Accrual-based and real earnings management and political connections

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Abstract

This study examines whether the trade-off between real and accrual-based management strategies differs between firms with and without political connections. We argue that politically connected firms are more likely to substitute real earnings management for accrual-based earnings management than non-connected firms. Although real earnings management is more costly, we expect that politically connected firms prefer this strategy because of its higher secrecy and potential to mask political favors. Using a unique panel data set of 5493 publicly traded firms in 30 countries, our results show that politically connected firms are more likely to substitute real earnings management strategies for accrual-based earnings management strategies than non-connected firms. We also find that when public monitoring and, therefore, the risk of detection increases, politically connected firms are more likely to resort to less detectable real earnings management strategies. Our finding that political connections play a significant role in the choice between accrual-based and real earnings management strategies suggests that focusing only on accrual-based measurements underestimates the total earnings management activities of politically connected firms.

Introduction

This study examines the relation between the political connections of firms and their choices for earnings management strategies in an international setting. Firms can use multiple earnings management strategies to manage their earnings, i.e., accrual-based and real earnings management (e.g., Badertscher, 2011). Accrual-based earnings management aims to obscure true economic performance by changing accounting methods or estimates within the generally accepted accounting principles (Dechow & Skinner, 2000). On the contrary, real earnings management alters the execution of real business transactions (Roychowdhury, 2006). By adapting the timing or structuring of real transactions, firms change their operating activities to meet or beat short-term earnings targets, which has direct cash flow consequences and also potential long-term consequences for their economic value. For these reasons, real earnings management strategies are considered to be relatively costly compared to accrual-based earnings management (Graham, Harvey, & Rajgopal, 2005). The advantage of real earnings management, however, is that it is more difficult to detect than accrual-based earnings management (Badertscher, 2011, Graham et al., 2005, Gunny, 2010). Prior studies have shown evidence that firms use the two earnings management strategies as substitutes in managing earnings (Badertscher, 2011, Cohen et al., 2008, Cohen and Zarowin, 2010, Zang, 2012). This study extends research on the trade-off between real and accrual-based management by examining whether the substitution of real earnings management for accrual-based earnings management strategies differs between firms with and without political connections. We argue that politically connected firms favor the relatively more costly real earnings management strategies because of their higher secrecy and are more likely to substitute relatively more costly and less detectable real earnings management strategies for accrual-based earnings management strategies than non-connected firms.

Firms have political connections if their controlling shareholders or top managers are members of national parliaments or governments or have close connections with a top politician or party (Faccio, 2006). Literature shows that politically connected firms have opportunities to gain a lot from their political connections (Faccio, 2010, Pastor and Veronesi, 2013).1 However, they are also under higher public scrutiny and subject to more extensive controls and public monitoring than non-connected firms (Chaney, Faccio, & Parsley, 2011). As a consequence, the gains from their connections may need to be hidden, particularly if they are large and of dubious legality (Fisman, 2001). The costs they face when the media and other political parties detect that a firm manages its earnings to mask private gains may wipe out the benefits from their connections (Faccio, 2006). After all, detection may damage the firm's reputation integrity, as well as the connected politicians' reputations, and increase political costs and the likelihood of outside intervention (Faccio, 2006, Kothari et al., 2012, Ramanna and Roychowdhury, 2010, Watts and Zimmerman, 1990). Additionally, connected firms may lose their privileged access to benefits from their political connections. For these reasons, we expect that politically connected firms are more likely to substitute real earnings management for accrual-based earnings management strategies than non-connected firms. In particular, when public monitoring is high, they are more likely to resort to the more costly real earnings management strategies than non-connected firms. Compared to accrual-based earnings management, real earnings management more effectively help politically connected firms to take advantage of escaping detection and maintain the connection's and the firm's reputation in the short run at the cost of the firm's long-term performance (Cohen and Zarowin, 2010, Cohen et al., 2008, Ewert and Wagenhofer, 2005, Graham et al., 2005).

Using a unique panel data set of 5493 publicly traded firms in 30 countries, our results show that, compared to non-connected firms, politically connected firms are more likely to substitute relatively more costly and less detectable real earnings management strategies for accrual-based earnings management strategies, after controlling for other incentives for earnings management. Particularly, politically connected firms established in countries with relatively high levels of public monitoring use relatively more real earnings management strategies. Results from additional analysis also show that firms with political connections engage in more real activities' manipulation than non-connected firms after controlling for other incentives for earnings management. The findings of additional analyses show that the results are robust to the inclusion or exclusion of countries with a very large number of observations, or with only a few observations, and to different measures of earnings management and public monitoring.

