Political Risk, Corporate Monitoring, and Financial Reporting Quality

• In Event: Managing and Responding to Risk

Abstract

Recent research shows that consistent with Watts and Zimmerman’s political cost hypothesis, financial reporting quality suffers as firms face increased levels of political risk. This paper evaluates how corporate monitors respond to increases in political risk and whether these responses effectively moderate the negative effects of political risk on financial reporting quality. Using a sample of U.S. firms from 2004 to 2018, we find that corporate monitors respond to increases in political risk with increased financial expertise on their boards and audit committees, and through greater effort by the audit committee and external auditors. However, the response from the board fails to moderate the negative consequences of political risk on financial reporting quality, and responses by audit committees and auditors only show moderation in certain settings. The results for audit committee financial expertise are mainly driven by firms with low exposure to government spending, while non-expert auditors drive the results for external auditors’ effort. Collectively, the evidence suggests that additional response by corporate monitors is needed to consistently moderate the negative effect of political risk on financial reporting quality.

Authors

• Deonette J Lambert, University of Oklahoma

• Brant E. Christensen, University of Oklahoma