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

• Author: Domingo Javier Santana‐Martín,Carolina Bona‐Sánchez,Jerónimo Pérez‐Alemán
• Date: 01 July 2014
• Published date: 01 July 2014
• DOI: http://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

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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

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