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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 scrutiny and 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 corporate governance system when assessing the credibility of accounting information. Keywords: Corporate Governance, Earnings Informativeness, Politically Connected Firms, Europe INTRODUCTION AND MOTIVATION T he 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 government inter- 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

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Politically Connected Firms and EarningsInformativeness in the Controlling versusMinority Shareholders Context:European Evidence

Carolina Bona-Sánchez, Jerónimo Pérez-Alemán*, andDomingo Javier Santana-Martín

ABSTRACT

Manuscript Type: EmpiricalResearch 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 ofpolitical connections on earnings informativeness. We also examine a question that has not been considered in previousresearch, namely, the impact of the level of divergence between the dominant owner’s voting and cash flow rights onearnings 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 theinformativeness of accounting earnings in politically connected firms.Theoretical/Academic Implications: We show that the relationship between political ties and earnings informativeness isexplained by an information effect, whereby politicians and shareholders are interested in providing as little information tothe market as possible in order to protect political ties from public scrutiny and prevent the leakage of competitive advantagesto competitors. Additionally, we show that the positive effect of divergence between the dominant owner’s voting and cashflow rights on earnings informativeness in firms that belong to a pyramid is explained both by an alignment effect, wherebypolitical 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 transparencyin order to promote a more efficient allocation of resources. In particular, the results suggest that in countries where recentreforms aim to improve investor protection and market confidence, regulators should encourage the disclosure of firmpolitical ties. The results of our study may also be useful to investors, financial analysts and auditors, as they highlight theimportance of considering specific features of the corporate governance system when assessing the credibility of accountinginformation.

Keywords: Corporate Governance, Earnings Informativeness, Politically Connected Firms, Europe

INTRODUCTION AND MOTIVATION

T he financial and institutional crisis affecting Europeancountries 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 onfirm behavior, particularly on the credibility of accountinginformation. The case of Bankia in Spain illustrates theconcern. The company, which has a strong political presenceon the board of directors, disclosed a profit of 305 millioneuros in 2011. However, after the Spanish government inter-vened in the company, Bankia restated its annual accountsand declared a loss of around 3,000 million euros, which ledto significant losses for thousands of minority shareholders.

*Address for correspondence: Jerónimo Pérez-Alemán, Facultad de CienciasEconómicas y Empresariales, Campus Universitario de Tafira, C.P.: 35017 Las Palmasde Gran Canaria, Spain. Tel: +34 928452816; Fax: +34 928458177; E-mail: [email protected]

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© 2014 John Wiley & Sons Ltddoi:10.1111/corg.12064

To the best of our knowledge, no previous research hasexamined 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 scandalsthat 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 asample of politically connected non-financial firms listedin 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 oneof the members of the board of directors has held a politi-cal position at the European, Spanish, or local level in thepast.

The Spanish context provides an interesting setting toexplore this question for several reasons. First, the massiveprivatization waves in Spain over the last few decades ledmany firms to appoint politically connected directors totheir board. As a result, political connections are common inSpain. Moreover, Spanish firms operate in an environmentwhere 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 widespreadpresence of dominant shareholders that frequently employmechanisms such as pyramidal structures or anti-takeoverdevices that enable them to acquire more voting than cashflow rights (e.g., Bona-Sánchez, Pérez-Alemán, & Santana-Martín, 2011a, 2011b; Cuervo, 2002; Faccio & Lang, 2002; LaPorta, López-de-Silanes, & Shleifer, 1999; Ruiz-Mallorquí &Santana-Martín, 2011; Santana-Martín & Aguiar-Díaz, 2006).As a result, political connections also have greater influenceon firm behavior in Spain.

The limited empirical evidence on the effect of a firm’spolitical ties on earnings quality generally supports a lowerlevel of earnings quality for politically connected firms (e.g.,Chaney et al., 2011; Riahi-Belkaoui, 2004). The researchdesign of these studies, however, does not allow the authorsto test hypotheses that could explain the relationshipbetween a firm’s political ties and earnings quality (Chaneyet al., 2011). Additionally, previous research in this areausually adopts an international perspective, which makesinterpretation of the results difficult as they may be affectedby differences in legal, judicial, and cultural factors thatmake 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 weakinstitutional environments, and that the costs and benefits ofpolitical connections vary across countries.

Our results show that political connections negativelyaffect the credibility of accounting earnings and hence theinformativeness of those earnings, consistent with an infor-mation effect whereby politicians and shareholders provideas little information to the market as possible in order toprotect 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 thedominant owner’s voting and cash flow rights increases,earnings informativeness also increases. These results areconsistent 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 shareholderplaces 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 ofpolitical ties on earnings quality in four ways. First, weprovide evidence on the link between political ties and earn-ings quality for a context in which ownership concentrationis 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 connectedfirms, a question that to the best of our knowledge has notbeen addressed in previous studies. Third, by using a theo-retical approach that combines resource dependence theory,agency theory, and stewardship theory, we shed light onhow political connections affect the credibility of accountingearnings in the Spanish setting. This integrated approachsuggests that, rather than act opportunistically, controllingowners act as good stewards of the resources provided tothem, and as a result positively affect earnings informative-ness. Fourth, compared to prior international studies in thearea, we examine a longer period of time and focus on asingle country, which allows for cleaner interpretation of theresults.

The remainder of the paper is structured as follows. In thesecond section we provide institutional background onpolitical connections in Spain. In the third section wedevelop our hypotheses on the relationship between firms’political connections and the informativeness of accountingearnings. In the fourth section we describe our researchdesign, 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 likelyto be significant in environments where regulations andgovernment control have important consequences for thecompany (Agrawal & Knoeber, 2001). Political connec-tions should therefore be more relevant in environmentscharacterized by a weaker legal system, a higher level ofcorruption and less transparency (Faccio, 2006). However,evidence on institutional characteristics that support tiesbetween politicians and companies is not conclusive. On theone 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 ofcorruption. On the other hand, political ties may also besignificant in highly developed institutional environmentssuch as Canada (Morck, Stangeland, & Yeung, 2000) and theUS (e.g., Cooper, Gulen, & Ovtchinnikov, 2010; Goldman etal., 2009). Nonetheless, Faccio (2006) shows that politically

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connected firms tend to account for a greater part of largelisted companies’ capitalization in countries with highercorruption and less transparency: politically connectedfirms account for 86 percent of the capitalization in Russia,41 percent in Thailand, 39 percent in the US and 22 percentin Ireland.

Several prior studies suggest that political connectionscan have beneficial effects. Agrawal and Knoeber (2001) andGoldman et al. (2009), for instance, argue that political con-nections can provide expertise on legislative and bureau-cratic procedures. Faccio (2006) argues that politicalconnections can lead to preferential treatment by the gov-ernment, through, for instance, increased access to bankfinancing, lower tax rates, preference in the award of gov-ernment contracts and less regulatory oversight over theconnected firm or greater oversight over the connectedfirm’s rivals. Moreover, Khwaja and Mian (2005) argue thatpolitically connected firms enjoy increased access to capitalfrom financial institutions.

In line with this positive view of political ties, Fisman(2001) shows that the market value of Indonesian firmsclosely related to the family headed by President Suhartoexperienced a significant decrease upon the release of nega-tive news about the president’s health. Similarly, Faccio andParsley (2009) find a significant decrease in firm value afterthe death of politicians residing or born in the same geo-graphic area as the head company. Goldman et al. (2009)further show that, compared to the presence of politicaldirectors on the board, corporate donations are a less reliableindicator of future performance.

