Politically Connected Firms and Earnings Informativeness in the Controlling versus Minority Shareholders Context: European Evidence

Date01 July 2014
Published date01 July 2014
DOIhttp://doi.org/10.1111/corg.12064
Politically Connected Firms and Earnings
Informativeness in the Controlling versus
Minority Shareholders Context:
European Evidence
Carolina Bona-Sánchez, Jerónimo Pérez-Alemán*, and
Domingo Javier Santana-Martín
ABSTRACT
Manuscript Type: Empirical
Research Question/Issue: Focusing on an environment where ownership concentration is prevalent and where the pres-
ence of politically connected directors on the board is the natural form of political connection, we analyze the effect of
political connections on earnings informativeness. We also examine a question that has not been considered in previous
research, namely, the impact of the level of divergence between the dominant owner’s voting and cash flow rights on
earnings informativeness for politically connected firms.
Research Findings/Insights: We find that the presence of politicians on the board negatively affects earnings informative-
ness. We also find a positive impact of the divergence between the dominant owner’s voting and cash flow rights on the
informativeness of accounting earnings in politically connected firms.
Theoretical/Academic Implications: We show that the relationship between political ties and earnings informativeness is
explained by an information effect, whereby politicians and shareholders are interested in providing as little information to
the market as possible in order to protect political ties from public scrutinyand prevent the leakage of competitive advantages
to competitors. Additionally, we show that the positive effect of divergence between the dominant owner’s voting and cash
flow rights on earnings informativeness in firms that belong to a pyramid is explained both by an alignment effect, whereby
political connections promote transparency, as well as by a stewardship effect, whereby the ultimate owner of the pyramid,
acting as a steward, places politicians on the board to increase the firm’s reputation and reports earnings in good faith.
Practitioner/Policy Implications: The results of our study may be useful to regulators interested in increasing transparency
in order to promote a more efficient allocation of resources. In particular, the results suggest that in countries where recent
reforms aim to improve investor protection and market confidence, regulators should encourage the disclosure of firm
political ties. The results of our study may also be useful to investors, financial analysts and auditors, as they highlight the
importance of considering specific features of the corporategovernance system when assessing the credibility of accounting
information.
Keywords: Corporate Governance, Earnings Informativeness, Politically Connected Firms, Europe
INTRODUCTION AND MOTIVATION
The financial and institutional crisis affecting European
countries such as Greece, Italy, Ireland, Portugal, and
Spain since mid-2007 has led to increased interest in the
study of political and business ties as well as their effect on
firm behavior, particularly on the credibility of accounting
information. The case of Bankia in Spain illustrates the
concern. The company, which has a strong political presence
on the board of directors, disclosed a profit of 305 million
euros in 2011. However, after the Spanish governmentinter-
vened in the company, Bankia restated its annual accounts
and declared a loss of around 3,000 million euros, which led
to significant losses for thousands of minority shareholders.
*Address for correspondence: Jerónimo Pérez-Alemán, Facultad de Ciencias
Económicas y Empresariales, Campus Universitario de Tafira,C.P.: 35017 Las Palmas
de Gran Canaria, Spain. Tel: +34 928452816; Fax: +34 928458177; E-mail: jperez@
defc.ulpgc.es
330
Corporate Governance: An International Review, 2014, 22(4): 330–346
© 2014 John Wiley & Sons Ltd
doi:10.1111/corg.12064
To the best of our knowledge, no previous research has
examined the credibility of accounting earnings for politi-
cally connected firms in Continental Europe. Our under-
standing of this issue is thus limited to accounts of scandals
that receive media coverage.
In this paper, we shed light on the earnings informative-
ness of politically connected firms in one Continental Euro-
pean country, namely, Spain. In particular, we examine a
sample of politically connected non-financial firms listed
in Spain over the period 2003–2011. Consistent with previ-
ous research (e.g., Boubakri, Guedhami, Mishra, & Saffar,
2012; Chaney, Faccio, & Parsley, 2011; Duchin & Sosyura,
2012; Faccio, 2006; Goldman, Rocholl, & So, 2009), we con-
sider a firm to be politically connected when at least one
of the members of the board of directors has held a politi-
cal position at the European, Spanish, or local level in the
past.
