son

equi

tyov

erth

ela

stfi

veye

ars,

(iii)

the

stan

dard

devi

atio

nof

the

resi

dual

sfr

oma

regr

essi

onof

ann

ualg

ross

dom

esti

cpr

oduc

tgro

wth

rate

son

ati

me

inde

xov

erth

esa

mpl

ing

peri

od,a

nd

(iv)

the

coef

fici

ento

fvar

iati

onof

year

lyav

erag

eex

chan

gera

tes

(US$

tolo

calc

urre

ncy

)ov

erth

esa

mpl

ing

peri

od.

Aut

hor

s’ca

lcul

atio

ns

IDV

Apr

efer

ence

for

alo

osel

ykn

itso

cial

fabr

icor

anin

depe

nde

nt,

tigh

tly

knit

fabr

ic.

Hof

sted

e[2

001]

UA

IT

he

degr

eeto

wh

ich

peop

lefe

elun

com

fort

able

wit

ham

bigu

ity

and

anun

cert

ain

futu

re.

Hof

sted

e[2

001]

PRED

ATIO

NA

nin

dex

that

inco

rpor

ates

mul

tipl

eat

trib

utes

capt

urin

gth

eef

fect

iven

ess

ofin

stit

utio

nal

and

polit

ical

syst

ems

incu

rbin

ggo

vern

men

text

orti

on.

Dur

nev

and

Fauv

er[2

009]

EXPR

OPR

IAT

ION

Ass

essm

ento

fth

eri

skof

am

odifi

cati

onin

aco

ntr

actt

akin

gth

efo

rmof

are

pudi

atio

n,p

ostp

onem

ent,

orsc

alin

gdo

wn

due

tobu

dget

cutb

acks

,in

dige

niz

atio

npr

essu

re,a

chan

gein

gove

rnm

ent,

ora

chan

gein

gove

rnm

ente

con

omic

and

soci

alpr

iori

ties

.Th

isva

riab

leis

reco

ded

tova

rybe

twee

n0

to10

wit

hh

igh

ersc

ores

indi

cati

ng

grea

ter

risk

ofex

prop

riat

ion

.

La

Port

aet

al.[

1998

]

(Con

tinue

d)


TA

BL

EA

1—C

ontin

ued

Vari

able

Defi

nit

ion

Sour

ce

EAR

NIN

GS

MG

NA

ggre

gate

earn

ings

man

agem

ents

core

:th

eav

erag

era

nk

acro

ssfo

urm

easu

res,

EM

1–E

M4.

EM

1is

the

coun

try’

sm

edia

nra

tio

ofth

efi

rm-le

vels

tan

dard

devi

atio

ns

ofop

erat

ing

inco

me

and

oper

atin

gca

shfl

ow(b

oth

scal

edby

lagg

edto

tala

sset

s).E

M2

isth

eco

untr

y’s

Spea

rman

corr

elat

ion

betw

een

the

chan

gein

accr

uals

and

the

chan

gein

cash

flow

from

oper

atio

ns

(bot

hsc

aled

byla

gged

tota

lass

ets)

.EM

3is

the

coun

try’

sm

edia

nra

tio

ofth

eab

solu

teva

lue

ofac

crua

lsan

dth

eab

solu

teva

lue

ofth

eca

shfl

owfr

omop

erat

ion

s.E

M4

isth

en

umbe

rof

‘‘sm

allp

rofi

ts’’

divi

ded

byth

en

umbe

rof

‘‘sm

all

loss

es’’

for

each

coun

try.

Leu

z,N

anda

,an

dW

ysoc

ki[2

003]

DIS

CL

OSE

An

asse

ssm

ento

fdis

clos

ure

requ

irem

ents

rela

tin

gto

:(i)

pros

pect

us;(

ii)co

mpe

nsa

tion

ofdi

rect

ors

and

key

offi

cers

;(iii

)ow

ner

ship

stru

ctur

e;(i

v)in

side

own

ersh

ip;(

v)co

ntr

acts

outs

ide

the

ordi

nar

yco

urse

ofbu

sin

ess;

and

(vi)

tran

sact

ion

sbe

twee

nth

eis

suer

and

its

dire

ctor

s,of

fice

rs,a

nd/

orla

rge

shar

ehol

ders

.Th

ein

dex

ran

ges

from

0to

1,w

ith

hig

her

valu

esin

dica

tin

gm

ore

exte

nsi

vedi

sclo

sure

requ

irem

ents

.

La

Port

a,L

opez

-de-

Sila

nes

,an

dSh

leif

er[2

006]

SUE

AU

DIT

OR

Inde

xof

the

proc

edur

aldi

fficu

lty

inre

cove

rin

glo

sses

from

the

audi

tor

ina

civi

llia

bilit

yca

sefo

rlo

sses

due

tom

isle

adin

gst

atem

ents

inth

eau

dite

dfi

nan

cial

info

rmat

ion

acco

mpa

nyi

ng

the

pros

pect

us.E

qual

son

ew

hen

inve

stor

sar

eon

lyre

quir

edto

prov

eth

atth

eau

dite

dfi

nan

cial

info

rmat

ion

acco

mpa

nyi

ng

the

pros

pect

usco

nta

ins

am

isle

adin

gst

atem

ent.