However, counter to the positive view of political ties,other studies find that tunneling and self-dealing activities bydominant shareholders are more pronounced in politicallyconnected firms when the aim of the political connection is toensure access to bank financing (Qian, Pan, & Yeung, 2011).According to this perspective, political connections canincrease the information asymmetry arising from the separa-tion of ownership and control (Chen et al, 2011). Thus, espe-cially in environments where external shareholders’ interestsare poorly protected, political ties can increase dominantowners’ incentives to expropriate minority shareholders’wealth. Taken together, the above arguments highlight theimportance of considering the institutional environmentwhen assessing the effect of political connections, as it influ-ences not only the intended purpose of such connections butalso the costs and benefits associated with them.

In Spain, ownership is highly concentrated in the hands ofbanks and families, with these core shareholders playingan active role in management (e.g., Cuervo, 2002; Faccio& Lang, 2002; La Porta et al., 1999; Ruiz-Mallorquí &Santana-Martín, 2011; Santana-Martín & Aguiar-Díaz, 2006).In this context, the board of directors is typically controlledby the executive or by external directors related to the domi-nant owner (Cuervo, 2002), while capital markets are rela-tively illiquid and have limited control ability. Therefore, inSpain, the traditional agency conflict between managers andshareholders (e.g., Fama, 1980; Fama & Jensen, 1983; Jensen& Meckling, 1976) becomes a conflict between the dominantowner and minority shareholders (e.g., Burkart, Panunzi, &Shleifer, 2003; La Porta, Lopez-de-Silanes, Shleifer, &Vishny, 2000; Villalonga & Amit, 2006).

Chen et al. (2011) argue that ownership concentrationfacilitates the development of political connections for atleast three reasons. First, ownership concentration increasesthe homogeneity of shareholder interests and reduces thecosts of carrying out collective actions to establish and main-tain connections with political elites. Second, ownershipconcentration helps to ensure that the benefit of the politicalconnection achieved by the dominant owner is not dilutedby the participation of other shareholders. Third, ownershipconcentration reduces the need to transfer informationabout political rents, which benefits not only the dominantowner but also politicians, as both have interests in keepingthe exchange of favors hidden.

In addition, the economic environment in Spain is charac-terized by weak investor protection (e.g., Djankov et al.,2008; La Porta et al., 1998), poor enforcement of propertyrights (e.g., La Porta et al., 1999) and a high level of corrup-tion (Transparency International, 2012). When companiescannot rely on the legal system to enforce contracts, politicalties become necessary to run businesses (Li, Meng, Qian, &Zhou, 2008). Indeed, many firms in Spain appointed politi-cally connected directors during the massive privatizationwaves over the past few decades. As a result of the abovefactors, political connections are common in Spain, withmore than 47.56 percent of listed firms having politicallyconnected boards,1 and have great influence on firmbehavior.

In sum, the above features of the Spanish corporate envi-ronment offer an ideal context for studying the relationshipbetween political ties and earnings informativeness. More-over, the features above suggest that the results from previ-ous studies on the effect of a firm’s political connections onthe properties of accounting earnings may not hold forSpanish firms.

HYPOTHESES

A number of corporate governance studies consider how thecomposition of the board of directors influences the proper-ties of accounting earnings (e.g., Beekes, Pope, & Young,2004; Bushman, Piotroski, & Smith, 2004; García-Osma &Gill-de-Albornoz Noguer, 2007; Ghosh, Marra, & Moon,2010; Klein, 2002; Laux & Laux, 2009; Peasnell, Pope, &Young, 2000; Vafeas, 2000). Nevertheless, the evidence is farfrom conclusive and thus the link between board composi-tion and the properties of reported earnings numbersremains unclear (Beekes et al., 2004). Additionally, previousevidence focuses mainly on board size and the role of execu-tive versus outside directors (e.g., Ahmed & Duellman,2007; Klein, 2002; Peasnell et al., 2000; Vafeas, 2000), withonly a few studies considering the specific roles of particulartypes of directors such as bankers, venture capitalists, orpolitically connected directors (Adams, Hermalin, &Weisbach, 2008).

The board serves two functions: monitoring, and provid-ing access to resources as well as guidance to management(e.g., Adams, Hermalin, & Weisbach, 2010; Zahra & Pearce,1989). The resource dependence theory developed by Pfefferand Salancik (1978) argues that by helping firms obtain valu-able resources and cope with various external uncertainties,

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political connections increase firm value (e.g., Faccio, 2006,2010; Faccio, Masulis, & McConnell, 2007; Faccio & Parsley,2009; Fisman, 2001; Goldman et al., 2009). However, studieson the effect of politically connected firms on the propertiesof accounting earnings are scarce. Moreover, these fewstudies usually focus on the classic agency conflict betweenmanagers and shareholders and adopt an international per-spective (e.g., Chaney et al., 2011; Riahi-Belkaoui, 2004), ana-lyzing countries with important institutional differences andhighly dissimilar types of political connections, which con-founds interpretation of the results.

The present study aims to fill a gap in previous literatureby examining the earnings informativeness of politicallyconnected firms in one country – Spain. As we discussabove, in Spain, the governance role of politically connecteddirectors focused on providing resources is shaped by anenvironment characterized by weak investor protection, lessdeveloped capital markets, and a large presence of domi-nant owners (e.g., Cuervo, 2002; Faccio & Lang, 2002; LaPorta et al., 1999; Santana-Martín & Aguiar-Díaz, 2006).Given dominant owners’ significant voting rights and fre-quent involvement in management decisions (e.g., Cuervo,2002; La Porta et al., 1999), political ties are likely to increasedominant shareholders’ incentives to expropriate minorityshareholders’ wealth. Thus, the main concern of corporategovernance in the Spanish setting is to safeguard against theself-serving behavior of the dominant shareholder andthereby prevent the expropriation of minority shareholders(e.g., Burkart et al., 2003; La Porta et al., 2000; Villalonga &Amit, 2006).

In the Spanish setting, political connections may have anegative effect on earnings informativeness. Spain has abank-oriented financial system (e.g., Cuervo, 1991; Ruiz-Mallorquí & Santana-Martín, 2011; Steinherr & Huveneers,1994) characterized by strong government intervention in theeconomy both through central banks and through politicalinfluence on financial institutions. The close relation betweenthe Spanish government and the banking industry makespolitically connected Spanish firms more likely to gain accessto debt financing on better terms (Boubakri et al., 2012). Thispotential resource benefit may be particularly important inSpain, where, according to the Global CompetitivenessReport 2013–2014 published by the World Economic Forum(2013), access to financing is regarded as the most problem-atic factor for doing business (indeed, Spain ranks 138thamong the 148 countries considered in terms of ease of accessto loans). However, firms with capital secured through politi-cal connections can afford to care less about market punish-ment (e.g., Chaney et al., 2011; Qian et al., 2011), decreasingthe cost of expropriation for politically connected firms. Thus,for politically connected firms in Spain, outside investors maypay less attention to accounting information because theyexpect this information to reflect the dominant owner’s self-interests rather than the firm’s true underlying economiccondition (expropriation effect).

A negative relationship between the presence of politicalconnections and the quality of accounting information couldalso arise as a result of an information effect whereby poli-ticians and dominant shareholders provide as little informa-tion to the market as possible to prevent the transmission ofproprietary information to competitors and to protect politi-

cal ties from public scrutiny (e.g., Boubakri et al., 2012;Chaney et al., 2011; Fan & Wong, 2002; Riahi-Belkaoui, 2004).Thus, for politically connected firms in Spain, the credibilityof accounting information might be reduced to the extentthat the market anticipates a preference for opacity.

