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«“Auditor Lobbying and Audit Quality” on October 18, 2013 1:30pm in MCRD164 AUDITOR LOBBYING AND AUDIT QUALITY Brian Burnett†, Hui Chen*, and ...»

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Distinguished Lecture Series

School of Accountancy

W. P. Carey School of Business

Arizona State University

Katherine Gunny

of

University of Colorado

will discuss

“Auditor Lobbying and Audit Quality”

on

October 18, 2013

1:30pm in MCRD164

AUDITOR LOBBYING AND AUDIT QUALITY

Brian Burnett†, Hui Chen*, and Katherine Gunny*

October 2013

Abstract: Regulators and the public have expressed concerns about accounting firms lobbying politicians and regulators on behalf of their own audit clients because it could pose an advocacy threat to auditor independence. In this study, we examine whether these lobbying activities by accounting firms are associated with their clients’ audit quality. Since required disclosures of lobbying activities under the Lobbying Disclosure Act are very limited, we construct a proxy to capture auditor lobbying on behalf of audit clients. Using our proxy for lobbying, we find that perceived audit quality (measured using earnings response coefficients) is negatively related to lobbying. However, we fail to find that actual audit quality is lower for these clients (measured as the propensity to restate earnings, propensity to issue a going-concern opinion, and discretionary accruals). Our findings suggest that investors perceive auditors’ lobbying for clients’ political interests as harmful to audit quality but that these concerns do not appear to materialize in the financial statements. Similar to the literature on nonaudit services and the self-interest threat, our evidence suggests that reputation concerns and litigation risk provide enough incentive for auditors to maintain their independence in the presence of an advocacy threat to auditor independence.

_____________________________

† Cal Poly, San Luis Obispo * University of Colorado, Boulder We thank Mark DeFond and Michael Ettredge for insightful discussions and comments. We thank Scott Bronson, Shuping Chen, Yonca Ertimur, Bjorn Jorgensen, Terry Neal, Steve Rock, Phil Shane, Naomi Soderstrom, and workshop participants at Claremont McKenna College, University of Colorado, Boulder, University of Miami, University of Regensburg, and the American Accounting Association Annual Meeting for their feedback. We thank Marc Cussatt for his research assistance.

0

1. Introduction Public accounting firms comprise one of the largest groups that lobby regulators at various levels of government. The lobbying arms of PricewaterhouseCoopers and Ernst &Young, for example, consistently rank among the top 20 lobbying firms in the country, based on lobbying revenue.1 Accounting firms lobby on their own behalf and on the behalf of their clients – some of whom are also their audit clients. Their lobbying for audit clients is controversial, and politicians, regulators, and the public have repeatedly expressed concerns about it.

According to a report by The Chicago Tribune (Lynch and Aubin, 2013), the Securities and Exchange Commission (SEC) is investigating one of the Big 4 firms about the lobbying it provides for its audit clients. Several politicians and regulators also have expressed concerns to the media. U.S. Sen. Carl Levin called for regulatory attention on auditors lobbying in March 2012: “The [Public Company Accounting Oversight Board] should look into whether lobbying by an accounting firm is the type of service that is or should be banned under the auditor independence law.” Douglas Carmichael, the former chief auditor for the PCAOB, has been quoted as saying that “lobbying members of Congress on behalf of audit clients would make the auditor an advocate for the client” (Aubin et al., 2012). On May 3, 2012, James Kroeker, then chief accountant for the SEC, said that auditors lobbying for clients may put themselves in the position of being the clients’ advocates and that investors would not trust the independence of these auditors (Kroecker, 2012). U.S. Sen. Jack Reed, a Rhode Island Democrat, also echoed the need for clarification on auditor lobbying. He stated that it was the SEC’s role to provide a definitive answer on whether lobbying for clients creates a threat to independence. So far, 1 Reported by the Center for Responsive Politics.

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to audit clients.

The political debate surrounding accounting firms lobbying for audit clients is longstanding. Around 2000, the SEC initiated a series of discussions scrutinizing certain auditorprovided nonaudit services. Lobbying on behalf of clients was included in the discussions but ultimately escaped scrutiny (Squires, 2003). The Sarbanes-Oxley’s Act of 2002 revived the debate, stating, “[t]he accounting firm should not act as an advocate of the audit client, which would be involved in providing legal and expert services to an audit client in legal, administrative, or regulatory proceedings” (Senate Report 107-205, Title II). But the law never gives clear guidance whether lobbying for clients violates this principle.

Despite the repeated regulatory concerns, both the scale and scope of auditor lobbying for clients are small. In fact, very few firms officially employ their own auditor to lobby the federal government.2 In addition, the revenue from lobbying service is typically only a fraction of auditing revenue. The current debate on the legality of such practice represents the regulators’ concern about its potential impairment of auditor independence. Specifically, auditor lobbying for audit clients could pose an advocacy threat to auditor independence which could lead to lower audit quality. Advocacy threat is one of the five threats to independence enumerated by the Conceptual Framework for AICPA Independence Standards.3 The AICPA conceptual framework defines an advocacy threat as “actions that promote an attest client’s interest or position.”4 Advocacy threats impair auditor independence when auditors promote a position to the point that 2 After merging with Compustat and Audit Analytics, there are only 16 publicly-traded firms (41 firm-years) in nonregulated industries that contract their own auditors as lobbyists from 1998-2008.





3 The other four threats are self-interest, self-review, familiarity, and intimidation.

4 For example, if an auditor advocates for a client to receive a loan based on the financial statements prepared and reviewed by the auditor, this could impair auditor independence. The auditor may be more inclined to represent transactions that lead to a greater likelihood of their client receiving the loan. Other examples of advocacy threat include the auditor promoting the client’s securities as part of an initial public offering or representing a client in court (Delaney and Whittington, 2011).

