Political alignment and audit pricing

• Author: Cameron Truong,Philip Shane,Anh Viet Pham,Mukesh Garg,Christofer Adrian
• DOI: http://doi.org/10.1111/ijau.12189
• Published date: 01 July 2020
• Date: 01 July 2020

ORIGINAL ARTICLE

Political alignment and audit pricing

Cameron Truong

1

| Mukesh Garg

1

| Christofer Adrian

1

| Anh Viet Pham

2

|

Philip Shane

3

1

Department of Accounting, Monash

University, Australia

2

Department of Banking and Finance, Monash

University, Australia

3

Department of Accounting, Monash

University/Mason School of Business, College

of William & Mary, Australia

Correspondence

CameronTruong, Department of Accounting,

Monash University, Caulfield East, Victoria

3145, Australia.

Email: cameron.truong@monash.edu

This article investigates the impact of political alignment on the pricing of audit ser-

vice for U.S. firms. While prior studies have mainly focused on the political connect-

edness stemming from firms' active political effort, our study is different as we

exploit changes in the U.S. political landscape, which are exogenous to firms. We

employ a political alignment index (PAI) of each state's leading politicians with the

presidential party to proxy for U.S. domestic firms' political alignment. We build upon

the policy risk theory, and conjecture that auditors take into account the risk emanat-

ing from firms' political geography position and price this risk in their audit service

fees. Our empirical results show a positive association between PAI and audit fees.

Collectively, our findings suggest that auditors perceive firms whose headquarters

are located in more politically aligned states to be riskier, while corporate diversifica-

tion and managerial ability act as effective mitigating factors.

KEYWORDS

audit pricing, diversification, managerial ability, political alignment

1|INTRODUCTION

The purpose of this article is to investigate whether auditors incorpo-

rate firms' exposure to time-varying policy risk in their assessment of

audit risk, and in turn audit fees. We use a firm's headquarters loca-

tion to examine policy risk as it exposes them to the dynamic

U.S. political map, which changes every 2 years. A new agenda from

changes in the political map can cause uncertainties relating to firms'

growth and future cash flows, which translates to new corporate risk-

taking strategies and reporting behavior, and constitutes a fixed effect

of policy risk for firms in the same location. This empirical investiga-

tion is particularly motivated by interests from regulators on under-

standing corporate political exposure and related policy and

regulatory risk (see, for example, Auditing Standard (AS) 2110.09

issued by the PCAOB, 2010).

1

Following recent developments in political-geography risk mea-

surement (e.g., Antia, Kim, & Pantzalis, 2013; Bradley, Pantzalis, &

Yuan, 2016; Gross, Konigsgruber, Pantzalis, & Perotti, 2016; Kim, Pan-

tzalis, & Park, 2012), we construct a state-level political alignment

index (PAI) as a proxy for firms' policy risk. Each state-level PAI is cali-

brated every 2 years using information from election results that

shape the political map at the country and state levels. The PAI mea-

sures the extent to which the federally elected president's party and

the elected politicians' party at the state level are aligned, thus

reflecting state-level political alignment. A higher PAI indicates greater

alignment between a state and the president's party. The advantage

of using the PAI is that this is not a choice of firms, and thus any find-

ing on the relation between political alignment and auditors' assess-

ment of risk is less subject to endogeneity concerns.

2

Our study builds on the policy-risk theory, which posits that

stronger political alignment with the president's party (i.e., unified

government) should result in policy changes being implemented with-

out gridlock (Fowler, 2006). This, in turn, increases uncertainty for

firms operating in states of high political alignment. By the same

token, because a divided government often forces parties to negotiate

hard and limits the range of policy changes (Fowler, 2006), firms from

states of weaker political alignment should be subject to lower levels

of policy risk through a reduction in the uncertainty associated with

significant policy changes. Following this line of reasoning, we argue

that firms located in more politically aligned states are exposed to

higher levels of policy risk, which should result in auditors exerting

greater audit efforts. Then, based on the argument that audit fees are

Received: 12 December 2018 Revised: 15 January 2020 Accepted: 22 January 2020

DOI: 10.1111/ijau.12189

Int J Audit. 2020;24:205–231. wileyonlinelibrary.com/journal/ijau ©2020 John Wiley & Sons Ltd 205

indicative of greater effort on the engagement (Eshleman & Guo,

2014), we conjecture that auditors consider policy risk arising from

firms' political-geography position and price this risk in their audit-

service fees.

The prediction for the effect of policy risk in auditing research

is, however, not without tension. Studies in the context of the

U.S. political economy have demonstrated that states with stronger

political alignment with the president's party often receive more

federal funds than other states. Beyer, Jensen, and Johnson (2006)

investigate the relations between political alignment and investment

returns over the period 1949–2004, and find that political harmony

(stronger political alignment) is better for equity investment. It is

also argued that the government's response to exogenous economic

shocks is relatively quicker under political harmony, which reduces

risks to the economy as a whole and to individual firms (Alt &

Lowry, 1994; Fowler, 2006). Taken together, the findings of these

studies highlight the benefits for firms operating in states with

stronger political alignment. As a consequence, the net effect of PAI

on audit fees is theoretically ambiguous, and remains an open

empirical question.