On the other hand, Qian et al. (2011) show that expro-priation occurs only in firms whose political connectionhelps them secure bank loan access. Thus, when the aim ofa political connection is not to secure financial capital butto benefit the company for innocuous reasons (Goldman etal., 2009), such as providing expertise or guidance, analignment effect may arise whereby the dominant owner’sreputation concerns increase the cost associated with anynon-value-maximizing behavior that is detected, decreasingthe dominant owner’s incentives to expropriate minorityshareholders’ wealth. In this case, politically connecteddirectors are less vulnerable to public scrutiny and hencethe benefits of increased transparency outweigh the costs,leading political ties to have a positive effect on earningsinformativeness.

Stewardship theory (e.g., Barney, 1990; Donaldson,1990a, 1990b) also suggests that the presence of politicallyconnected directors can positively affect earnings informa-tiveness. According to stewardship theory, controllingshareholders, due to their large stakes and long investmenthorizons, view the firm’s health as an extension of their ownwell-being. As a result, controlling shareholders have thesame objectives as the company and hence behave as goodstewards of the resources provided to them (Donaldson &Davis, 1991). The stewardship theory therefore predicts thatcontrolling owners place politically connected directors onthe board to help the firm navigate the government and toenhance the firm’s reputation, and further protect the firm’sreputation, report earnings in good faith.

In sum, political ties are expected to affect earnings infor-mativeness. However, the direction of the relation betweenpolitical ties and earnings informativeness is an empiricalquestion. We therefore state our first hypothesis as follows:

Hypothesis 1. The presence of political ties affects the informa-tiveness of accounting earnings.

Hypothesis 1a. The presence of political ties has a negative effecton the informativeness of accounting earnings.

Hypothesis 1b. The presence of political ties has a positive effecton the informativeness of accounting earnings.

In Continental Europe, dominant shareholders use pyra-midal structures to acquire power (e.g., Claessens, Djankov,& Lang, 2000; Faccio & Lang, 2002; La Porta et al., 1999).Pyramids facilitate the accumulation of power because theyallow for greater control of corporate wealth with lessinvestment by the owner (Morck, Wolfenzon, & Yeung,2004), that is, they allow dominant owners to obtain greatercontrol rights than cash flow rights. This divergencebetween the dominant owner’s voting and cash flow rightsincreases his incentives to expropriate minority sharehold-ers (e.g., Bebchuk, Kraakman, & Triantis, 2000; Bona-Sánchez, Pérez-Alemán, & Santana-Martín, 2013; Claessens,

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Djankov, Fan, & Lang, 2002; Fan & Wong, 2002; Francis,Schipper, & Vincent, 2005; Haw, Hu, Hwang, & Wu, 2004;Lee, 2007; Santana-Martín, Bona-Sánchez, & Pérez-Alemán,2007). Not surprisingly, previous literature finds a negativerelationship between the divergence in the dominantowner’s voting and cash flow rights and the quality ofaccounting earnings (e.g., Fan & Wong, 2002; Bona-Sánchezet al., 2011a). However, no prior study analyzes the effect ofthe divergence between the dominant owner’s voting andcash flow rights on the quality of accounting information inpolitically connected firms.

On the one hand, agency theory predicts that the presenceof political connections may intensify the negative relation-ship previously documented between the divergence in thedominant owner’s voting and cash flow rights and the infor-mativeness of accounting earnings. First, the complicatedagency environments involving pyramidal groups mayincrease dominant shareholders’ ability to expropriateminority shareholders’ wealth (Bebchuk et al., 2000). More-over, guarantees provided by pyramids to outside investorsthrough the possibility of translating financial resourcesfrom one company to another inside the pyramid can beleveraged up by political ties since these connections facili-tate access to financial capital. Thus, the existence of financ-ing sources other than the capital markets together with theexistence of political connections can make the dominantowner of a politically connected firm belonging to a pyra-midal group less sensitive to the pressures of capitalmarkets, increasing his incentives to expropriate minorityshareholders’ wealth and thus decreasing earnings informa-tiveness (expropriation effect).

Further, following a similar rationale as above, the nega-tive effect of the divergence between the controllingowner’s voting and cash flow rights on earnings informa-tiveness may also be explained by politicians and share-holders providing as little information to the market aspossible in order to protect political ties from public scru-tiny as well as firms’ competitive advantages (informationeffect) (Fan & Wong, 2002). For instance, politically con-nected directors of a company belonging to a pyramidalgroup are more vulnerable to public scrutiny because pyra-mids potentially generate higher agency costs and informa-tion asymmetries (e.g., Campello, Lin, Ma, & Zou, 2011;Lin, Ma, Malatesta, & Xuan, 2013). Moreover, the benefitsthat politically connected directors bring to the companyextend to all companies in the pyramid group and accord-ingly the need to prevent proprietary information is greaterfor pyramidal groups.

On the other hand, as the divergence between the domi-nant owner’s voting and cash flow rights increases, politicalties may help align the interests of dominant owner andminority shareholders. As before, when the main aim of thepolitical connection is to benefit the firm for innocuousreasons (Goldman et al., 2009), political directors are lessvulnerable to public scrutiny. Moreover, when pyramids areless dependent on political connections to obtain financialresources under favorable terms, the costs of expropriationactivities increases for both the dominant shareholder andthe entire pyramid, reducing the incentives of the dominantowner of a pyramidal group to engage in opportunisticbehavior. In this setting, the benefits of increased transpar-

ency outweigh the costs, and hence political ties have apositive effect on earnings informativeness (alignmenteffect).

In addition, despite a substantial literature that viewspyramids as a device through which controlling sharehold-ers expropriate minority shareholders for their privatebenefit (e.g., Bae, Kang, & Kim, 2002; Baek, Kang, & Lee,2006; Bertrand, Mehta, & Mullainathan, 2002; Claessens etal., 2002; Johnson, La Porta, Lopez-de-Silanes, & Shleifer,2000), the dominant owner of a pyramid might not be moti-vated by opportunistic goals as agency theory predicts butinstead behave as a good steward of corporate resources. Inline with this perspective, pyramid structures allow thedominant owner to create an internal capital market that canbe used to fund projects (e.g., Cestone & Fumagalli, 2005;Cuervo, 2002; Williamson, 1985). Desai, Foley, and Hines(2004) find that such internal capital markets tend to beemployed to obtain funds at a lower cost. Moreover, theability to shift resources (“propping”) in pyramidal businessgroups provides outside investors with intercorporate insur-ance in the case of financial distress (e.g., Bae et al., 2002;Friedman, Johnson, & Mitton, 2003; Jian & Wong, 2010;Riyanto & Toolsema, 2008), which may be important incountries with weak legal environments that make debtunappealing because creditors cannot effectively takecontrol of collateral. Under this perspective, the dominantowner of a pyramidal structure, due to their large stake andlong investment horizon, will view the pyramid’s health asan extension of their own well-being. This long-termhorizon increases concerns about the firm’s reputation.Khanna and Palepu (2000) argue that pyramidal structuresallow for the coordination of favors and trust, and thuspromote the scaling up of reputation in the relationshipbetween insiders and political elites, a benefit that may be ofparticular value when capital markets are less developedand trust-based relationships are key to concluding con-tracts. The stewardship theory therefore predicts that thedominant owner of a pyramid places politically connecteddirectors on the board to help the firm navigate the govern-ment and to enhance the firm’s reputation, and as stewards,dominant owners report earnings in good faith, increasingearnings informativeness.

