Do Political Connections Affect the Conservative Financial Reporting of Family Firms?
Round 1
Reviewer 1 Report
Thank you for the proposal to review the article. The article deals with important and current topics concerning political relations and accounting conservatism, which is reflected in the approach to financial reporting. My suggestions are:
Re-think the title. Refer it to aim of your study.
Re-think the name of point 2.2. ... the conservatism of what?
2.3. The point should be written in normal style, not italics.
The issue of conservative accounting is translated into "conservative financial reporting". It will be good to improve this issue in the theoretical part for example in point 2.1. (e.g. Guay, W. R., 2008).
Re-think the presented question in the conclusions (at the beginning).
How does this relate to the aim formulated in the abstract or in the introduction or hypothesis?
Add the information about limitations in the conclusions.
Author Response
Response letter to Reviewer 1
Manuscript ID: sustainability-594468
We would like to thank you for your efforts in helping us to produce a much better manuscript. In this version, we have made the many important revisions as detailed below:
(1)Comment of the Reviewer
Re-think the title. Refer it to aim of your study.
Authors’ Response
Thank you for your suggestion. Our previous title “Do Political Connections Affect the Conservatism in Financial Reporting of Family Firms?” is not aim of our study. Therefore, to suitable for the research issue, we change our title as “Do Political Connections Affect the Conservative Financial Reporting of Family Firms?” in this manuscript.
(2)Comment of the Reviewer
Re-think the name of point 2.2. ... the conservatism of what?
Authors’ Response
We agree with the reviewer’s comment that it is not clear of the name of point 2.2. “Family control and conservatism” in our previous manuscript. Therefore, in order to describe the name of Section2.2 clearly, we change the name as “Family control and conservative financial reporting”, which could be more suitable for our theoretical inference.
(3)Comment of the Reviewer
2.3. The point should be written in normal style, not italics.
Authors’ Response
Thanks for the reviewer’s suggestion. We have revised the written of the point in normal style in this manuscript.
(4)Comment of the Reviewer
The issue of conservative accounting is translated into "conservative financial reporting". It will be good to improve this issue in the theoretical part for example in point 2.1. (e.g. Guay, W. R., 2008).
Authors’ Response
We appreciate the reviewer’s kind words with respect to the improvement of our paper. In this version, we have translated “conservative accounting” into “conservative financial reporting” in our title, the name of Section 2.2 and the sentence to improve the issue in the theoretical part of Section 2.1.
(5)Comment of the Reviewer
Re-think the presented question in the conclusions (at the beginning).How does this relate to the aim formulated in the abstract or in the introduction or hypothesis
Authors’ Response
We agree with the reviewer’s comment that we should re-think the question and how it is relate to the abstract, introduction or hypothesis. In this manuscript, we mentioned that “this study address a question that has not been discussed in prior studies, namely how the political connections affect the timely recognition of economic loss and gain for family firms.” However, the question we present is too intensesince there are several studies investigating the relationship between political connections and the quality of financial reporting. Therefore, we revise the writing at the beginning of the conclusions in this manuscript. We address the issue we want to investigate and then discuss the findings, implication for the contribution and the limitation. The partial discussion is reproduced as follows (please see page 21, first paragraph):
“This study examines how political connections affect conservative financial reporting, which is how the political connections affect the timely recognition of economic loss and gain for family firms. This study analyzes the role of conservative financial reporting and contract decisions of family firms. Unlike prior research that investigate the effect of corporate governance in earnings conservatism [34, 80], we not only provide the evidence on the impact of specific family firm features on accounting conservatism but also reveal the significant moderating effect of political connections as an important determinant of accounting conservatism. We expand the research field on the relation between the political economy and the quality of accounting information, which mainly focuses on a setting in whichagency conflict stems from family members and other stakeholders. It indicates that the government and capital market regulatory authorities easily neglect the supervision and regulation of politically connected firms and weaken the punishment upon their improper behaviors of earnings disclosure. It supports that politically connected family firms are less likely to release bad news in a timely manner as compared with good news.”
(6)Comment of the Reviewer
Add the information about limitations in the conclusions.