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of clients means representing and advocating the clients’ political interests, which could lead to an advocacy threat (Shaub, 2005). The auditor may lose objectivity and professional skepticism during the financial reporting process. And even if auditors do not lose their skepticism, others may perceive them as losing it which could affect actual or perceived audit quality.

On the other hand, auditors have market-based incentives to maintain their independence, protect their reputation, and reduce their litigation risk (DeAngelo 1981; Watts and Zimmerman 1983). The incentive to protect their reputation and avoid litigation may be strong enough to ensure auditors maintain their independence and provide high audit quality. As such, whether auditor lobbying for clients leads to lower audit quality remains an open empirical question.

To our knowledge, no academic study has examined this issue systematically. The main reason for the lack of empirical evidence is that the officially disclosed auditor-provided lobbying services for audit clients are very limited. Due to the small sample, failing to find evidence consistent with an impaired audit quality could simply be the result of insufficient statistical power.5 Further, the regulators’ concern about advocacy threat does not stop at the officially disclosed lobbying activities only. While accounting firms have strong incentives to lobby for their clients,6 the majority of auditor lobbying for their clients is implicit (Watts and Zimmerman, 1986). That is, an accounting firm does not have to sign an explicit contract to lobby on behalf of their client and does not have to register its lobbying activities with regulators, but its political activities still promote its clients’ interests.

5 As shown in Panel B of Table 1, we fail to find the audit quality of client firms that officially hire their auditors as lobbyists is significantly different from the control group.

Watts and Zimmerman (1982) propose that accounting firms’ wealth is a function of their clients’ wealth.

6 Therefore accounting firms may advocate for their clients’ interests as they could benefit indirectly if their clients thrive.

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analyzing their political action committee (PAC) contributions.7 This proxy attempts to capture both officially disclosed and undisclosed lobbying activities. Corporate PACs strategically select politicians who hold key positions overseeing policies concerning these companies, and donate to these politicians to show their support and foster opportunities of further contacts. PACs are funded by company executives, employees, and shareholders of the firm. For example, Big 4 PAC contributions are funded almost exclusively by their own partners from local offices.

Therefore, when an auditor’s PAC and its client’s PAC choose to make political contributions to the same politicians, we conjecture that they share similar political goals and preferences and that the auditor is more likely to lobby for positions favored by the client. As such, we measure auditor lobbying for a client as the percentage of overlap of the politicians that the auditor and the client donate to through PAC contributions.

We implement two validity tests to provide evidence that our measure of auditor lobbying captures both disclosed and undisclosed lobbying. First, using the limited data that discloses accounting firms’ lobbying activities, we find that our auditor lobbying measure is significantly higher for clients that formally hire their own auditors to lobby. Second, undisclosed lobbying activities auditors undertake on behalf of their clients are not explicitly contracted or observable. However, Watts and Zimmerman (1986) suggest that, even though an auditor does not explicitly charge clients for these types of lobbying activities, these services 7 American corporations are prohibited from directly giving donations to politicians by the Taft-Hartley Act of 1947.

However, they are allowed to establish PACs, which are separate entities dedicated to promote the corporation’s political interests. A corporate PAC solicits contributions from the affiliated company’s executives, employees and shareholders, etc., and makes donations to selected politicians. Although companies are forbidden from directly contributing to their own PACs, they provide the PACs with administrative and executive support. Typically, corporate executives also serve as the chairpersons and treasurers of these PACs and are directly involved in deciding which politicians to contribute to.

–  –  –

associated with audit fees consistent with our proxy capturing undisclosed lobbying activities.

Next, we examine the relation between our measure of auditor lobbying and several proxies of audit quality. We find that perceived audit quality (measured using earnings response coefficients) is negatively related to lobbying. However, we fail to find a negative association between actual audit quality (measured as the propensity to restate earnings, propensity to issue a going-concern opinion, and discretionary accruals) and our proxy for lobbying. Our evidence suggests that stock market participants perceive auditors’ lobbying for clients’ political interests as harmful to audit quality but that these concerns may not materialize in the financial statements. This result is consistent with the literature on whether auditor-provided nonaudit services create an economic bond (i.e., self-interest threat) that impairs auditor independence.

Specifically, while Francis and Ke (2002) find a negative relation between nonaudit services and perceived audit quality, many studies fail to find an association between nonaudit services and actual audit quality (DeFond et al. 2002; Ashbaugh et al. 2003; Chung and Kallapur 2003;

Larcker and Richardson 2004; Reynolds et al. 2004) with the exception of Frankel et al. (2002).

Our study makes three contributions. We contribute to the lobbying literature in accounting, as we are the first researchers to examine the impact of accounting firms lobbying on behalf of their own audit clients. Puro (1984) examines accounting firms lobbying behavior at the Financial Accounting Standards Board (FASB) level. She scrutinizes comment letters written to the FASB to identify auditing firms’ lobbying positions and relates it to the auditors’ underlying incentives. Several other studies examine corporations lobbying the FASB for themselves on various accounting regulations such as accounting for employers’ pensions (Francis, 1987) or accounting for oil and gas production (Deakin, 1989). Other studies examine

–  –  –

disclosure rules (Lo, 2003) and the passage of Sarbanes-Oxley (Hochberg et al., 2009). Ramanna (2008) examines corporations’ lobbying on fair-value accounting issues, specifically through PAC contributions to congressional members. While these studies examine how firms (clients and auditors) lobby on their own behalf, our paper is the first to examine the audit quality implications of accounting firms lobbying on behalf of their audit clients.

We also contribute to the study of threats to auditor independence. The Conceptual

Framework for AICPA Independence Standards identifies five threats to auditor independence:



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