As before, the above discussion suggests that the diver-gence between the dominant owner’s voting and cash flowrights affects earnings informativeness in politically con-nected firms, but the direction of the relation is an empiricalquestion. Therefore, our second hypothesis is:

Hypothesis 2. The divergence between the dominant owner’svoting and cash flow rights in politically connected firms affectsthe informativeness of accounting earnings.

Hypothesis 2a. The divergence between the dominant owner’svoting and cash flow rights in politically connected firms has anegative effect on the informativeness of accounting earnings.

Hypothesis 2b. The divergence between the dominantowner’s voting and cash flow rights in politically connectedfirms has a positive effect on the informativeness of accountingearnings.

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RESEARCH DESIGN

DataThe initial sample comprises 114 non-financial firms listedon the Spanish stock exchange at the end of 2011. In ourregression analysis, we apply the method developed byHadi (1994) to eliminate outliers, which represent 11.7percent of the total sample. As a result, we obtain an unbal-anced panel of 112 companies (689 firm-year observations),with 85 percent of the firms having five or more observa-tions over the 2003–2011 period. Our sample starts in 2003,when a law designed to increase the transparency of finan-cial reporting was passed. This law requires that Spanishlisted firms provide the annual corporate governancereport.

Defining Politically Connected FirmsThe low transparency associated with links between corpo-rate and political elites together with the absence of a gen-erally accepted definition of political connections makes itdifficult to empirically study the relationship between politi-cal ties and corporate behavior (Chen et al., 2011). A firm’spolitical ties can result from the movement of politiciansfrom the political setting to the business setting (revolvingdoor) or vice versa (reverse revolving door). In this paper wefocus on revolving door cases. More specifically, followingearlier literature (e.g., Boubakri et al., 2012; Chaney et al.,2011; Chen et al., 2011; Duchin & Sosyura, 2012; Faccio, 2006;Goldman et al., 2009), we consider the presence of politi-cians on the firm’s board of directors as a proxy for theexistence of political connections.

We hand-collect information about the presence of politi-cians on the board of directors over the period 2003–20112

using various sources. First, we examine the curriculum vitaeof the members of the board from the annual corporate gov-ernance reports published by the Spanish Security ExchangeCommission (Comisión Nacional del Mercado de Valores)and from the firms’ websites. For the firms for which thisinformation is not available, we asked the firms for thisinformation. As an example, we classify the firm GasNatural as a politically connected firm in 2011 because atleast one of the board members had previously held a lead-ership position in politics (Mr. Felipe González Márquezwas the President of the Spanish Government from 1982 to1994). Another politically connected firm is Vueling, becauseboard member Mr. Josep Piqué Camps held several politicalpositions in the Spanish government over the period 1996–2003.

Variables and ModelsFollowing previous literature (e.g., Ahmed, Hossain, &Adams, 2006; Fan & Wong, 2002; Francis et al., 2005; Imhoff& Lobo, 1992; Subramanyam & Wild, 1996; Teo & Wong,1993; Warfield, Wild, & Wild, 1995; Yeo, Tan, Ho, & Chen,2002), we measure the informativeness of accounting earn-ings by examining the earnings response coefficient (ERC)from a regression of cumulative abnormal stock returns(CAR) on net income:

CAR NIit o it it= + +ψ ψ ε1 (1)

where:

CARit is the firm’s equal-weighted market-adjusted cumula-tive monthly stock return for the 12-month period endingthree months following the end of the fiscal year.NIit is net earnings in year t divided by the market value ofequity at the beginning of year t.εit is the error term for firm i in year t.

We expect a positive and significant coefficient on ψ1,suggesting that earnings have an information role, that is,the stock market incorporates earnings credibility into theprice formation process.

To analyse the effect of our variables on earnings informa-tiveness, we expand the ERC model in equation (1) byincluding interactions between our variables and NIit inequations (2) and (3), where we use two alternatives mea-sures of political connections:

CAR NI POLIT xNIPOLIT xDIVERG xNID

it o it it it

it it it

= + +++

α α ααα

1 2

3

4 IIVERG xNI BOARD xNIMKBOOK xNI LEV xNI

it it it it

it it it it

++ ++

αα α

5

6 7

αα η φ ε8SIZE xNIit it k j it+ + + (2)

CAR NI POLIT HL xNIPOLIT HL xDIVERG xNI

it o it it it

it it

= + ++χ χ χ

χ1 2

3

__ iit

it it it it

it it it

DIVERG xNI BOARD xNIMKBOOK xNI LEV

+ ++ +

χ χχ χ

4 5

6 7 xxNISIZE xNI

it

it it k j it+ + + +χ η φ ε8 (3)

In equation (2), POLITit is a dummy variable that takes thevalue of 1 if at least one of the members of the board ofdirectors has held a political position at the European,Spanish, or local level in the past, and 0 otherwise. Thisapproach is consistent with previous literature (e.g.,Boubakri et al., 2012; Chaney et al., 2011; Duchin & Sosyura,2012; Faccio, 2006; Goldman et al., 2009). Following Faccio(2006, 2010), Li et al. (2008), Goldman et al. (2009), Boubakri,Cosset, and Saffar (2008), Boubakri et al. (2012), and You andDu (2012), we use a more restrictive definition of politicalconnections. Thus, in equation (3) we include POLIT_HLit, adummy variable that takes the value of 1 if at least one of themembers of the board held a high-level political position atthe European or Spanish level in the past, and 0 otherwise.The effect of a firm’s political connections on earnings infor-mativeness (Hypothesis 1) is captured by coefficients α2 andχ2 in equations (2) and (3), respectively.

To test Hypothesis 2 we include DIVERGit interacted withPOLITit (in equation 2) or POLIT_HLit (in equation 3). Thevariable DIVERGit measures the degree of divergencebetween the dominant owner’s voting and cash flow rights.To identify a firm’s dominant owner and measure his votingand cash flow rights, we follow La Porta et al. (1999) and usethe control chain methodology. The coefficients α3 (in equa-tion 2) and χ3 (in equation 3) capture the effect of divergenceon earnings informativeness for politically connected firms.

To control for the effect of board size, we include in ourregressions BOARDit, measured as the natural logarithm of

POLITICAL TIES AND EARNINGS INFORMATIVENESS 335

Volume 22 Number 4 July 2014© 2014 John Wiley & Sons Ltd

the total number of directors on the board. To control for theeffect of other variables that could potentially affect earningsinformativeness, we include3 the value of equity ratio at theend of the year (MKBOOKit), leverage (LEVit), measured astotal debt in year t divided by total assets at the beginning ofthe year t, and size (SIZEit), measured as the natural loga-rithm of the market value of equity. We also include dummyvariables ϕj and ηk to control for industry and year effects,respectively.

EMPIRICAL RESULTS

Descriptive StatisticsTable 1 (Panel A) reports the percentage of Spanish compa-nies with political directors on the board. As we can see, onaverage, 47.56 percent of sample firms are politically con-nected (at least one of the board members has previouslyengaged in politics, or held office in European, Spanish, orlocal government). Over the period 2003–2011, we see asignificant increase in the percentage of politically connectedfirms, rising from 42.9 percent in 2003 to 48.5 percent at theend of 2011. If we use a more restrictive definition of politicalconnections, classifying a firm as politically connected onlywhen at least one of the board members has held a high-levelpolitical position at the European or Spanish level, we seethat, on average, 34.34 percent of sample firms are politicallyconnected, increasing 11 percent over the sample period. Aswe can see in Table 1 (Panel A), the growth rate for politicallyconnected firms is higher when we only consider high-levelpoliticians on the board than when we consider all types ofpoliticians on the board, at 13.1 percent and 38.5 percent,respectively. These results highlight the increasingly impor-tant role of high-level politicians on the board of firms listedon the Spanish stock exchange.

