Political connections and audit report lag: Indonesian evidence

• Date: 05 March 2018
• DOI: https://doi.org/10.1108/IJAIM-08-2016-0086
• Published date: 05 March 2018
• Pages: 59-80
• Author: Ahsan Habib,Abdul Haris Muhammadi
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

Political connections and audit

report lag: Indonesian evidence

Ahsan Habib

Department of Accounting, Massey University, Auckland, New Zealand, and

Abdul Haris Muhammadi

Directorate General of Taxes, Ministry of Finance, Jakarta, Indonesia

Abstract

Purpose –This paper aims to investigatethe association between political connectionsand the audit report

lag and whether relatedparty transactions moderate the association betweenthe two.

Design/methodology/approach –An ordinary least square regression is estimated whereby audit

report lag is regressedon political connections, related party transactionsand the interaction between the two.

Data on the number and amounts of RPTs are hand-collected from audited financial reports. A firm-year

observation is politically connected if at least one large shareholder (controlling at least 10 per cent of the

votes directly or indirectly)or board member or commissioner is a current or formerMember of Parliament, a

ministeror head of local government or closely related to a politician or party.

Findings –Findings show that the audit report lag is relatively short for politically connected firms but

increases when such firms conduct both operating and loan-type related party transactions. This suggests

that auditors understand the incentives for, and the implications of, related party transactions and hence

exert additional audit efforts in scrutinizing financial statements: activities that will increase the audit

report lag.

Originality/value –Althougha large body of empiricalresearch exists on the determinants of audit report

lag, none has examined the impact of political connections. This paper further contributes to the auditing

literatureby documenting auditors’evaluation of relatedparty transactions in a developing country.

Keywords Indonesia, Political connections, Related party transactions, Audit report lag

Paper type Research paper

1. Introduction

This paper investigates the association between political connections and audit report lag

(hereafter ARL) in Indonesia and whether related party transactions (hereafter RPTs)

conducted by the connected firms moderate the association between the two. Political

connections formed and maintained by corporations are pervasive (Faccio,2006, 2010)

because such connections allow firms preferential access to borrowings, among many other

benefits (Faccio, 2006;Khwaja and Mian, 2005, among others). However, political

connections are also viewed as harmful to the minority shareholders, as these connections

can lead to high agency costs (Khan et al., 2016), corporate overinvestment (Su et al.,2013),

rent-seeking activities (Frye and Shleifer, 1997), tunnelling (Qian et al.,2011) and earnings

management (Chaney et al., 2011)[1]. Given the implications of political connections for

financial reporting, it is useful to examine auditors’response to firms’political connections

empirically. Whether auditors considerboth the benefits and costs associated with political

connections whilst conducting their audit work is important for the credibility of financial

statements. Prior researchhas examined the effect of political connections on auditor choice

(Guedhami et al., 2014) and audit fees (Gul, 2006). We consider another important aspect

related to external auditing:ARL.

Audit report

lag

59

Received27 August 2016

Revised7 February 2017

Accepted8 February 2017

InternationalJournal of

Accounting& Information

Management

Vol.26 No. 1, 2018

pp. 59-80

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-08-2016-0086

The current issue and full text archive of this journal is available on Emerald Insight at:

www.emeraldinsight.com/1834-7649.htm

ARL is defined as the period between a company’sfiscal year-end and the audit report

date, and it is one of the few externally observable audit output variables that allow

outsiders to gauge audit efficiency (Bamber et al.,1993). Because the audit report contains

the auditor’s opinion regarding the credibility of the financial statements, investors

generally prefer shorterreporting lags because the earlier they receive the audit opinion,the

more rapidly they can adjust their investment preferences. As ARL is expected to vary

cross-sectionally because of firm and audit-specific characteristics, an understanding of the

possible determinants of ARL will be likely to provide insights into audit efficiency. Prior

research has generallyexamined audit and auditor-attributes, as wellas certain firm-specific

factors as the potential determinantsof ARL (Ashton et al., 1987;Bamber et al.,1993, among

many others). However, the impact of a broader institutional environment on ARL remains

unexplored.

There are competing hypothesesregarding the association between political connections

and ARL. Arguments for a short ARL may stem from a signalling perspective. Connected

firms are under higher public scrutiny and subject to more extensive controls and public

monitoring than non-connectedfirms (Chaney et al.,2011). As timely audit report provides a

credible assurance to outside stakeholdersabout the quality of financial reporting, it may be

surmised that connected firms publish audited financial statements sooner than their non-

connected counterparts as a signalling mechanism. However, a competing perspective

hypothesises longer ARLs for connected firms, as Chaney et al. (2011) document inferior

reporting quality for connected firms compared to their non-connected counterparts. A

greater amount of financial statement manipulation may be carried out by the connected

firms to mask rent-seeking activities, accomplished primarily through tunnelling resources

from minority shareholders (Chaneyet al., 2011). Detecting and reporting such rent-seeking

activities requireadditional audit efforts and, hence, may increase ARL.

Firms with incentives to tunnel resources from minority shareholders require channels

through which this can be achieved.We consider RPTs as one such channel and investigate

whether ARL for connected firms varies conditionallyon different categories of RPT. RPTs

are diverse, and often complex, businesstransactions between a firm and its own managers,

directors, principal owners or affiliates. Benefits of RPTs include lower transaction costs

and higher firm values (Chen et al., 2012;Khanna and Palepu, 2000) and realignment of

firms’operations (Cheunget al., 2009). However, RPTs are also viewed as detrimental to the

stakeholders, as RPTs might be usedby controlling shareholders as tools for tunnellingand

earnings management (Chang and Hong,2000;Cheung et al., 2009;Jian and Wong, 2010;Su

et al.,2013). If auditors understand the incentives for and implications of RPTs, they are

likely to exert additional audit efforts to scrutinise financial statements: activities that will

increase ARL. Extant research has shownthat auditors do price risk arising from RPTs, in

particular abusiveRPTs, into their audit pricing decisions (Habib et al., 2015).

Indonesia is used as the research setting because political connections play a dominant

role in determining firm value (Fisman, 2001). Leuz and Oberholzer-Gee (2006) document

that the volatility of the performance of connected firms increases with changes in the

fortune of their connections.Second, RPTs are significant in Indonesia, as more than 90 per

cent of listed firms in Indonesia conduct various forms of RPTs that might provide

opportunities for connected firms to siphon resources from minority stakeholders. Finally,

from an auditing landscape view, unlike Western countries where the majority of listed

firms are audited by Big 4 audit firms, the ratio is much smallerin Indonesia (for our sample

it is 42 per cent). The presence of a large number of second-tier audit firms has implications

for audit pricing,auditor choice and ARL.

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