The Spanish context provides an interesting setting to
explore this question for several reasons. First, the massive
privatization waves in Spain over the last few decades led
many firms to appoint politically connected directors to
their board.As a result, political connections are common in
Spain. Moreover, Spanish firms operate in an environment
where the legal system provides weak protection of minor-
ity shareholders’ rights (e.g., Djankov, La Porta, López-de-
Silanes, & Shleifer, 2008; La Porta, López-de-Silanes,
Shleifer, & Vishny, 1998), the level of corruption is high
(Transparency International, 2012), and ownership struc-
tures of listed firms are characterized by the widespread
presence of dominant shareholders that frequently employ
mechanisms such as pyramidal structures or anti-takeover
devices that enable them to acquire more voting than cash
flow rights (e.g., Bona-Sánchez, Pérez-Alemán, & Santana-
Martín, 2011a, 2011b; Cuervo, 2002; Faccio & Lang, 2002; La
Porta, López-de-Silanes, & Shleifer, 1999; Ruiz-Mallorquí &
Santana-Martín, 2011; Santana-Martín & Aguiar-Díaz, 2006).
As a result, political connections also have greater influence
on firm behavior in Spain.
The limited empirical evidence on the effect of a firm’s
political ties on earnings quality generally supports a lower
level of earnings quality for politically connected firms (e.g.,
Chaney et al., 2011; Riahi-Belkaoui, 2004). The research
design of these studies, however, does not allow the authors
to test hypotheses that could explain the relationship
between a firm’s political ties and earnings quality (Chaney
et al., 2011). Additionally, previous research in this area
usually adopts an international perspective, which makes
interpretation of the results difficult as they may be affected
by differences in legal, judicial, and cultural factors that
make it hard to disentangle firm-level effects from country-
level ones (e.g., Gul, 2006; King & Santor, 2008; Miller, 2004).
Indeed, Faccio (2010) shows that differences between politi-
cally connected and unconnected firms are greater in weak
institutional environments, and that the costs and benefits of
political connections vary across countries.
Our results show that political connections negatively
affect the credibility of accounting earnings and hence the
informativeness of those earnings, consistent with an infor-
mation effect whereby politicians and shareholders provide
as little information to the market as possible in order to
protect the firm’s political ties from public scrutiny and
prevent the leakage of competitive advantages to competi-
tors. In addition, we find that as the separation between the
dominant owner’s voting and cash flow rights increases,
earnings informativeness also increases. These results are
consistent with both an alignment effect, whereby the ben-
efits of increased transparency outweigh the costs for politi-
cally connected firms, and with a stewardship effect,
whereby, acting as a steward, the controlling shareholder
places politicians on the board to increase the firm’s reputa-
tion and reports earnings in good faith.
Our study contributes to the literature on the effect of
political ties on earnings quality in four ways. First, we
provide evidence on the link between political ties and earn-
ings quality for a context in which ownership concentration
is prevalent and the presence of politically connected direc-
tors on the board is the natural form of political connection.
Second, we analyze how the divergence between the domi-
nant owner’s voting and cash flow rights affects the infor-
mativeness of accounting earnings for politically connected
firms, a question that to the best of our knowledge has not
been addressed in previous studies. Third, by using a theo-
retical approach that combines resource dependence theory,
agency theory, and stewardship theory, we shed light on
how political connections affect the credibility of accounting
earnings in the Spanish setting. This integrated approach
suggests that, rather than act opportunistically, controlling
owners act as good stewards of the resources provided to
them, and as a result positively affect earnings informative-
ness. Fourth, compared to prior international studies in the
area, we examine a longer period of time and focus on a
single country,which allows for cleaner interpretation of the
results.
The remainder of the paperis structured as follows. In the
second section we provide institutional background on
political connections in Spain. In the third section we
develop our hypotheses on the relationship between firms’
political connections and the informativeness of accounting
earnings. In the fourth section we describe our research
design, and in the fifth section we present empirical results.
Our final section provides a summary and concludes.
INSTITUTIONAL BACKGROUND
The effect of political connections on firm behavior is likely
to be significant in environments where regulations and
government control have important consequences for the
company (Agrawal & Knoeber, 2001). Political connec-
tions should therefore be more relevant in environments
characterized by a weaker legal system, a higher level of
corruption and less transparency (Faccio, 2006). However,
evidence on institutional characteristics that support ties
between politicians and companies is not conclusive. On the
one hand, Faccio (2006) and Chen, Li, Zu, and Sun (2011)
find that political connections are more prevalent and stron-
ger in countries with a weak legal system and a high level of
corruption. On the other hand, political ties may also be
significant in highly developed institutional environments
such as Canada (Morck, Stangeland, & Yeung, 2000) and the
US (e.g., Cooper, Gulen, & Ovtchinnikov, 2010; Goldman et
al., 2009). Nonetheless, Faccio (2006) shows that politically
POLITICAL TIES AND EARNINGS INFORMATIVENESS 331
Volume 22 Number 4 July 2014© 2014 John Wiley & Sons Ltd

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