Table 1 (Panel B) reports the number of politicians on theboard in politically connected firms. We see that most politi-cally connected firms include one politician on the board ofdirectors, with the fraction of firms including one politicianon the board ranging from a low of 59.6 percent in 2011 to ahigh of 73.9 percent in 2005. The percentage of politicallyconnected firms with two politicians on the board is quitelower for all years, at 13 percent in 2005 and 28.8 percent in2011. Using the more restrictive definition of political con-nections, we see that 100 percent of politically connectedfirms include only one high-level politician on the board,with the only exception being 2011. As we can also see, nosample firm has three or more high-level politicians on theboard of directors.

Table 1 (Panel C) reports executive and non-executivepositions held by politicians on the board. The results revealthat the average (median) percentage of politicians holding anon-executive position is 90 percent (100 percent), whichindicates that politicians do not form part of the executivemanagement team. Moreover, there are no hierarchical dif-ferences among all types of politicians.

Regarding ownership in the hands of politicians on theboard, Table 1 (Panel D) reports that politicians own, onaverage, around .25 percent of a firm’s shares, suggestingthat politicians on the board of directors do not hold theirposition on the board by virtue of their ownership stake.

Table 2 presents the percentage holdings of large share-holders. Comparing the shareholdings of the largest threeshareholders, we find that the largest shareholder holds onaverage around 30 percent of total shares outstanding, whilethe second and third largest shareholders together holdaround 12 percent of the firm’s shares. These results confirma significant amount of ownership concentration in thehands of the dominant shareholder.

Table 3 (Panel A) presents descriptive statistics for theother variables. The average return (CAR) is −.034. Averagenet income (NI) is .049, while the average divergencebetween voting and cash flow rights (DIVERGE) is 4.533percent, indicating that the dominant owner possesses, onaverage, 4.533 percent more voting rights than cash flowrights. Table 3 (Panel B) reports correlations among the vari-ables, and suggests that multicollinearity does not affectsubsequent regressions.4 Nevertheless, we conduct a formaltest to ensure that multicollinearity is not present in ourregressions. In particular, we calculate the variance inflationfactor (VIF) for each independent variable included in theestimated model. The highest VIF for our models is wellbelow 5 (the threshold value indicating that multicollinearitymight be present) (Studenmund, 1997). We therefore con-clude that multicollinearity is not a problem in our sample.

Multivariate TestsWe estimate all the regressions using a panel data procedure,namely, generalized method of moments (GMM). The GMMprocedure allows us to address potential endogeneity prob-lems by using the right-hand side variables in the modellagged two to six times as instruments; the only exceptionsare the year effects variables, which are considered exog-enous. The original Arellano and Bond (1991) approach canperform poorly, however, if the autoregressive parametersare too large or the ratio of the variance of the panel-leveleffect to the variance of the idiosyncratic error is too large.Drawing on Arellano and Bover (1995), Blundell and Bond(1998) develop a system GMM estimator that addressesthese problems by expanding the instrument list to includeinstruments for the level equation. In this paper, we use thesystem GMM approach to estimate our models.5

The consistency of GMM estimates depends on both anabsence of second-order serial autocorrelation in the residu-als and on the validity of the instruments. To check forpotential model misspecification, we use the Hansen statisticof over-identifying restrictions. We next examine the m2

statistic developed by Arellano and Bond (1991) to test forthe absence of second-order serial correlation in the first-difference residual. Finally, we conduct three Wald tests,specifically, a Wald test of the joint significance of thereported coefficients (z1), a Wald test of the joint significanceof the time dummies (z2) and a Wald test of the joint signifi-cance of the industry dummies (z3).

Model 1 in Table 4 presents results on the basic relationbetween earnings and returns. As expected, ψ1 is positiveand statistically significant, suggesting that the stock marketincorporates earnings credibility into the price formationprocess. Models 2 and 3 in Table 4 report results on the effectof political connections on earnings informativeness. In par-ticular, Models 2 and 3 show a negative and statistically

336 CORPORATE GOVERNANCE

Volume 22 Number 4 July 2014 © 2014 John Wiley & Sons Ltd

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POLITICAL TIES AND EARNINGS INFORMATIVENESS 337

Volume 22 Number 4 July 2014© 2014 John Wiley & Sons Ltd

significant effect of the presence of politicians and high-levelpoliticians on the board of directors on earnings informa-tiveness (α2 = −.93, p .001 and χ2 = −.61, p. .001, respectively).These results are consistent with Hypothesis 1a, whichposits that political connections are negatively associatedwith earnings informativeness, in line with both the expro-priation and the information effects.

To distinguish between these two effects, we examine therelation between political connections and firm value asmeasured by Tobin’s Q (the ratio of the market value of thefirm to the book value of assets), controlling for divergence(DIVERGit) and size (SIZEit), as follows:

TOBINQ POLIT DIVERGBOARD SIZE

it o it it

it it k j

= + ++ + + + +λ λ λ

λ λ η φ1 2

3 4 εεit (4)

TOBINQ POLIT HL DIVERGBOARD SIZE

it o it it

it it k

= + ++ + + +ω ω ω

ω ω η1 2

3 4

_φφ εj it+ (5)

If λ1 and ω1 in equations (4) and (5), respectively, are nega-tive, then the results for α2 and χ2 in equations (2) and (3),respectively, would be consistent with an expropriationeffect; conversely, if λ1 and ω1 are positive, then the results inequations (2) and (3) would be consistent with an informa-tion effect. Models 4 and 5 in Table 5 show a positive andstatistically significance effect of political connections onfirm value (λ1 = .12, p .001 and ω1 = .20, p .001), which isconsistent with an information effect (Fan & Wong, 2002),whereby politicians and shareholders are interested inproviding as little information to the market as possiblein order to protect political ties from public scrutiny andto protect the firm’s competitive advantages. Thus, ourresults show that an information effect, rather than an expro-priation effect, explains the negative association betweenthe presence of politicians on the board and earningsinformativeness.

Table 4 (Models 2 and 3) reports results for Hypothesis 2,which predicts a statistically significant effect of divergencein the dominant owner’s voting and cash flow rights inpolitically connected firms on earnings informativeness. Thecoefficients in Model 2 (α3 = .13, p .001) and Model 3(χ3 = .08, p .001) indicate that the greater the divergence inthe dominant owner’s voting and cash flow rights in politi-cally connected firms, the greater the earnings informative-ness. These results are consistent with Hypothesis 2b, whichpredicts that controlling shareholders increase earningsinformativeness. These results are in line with an alignmenteffect, whereby the presence of a politically connected direc-tor on the board benefits the company for innocuous reasons(Goldman et al., 2009), reducing the need to increase opacityto protect political ties from public scrutiny and increasingthe cost of expropriation activities for the dominant owner,which have a positive effect on earnings informativeness.The results are also consistent with the dominant share-holder of a pyramidal structure acting as a steward of thecompany assets, placing political directors on the board tohelp the firm navigate the government (Goldman et al., 2009)or to increase the company’s reputation, and reporting earn-ings in good faith.

