Political connections and audit report lag: Indonesian evidence

Date05 March 2018
Published date05 March 2018
AuthorAhsan Habib,Abdul Haris Muhammadi
Subject MatterAccounting & 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
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 nancial reports. A rm-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 rms but
increases when such rms 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 nancial 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 auditorsevaluation 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 rms moderate the association between the two. Political
connections formed and maintained by corporations are pervasive (Faccio,2006, 2010)
because such connections allow rms preferential access to borrowings, among many other
benets (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
nancial reporting, it is useful to examine auditorsresponse to rmspolitical connections
empirically. Whether auditors considerboth the benets and costs associated with political
connections whilst conducting their audit work is important for the credibility of nancial
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
Received27 August 2016
Revised7 February 2017
Accepted8 February 2017
InternationalJournal of
Accounting& Information
Vol.26 No. 1, 2018
pp. 59-80
© Emerald Publishing Limited
DOI 10.1108/IJAIM-08-2016-0086
The current issue and full text archive of this journal is available on Emerald Insight at:
ARL is dened as the period between a companysscal 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 efciency (Bamber et al.,1993). Because the audit report contains
the auditors opinion regarding the credibility of the nancial 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 rm and audit-specic characteristics, an understanding of the
possible determinants of ARL will be likely to provide insights into audit efciency. Prior
research has generallyexamined audit and auditor-attributes, as wellas certain rm-specic
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
There are competing hypothesesregarding the association between political connections
and ARL. Arguments for a short ARL may stem from a signalling perspective. Connected
rms are under higher public scrutiny and subject to more extensive controls and public
monitoring than non-connectedrms (Chaney et al.,2011). As timely audit report provides a
credible assurance to outside stakeholdersabout the quality of nancial reporting, it may be
surmised that connected rms publish audited nancial statements sooner than their non-
connected counterparts as a signalling mechanism. However, a competing perspective
hypothesises longer ARLs for connected rms, as Chaney et al. (2011) document inferior
reporting quality for connected rms compared to their non-connected counterparts. A
greater amount of nancial statement manipulation may be carried out by the connected
rms 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 rms varies conditionallyon different categories of RPT. RPTs
are diverse, and often complex, businesstransactions between a rm and its own managers,
directors, principal owners or afliates. Benets of RPTs include lower transaction costs
and higher rm values (Chen et al., 2012;Khanna and Palepu, 2000) and realignment of
rmsoperations (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 nancial 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 rm value (Fisman, 2001). Leuz and Oberholzer-Gee (2006) document
that the volatility of the performance of connected rms increases with changes in the
fortune of their connections.Second, RPTs are signicant in Indonesia, as more than 90 per
cent of listed rms in Indonesia conduct various forms of RPTs that might provide
opportunities for connected rms to siphon resources from minority stakeholders. Finally,
from an auditing landscape view, unlike Western countries where the majority of listed
rms are audited by Big 4 audit rms, the ratio is much smallerin Indonesia (for our sample
it is 42 per cent). The presence of a large number of second-tier audit rms has implications
for audit pricing,auditor choice and ARL.

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