Political connections and earnings quality. How do connected firms respond to changes in political stability and government effectiveness?

• Pages: 339-356
• Published date: 03 October 2016
• DOI: https://doi.org/10.1108/IJAIM-05-2016-0056
• Date: 03 October 2016
• Author: Iman Harymawan,John Nowland
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

Political connections and

earnings quality

How do connected rms respond to changes

in political stability and government

effectiveness?

Iman Harymawan

Department of Accounting, Universitas Airlangga, Surabaya,

Indonesia, and

John Nowland

Department of Accounting, Illinois State University, Normal, Illinois, USA

Abstract

Purpose – The purpose of this study is to investigate how the earnings quality of politically connected

rms is affected by changes in political stability and government effectiveness in a developing country.

Design/methodology/approach – This study uses a sample of 2,073 rm-year observations from

349 rms listed on the Indonesian Stock Exchange from 2003 to 2012 to examine how political stability

and government effectiveness affect the earnings quality of politically connected rms, relative to

non-politically connected rms. A two-stage model is used to address self-selection issues in the choice

of rms to establish political connections.

Findings – This study nds that increased government effectiveness reduces the benets of political

connections, requiring politically connected rms to be more responsive to market pressures and

resulting in higher earnings quality. However, increased political stability enhances the certainty of

benets from political connections, reducing the need for politically connected rms to respond to

market pressures and resulting in lower earnings quality.

Research limitations/implications – For policymakers, these results indicate that different

dimensions of political and economic development can affect the incentives of rms with political

connections in different ways.

Originality/value – This study nds that the earnings quality of politically connected rms increases

as government effectiveness improves, but it decreases as the political environment becomes more

stable.

Keywords Earnings quality, Political connections, Political stability, Government effectiveness

Paper type Research paper

1. Introduction

Prior studies indicate that rms can derive signicant benets from political

connections, including preferential access to nancing, preferential treatment in the

award of government contracts and greater likelihood of government bailout during

crises (Agrawal and Knoeber, 2001;Backman, 2001;Blau et al., 2013;Claessens et al.,

The authors gratefully acknowledge Mara Faccio and Walid Saffar for the data sharing of

politically connected rms in Indonesia.

The current issue and full text archive of this journal is available on Emerald Insight at:

www.emeraldinsight.com/1834-7649.htm

Stability and

government

effectiveness

339

Received 18 May 2016

Revised 24 July 2016

Accepted 5 August 2016

InternationalJournal of

Accounting& Information

Management

Vol.24 No. 4, 2016

pp.339-356

©Emerald Group Publishing Limited

1834-7649

DOI 10.1108/IJAIM-05-2016-0056

2008;Cull and Xu, 2005;Faccio et al., 2006;Goldman et al., 2011;Johnson and Mitton,

2003;Karpoff et al., 1999;Khwaja and Mian, 2005;Yeh et al., 2013). In addition, Chaney

et al. (2011) show that political connections have an inuence on the nancial reporting

quality of rms. For example, as rms can secure nancing through their political

connections, they have less of a need to respond to external market pressures, resulting

in the disclosure of lower-quality accounting information.

As the literature suggests, the benets of political connections are greatest in

countries that are less developed and have higher levels of corruption (Faccio, 2006;

Faccio, 2010;Chen et al., 2010;Boubakri et al., 2012). The obvious policy implication is

that increased political and economic development should reduce the need for rms to

rely on their political connections and increase the need for rms to respond to market

pressures. We examine this issue in this paper, as we investigate whether time series

changes in the institutional environment in a developing country have an effect on the

nancial reporting quality of politically connected rms.

We specically examine changes in political stability and government effectiveness,

as we expect them to have different inuences on the trade-off that connected rms face

between the benets they receive from their political connections versus their need to

respond to market pressures. We predict that as government effectiveness increases, the

benets that connected rms derive from their political connections are eroded, forcing

them to be more responsive to market pressures and resulting in higher earnings

quality. However, we also propose that increased political stability actually helps rms

with political connections to be more certain of deriving benets from their connections,

reducing the need for connected rms to respond to market pressures and resulting in

lower earnings quality. Thus, we predict that increases in political stability and

government effectiveness will have opposing effects on the accounting quality of

politically connected rms.

To investigate this issue, we use a sample of listed rms from Indonesia, a developing

market with a strong history of political connections in business. Fisman (2001) nds

that politically connected rms in Indonesia strongly rely on the benets from their

connections. Leuz and Oberholzer-Gee (2006) show that connected rms face nancing

difculties when their political connections fall from power. Thus, Indonesia is an ideal

setting to examine the effect of changes in political stability and government

effectiveness on the earnings quality of politically connected rms.

In our analysis, we use a sample of 2,073 rm-year observations from 349 rms listed

on the Indonesian Stock Exchange (IDX) from 2003 to 2012 and a two-stage regression

model to address self-selection issues in the choice of rms to establish political

connections. Our results indicate that the earnings quality of politically connected rms,

relative to non-politically connected rms, increases as government effectiveness

improves, but decreases as the political environment becomes more stable. These results

are consistent across our additional tests, which include rm random effects, a

propensity score matched sample approach and alternative measures of earnings

management.

This study adds new evidence to the literature on political connections in emerging

markets. Prior studies have examined how rms respond to changes in the strength of

their political connections, e.g. when their political connections lose power through

election losses (Fisman, 2001;Leuz and Oberholzer-Gee, 2006). In this paper, we examine

how rms with political connections respond to changes in their institutional

IJAIM

24,4

340