Authors’ Response
We appreciate the reviewer’s suggestion. Following the suggestion, we add the information about limitation of our research findings in the conclusion part. The main limitation of our study is the measurement of political connection, which only captures a shelter of business risk. We would like to suggest future study could further examine another proxy for a shelter of business risk. The partial discussion is reproduced as follows (please see page 21, last paragraph):
“A potential limitation of this study is the measure of political connection, because our measure of political connections only captures a shelter of business riskand identify for pursuing politician personal benefits. There still exists another proxy for a shelter of business risk and future research can further explore the shelter of business risk. In fact, this study still provides several avenues for future research. It would be interesting for future studies that compare the economic consequences of the family firms inherited by the founders’ descendants and those managed by outsiders. While few family firms have currently passed their ownership and control to outsiders, this new issue can create a better research field of how the family succession process serves as a specific factor in accounting quality and information transparency of family firms.”
Author Response File: 
Author Response.docx
Reviewer 2 Report
Abstract:
The authors correctly present the study they intend to do and their objectives.They should enter the number of companies studied, ie they should refer for example: "From a population of X companies the sample studied were Y companies".
Introduction:
Well done, but in my opinion is not necessary the last text because all readers will see the sections of paper.
In the end of this section authors present the step investigation but this is not necessary in this form. Please, if you want to describe the steps show this with methods used to complete this section and what contributes you give to the literature. Do not just list the sections but briefly explain each one.
Literature Review and Hypothesis:
he Literature Review is quite robust and complete however I think the authors can introduce more citations of important works in this field for example:
1-Gul, F. A. (2006). Auditors' response to political connections and cronyism in Malaysia. Journal of Accounting Research, 44(5), 931-963.
2-Marzuki, M. M., & Wahab, E. A. A. (2016). Institutional factors and conditional conservatism in Malaysia: Does international financial reporting standards convergence matter?. Journal of Contemporary Accounting & Economics, 12(3), 191-209
Hypothesis:
My first question is: The study have only one hypothesis? Why authors didn´t put more? They have enought literature?
Despite the scarcity of hypotheses, the model presented is robust and in line with the explicit literature.
Data:
Very good sample with robust data.
Results:
Very interesting results for the evolution of the literature in this area.
The authors performed the main tests of statistical consistency and robustness of the data. Statistical validity is very good, presenting these results as extrapolate to other studies and other realities.
Conclusions:
This is a very good article in all sections: on the literature, methodology, results and related discussion. Please write a better conclusion for this work.
I advise the authors to summarize their main findings in the conclusion. The authors should think like this: if someone just reads the abstract and the conclusion of our work would realize what we study, what we discover, what we investigate, what we contribute to the advance of the literature?
Author Response
Response letter to Reviewer 2
Manuscript ID: sustainability-594468
We would like to thank you for your efforts in helping us to produce a much better manuscript. In this version, we have made the many important revisions as detailed below:
(1)Comment of the Reviewer
The authors correctly present the study they intend to do and their objectives.They should enter the number of companies studied, ie they should refer for example: "From a population of X companies the sample studied were Y companies”.
Authors’ Response
Thank for the reviewer’s suggestion. To clearly mention the number of sample, we add the description of sample in our abstract as follows:
“Using data for Taiwanese listed firms between 1996 and 2012, the final sample observations are 13,877firm-year observations from a population of21,393 firm-year observations. We find that political connections weaken the positive relationship between family ownership and conservative financial reporting.”
Furthermore, we provide clearer the process of sample selection in Section 4.1 as follows:
“Our initial sample (1996-2012) is obtained from the Taiwan Economic Journal (TEJ) database for publicly listed firms, which provides data on corporate governance structures since 1996 as well as financial and stock price data. The initial sample consists of non-financial firms listed with 21,393 firm-year observations. A total of 6,550 firm-year observations were eliminated due to insufficient stock price data while another 906 and 60 firm-year observations were deleted due to insufficient financial data (NI, CFO) and firm age (AGE), respectively.”(Please see page 10)
(2)Comment of the Reviewer
Well done, but in my opinion is not necessary the last text because all readers will see the sections of paper.In the end of this section authors present the step investigation but this is not necessary in this form.
Authors’ Response
We agree with the reviewer’s comment that it is not necessary to list the sections. Following the reviewer’s suggestion, we delete the sections of the step investigation.
