Political Connections and Earnings Quality: How Do Connected Firms Respond to Changes in Political Stability and Government Effectiveness?

Abstract

Purpose – The purpose of this study is to investigate how the earnings quality of politically connected
firms is affected by changes in political stability and government effectiveness in a developing country.
Design/methodology/approach – This study uses a sample of 2,073 firm-year observations from
349 firms listed on the Indonesian Stock Exchange from 2003 to 2012 to examine how political stability
and government effectiveness affect the earnings quality of politically connected firms, relative to
non-politically connected firms. A two-stage model is used to address self-selection issues in the choice
of firms to establish political connections.
Findings – This study finds that increased government effectiveness reduces the benefits of political
connections, requiring politically connected firms to be more responsive to market pressures and
resulting in higher earnings quality. However, increased political stability enhances the certainty of
benefits from political connections, reducing the need for politically connected firms to respond to
market pressures and resulting in lower earnings quality.
Research limitations/implications – For policymakers, these results indicate that different
dimensions of political and economic development can affect the incentives of firms with political
connections in different ways.
Originality/value – This study finds that the earnings quality of politically connected firms increases
as government effectiveness improves, but it decreases as the political environment becomes more
stable.