With respect to the control variables, the results in Table 4show that the greater the divergence in the dominant

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338 CORPORATE GOVERNANCE

Volume 22 Number 4 July 2014 © 2014 John Wiley & Sons Ltd

owner’s voting and cash flow rights, the lower the earningsinformativeness (the coefficient on DIVERGit × NIit is nega-tive and significant in Models 2 and 3). This result is consis-tent with previous literature (e.g., Bona-Sánchez et al., 2013;Fan & Wong, 2002; Francis et al., 2005; Lee, 2007; Santana-Martín et al., 2007), showing that as divergence in the domi-nant owner’s voting and cash flow rights increases, thedominant owner’s incentives to expropriate minority share-holders increase, which negatively affects earnings informa-tiveness. Moreover, also in line with previous studies (e.g.,Ahmed et al., 2006; Firth, Fung, & Rui, 2007; Vafeas, 2000),the models show a negative coefficient on NIit × BOARDit,suggesting that investors put greater value on earningsinformation by firms with smaller boards. Finally, themodels show positive coefficients on NIit × SIZEit, NIit ×LEVit, and NIit × MKBOOKit, indicating that the greater thelevel of the respective variable, the greater the earningsinformativeness. These results are consistent with priorstudies that focus on other geographic contexts (e.g., Fan &Wong, 2002; Francis et al., 2005).

Sensitivity AnalysisOur results above are robust to the use of two differentmeasures of political connections (POLITit and POLIT_HLit).

In this section we first extend our analysis by considering analternative measure of accounting earnings, namely, netoperating income (NO) instead of net income (NI). Theresults are reported in Table 6. The results are not differentfrom those obtained in Table 4, and thus provide furtherevidence in support of Hypotheses 1a and 2b.

Next, in order to check whether our results are sensitive tothe number of politicians on the board, we create two newvariables: POLBOARDit, the percentage of politicians on theboard (measured as the number of board members that haveengaged in politics or held office in a European, Spanish, orlocal government divided by total number of directors onthe board), and POLBOARD_HLit, the percentage of high-level politicians on the board (measured as the number ofboard members that have held a high-level position at theEuropean or Spanish level divided by total number of direc-tors on the board). Results are reported in Table 6 (Models 8and 9). Overall, our findings are consistent with previousresults in Table 4 (Models 2 and 3).

SUMMARY AND CONCLUSION

Prior accounting literature examines the influence of thepolitical context in accounting (e.g., Watts & Zimmerman,

TABLE 3Descriptive Statistics and Correlation Matrix

Panel A. Descriptive statistics

Average Median Standard Deviation Minimum Maximum

CARit −.034 .011 .345 −1.521 1.182NIit .049 .056 .082 −.307 .359DIVERGit 4.533 0 7.415 0 36.64MKBOOKit 2.342 1.833 1.808 −3.624 9.727LEVit .708 .662 .376 .087 5.708SIZEit 13.479 13.312 1.838 9.383 18.48

Panel B. Correlation matrix

CARit NIit POLITit POLIT_HLit DIVERGit MKBOOKit LEVit

NIit .32POLITit .01 −.03POLIT_HLit .00 .01 .48DIVERGit −.01 .01 .05 −.04MKBOOKit .08 .06 .04 .07 .03LEVit −.07 .05 .00 −.03 .01 .14SIZEit .24 .25 .27 .23 .13 .05 .16

CARit is the firm’s equal-weighted market-adjusted cumulative monthly stock return for the 12-month period ending three monthsfollowing the end of the fiscal year. NIit is net earnings in year t divided by the market value of equity at the beginning of year t. POLITit

is a dummy variable that takes the value of 1 if at least one of the members of the board of directors has ever engaged in politics, holdingoffices in European, Spanish, or local government and 0 otherwise. POLIT_HLit is a dummy variable that takes the value of 1 if at least oneof the members of the board held a high-level political position at the European or Spanish level in the past, and 0 otherwise. DIVERGit

measures the degree of divergence between the dominant owner’s voting and cash flow rights. MKBOOKit is the value of equity ratio atthe end of the year. LEVit is total debt in year t divided by total assets at the beginning of year t. SIZEit is the natural logarithm of the marketvalue of equity.

POLITICAL TIES AND EARNINGS INFORMATIVENESS 339

Volume 22 Number 4 July 2014© 2014 John Wiley & Sons Ltd

1978, 1986). Political forces can include state ownership oflisted firms, state control of the banking sector or regulationof capital market activity, government intervention in busi-ness or industry activities, expropriation, corruption, andcronyism (Piotroski, 2012). Some accounting studies showthat firms with higher government share ownership are

associated with a lower level of financial transparency(Bushman et al., 2004), while others show that managersadjust their firm’s financial reporting based on the degreeof state involvement in economic decisions (Bushman &Piotroski, 2006). In this paper we extend this line of work byshowing how the presence of political ties affects firms’

TABLE 4Political Connections and Earnings Informativeness

Model 1 (Eq. 1):

CAR NIit o it it= + +ψ ψ ε1

Model 2 (Eq. 2):

CAR NI POLIT xNI POLIT xDIVERG xNI Dit o it it it it it it= + + + +α α α α α1 2 3 4 IIVERG xNIBOARD xNI MKBOOK xNI LEV xNI

it it

it it it it it it+ + + +α α α5 6 7 αα η φ ε8SIZE xNIit it k j it+ + +

Model 3 (Eq.3):

CAR NI POLIT HL xNI POLIT HL xDIVERG xNIit o it it it it it= + + +χ χ χ χ1 2 3_ _ iit it it

it it it it it

DIVERG xNIBOARD xNI MKBOOK xNI LEV

++ + +

χχ χ χ

4

5 6 7 xxNI SIZE xNIit it it k j it+ + + +χ η φ ε8

Model 1 Model 2 Model 3

NIit .31*** (3.34) .17*** (3.25) 1.02*** (3.27)POLITit × NIit −.93*** (−11.71)POLIT_HLit × NIit −.61*** (−6.21)POLITit × DIVERG x NIit .13*** (11.64)POLIT_HLit × DIVERG x NIit .08*** (6.06)DIVERGit × NIit −.05*** (−5.45) −.02*** (−4.00)BOARDit × NIit −.26** (−2.19) −.42*** (−4.25)MKBOOKit × NIit .001 (1.37) .001 (1.52)LEVit × NIit .12 (.89) .26** (2.62)SIZEit × NIit .02*** (3.82) .03* (1.66)Constant −.05*** (−3.77) −.08*** (−3.41) −.08*** (−3.03)Year effect Yes YesIndustry effect Yes YesHansen 7.61 (.37) 98.18 (1.00) 95.83 (1.00)Test m2 −1.29 (.19) −.67 (.50) −.81 (.42)Test z1 385.95*** 228.06***Test z2 594.34*** 183.76***Test z3 47.49*** 29.77***

CARit is the firm’s equal-weighted market-adjusted cumulative monthly stock return for the 12-month period ending three monthsfollowing the end of the fiscal year. NIit is net earnings in year t divided by the market value of equity at the beginning of year t. POLITit

is a dummy variable that takes the value of 1 if at least one of the members of the board of directors has held a political position at theEuropean, Spanish, or local level in the past, and 0 otherwise. POLIT_HLit is a dummy variable that takes the value of 1 if at least one ofthe members of the board held a high-level political position at the European or Spanish level in the past, and 0 otherwise. DIVERGit

measures the degree of divergence between the dominant owner’s voting and cash flow rights. BOARDit is the natural logarithm of thetotal members on the board. MKBOOKit is the value of equity ratio at the end of the year. LEVit is total debt in year t divided by total assetsat the beginning of year t. SIZEit is the natural logarithm of the market value of equity. Hansen, test of over-identifying restrictions, underthe null hypothesis that all instruments are uncorrelated with the disturbance process. m2, statistical test for lack of second-order serialcorrelation in the first-difference residual. z1, Wald test of the joint significance of the reported coefficients. z2, Wald test of the jointsignificance of the time dummies. z3, Wald test of the joint significance of the industry dummies.***,**,*,†: Statistically significant at p .001, p .01, p .05 and p .10, respectively.In parentheses, t-statistics based on robust standard errors.