(3)Comment of the Reviewer
Literature Review is quite robust and complete however I think the authors can introduce more citations of important works in this field for example:
Gul, F. A.(2006). Auditors' response to political connections and cronyism in Malaysia. Journal of Accounting Research, 44(5), 931-963. Marzuki, M. M., & Wahab, E. A. A. (2016).Institutional factors and conditional conservatism in Malaysia: Does international financial reporting standards convergence matter?. Journal of Contemporary Accounting & Economics, 12(3), 191-209.
Authors’ Response
As the reviewer’s mention, we should introduce more citations in this research field. In this manuscript, we add these two literatures in Section 2.2 and Section 3.3. Gul (2006) finds that auditors input a greater effort for the firms with political connections because of information asymmetry, suggesting that politically connected firms may lead to poor financial reporting quality. We input Gul’s research in our inference of hypothesis 2. Moreover, since Marzuki and Wahab (2016) provide a very clear description of the measurement of C_score, we input Marzuki and Wahab’s research in the methodology of testing model. The partial discussions are presented as follows:
“However, from the minority shareholder’s point of view, political connections may exacerbate the agency problem between family and minority shareholders. Due to rent-seeking activities of government bureaucrats, they are more interested in their own extraction or political objective [63, 64]. Moreover, to ensure the achievement of rent-seeking through political connections, the controlling shareholders may need a concentrated control structure to retain their own decision power. Fan and Wong [22] find that Asian family firms have lower quality of reported earnings. They statethe finding mainly driven by an entrenchment effect, where family firms are more likely to manipulate earnings to hide expropriation activities. In addition, Gul [65] suggests that auditors input a greater effort for the firms with political connections due to higher information asymmetry. Therefore, it will exacerbate family-minority shareholder agency conflicts. Because minority shareholders lack timely inside information, have weaker power to monitor families, and exercise less control over families’ activities, they have a greater demand for conservative financial reporting to avoid benefit extractions undertaken by families and government officials. ”(Please see page 6)
“Second, we develop an estimation of the timeliness of good news (G_Score) and the incremental timeliness of bad news (C_Score) as linear functions of size, market-to-book value, and financial leverage [Marzuki and Wahab, 68].
(2)
(3)”
(Please see page 8)
Gul, F. A. (2006), Auditors’ response to political connections and cronyism in Malaysia, Journal of Accounting Research, 44(5), 931-963. Marzuki, M. M. and E. A. A. Wahab (2016), Institutional factors and conditional conservatism in Malaysia: Does international financial reporting standards convergence matter? Journal of Contemporary Accounting& Economics, 12(3), 191-209.
(4)Comment of the Reviewer
My first question is: The study has only one hypothesis? Why authors didn´t put more? They have enough literature?Despite the scarcity of hypotheses, the model presented is robust and in line with the explicit literature.
Authors’ Response
We agree with the reviewer’s suggestion that we have enough literature review and could provide more hypotheses in the study. Therefore, we have revised our manuscript from one hypothesis to two hypotheses. Our hypotheses are“family firms tend to have more conservative financial reporting” and“political connections will moderate the effect of family control on conservative financial reporting.” First, we would like to investigate family firm’s conservative attitude towards financial reporting. Second, we also want to test the moderate role of political connections. The inferences of these two hypotheses are described as follows:
“2.2. Family control and conservative financial reporting
Following prior research [1,2,3], the definition of family firms is considered as owner-managed enterprises with family members by blood or marriage, and the families are chief executive officers, directors or blockholders. While most non-family firms are usually characterized as having dispersed ownership and a separation between ownership and control, family firms face fewer owner–manager conflicts and appear a special class of large shareholders, a specific ownership structures, a powerful voice, and strong motives to engage in influencing managerial effort [40,41,42]. However, relative to non-family firms, family firms have severe agency problems stemming from conflicts between dominant and minority (small) shareholders. Families’ wealth is disproportionately tied up with the firms and such concentrated ownership results in closer monitoring of management by the controlling families [43, 44]. As family control increases, family tends to maintain ownership over a longer horizon, or passes it onto descendants or relatives [41]. However, this tight control may allow family self-dealings to go internally unchallenged by other shareholders and be more likely to extract rent at the expense of minority shareholders [45]. This may give family owners incentives to use their private information to overstate financial performance. In turn, minority shareholders may take actions to protect their personal wealth and avoid benefit extractions undertaken by families [46, 47]. Requiring conservative accounting is a useful tool to resolve this agency problem to mitigate potential higher agency cost arising from price protection of minority shareholders. As asymmetric verifiability brings timely recognition of losses, it can provide minority shareholders a signal to understand the reason of the losses. Such an asymmetric timeliness in recognition of accounting losses and possible investigations by minority shareholders induce families to be sensible in their management policies. Therefore, conservative financial reporting is a governance mechanism that can decrease a family’s intention to overstate and manipulate accounting numbers.
