Politically Connected firms, Legal Enforcement and Analysts’ Forecast Attributes
Charles J. P. Chen
CityUniversity of Hong Kong
Yuan Ding*
ChinaEuropeInternationalBusinessSchool (CEIBS)
Chansog (Francis) Kim
CityUniversity of Hong Kong
OldDominionUniversity
April 14, 2007
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Comments welcome.
* Address for correspondence: Yuan Ding, China Europe International Business School (CEIBS), 699 Hongfeng Road, 201206 Shanghai, P. R. China. Email: . The authors would like to thank Junghun (Jay) Lee (the discussant), Giorgio Gotti (the discussant), Henri-Claude de Bettignies,ChunChang, Yan Gao, Kari Lukka, Bala Ramasamy,Hannu Schadewitz,BinXu, Yimin Zhang, Xinge Zhao, Tian Zhu and workshop participants at Seoul National University(November 2006), 13th Annual Mid-Year Conference of the International Accounting Section of the American Accounting Association(Charleston, USA,February 2007), research seminar at Turku School of Economics (Finland, March 2007) andresearch seminar at China Europe International Business School (Shanghai, April 2007) for their helpful comments and advice.Charles Chen and Yuan Ding acknowledge the financial support of Procore - France/Hong Kong Joint Research Scheme. Authors are gratefully to Mara Faccio for generously providing her list of politically connected firms. The research assistance of Ching Tung Yu is greatly appreciated.Part of the research was conducted when the second author was affiliated with HEC School of Management, Paris.
Politically Connected firms, Legal Enforcement and Analysts’ Forecast Attributes
Abstract
We study the association between a firm’s political connection and analysts’ earnings forecasts in an international context. We find thatanalysts experience more difficulties in predicting earnings of firms withpolitical connection than firms without it. However, inthose jurisdictions that have effective law enforcement, earnings forecastsare less influenced by the firms’ political connections. Our findingscontribute to the literature by identifying political connection as anadditional dimension to theforecasting difficulty and by showing thateffective legal enforcement can lessen the effect of political connectionand improve financial analysts’forecasts.
Key words: analysts’ earnings forecasts; political connection; legal enforcement; forecast attributes.
I.INTRODUCTION
This study investigates whether corporate political connection affects the attributes of financial analysts’ earnings forecasts. This is an important research question not only because attributes of analysts’ forecasts are of interest to finance and accounting researchers; but also because political connectionplays an important role in many of the world’s largest and most important economies (Fisman, 2001, p. 138). Extant literature has identifiedboth firm-level and institutional factorsthat affect the properties of analysts’ forecasts(O'Brien, 1990; Brown, 1993; Ghosh and Whitecotton, 1997; Kwon, 2002; Hope, 2003; Clarke and Subramanian, 2006). Extending this line of research, we propose that in addition to the inherent uncertainty of earnings, political connectionby itself complicates the task of forecasting earnings both becausepolitical favoritism is often granted covertly and because the effects of political dealings on future earnings arecomplex and very difficult to forecast. This conjecture, which we refer to as analyst task difficulty hypothesis, suggests that analyst earnings forecasts are less accurate, more optimistic, and more divergent for firms with political connection than for firms without it.[1] Therefore, there should be systematic differences in theanalysts’ forecast attributes between connected and non-connected firms.
As enforcement of law can be expected to deter politicians from frequently engaging in granting large amounts of benefits to connected firms(Faccio, 2006a), we also propose that effective enforcement of law can mitigate the impact of political connection on financial analysts’ forecast attributes. This conjecture, which we refer to as law enforcement effectiveness hypothesis, predicts that the effect of political connection on analysts’ forecast attributes attenuate in jurisdictions with more effective enforcement of law.