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financial reporting choices. In particular, we examine theimpact of the presence of political connections on the infor-mativeness of accounting earnings.

Our results show that in an environment where owner-ship concentration is prevalent and the board of directors ispolitically connected, political ties negatively affect earningsinformativeness. The results are consistent with an informa-tion effect (Fan & Wong, 2002), whereby politicians andshareholders are interested in providing as little informationto the market as possible in order to protect political tiesfrom public scrutiny and to prevent the leakage of competi-tive advantages to competitors.

Our study addresses a question that has not been consid-ered in previous research, namely, how the divergencebetween the dominant owner’s voting and cash flow rightsaffects the informativeness of accounting earnings for politi-cally connected firms. Our study reveals a positive incidencebetween divergence and earnings informativeness. Theresults are consistent with the presence of an alignmenteffect, whereby the presence of a politically connected direc-

tor on the board of a company belonging to a pyramidalstructure might benefit the firm for innocuous reasons,increasing the costs of expropriation and reducing the needto increase opacity as a way to protect political ties frompublic scrutiny. This result is also consistent with the domi-nant shareholder of a pyramid acting as steward of corpo-rate assets, placing politically connected directors on theboard to help the firm navigate the government (Goldman etal., 2009) and increase the firm’s reputation, and reportingearnings in good faith.

The result that political ties decrease earnings informative-ness is in line with previous studies (e.g., Chaney et al., 2011;Chen et al., 2011; Gul, 2006; Riahi-Belkaoui, 2004). However,we go further to show that political connections do notincrease the expropriation of minority shareholders’ wealthby dominant owners. Rather, political connections encour-age dominant owners to increase long-term value, but thisvalue-maximizing behavior does not translate into a positiveeffect on earnings informativeness given the need to protectpolitical ties from public scrutiny. Moreover, in the Spanish

TABLE 5Political Connections and Firm Value

Model 4 (Eq.4):

TOBINQ POLIT DIVERG BOARD SIZEit o it it it it k j= + + + + + + +λ λ λ λ λ η φ1 2 3 4 εεit

Model 5 (Eq.5):

TOBINQ POLIT HL DIVERG BOARD SIZEit o it it it it k= + + + + + +ω ω ω ω ω η1 2 3 4_ φφ εj it+

Model 4 Model 5

POLITit .12*** (5.80)POLIT_HLit .20*** (5.10)DIVERGit −.006*** (−6.26) −.009*** (−11.83)BOARDit −.37*** (−6.35) −.25*** (−5.26)SIZEit .16*** (17.55) .16*** (19.21)Constant .26* (1.73) −.02*** (−.13)Year effect Yes YesIndustry effect Yes YesHansen 91.36 (.99) 96.02 (.99)Test m2 −.83 (.41) −.73 (.46)Test z1 79.85*** 228.26***Test z2 151.76*** 184.28***Test z3 98.47*** 63.62***

TOBINQit, the ratio of the market value of the firm to the book value of assets. NIit is net earnings in year t divided by the market valueof equity at the beginning of year t. POLITit is a dummy variable that takes the value of 1 if at least one of the members of the board ofdirectors has held a political position at the European, Spanish, or local level in the past, and 0 otherwise. POLIT_HLit is a dummy variablethat takes the value of 1 if at least one of the members of the board held a high-level political position at the European or Spanish levelin the past, and 0 otherwise. DIVERGit measures the degree of divergence between the dominant owner’s voting and cash flow rights.BOARDit is the natural logarithm of the total members on the board. SIZEit is the natural logarithm of the market value of equity. Hansen,test of over-identifying restrictions, under the null hypothesis that all instruments are uncorrelated with the disturbance process. m2,

statistic test for lack of second-order serial correlation in the first-difference residual. z1, Wald test of the joint significance of the reportedcoefficients. z2, Wald test of the joint significance of the time dummies. z3, Wald test of the joint significance of the industry dummies.***,**,*,†Statistically significant at p .001, p .01, p .05 and p .10, respectively.In parentheses, t-statistics based on robust standard errors.

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TABLE 6Political Connections and Earnings Informativeness: Sensitivity Analysis

Model 6 (Eq. 6):

CAR NO POLIT xNO POLIT xDIVERG xNO Dit o it it it it it it= + + + +α α α α α1 2 3 4 IIVERG xNOBOARD xNO MKBOOK xNO LEV xNO

it it

it it it it it it+ + + +α α α5 6 7 αα η φ ε8SIZE xNOit it k j it+ + +

Model 7 (Eq. 7):

CAR NO POLIT HL xNO POLIT HL xDIVERG xNOit o it it it it it= + + +α α α α1 2 3_ _ iit it it

it it it it it

DIVERG xNOBOARD xNO MKBOOK xNI LEV

++ + +

αα α α

4

5 6 7 xxNO SIZE xNOit it it k j it+ + + + +α η φ ε8

Modelo 8 (Eq. 8):

CAR NI POLBOARD xNI POLBOARD xDIVERG xNIit o it it it it it= + + +α α α α1 2 3 iit it it it it

it it it

DIVERG xNI BOARD xNIMKBOOK xNI LEV

+ ++ +

α αα α

4 5

6 7 xxNI SIZE xNIit it it k j it+ + + +α η φ ε8

Model 9 (Eq. 9):

CAR NI POLBOARD HL xNI POLBOARD HL xDIVERit o it it it it= + + +α α α α1 2 3_ _ GG xNIDIVERG xNI BOARD xNI MKBOOK xNI

it it

it it it it it it+ + + +α α α α4 5 6 77 8LEV xNI SIZE xNIit it it it k j it+ + + +α η φ ε

Model 6(NOit)

Model 7(NOit)

Model 8(POLBOARDit)

Model 9(POLBOARD_HLit)

NIit 2.16*** (5.81) 1.34*** (3.23)NOit 2.14*** (11.38) 1.25*** (6.69)POLBOARDit × NIit −.05*** (−5.35)POLITIit × NOit −.98*** (−7.92)POLBOARD_HLit × NIit −.06*** (−9.05)POLIT_HLit × NOit −.57*** (−8.07)POLBOARDit × DIVERG it × NIit .009*** (8.44)POLITit × DIVERG it × NOit .07*** (4.72)POLBOARD_HLit × DIVERG it × NIit .01*** (8.50)POLIT_HLit × DIVERG it × NOit .03*** (6.24)DIVERGit × NIit −.07*** (−6.03) −.02** (−3.02)DIVERGit × NOit −.08*** (−7.77) −.03*** (−12.86)BOARDit × NIit −.50*** (−4.74) −.45*** (−3.92)BOARDit × NOit −.18** (−2.46) −.007* (−1.67)MKBOOKit × NIit .002*** (3.69) −.001 (−.97)MKBOOKit × NOit .003*** (4.15) .001* (2.18)LEVit × NIit .006 (.53) .29*** (2.77)LEVit × NOit .59*** (4.15) .21* (1.66)SIZEit × NIit −.01 (−.75) .02 (.86)SIZEit × NOit .26*** (15.04) .16*** (8.36)Constant −.02 (−1.16) .01 (.76) −.09*** (−6.24) −.06*** (−3.20)Year effect Yes Yes Yes YesIndustry effect Yes Yes Yes YesHansen 93.62 (1.00) 90.52 (1.00) 87.77 (1.00) 92.64 (1.00)Test m2 −1.16 (.25) −1.12 (.26) −.76 (.45) −.82 (.411)Test z1 336.46*** 120.19*** 297.56*** 890.28***Test z2 130.36*** 119.38*** 22.08*** 31.89***Test z3 353.88*** 313.95*** 301.06*** 403.42***