Shareholder litigation is also an essential driver for managers to engage in conservative accounting practices[4]. Litigation leads to asymmetric payoffs in that overstating the firm’s performance or net assets is more likely to increase litigation risk. By understating net assets or performance, conservative accounting decreases firm’s perceived litigation cost and then constrains opportunistic payments to related parties and managers [48, 49]. Family owners are more interested in firm survival and have greater incentives to avoiding risky and illegal activities because of the longer investment horizon[1, 50]. When a families’ ownership position is closely tied to the firm, family owners prefer lower litigation risk [51, 52]. Moreover, since families’ wealth is disproportionately tied up with the firm, they are more likely to implement a conservative reporting, which can reduce their litigation risk. Basu [48] and Holthausen and Watts[53] suggest that conservative financial reporting is to generate an understatement of net assets by requiring a higher degree of verification for gains than for losses. Blunck [54] finds that higher conservative financial reporting is related to a higher dismissal rate of lawsuits and fewer litigation cases. As asymmetric recognition in overstating the firm’s net assets could generate higher litigation costs than understating net assets, family firms tend to report conservative accounting numbers to avoid potential lawsuits.
In sum, family firms have concentrated ownership, an interest in long-term viability, and concerns over reputation, they have a greater incentive to mitigate agency conflicts with minority shareholders anddeter potential litigation risks. Recently, Chen et al. [11] provide evidence that family firms are more likely to engage in conservative accounting reporting compared with nonfamily firms. Thus,based on the above discussion, we expect that family firms tend to implement conservative financial reporting and our first hypothesis is stated as follows:
H1: Ceteris paribus, family firms tend to have more conservative financial reporting
2.3. The moderating role of political connections
Political connections have a very significant influence on firm’s economic activities [55, 56]. Previous research suggests that politically connected firms not only avoid firms from the government expropriation, but also enable them to enjoy substantial political benefits [57, 58, 59]. As politically connected firms actively build and obtain political resources through appropriate government channels and authority, they can receive ex post financial assistance and preferential corporate bailouts, avoid stringent regulations, and decrease the cost of contract. Faccio [60] documents that politically connected firms are revealed to pay fewer taxes; thereby benefiting from lower operating costs. Goldman et al. [58] find that politically connected firms receive more government procurement contracts than the firms without political connections. The above evidence supports the notion that the presence of incentives for government officials and bureaucrats to seek in rent-seeking leads firms to obtain an alternative shelter through political connections.
While political connections could provide firms several benefits, the corporate governance literature argues that the establishment of political ties will cause some negative effects to firms [61, 62]. Prior studies suggest that political connections lead to lower quality of accounting information and exacerbate information asymmetry [9, 49]. Chaney et al. [18] suggest that since governmentbureaucrats provide protection to the firms, politically connected firms care less about the quality of accounting information, and pay less attention to accurately portraying the earnings. They also find that managers of politically connected firms have less incentive to respond to market pressures to improve the quality of financial reporting. Chen et al. [49]provide evidence that analysts’ earnings forecasts are less accurate for politically connected firms. Additionally,Piotroski et al. [19] find that state-owned enterprises (SOEs) are more likely to hide bad news of expropriation-related activities and suppress the inefficient allocation of resources in order to achieve their political objectives.