Corporate executives tend to conceal information about expected future benefits arising from their connections with politicians unless it is required to be disclosed and non-compliance with such requirement is expected to be costly. This is so because public knowledge of political favoritism not only often leads to unfavorable publicity for the firm, but it also may cause troubles for the politicians involved. Therefore, it is more costly for financial analysts to obtain information about political benefits that a connected firm may expect to receive. Even if such information were available to the analysts, the exact impact of politically motivated transactions on future earnings will be much more difficult to estimate as compared to that of normal business transactions. First, the realization of political benefits is often dependent upon the swing of the political pendulum which falls outside the expertise area of financial analysts which normally does not include estimation of the outcome of political events. Second, both financial institutions and their employed financial analysts could be intimidated by the firm’s political influence and have strong incentives to exclude the effect of expected political favoritism in their earnings forecasts, because showing the effect of political favoritism would be similarto confessing their possession of private information about politicians’ under-the-table deals with corporations. This would offend both the corporate executives and their powerful political allies. There are at least three obvious undesirable consequences: 1) the corporate executives may cease to co-operate with financial analysts, making their future forecasts less accurate[2]; 2) the corporation may shun away from the analysts’ employer in their future financial dealings, directly reducing the revenue of the financial institution involved[3]; 3) the politicians concerned may retaliate against the financial analysts and their employers, especially in jurisdictions with weak enforcement of law. The above discussion suggests that we should investigate whether political connection per seaffects the attributes of financial analysts’ earnings forecasts and the effectiveness of enforcement of law must be incorporated into this investigation as a mediating institutional factor.
Although political connection is an important social economic issue with broad implications, there were only few studies in this area (Krueger, 1974; Roberts, 1990; Fisman, 2001)until Faccio (Faccio, 2006b, 2006a; Faccio et al., 2006; Faccio and Parsley, 2006) made a breakthrough. The previous lack of systematic research in this area was mainly due to difficulties in defining political connections, collecting the appropriate data and estimating the value of such connections. By identifying 541 connected firms in 35 countries out of 20,202 publicly traded firms in 47 countries between 1997 and 2003, Faccio (2006b)was able to investigate the common characteristics shared by countries with widespread political connections and whether such connections add to company value. Faccio et al. (2006) analyzed the likelihood of government bailouts of 450 politically-connected (but publicly-traded) firms from 35 countries over the period 1997 through 2002 and found that connected firms are more likely to be rescued by government. Furthermore, based on their examination of a large number of sudden deaths of politicians around the world, Faccio and Parsley (2006)found that these incidences were associated with a 2% decline in market value of politically connected companies.
Adding to this strand of emerging literature, we identify political connection as an additional dimension of financial analysts’ forecast difficulties and find that, after controlling for inherent differences in earnings quality, connected firms are associated with less accurate analysts’ forecasts, more optimistic forecast biases and a higher level of forecast divergence. These findings are consistent with the extant literature that shows1) a positive relationship between the complexity of the forecasting task and the error of analysts’ earnings forecasts (Brown et al., 1987; Bhushan, 1989; Lang and Lundholm, 1996; Clement, 1999), 2) less predictable earnings leads to more optimistic biases in analysts’ earnings forecasts (Das et al., 1998; Lim, 2001; Duru and Reeb, 2002), and 3) both uncertainty and opacity increase analysts forecast divergence (Daley et al., 1988; Imhoff Jr. and Lobo, 1992; Barron and Stuerke, 1998; Park, 2005).[4]
The remainder of the paper proceeds as follows: section two develops hypotheses; section three presentsvariable definitions and empirical models; section four identifies data source and reports descriptive statistics; section five discusses empirical analysis results, and section six summarizes robustness check results followed by conclusions in section seven.
II.HYPOTHESIS DEVELOPMENT
The main objective of the paper is to investigate how political connection influences analysts’ forecast attributes.Political connection can be expected to either increase or decrease the firm’s earnings volatility.On the one hand, it can be argued that political favoritism often comes in a windfall manner that creates crests in a firm’s earnings time series, amplifying the variance of earnings. On the other hand, politicians could use their influence to help the connected firms smooth their earnings by transferring political favors when earnings are extremely low. Ex ante, both arguments appear to be sensible.It is therefore an empirical issue whether political connection systematically increases or decreases earnings volatility.
