Politically Connected Audit Committees, Earnings Quality and External Financing: Evidence from Korea

• Date: 01 August 2017
• Published date: 01 August 2017
• Author: Bomi Song,Hyungjin Cho
• DOI: http://doi.org/10.1111/ajfs.12182

Politically Connected Audit Committees,

Earnings Quality and External Financing:

Evidence from Korea*

Hyungjin Cho

Department of Business Administration, Universidad Carlos III de Madrid, Spain

Bomi Song**

College of Business Administration, Seoul National University, Republic of Korea

Received 16 May 2016; Accepted 9 February 2017

Abstract

Using listed firms with audit committees in the Korea Composite Stock Price Index (KOSPI)

market, we find that firms with a politically connected audit committee have higher earnings

quality than those without such connections. We also find that firms with a politically

connected audit committee have better access to equity financing, but obtain a larger amount

of funds only when their earnings quality is higher. Overall, contrary to popular concerns

over the negative influence of political connections, our results suggest that audit committees

having political connections fulfil their crucial oversight duties.

Keywords Audit committee; Political connections; Earnings quality; External financing

JEL Classification: G30, G34, M41

1. Introduction

There is growing concern that politically connected audit committees play a lobby-

ing or protection role for the benefit of connected firms rather than a monitoring

role for securing the firm’s accounting transparency.

1

An audit committee is

*The authors appreciate the helpful comments of two anonymous referees, Tae Sik Ahn,

Seong-Pyo Cho, Jong-Hag Choi, Kee H. Chung (editor), Jeong-Hoon Hyun, Mi-Ok Kim,

Hyun Ah Kim, Woo-Jong Lee, Jae-Yong Shin, seminar participants at Seoul National Univer-

sity, and participants at the Korean Academic Society of Taxation 2016 Spring Symposium

and the Korean Accounting Association 2016 Annual Summer/International Conference.

**

Corresponding author: Bomi Song, 414 ho, Gwanak-ro, Gwanak-gu, Seoul, 08826, Republic

of Korea. Tel/Fax: +82-2-878-0101, email: springsbm@snu.ac.kr.

1

The news article in The Financial News on May 3, 2015 (available from http://www.fnnews.c

om/news/201505031706068787) is a good example of the concern over the role of politically

connected audit committee members.

Asia-Pacific Journal of Financial Studies (2017) 46, 609–634 doi:10.1111/ajfs.12182

©2017 Korean Securities Association 609

responsible for overseeing the firm’s financial reporting and disclosure process;

monitoring the choice of accounting policies and principles; and overseeing the

hiring, performance, and independence of the external auditor, regulatory

compliance, ethics, and whistleblower hotlines (Larcker and Tayan, 2011). Also,

audit committee members bear litigation and reputational costs for the failure of

corporate financial reporting (Becker et al., 1998; Srinivasan, 2005). As a result, the

audit committee is more closely related to the quality of accounting information

than the board of directors. Therefore, politically connected audit committee mem-

bers can be a more important channel through which political connections influ-

ence a firm’s reporting choices, relative to the other directors with political

connections.

Political connections are defined as having major shareholders or senior officers

(chief executive officer (CEO), president, chairman, or director) being a member of

parliament, government, or being closely related to a leading politician or a party

(Faccio et al., 2006). Such political connections can be valuable resources to firms

(e.g., Faccio et al., 2006; Claessens et al., 2008; Goldman et al., 2009; Boubakri

et al., 2012; Adelino and Dinc, 2014). In contrast, there is concern that managers

with political connections would distort resource allocation by extracting resources

from firms to fulfil objectives that are not aligned with shareholders and, thus, show

poor firm performance relative to non-connected firms (e.g., Hung et al., 2012). In

a similar vein, firms with political connections are more likely to misrepo rt

accounting earnings in order to make it less difficult for insiders, such as managers,

to extract private control benefits or to protect political favors of dubious legality

than firms with no such connections (Leuz and Oberholzer-Gee, 2006; Ramanna

and Roychowdhury, 2010). Firms with political connections are also less likely to

respond to market pressures of high-quality accounting information since they have

preferential access to debt finance (Chaney et al., 2011). Taken together, on account

of the benefits and costs of political connections, an increasing number of studies

do not show consistent results on the benefits and costs of political connections to

firms.

To examine the relation between a politically connected audit committee and a

firm’s earnings quality, we hand-collected the audit committee data of listed firms

in the Korea Composite Stock Price Index (KOSPI) market from 2000 to 2012. We

use Korean data because Korea is an economy where political intervention plays an

important role (Chang, 1993, 2003; Siegel, 2007). In addition, Korea is often catego-

rized as a high-corruption country, implying that the value of political connections

is high (Faccio et al., 2006; Chaney et al., 2011).

2

Meanwhile, since 2000, Korean

public firms with total assets larger than or equal to KRW2 trillion (around USD2

2

Siegel (2007) provides an example of the importance of political connections in Korea. In

2006, LG, a large conglomerate in Korea, was able to attract a Dutch electronics manufac-

turer, Philips, to form a joint venture because its political connections led it to obtain cheap

land near Seoul and favorable tax treatment with government support.

H. Cho and B. Song

610 ©2017 Korean Securities Association