While family firms, who have long-term intentions and reputation concerns, have more incentives to provide conservative financial reporting,we argue that political connections may significantly affect family firm’s attitude toward accounting conservatism. First, although government bureaucrats enables family firms to enjoy several privileges and have lower cost of contract, such as government subsidies, preferential financial assistance, tax reductions, lucrative government contracts, and competitive advantage, [57, 58, 59], government bureaucrats are more interested in rent-seeking/extraction and political objectives than maximizing performance and corporate efficiency [63, 64]. Sincegovernment bureaucrats generally provide protection to politically connected firms who disclose lower earnings quality [26], these firms would receive lighter penalties or even not be penalized under the regulations[19]. Due to weak punishment upon their improper behaviors of earnings disclosure, politically connected family firms are less likely to release bad news in a timely manner. That is, political connections lower family firms’ litigation risks and reduce their incentives to imply conservative accounting.
However, from the minority shareholder’s point of view, political connections may exacerbate the agency problem between family and minority shareholders. Due to rent-seeking activities of government bureaucrats, they are more interested in their own extraction or political objective [63, 64]. Moreover, to ensure the achievement of rent-seeking through political connections, the controlling shareholders may need a concentrated control structure to retain their own decision power. Fan and Wong [22] find that Asian family firms have lower quality of reported earnings. They statethe finding mainly driven by an entrenchment effect, where family firms are more likely to manipulate earnings to hide expropriation activities. In addition, Gul [65] suggests that auditors input a greater effort for the firms with political connections due to higher information asymmetry. Therefore, it will exacerbate family-minority shareholder agency conflicts. Because minority shareholders lack timely inside information, have weaker power to monitor families, and exercise less control over families’ activities, they have a greater demand for conservative financial reporting to avoid benefit extractions undertaken by families and government officials.
In summary, politically connected family firms may implement less conservative financial reporting if they face lower punishment for improper information disclosure and lower downside default risk. On the other hand, politically connected family firms may need more conservative accounting if minority shareholders perceive the severe entrenchment effect by families and government bureaucrats. As a result of these competing explanations, we make a non-directional prediction as follows:
H2: Ceteris paribus, political connections will moderate the effect of family control on conservative financial reporting.”
(5)Comment of the Reviewer
This is a very good article in all sections: on the literature, methodology, results and related discussion. Please write a better conclusion for this work.
I advise the authors to summarize their main findings in the conclusion. The authors should think like this: if someone just reads the abstract and the conclusion of our work would realize what we study, what we discover, what we investigate, what we contribute to the advance of the literature?
Authors’ Response
We agree with the reviewer’s comment that we should re-think how to summarize our findings in the conclusion and what the contributions to the further studies. In this manuscript, we address the issue we want to investigate and then discuss the findings, implication for the contribution and thelimitation. The partial discussion is reproduced as follows (please see page 21):
“5. Conclusions
This study examines how political connections affect conservative financial reporting, which is how the political connections affect the timely recognition of economic loss and gain for family firms. This study analyzes the role of conservative financial reporting and contract decisions of family firms. Unlike prior research that investigate the effect of corporate governance in earnings conservatism [34, 80], we not only provide the evidence on the impact of specific family firm features on accounting conservatism but also reveal the significant moderating effect of political connections as an important determinant of accounting conservatism. We expand the research field on the relation between the political economy and the quality of accounting information, which mainly focuses on a setting in whichagency conflict stems from family members and other stakeholders. It indicates that the government and capital market regulatory authorities easily neglect the supervision and regulation of politically connected firms and weaken the punishment upon their improper behaviors of earnings disclosure. It supports that politically connected family firms are less likely to release bad news in a timely manner as compared with good news.
Further analysis suggests that family firms with founder or descendentCEOs who have political connections are also less likely to engage in conservative financial reporting. After checking the robustness of these findings, we control for sample-selected problems and endogeneity, consider an alternative definition of political connections, and use another accounting conservatism measurement; however, the results are still robust to all of these sensitivity examinations.Therefore, this study contributes the academy literature on how political connections affect the family owners’ reporting incentives. Policy makers may consider political connections as an essential factor with respect to establishing governance practice in family firm.
A potential limitation of this study is the measure of political connection, because our measure of political connections only captures a shelter of business riskand identify for pursuing politician personal benefits. There still exists another proxy for a shelter of business risk and future research can further explore the shelter of business risk. In fact, this study still provides several avenues for future research. It would be interesting for future studies that compare the economic consequences of the family firms inherited by the founders’ descendants and those managed by outsiders. While few family firms have currently passed their ownership and control to outsiders, this new issue can create a better research field of how the family succession process serves as a specific factor in accounting quality and information transparency of family firms.”