CARit is the firm’s equal-weighted market-adjusted cumulative monthly stock return for the 12-month period ending three months following the end of the fiscal year. NIit is net earningsin year t divided by the market value of equity at the beginning of year t. NOit is net operating income at year t divided by market value of equity at the beginning of year t. POLITit is a dummyvariable that takes the value of 1 if at least one of the members of the board of directors has held a political position at the European, Spanish, or local level in the past, and 0 otherwise.POLIT_HLit is a dummy variable that takes the value of 1 if at least one of the members of the board held a high-level political position at the European or Spanish level in the past, and 0otherwise. POLBOARDit is the percentage of politicians on the board, measured as the members of the board of directors that have ever engaged in politics, holding offices in European,Spanish, or local government divided by total members of the board. POLBOARD_HLit is the percentage of high-level politicians on the board, measured as the members of the board ofdirectors that have held a high-level position at the European or Spanish level divided by total members of the board. DIVERGit measures the degree of divergence between the dominantowner’s voting and cash flow rights. BOARDit is the natural logarithm of the total members on the board. MKBOOKit is the value of equity ratio at the end of the year. LEVit is total debt inyear t divided by total assets at the beginning of year t. SIZEit, is the natural logarithm of the market value of equity. Hansen, test of over-identifying restrictions, under the null hypothesisthat all instruments are uncorrelated with the disturbance process. m2, statistic test for lack of second-order serial correlation in the first-difference residual. z1, Wald test of the jointsignificance of the reported coefficients. z2, Wald test of the joint significance of the time dummies. z3, Wald test of the joint significance of the industry dummies.***,**,*,†Statistically significant at p .001, p .01, p .05 and p .10, respectively.In parentheses, t-statistics based on robust standard errors.

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context, where pyramids are common, as divergencebetween the dominant owner’s voting and cash flow rightsincreases, the benefits of transparency are often likely toexceed the costs. Thus, while previous literature finds anegative relationship between divergent voting and cashflow rights and earnings informativeness (e.g., BonaSánchez et al., 2011a; Fan & Wong, 2002), we show that thisrelationship becomes positive when one jointly considersthe effect of divergence and the presence of political ties.

This paper contributes to the literature on the relationbetween the political economy and accounting quality inseveral ways. First, unlike previous literature, we focus on asetting where ownership concentration is prevalent andwhere the presence of politically connected directors on theboard is the natural form of political connection. Second, weinvestigate the effect of the divergence between the domi-nant owner’s voting and cash flow rights through pyramidson the informativeness of accounting earnings for politicallyconnected firms, a question that, to the best of our knowl-edge, is not addressed in previous studies. We thus providenovel evidence on the effect of political connections on earn-ings informativeness that is difficult to capture in the US orUK context, where pyramidal structures are not prevalent.Third, we focus on a single country, which allows us tosidestep concerns that plague international studies, such aslimited sample size, endogeneity in country-level variables,noisy variables, and correlated omitted variables (Miller,2004). Finally, by using an integrated theoretical approachwe provide a better understanding of the dynamics of politi-cal ties and their effect on earnings quality. In particular, wecontribute to resource dependence theory by showing howthe resource-providing function of the board of directorsaffects accounting earnings. Moreover, we contribute toagency theory by showing that politically connected direc-tors can incentivize controlling shareholders to increaseearnings informativeness. We also contribute to stewardshiptheory by showing that acting as steward of company assets,the ultimate owner of a pyramid places politically connecteddirectors on the board to help the firm navigate the govern-ment and to increase the firm’s reputation.

Our results have important implications that may gener-alize to other settings with similar institutional characteris-tics. First, our results should be of interest to regulatorsinterested in improving investor protection and market con-fidence to promote a more efficient allocation of resources.In particular, the results suggest that regulators shouldencourage the disclosure of political connections, as thisinformation can positively affect earnings informativeness,and perhaps be as important as including the executive ornon-executive role of corporate directors. Moreover, anoveremphasis of corporate governance codes and regula-tions on board independence should not lead regulators toforget other important aspects of boards functioning as wellas their effect on the properties of accounting earnings.

Our results may be also useful to managers and auditorsinterested in increasing transparency. Further, the results ofthis paper may be useful to investors and financial analysts,as they highlight the importance of considering characteris-tics of the corporate governance system when assessing thecredibility of accounting information. In particular, knowl-edge of how earnings informativeness varies with political

connections should help investors in their investmentsdecisions.

We note that our research design is subject to the limita-tion related to the difficulty in measuring political connec-tions. To build our sample of politically connected firms, wetake advantage of the regulatory requirement in Spain thatfirms publish directors’ curriculum vitae in their annual cor-porate governance reports. We acknowledge that close rela-tionships with political elites not involving the presence of apolitically connected director on the company’s board arenot considered in our empirical analysis.

This paper suggests several avenues for future research.First, it would be interesting to analyze the relationshipbetween political ties and earnings informativeness depend-ing on the nature of the dominant owner, for example,family firms or institutional shareholders. It would also beinteresting to study the case of cross-listed companies. Addi-tionally, future work could investigate the effect of certainboard characteristics, such as the degree of the politicaldirector’s involvement, on accounting informativeness.

ACKNOWLEDGEMENTS

The authors gratefully acknowledge the helpful commentsand suggestions received from the referees and from theAssociate Editor, Igor Filatotchev. We also thank theResearch Agency of the Spanish Government for financialsupport (Project ECO2011-29144-CO3-02).

NOTES

1. In contrast to the more widely studied Chinese environment,where political connections result from the state’s direct invest-ment in companies (Qian et al., 2011) as part of the government’seffort to create “national champions” on the global market, in theSpanish context politically connected directors on the board isthe commonly observed form of political connections.

2. The Spanish law (5/2006) governing the movement of publicofficials between the public and private sectors requires a two-year wait between working for the government and taking a jobin the private sector.

3. For a discussion justifying the inclusion of these variables, seeFan and Wong (2002).

4. The correlation between POLIT and POLIT_HL is not a concernin our study because these variables are never in the samemodel.

5. More precisely, we use the two-step system GMM estimationincluded in the xtabond2 stata routine written by Roodman(2008). The two-step estimation estimates the regression withheteroskedasticity-robust standard errors.

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Carolina Bona-Sánchez is an Associate Professor ofAccounting at the University of Las Palmas de Gran Canaria,Spain. Her research focuses on corporate governance andearnings quality. She has published academic peer-reviewed

articles in journals such as European Accounting Review andJournal of Business Finance & Accounting, among others.

Jerónimo Pérez-Alemán is an Associate Professor ofAccounting at the University of Las Palmas de Gran Canaria,Spain. His research focuses on corporate governance andearnings quality. He has published academic peer-reviewedarticles in journals such as European Accounting Review andJournal of Business Finance & Accounting, among others.

Domingo Javier Santana-Martín is a Professor of Account-ing at the University of Las Palmas de Gran Canaria, Spain.His research focuses on corporate governance and corporatefinance. He has published academic peer-reviewed articlesin journals such as Journal of Banking and Finance, CorporateGovernance: An International Review, European AccountingReview and Journal of Business Finance & Accounting, amongothers.

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