Politically connected firms have low earnings quality

Introduction:

It is widely known fact that political connectedness favors a firm in many ways like debt
financing, stronger market power and increases chance of tax evasion. This has given those
firms incentive to breach the law in their favor in terms of manipulating the financial
statements and in getting excessive loans which results in accumulation of NPA for banks. We
can relate the scams like Sathyam ,2G and mining scandals to political connectedness and it is
the need of the hour to study the impact of political connectedness on earnings quality.

Financial statements are one of the rich sources of information for analyst and Investors about
a company. If the quality of earnings of the firms are manipulated by aggressive accounting, it
will be difficult for analyst to value the firms and it may lead to over valuation because of
manipulated information in the financial statements. The wrong valuation will force the banks
to give excessive loans which may not be backed by assets or future cashflows thus resulting in
higher NPA. Investors may end up taking wrong decisions in buying or selling the stocks
because of improper valuation.

Definition of Political connectedness

We define political connectedness in line with Faccio (2006) and adapt it to Indian political
context. A company is said to be politically connected if it meets the following connections:

1. Share ownership in a company by a politician or legal heirs of a politician

a. If one of its large shareholders (controlling at least 10% of voting shares) or top
executive (CEO, president, vice-president, chairman, or secretary) is a member of
parliament or state legislature;
b. If the Member of parliament or State legislature is close relative of one of its
large share holders or top executive. (Spouse, child, siblings or parent is
considered as relative).
c. If the shareholding value of a politically connected person is less than 10%, we
also look into the possibilities of the same person being a director/holding any
other important post of a different firm that owns substantial shares in the
business
2. Social and Business network
a. If the top executive of the company have connection with a politician in the form
of personal friendship, family relationship. (This data can be gathered only from
the news articles and political magazines)
b. Relatives/friends of politically influential persons (like party leaders) are also
considered for establishing political connection

3. Political Funding
a. If a company has made donations consistently and substantially (top 70
percentile of donations) to the parties directly or by the means of electoral trust,
it is considered to be a politically connected firm
Since most of the politically owned firms are private limited companies and data availability of
these firms are scare, we limit our study to politically connected listed firms (Listed in NSE and
BSE).

Most of the share holdings by a MP or MLA may be held by their loyal benamis, which makes it
difficult to establish political connectedness and we ignore these firms in our study

Measuring Earnings Quality

Earnings Persistence

Earnings persistence is a measure to understand the firm's ability to sustain earnings over a
period of time. High variation of earnings may indicate a possibility of management. Earnings
persistence is measured by the following equation (Boonlert-U-Thai et al (2006) and Ali et al.
(2007))

Earningsi,t / Total Assetsi,t-1 = α + β * (Earningsi,t-1 / Total Assetsi,t-1 )) + εi,t

Earnings is the net income before extra ordinary items. Value of β close to 1 indicates higher
persistent earnings and β close to 0 implies high transitory earnings.

Value Relevance

Pi,t=α + β1*BVi,t+ β2*EPSi,t + εi,t

Value relevance is the explanatory power that earnings and Book value have on stock returns
Earnings variability, Smoothness and predictability:

Earnings variability is the standard deviation of earnings over time. Higher variability generally
indicates lower Earnings Quality.

Variability = σ(Ei,t)
SMOOTH = σ(Ei,t)/σ(CFOi,t)
PRED= SQRT(σ2(εi,t))
Higher values of smooth implies greater variation in earnings than cash flows - lower earnings
quality

Penman Index, Leoz Index

Penman Index = Operational Cash flow / Net Profit

Leoz Index = standard deviation (operational profit)/ standard deviation (operational cash flow)

Operational earnings consists of cash and accrual items. Therefore ,the existing figures of operational
earnings can be manipulated; but operational cash flow is an objective real number which is less subject
to manipulation. With smoothing of income, standard deviation in several successive years will become
less than operational cash flow standard deviation . So, the low number of this ratio is a sign of low
earnings quality.

Accrual Based Measurement of Earnings Quality

Dichev and Dechow model:

Jones Model:

TAit/Ait-1 = α[1/Ait-1] + β[∆REVit/Ait-1] + γ[PPEit/Ait-1] +eit

Approach:

• Based on the above mentioned criteria, we shortlisted companies that have political
connections
• These companies were group and analyzed based on their sectors - Construction;
Electronics; Media; Cements; Power
• Within the sector, the company in focus is compared with the firms that have similar
market capitalization and those firms that have highest profits
• Research shows that there is no one method to measure earnings quality (which is also
highly debated), we chose to include all the relevant metrics to analyze earnings quality

Results:
Construction Sector

Politically connected firm : Madhucon Projects

Peer Comparison:
Supreme Infrastructure/Prathiba Industries/ Prakash Constrowell/Dilip BuildCon

Madhucon Supreme Infrastructure Prathiba Industries Dilip BuildCon

Earning Smoothness 1.17 0.64 0.11 0.38
Variability 386.71 300.47 297.85 165.82
Predictability 0.05 0.013 0.037

No No Statistical
Value Relevance (R2) 0.69
Statistical Significance
Significance
Earnings Persistence
Penman Index 8.47
Leoz Index 1.41 0.78 1.630 3.346
References:

1. http://www.gettrymarcus.com/wp-content/uploads/pdfs/MW-Analyzing-Earnings-
Quality-as-a-Financial-Forensics-Tool.pdf

2. https://journal-archieves36.webs.com/529-541.pdf

3. http://www.scielo.br/pdf/ram/v18n3/1678-6971-ram-18-03-0203.pdf

4. http://academicjournals.org/journal/AJBM/article-full-text-pdf/DEE1A7966458

5. https://www.investopedia.com/university/accounting-earnings-quality/earnings5.asp

6. http://commons.ln.edu.hk/cgi/viewcontent.cgi?article=1010&context=ljbfe

7. https://www.theseus.fi/bitstream/handle/10024/96203/Earnings%20management%20t
hesis.pdf?sequence=1

8. A STUDY TO MEASURE QUALITY OF EARNINGS IN FINANCIAL STATEMENTS OF COMPANIES

LISTED AT THE NAIROBI STOCK EXCHANGE