Though the descriptive statistics of our sample in Table 3 show a lower disclosure level, low accrual quality,and a higher level of cash flow from operations (CFO) for politically connected firms than for non-connected ones,we believe that, even after controlling for this effect, the political connection may still affect analysts’ forecast attributes. There are at least two explanations. First, the impact of political connection on firm’s performance is often abrupt. Since forthcoming transactions carrying political favoritism are often not disclosed or not completely disclosed, analysts have difficulty predicting the firm’s future earnings based on historical data and other publicly available information. Second, even when these forthcoming transactions were disclosed, it would be extremely difficult to predict their impact on the firm’s future earnings because of their sudden and interruptive nature.
However, one may question the link between forecast attributes and the forecasting task complexity associated with political connection since the extant literature shows that firms may manipulate theirs earnings to meet the analysts’ forecasts as well[5]. For example, using U.S. data, Degeorge, Patel and Zeckhauser (1999) find that companies apparently strive to meet or exceed the analyst consensus forecast for quarterly earnings (consensus fixation). Graham, Harvey and Rajgopal (2005)show that top U.S. executives are willing to give up positive NPV projects to meet earnings benchmarks. However, managers of politically connected firms can be expected to behave differently, because they enjoy preferential government treatments and they are relatively immune to merger and acquisition threats. In other words, they have more job security which makes avoiding poor firm performance less an incentive for them to manipulate earnings to meet analysts’ targets. Of course, an opposing argument also exists. Due to government-provided protection from public scrutiny, managing earnings may cost managers of politically connected firms less, because even if their wrong doings were exposed, politicians could lend them a hand to minimize the adverse effect on the firm and its executives. It remains an empirical question whether the reduced incentive to manage earnings can out-weight the effect of decreases in monitoring mechanisms for politically connected firms[6].
Political Connection and Forecast Error
The error of an earnings forecast depends on the difficulty or complexity of the forecasting task (Duru and Reeb, 2002). We propose that there are at least three reasons that political connection makes the analysts’ forecasting task more difficult. First, political connection adds a new dimension to the earnings generating process. Krueger (1974) suggests that entrepreneurs expend resources on politicians to compete for economic rent which could be granted by the government in the form of favorable tax treatment, profitable projects, preferential access to markets, cheap financing, government subsidies,and etc. The pay-backs of political connection usually come in a windfall fashion which inevitably affects the pattern of the flow of the reported earnings of the connected firm, making analysts’ forecast task more complex. On the other hand, when government officials lose their political influence, the cash flow into the connected firm will dwindle and so will firm value as is indicated by findings in Fisman (2001) and Faccio and Parsley (2006). Theunpredictable nature of the adverse effect of falling out of political favor complicates the earnings forecasting task as well.[7]
Another reason that political connection can make earnings forecasting task more difficult is due to the possibility that connected firms may request the government to help them smooth their earnings by granting political favors when earnings shrink. Though government aids may fill up the valleys in the earnings pattern, they also increase the forecasting difficulty. First, there is high uncertainty about when and how much government aid the connected firm may receive, if it comes at all. The uncertainty arises from the fact that granting government aid would offset the equilibrium status of the political arena leading to redistribution of wealth among stakeholders. Obviously, this is not an easy task that can be accomplished without much political maneuver. Furthermore, either the success or the failure in securing government aid will increase the fluctuation of earnings in the future. In receiving government aids, the connected firm will have in its earnings a more transit component that is not expected to persist into the future, making the crystal ball more smudged for financial analysts to look into. If it turns out that government does not grant the favors in time to be reported in the current earnings, future earnings will be contingent upon the outcome of the connected firm’s political efforts, which often times is not an area in which many financial analysts have expertise or experience[8].
