Quality Accounting Information in Politically Connected Firms by SSRN
Vanderbilt University – Accounting
Purdue University – Krannert School of Management; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)
Vanderbilt University – Finance
July 6, 2010
We document that the quality of earnings reported by politically connected firms is significantly poorer than that of similar non-connected companies. Our results are not due to firms with ex-ante poor earnings quality establishing connections more often. Instead, our results suggest that, because of a lesser need to respond to market pressures to increase the quality of information, connected companies can afford disclosing lower quality accounting information. In particular, lower quality reported earnings is associated with a higher cost of debt only for the non-politically connected firms in the sample.
Quality Accounting Information in Politically Connected Firms – Introduction
In this paper we investigate whether earnings quality varies systematically with political connections in a wide sample of countries and politically connected firms. Overall, our results reveal that the presence of political connections is associated with a lower quality of accounting earnings. We document that political connections have incremental explanatory power beyond country, regulatory, and firm specific ownership characteristics.
Ex-ante, one could have argued that because connected firms are subject to extensive controls and monitoring (including scrutiny by the media), political connections would, in
fact, be associated with better earnings quality. This, however, is not the case. Based on the results in prior research, three explanations are consistent with our finding that the quality of earnings of politically connected firms is poorer than the quality of earnings of similar nonconnected peers. First, as politically connected firms typically derive gains from their connections1 over and above the payments they make,2 insiders may hide, obscure, or at least attempt to delay reporting the benefits received with the purpose of intentionally misleading investors to gain at their expense (e.g., Schipper, 1989, or Leuz, Nanda and Wysocki, 2003). In a closely related paper, Leuz and Oberholzer-Gee (2006) argue that the higher transparency associated with foreign financing makes it harder for connected companies to extract political favors, especially those of dubious legality. As a consequence, connected firms that enjoy substantial political benefits are likely to choose to remain less transparent by raising capital domestically – a prediction that is strongly supported by Leuz and Oberholzer-Gee’s (2006) results. According to this first hypothesis, connected firms would be more opaque than similar non-connected firms. We employ accruals quality as one specific measureable proxy of this opacity.
Second, to the extent that politicians provide protection to their related companies so that low quality accounting information is not penalized, connected firms might simply care less about the quality of the information they disclose, and invest less time to accurately portray their accruals. In this case, the quality of information would be low due to inattention on the part of the firm’s managers. This represents a more benevolent interpretation of poor accruals quality. Third, it might simply be the case that firms with poor earnings quality are more likely to establish political connections. In all cases, political connections would be associated with poor information quality, as we find.
We run two sets of tests to attempt to distinguish among these possible explanations. First, for a sub-sample of firms for which the date of establishment of a connection could be determined, we investigate whether poor accruals quality has an impact on the likelihood that a company establishes a connection in a given year. We find no significant association between the quality of earnings and the likelihood that a connection is established. This allows us to rule out that, on average, our results are simply due to firms with ex-ante poor earnings quality establishing connections more often.
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