In examining the effect of political alignment on audit fees, we

follow the extant literature (see, for example, Di Giuli & Kostovetsky,

2014; Hilary & Hui, 2009; Korniotis & Kumar, 2013; Pirinsky & Wang,

2006) and choose the firm's headquarters location as a proxy for the

firm's location given that it represents the core of a firm's business

activities (Chaney, Sraer, & Thesmar, 2012; Pirinsky & Wang, 2006;

Tuzel & Zhang, 2017). Chaney et al. (2012) document that 80% of

firms that report real estate ownership in both Compustat and in their

Form 10-K file have a substantial portion of properties in states where

their headquarters are located. Thus, we argue that a firm's headquar-

ters location is a reasonable proxy for the location of its business

operations.

3

Our empirical results can be summarized as follows. Using a sam-

ple of 47,179 firm-year observations of U.S.-listed firms over the

period 2001–2015, we document that PAI is positively associated

with audit fees after controlling for firm and auditor characteristics,

industry-fixed effects, and year-fixed effects. The primary findings of

this study are in line with the notion that auditors perceive firms that

are more politically aligned as carrying higher risk, and thus charge

higher audit fees. Results based on a propensity score matched sam-

ple and an annual-change model lend further support to our main

findings.

To the extent that political alignment increases audit fees, we

expect that there might be systematic differences between firms with

strong political connections and those with weaker political connec-

tions (Bradley et al., 2016; Gross, Königsgruber, Pantzalis, & Perotti,

2016; Pham, 2019). Our results suggest that the positive association

between political alignment and audit fees is more pronounced for

firms with stronger political connections. These findings suggest that

active political effort might not effectively mitigate a firm's exposure

to policy risk. Further, our empirical findings provide evidence that

political alignment is positively related to various factors related to

auditors' risk perceptions, such as earnings management, financial

restatements, internal control material weakness (ICMW), and the

likelihood of the auditor issuing an incorrect going-concern opinion.

We also conduct several additional analyses, mainly to examine

the varying effect of political alignment on audit fees. First, while the

assumption of exposure to changes in the political landscape based on

the state of the firm's headquarters is intuitively plausible, we

acknowledge that some firms might have operations in multiple states

outside their headquarters. In such cases, the effect of political align-

ment on audit fees should vary. To address this issue, we test whether

the effect of political alignment on audit fees changes in relation to

the degree of firm's geographic concentration. Specifically, we follow

Garcia and Norli (2012) in measuring geographic concentration using

the ratio of the number of mentions of the headquarters state relative

to all other states mentioned in Form 10-K. We document that firms

with more concentrated operations in the headquarters state pay

higher audit fees than firms that are more geographically dispersed.

Second, we consider the role of managerial ability in mitigating

the effect of political alignment on audit fees. We argue that firms

with more capable managers are perceived by auditors as better at

managing policy risk (Abernathy, Kubick, & Masli, 2018; Krishnan &

Wang, 2015). Consistent with our prediction, we find that the positive

association between political alignment and audit fees is less pro-

nounced among firms with higher managerial ability. These results

demonstrate that hiring more capable managers acts as an effective

business strategy in alleviating the risk resulting from changes in the

political landscape. In addition, we also document that the adverse

impact of political alignment on audit fees is mitigated among firms

with better social performance.

Third, we consider the economic and political influence of firms

to the state. Using number of employees to measure a firm's political

influence (Heese, 2019), we find that the positive association between

political alignment and audit fees is more pronounced among firms

employing a large number of employees. Next, we also examine

whether the relations between political alignment and audit fees vary

across different investor sentiment periods. Our results suggest that

the positive relation between political alignment and audit fees is less

pronounced during a high-sentiment period. To the extent that senti-

ment affects auditors' assessment of risk, our results are consistent

with the proposition that risk is priced lower (higher) in high (low)

investor sentiment states (Doran, Jiang, & Peterson, 2012; Fong &

Toh, 2014).

In our final avenue of inquiry, we examine the effect of federal

and state elections on the relation between political alignment and

audit fees. During election years, political uncertainty can arise, which

might affect firms' policy risk. We find that the effect of political align-

ment on audit fees is less pronounced during the state-election years;

however, we do not find significant results for federal-election years.

Taken together, these findings suggest that during state-election

years, auditors might anticipate the political alignment to change, and

therefore view the PAI to be relatively less important than it is in non-

election years.

Our article makes three important contributions to the literature.

First, our study contributes to the audit pricing literature by

206 TRUONG ET AL.