Last but not the least, our proposal that government decisions significantly influence the error of earnings forecasts of connected firms is consistent with prior studies that document that the equity value of politicallyconnected firms can be easily affected by political events (Roberts, 1990; Fisman, 2001; Faccio, 2006b). Fisman (2001) argued that “in Southeast Asia, political connectedness, rather than fundamentals such as productivity, was the primary determinant of profitability and this had led to distorted investment decisions”. At the same time, political connection often links to greater opacity at firm level. Due to government-provided shielding from market monitoring mechanisms (e.g., regulatory disclosure requirements, investors’ demand for transparency, etc.), managers enjoy more financial disclosure discretion in firms with political connection, which increases information asymmetry between analysts and management. Therefore, analysts are less likely to forecast future earnings of these firms accurately[9].
H1: Firms with political connection are associated with less accurate analysts’ earnings forecasts, ceteris paribus.
Political Connection and Optimistic Bias
There are several reasons for us to expect that politically connected firms are associated with more optimistic bias in financial analysts’ forecasts. First, as previously discussed, earnings of politically connected firms are more difficult to predict. Lim (2001) shows that analysts issue more favorable forecasts for firms with less predictable earnings in order to maintain favorable relations with managers who allow them to obtain access to private information. Extant literature also shows that financial community tends to be friendlier with politically connected firms. For instance, Hutchcroft (1998)describes how troubled banks that lent to Philippines President Marcos and his cronies enjoyed important privileges, including “emergency loans and generous equity infusions from state banks.” The cozy relationship between the financial community and connected firms can be expected to contribute to the optimistic bias in analysts’ forecasts.
Second, analysts may overweigh their private information on political connection relative to other public accounting information. Since the excess weight on private information is more pronounced in good news than in bad news, it leads to optimistic bias in analyst forecasts. Both economic incentives and behavioral bias can affect the degree of the deviation from efficient weighting on private and public information (Chen and Jiang, 2006). It can be reasoned that private information about politically connected firms more often than not is positive and the overweight placed on it leads to an upward bias. Especially, the behavioral bias (e.g., overconfidence) may be more severe in some countries with less-developed analyst industry (see Jiang et al., 2005 for the review on overconfidence).
Third,empirical evidence suggests that financial institutions often treat connected firms more optimistically than others. For instance, Faccio et al. (2006) find politicallyconnected (but publicly-traded) firms are more likely to be bailed out than are their non-connected peers, although the former exhibit significantly poorer operating performance than the latter at the time of the bailout and over the following two years. Furthermore, they also confirm former systematic and anecdotal evidence that politically connected firms make greater use of debt financing than their non-connected peers.
Fourth, unfavorable forecasts may upset not only the firm but also its political connection, leading to undesirable consequences for both the individual analysts and their affiliated securities firms, particularly, if the enforcement of law is so poor that politicians can act without serious concerns for check and balance imposed by the rule of law. Therefore, we hypothesize:
H2: Firms with political connection are associated with more optimistically biased analysts’ earnings forecasts, ceteris paribus.
Political Connection and Analysts’ Forecast Dispersion
Analysts’ forecast dispersion has been employed by prior studiesas a proxy for the effect of information asymmetry among investors of the forecasted firm. Some early researches show that forecast dispersion is likely to reflect uncertainty about the price irrelevant component of firms' financial reports (Daley et al., 1988; Imhoff Jr. and Lobo, 1992). Others conclude later that, if forecast dispersion after (i.e., conditional on) an earnings announcement reflects uncertainty about firms' future cash flows and this uncertainty causes investors to desire additional information, then dispersion will be positively associated with both (a) the level of demand for more information and (b) the magnitude of price reactions around the subsequent earnings release (Abarbanell et al., 1995). Furthermore, Barron and Stuerke (1998) found the dispersion in analysts' earnings forecasts serves as a useful indicator of uncertainty about the price relevant component of firms' future earnings.