Policy Uncertainty, Earnings Management, and the Role of Political Connections 

By | May 9, 2022

Political decisions shape the operating environment for the economy as well as the individual firm. Political and regulatory reactions to the Global Financial Crisis, government shutdowns, or major tax reforms number prominently among them. As reactions from political actors are rarely clear-cut ex ante, grave crises give rise to political uncertainty. 

Political uncertainty affects economic growth, the business cycle, as well as investment dynamics. There is robust evidence that political uncertainty is highly relevant for individual firms and their investors, with negative consequences for business decisions on corporate innovation, investment, and mergers and acquisitions. Political uncertainty is also relevant to firms’ financial disclosures. Firms try to manage discretionary accruals to minimize the costs of potentially adverse regulatory outcomes or sway legislation in their favor. Managers also have a motivation to camouflage a lack of value-creating investment alternatives caused by political uncertainty. 

While there is no doubt that political connections have direct positive real effects (e.g., in the form of tax savings, government contracts, etc.), the results on the association of political connections and disclosure decisions at the firm level are inconclusive and largely contradictory. While some studies find that politically connected firms are subject to less capital market pressure and, hence, (may) reduce earnings quality, others find that politically connected firms are able to shield themselves from public scrutiny and potential expropriation of assets by the state – which, in turn, enables them to reduce income-decreasing discretionary earnings management and, thus, increase earnings quality. Against this backdrop, we explore in detail whether the impact of political connections on earnings management has to be viewed in the context of political uncertainty, and show that political connections have a moderating influence on the relationship between political uncertainty and earnings quality. 

We argue our hypothesis on this moderating role of corporate political connections along two possible mechanisms. First, considering the complexity of political decisions, firms cannot fully anticipate which political decision is the more likely outcome. Offering information and expertise to politicians (i.e., lobbying) deepens political ties and provides firms preferential access to the regulatory and legislative process. This increases the quantity and quality of managers’ information about lawmakers’ objectives, as well as the potential impact and timing of various policy alternatives. Therefore, lobbying reduces the wide array of potential policy outcomes and narrows it down to a smaller, more manageable set. Second, as high political uncertainty indicates that policies are not yet settled, firms still have the opportunity to shape the political and regulatory outcome in their favor. When the wide range of decisions has not yet been filtered down, this is where firms have the most opportunity to intervene. 

We rely on a measure of political uncertainty based on the US firm-political risk index proposed by Hassan et al. (2019). As a proxy for political connectedness, we use firms’ total corporate lobbying expenditures, based on the US Lobbying Disclosure Act of 1995 (LDA). We obtain our lobbying data from the OpenSecrets website. Since OpenSecrets does not provide any standard company identifiers (e.g., Central Index Key, Committee on Uniform Securities Identification Procedure), we use a fuzzy-matching procedure in order to archive the broadest possible sample of (non-)lobbying firms. More specifically, we significantly extend the quantity and quality of firm-year observations beyond manual matching approaches or automated exact name-matching procedures employed in prior literature. After merging financial data from Compustat, the firm-political risk index, and the LDA-data, our final sample consists of 15,664 firm-year observations from 2002 through 2018. 

Our results have several important implications. Most importantly, we find empirical support that the relationship between political uncertainty and firms’ earnings management is a function of lobbying. In other words, corporate political connections fostered through lobbying have a mitigating effect on the well-documented association between political risk and uncertainty and firms’ earnings management behavior. The results are robust to a battery of additional tests. 

Our evidence is relevant for both firms and their investors. Since firms benefit from being able to correctly anticipate or shape future political decisions, the mitigating effect of political connections on political uncertainty-induced earnings management indicates a potential competitive advantage for firms. Our results suggest that political connections play a role in the firm’s risk management portfolio to cope with political uncertainty. Our findings are also relevant for legislators. Since we find significant differences between lobbying and non-lobbying firms, we conclude that existing transparency guidelines are not sufficient to reduce the discrepancy between individual opportunities to cope with, and potentially influence, political decisions. 

Moritz Hölzer is a Researcher at the University of Bremen 

Thomas R. Loy is Professor of Management Accounting and Information Systems at the University of Bremen 

Jochen Zimmermann is Professor of Accounting and Control at the University of Bremen 

This post is adapted from their paper, “Policy Uncertainty, Earnings Management and the Role of Political Connections” available on SSRN

The views expressed in this post are those of the author(s) and do not represent the views of the Global Financial Markets Center or Duke Law.

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