Do Political Connections Add Value to Audit Firms? Evidence from IPO Audits in China

Abstract

Audit firms become politically connected when their partners are appointed to the regulatory committee that screens prospective initial public offering (IPO) companies. Connections with regulators may enable audit firms to gain insights into the regulatory process which can help their clients prepare IPO applications, and lobby for favorable regulatory decisions. These arguments suggest that connections with regulators may help audit firms reduce IPO rejection risk for their clients, thus allowing them to charge higher IPO audit fees and gain more IPO clients. Regulatory committee appointments may benefit non-top tier audit firms more than they do top tier audit firms because reputational concerns are likely to encourage the latter to refrain from helping their clients raise the likelihood of passing the IPO screening process to a level higher than that justified by their clients’ fundamentals. Consistent with these arguments and predictions, the findings of this study show that after their partners are appointed to the IPO screening committee, non-top audit firms significantly increase their IPO audit fees and IPO market share, and reduce IPO rejection risk for their clients, whereas top tier audit firms do not.