This paper contributes to the ongoing research related to earnings management in three ways. First, we add to the extant earnings management literature that considers both real and accrual-based earnings management as substitutes in managing earnings (Cohen and Zarowin, 2010, Ewert and Wagenhofer, 2005, Zang, 2012). Studies show that firms switch from one type of earnings management to another after new legislation, e.g., the passage of SOX (Cohen et al., 2008), or around seasoned equity offerings (Cohen & Zarowin, 2010), and evidence that firms trade off between real activities' manipulation and accrual-based earnings management based on their relative costliness (Zang, 2012). Our results add to this literature by showing that the tendency of firms to trade off accrual-based versus real earnings management also varies with the presence of specific firm characteristics, i.e., the existence of political connections. Second, our study complements a growing body of international literature on political connections. Recent studies that examine the differences in earnings management between politically connected and non-connected firms report that the presence of political connections is associated with a lower accruals quality (Chaney et al., 2011, Ramanna and Roychowdhury, 2010, Riahi-Belkaoui, 2004). The current evidence is on accrual-based earnings management, and it therefore neglects the potentially more hazardous effects of real earnings management. This study extends the literature on the relationship between political connections of firms and earnings management by investigating whether the trade-off between real and accrual-based management differs between firms with and without political connections. We show that companies' political connections play a significant incremental role in explaining variance in the trade-off between accrual-based and real earnings management strategies. Our results also indicate that, at least for politically connected firms, if firms use accrual-based and real earnings management strategies as substitutes, studying only the former is likely to underestimate their total earnings management activities. Finally, our study complements literature on the role of public monitoring and governance by showing that politically connected firms that are established in countries with relatively high (low) levels of public monitoring are more (less) likely to substitute real earnings management for accrual-based earnings management to hide the gains that they typically derive from their political connections.

The remainder of this paper is structured as follows. First, we present a review of the related literature and develop hypotheses on the associations between firms' political connections and their use of real and/or accrual earnings management strategies associated with reporting earnings. This is followed by the research method, the results, and robustness tests. Third, we draw conclusions, discuss the limitations of our study, and indicate directions for further research.

Section snippets

Literature review and development of hypotheses

Firms can use multiple earnings management strategies, i.e., accrual-based and real earnings management, to manage their earnings (e.g., Badertscher, 2011, Cohen and Zarowin, 2010, Dechow et al., 2010, Kothari et al., 2012). Accrual-based earnings management occurs when managers choose accounting policies from a set of generally accepted policies to achieve earnings objectives. Real earnings management occurs when managers undertake actions that change the timing or structuring of operations

Data

To test the above hypotheses, we used the firms included in the study of Faccio (2006) as a starting point. This database includes 20,202 publicly traded firms in 47 countries during the years 1997–2001, comprising 607 political connections of 541 firms. A firm is identified as being connected with a politician if “at least one of its large shareholders (anyone controlling at least 10% of voting shares) or one of its top officers (CEO, president, vice-president, chairman, or secretary) is a

Results

Table 4 reports the results of the regression analyses for the hypothesized relationships between real earnings management and accrual-based earnings management, political connections, the level of public monitoring, and the combinations of accrual-based earnings management, political connections, and public monitoring.

Panel A of Table 4 reports negative and significant associations between accrual-based earnings management and real earnings management when real earnings management was measured

Robustness

Panel A of Table 1 shows that the United States, Japan, and the United Kingdom are relatively well represented in our data set, with respectively 2786 (51%), 1074 (20%), and 710 (13%) observations. To check that our results are not influenced by the inclusion (or exclusion) of one of these countries, we recursively repeated our main analyses after eliminating these three countries, one at a time, from the analysis. In addition, we repeated our main analyses after eliminating the countries with

Conclusion and discussion

This study examined whether politically connected firms are more likely to substitute real earnings management for accrual-based earnings management than non-connected firms. We argue that politically connected firms favor the relatively more costly real earnings management strategies because of its higher secrecy. Particularly, when public monitoring and the risk of detection increase, firms have more incentives to substitute real earnings management for accrual-based earnings management

Acknowledgment

We would like to thank the anonymous reviewers and co-editor of the journal, Paul K. Chaney for their constructive comments.

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