Equ

als

two-

thir

dsw

hen

inve

stor

sm

usta

lso

prov

eth

atth

eyre

lied

onth

epr

ospe

ctus

and/

orth

atth

eir

loss

was

caus

edby

the

mis

lead

ing

acco

unti

ng

info

rmat

ion

.E

qual

son

e-th

ird

wh

enin

vest

ors

mus

tals

opr

ove

that

the

audi

tor

acte

dw

ith

neg

ligen

ce.E

qual

sze

roif

rest

itut

ion

from

the

audi

tor

isei

ther

unav

aila

ble

orth

elia

bilit

yst

anda

rdis

inte

nto

rgr

oss

neg

ligen

ce.

La

Port

a,L

opez

-de-

Sila

nes

,an

dSh

leif

er[2

006]

LG

DPC

Th

en

atur

allo

gari

thm

ofth

eco

untr

y’s

GD

Ppe

rca

pita

den

omin

ated

inU

Sdo

llars

.W

orld

Dev

elop

men

tIn

dica

tors

[200

8]

FDI

Fore

ign

dire

ctin

vest

men

tdiv

ided

byG

DP.

Wor

ldD

evel

opm

entI

ndi

cato

rs[2

008]


T A B L E A 2Means for Country Level Institutional Infrastructure Variables

Country RESTRICTIONS EXPROPRIATION ANTISELF PROTECTION

Austria 2.00 0.31 0.21 0.10Belgium 0.00 0.37 0.54 0.07Canada 2.00 0.33 0.64 0.96Chile 2.00 2.50 0.63 0.61Denmark 1.00 0.33 0.46 0.36Finland 1.00 0.33 0.46 0.47France 2.00 0.35 0.38 0.47Germany 2.00 0.10 0.28 0.00Greece 4.00 2.88 0.22 0.32Hong Kong 1.00 1.71 0.96 0.85India 0.00 2.25 0.58 0.77Indonesia 0.00 2.84 0.65 0.51Ireland 4.00 0.33 0.79 0.48Israel 4.00 1.75 0.73 0.59Italy 0.00 0.65 0.42 0.20Japan 0.00 0.33 0.50 0.42Korea, South 1.00 1.69 0.47 0.36Malaysia 0.00 2.05 0.95 0.73Mexico 0.00 2.71 0.17 0.10Philippines 6.00 4.78 0.22 0.81Singapore 3.00 0.70 1.00 0.77Spain 3.00 0.48 0.37 0.55Sweden 1.00 0.60 0.33 0.39Switzerland 2.00 0.02 0.27 0.30Taiwan 0.00 0.88 0.57 0.55Thailand 3.00 2.58 0.81 0.37United Kingdom 2.00 0.29 0.95 0.78United States 4.00 0.02 0.65 1.00

This table reports the means for the four conditioning variables capturing countries’ governanceinstitutions.


TA

BL

EA

3C

orre

latio

nsB

etw

een

the

Mai

nR

egre

ssio

nVa

riab

les

BIG4

CONNECTED

LARGEOWN

STATEOWN

COMPLEXITY

FOREIGNSALES

FINANCING

CROSS-LISTING

SIZE

ROA

LEVERAGE

GROWTH

INV

FDI

LGDPC

CO

NN

ECT

ED0.

06LA

RG

EO

WN

0.00

0.01

STAT

EO

WN

–0.1

3–0

.04

0.15

CO

MPL

EX

ITY

–0.0

20.

050.

02–0

.08

FOR

EIG

NSA

LES

0.11

0.04

–0.0

5–0

.05

–0.0

2FI

NA

NC

ING

–0.0

4–0

.02

0.01

–0.0

3–0

.06

0.00

CR

OSS

-LIS

TIN

G0.

090.

10–0

.11

–0.0

20.

000.

13–0

.03

SIZE

0.11

0.04

0.06

0.11

0.15

–0.1

6–0

.13

0.16

RO

A0.

110.

020.

080.

010.

040.

040.

040.

020.

11LE

VER

AG

E0.

020.

110.

00–0

.03

0.04

0.03

0.07

0.05

0.20

–0.0

5G

RO

WT

H–0

.05

–0.0

40.

020.

03–0

.08

0.00

0.42

–0.0

20.

000.

240.

00IN

V–0

.04

–0.0

90.

04–0

.05

0.09

0.08

–0.0

6–0

.07

–0.1

00.

09–0

.14

–0.0

4FD

I0.

060.

030.

02–0

.03

–0.0

90.

190.

080.

03–0

.39

0.03

–0.0

30.

070.

02LG

DPC

0.15

–0.2

3–0

.27

–0.2

3–0

.08

0.19

–0.0

30.

06–0

.19

–0.0

6–0

.04

–0.0

7–0

.05

0.08

SUE

AU

DIT

OR

0.07

–0.0

8–0

.24

0.01

0.06

0.05

–0.0

2–0

.01

–0.0

3–0

.02

–0.1

5–0

.04

0.08

0.01

0.16

Th

ista

ble

repo

rts

corr

elat

ion

sfo

rth

ere

gres

sion

vari

able

sw

hile

allo

win

gfo

rco

untr

yan

dfi

rmle

vel

clus

teri

ng

for

asa

mpl

eof

1,37

1po

litic

ally

con

nec

ted

firm

san

d1,

911

non

con

nec

ted

firm

sfr

om28

coun

trie

s.B

oldf

ace

indi

cate

sst

atis

tica

lsig

nifi

can

ceat

the

1%le

vel.

Th

ede

fin

itio

ns

and

data

sour

ces

for

the

vari

able

sar

eou

tlin

edin

tabl

eA

1.


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