Can We Trust the Accounting Discretion of Firms with Political Money Contributions? Evidence from U.S. IPOs

Antonios Kallias is a Lecturer in Accounting and Finance at Cardiff Business School; Konstantinos Kallias is a Senior Lecturer in Accounting and Financial Management at Portsmouth Business School; and Song Zhang is a Lecturer in Banking and Finance at the Centre for Responsible Banking & Finance, University of St Andrews School of Management. This post is based on their recent paper, forthcoming in the Journal of Accounting and Public Policy.

Related research from the Program on Corporate Governance includes Corporate Political Speech: Who Decides? (discussed on the Forum here) by Lucian Bebchuk and Robert J. Jackson Jr.; The Untenable Case for Keeping Investors in the Dark (discussed on the Forum here) by Lucian Bebchuk, Robert J. Jackson Jr., James David Nelson, and Roberto Tallarita; and The Politics of CEOs (discussed on the Forum here) by Alma Cohen, Moshe Hazan, Roberto Tallarita, and David Weiss.

In our paper, Can we trust the accounting discretion of firms with political money contributions? Evidence from U.S. IPOs, which was recently accepted for publication in the Journal of Accounting and Public Policy, we investigate the use of accounting discretion by initial public offering (IPO) firms with political money contributions (PMCs).

IPOs are conducive to the study of how political connections and accounting discretion interact; the reported financial data in IPO prospectuses claim a substantially larger influence on investment decisions than the financial statements released by listed companies, as there is little, if any, coverage of the issuing firm prior to going public. The information asymmetries generate competing incentives in IPO earnings reporting. One possibility is that managers systematically report discretionary accruals that result in reduced profitability, aimed at detracting attention from themselves and their political network. Alternatively, the influence that political ties have over the institutional and regulatory landscape could favor reporting decisions that raise the accounting bottom line and, consequently, the IPO offer price. Both predictions, despite the opposite directions, are consistent with earlier research describing an antagonistic relationship between political connections and accounting quality.

Our study broadens the extant research by testing these predictions against a different reporting motivation, whereby IPO issuers with PMCs utilize accounting discretion to inform rather than mislead investors. Two empirical patterns and a puzzle are in line with the use of accruals as a signaling device. First, discretionary accruals are likely to be informative when investors are generally optimistic about the firm’s prospects. Second, income-increasing reporting can signal expected political gains while suppressing disclosure of the underlying political quid pro quo agreements. However, research on IPO issuers with PMC activity exclusively attributes signaling capacity to PMCs, creating a paradox where the magnitude of the reported effects contradicts with the small political budgets of the issuers.

We reveal intensive use of income-increasing discretionary accruals by PMC issuers, with each dollar spent having incremental capacity to explain the accruals beyond a variety of firm- and IPO-specific variables. Concerns about non-random selection and the endogenous choice to set aside a political budget are allayed by a rigorous methodological strategy based on Heckman, instrumental variables, and maximum likelihood estimation. Further concerns about likely measurement error are mitigated by the use of different approaches for the recognition of accruals and PMC.

We follow the effects of PMC issuers’ accounting discretion far into the aftermarket in an effort to determine if the result of income-increasing accruals is an artifact of opportunism or information revelation. Our investigation produces three sets of results. Accounting-wise, the discretionary accruals taken at IPO positively associate with future reported performance. Differences-in-differences estimation based on a quasi-natural experiment confirms that this relationship is not just a result of better quality firms being able to spend more on political activities. At the level of stock price performance, the release of the first post-IPO results is not met with a systematic reaction from market investors. Furthermore, there is no correlation between accruals and long-term stock returns to signal market disappointment. The final level of our analysis focuses on IPO survivorship, where PMC issuers have a smaller failure rate and endure longer in the public domain. Overall, our data supports the accruals decisions made in the run-up to the IPO and shows that PMC issuers generally use their accounting discretion to enlighten rather than deceive investors.

We examine circumstances with a likely moderating influence on the PMC issuers’ accruals. We take into account a firm’s reliance on politics first. When the government retains the ability to bring about industry-wide wealth redistributions, either as a buyer or a regulator, access to policymakers creates a stronger informational advantage. Our data support this intuition by demonstrating that the level of income-increasing accruals is larger in sectors with extensive regulation and heavy government spending. By means of a comprehensive index of political sensitivity, we obtain similar results for the cross-section of issuers with a high sensitivity to policy outcomes. In contrast, our analysis for potential variation due to partisan preferences shows that this factor has little to no influence on IPO reporting.

As the first study to identify earnings quality in the presence of active political strategies, we contribute a fresh viewpoint to the literature on the political connections-accounting quality interface. Prior studies all share the belief that opportunistic incentives are essential for a high accruals level, whether this belief is portrayed as apprehension over regulatory sanctions or as a conflict with internal moral standards. Our research challenges the propensity of PMC firms to deceive and generalizes from a context that is particularly susceptible to opportunism by offering empirical ground to the possibility that accounting discretion might be utilized to get around the limitations that political connections place on communication with investors.

By increasing knowledge of the reasons why and how managers employ discretionary accruals for signaling, our work conveys novel insights to the body of research on the topic. Badertscher et al. (2012) establish a dichotomy when examining the conditions that lead to signaling, showing that managers use their accounting discretion to convey private information when a firm would meet (or miss) an earnings target anyhow. This finding suggests that informative accounting can arise when it is unimportant or, at the very least, when there are low stakes involved. However, the IPO wealth transfers are of high economic significance. Our evidence also differs from earlier research on the use of signals. Baik et al. (2020) find that managers who can forecast future performance, on average, use this skill to engage in income smoothing. Managers of PMC issuers, also better able to predict future performance through the political networks, signal around the listing year, which is when information asymmetries are most pronounced, and then relax the use of the signal so that, starting from the second year after the IPO, the difference in the level of discretionary accruals between PMC and non-PMC issuers becomes statistically insignificant. As a result, we demonstrate that the use of accounting discretion for communicating private information is more widespread and complex than currently recognized.

Our evidence has significant policy implications, cautioning standard setters against restricting accounting discretion because doing so could have the unintended consequence of preventing investors from making informed decisions when firms are confronted with the challenge of blocked communication. From the standpoint of regulatory agencies, such as the SEC, our findings serve to relieve the burden of having to devote more resources to the oversight of financial disclosures made by PMC firms. By extension, our findings also suggest that attention should be directed away from the accuracy of reported profits and toward determining the exact nature of their source and if they might be connected to an unfair competitive advantage. This raises questions about the democratic system’s capacity for self-regulating and for enforcing proper checks and balances, both of which are in the larger public interest.

The complete paper is available here.

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