Author Response File: Author Response.docx
Reviewer 3 Report
Introduction is good, focused on the aim. Maybe you can improve it if you includes also why is interesting analyse the moderator effect.
About literature review:
Line 125: I don´t understand why authors compare family firms with public firms. Maybe you can compare with other non-family firms but, why do you introduce public firms in the paper? I miss a explication about family firms. This journal is not only about family firms, so the public need more information about this area. The title "2.3. The moderating role of political connections" is in italics, while previous sub-sections (2.1 and 2.2) are in bold and without italics. Please, review the format in all document and standardize the format.
I also miss a section about methodology.
Discussion should be improve with more detail.
Finally, about the conclusions, it could be improve. I miss:
Implications for scholars Implications for family firms Limitations
Author Response
Response letter to Reviewer 3
Manuscript ID: sustainability-594468
We would like to thank you for your efforts in helping us to produce a much better manuscript. In this version, we have made the many important revisions as detailed below:
(1)Comment of the Reviewer
Introduction is good, focused on the aim. Maybe you can improve it if you includes also why is interesting analyze the moderator effect.
Authors’ Response
We appreciate the reviewer’s comment. According to the suggestion, we have re-written the introduction and described the moderator effect of political connections clearly in this manuscript. We mention that while establishing good connections with government officials could provide a useful mechanism from firm’s business risk and economic uncertainty, political connections may bring some negative effects to the firms. Thus, exploring the moderating role of political connectionscan create a new avenue of research on family firms.The partial discussion is reproduced as follows (please see page 1, third paragraph):
“Since social network and business relationships are highly emphasized, establishing good connections with government officials can provide a useful mechanism for firms from economic uncertainty. Several studies support that political connections produce benefits in various forms, such as preferential access to capital, favorable regulatory treatments, and government bailouts [12-14]. However, the establishment of political connections may bring some negative effects to the firms. As firms typically obtain considerable benefits from their political connections,they have less demand to respond to market pressures regarding their reporting policies [18]. Prior research suggests that politically connected firms face fewrequirements ofinformation transparency, lower earnings quality, and higher information asymmetry [18,19]. In contrast, if political connection exacerbates rent-extraction from minority shareholders that results in more severe agency problems, then minority shareholders may require family firms to provide better monitoring mechanisms due to price protection [20]. Thus, exploring the moderating role of political connectionscan create a new avenue of research on family firms.”
(2)Comment of the Reviewer
I don´t understand why authors compare family firms with public firms. Maybe you can compare with other non-family firms but, why do you introduce public firms in the paper? I miss a explication about family firms. This journal is not only about family firms, so the public need more information about this area.
Authors’ Response
Thank you for your suggestion. As the reviewer’s mention, it will be misunderstanding for the readers about comparison of family firms and public firms. In this manuscript, we have revised to compare family firms with non-family firms. Therefore, at the beginning of Section 2.2, we discuss the definition and explanation of family firms and then describe a comparison between family firms and non-family firms. The partial discussion is reproduced as follows (please see page 4):
“ 2.2. Family control and conservative financial reporting
Following prior research [1,2,3], the definition of family firms is considered as owner-managed enterprises with family members by blood or marriage, and the families are chief executive officers, directors or blockholders. While most non-family firms are usually characterized as having dispersed ownership and a separation between ownership and control, family firms face fewer owner–manager conflicts and appear a special class of large shareholders, a specific ownership structures, a powerful voice, and strong motives to engage in influencing managerial effort [40,41,42]. However, relative to non-family firms, family firms have severe agency problems stemming from conflicts between dominant and minority (small) shareholders.“
(3)Comment of the Reviewer
The title "2.3. The moderating role of political connections" is in italics, while previous sub-sections (2.1 and 2.2) are in bold and without italics. Please, review the format in all document and standardize the format.
Authors’ Response
Thanks for the reviewer’s suggestion. We have revised the written of the point in bold and without italics style in this manuscript.
(4)Comment of the Reviewer
I also miss a section about methodology.Discussion should be improved with more detail.
Authors’ Response
We appreciate the reviewer’s kind words with respect to the improvement of our paper. In this manuscript, we have added the methodology in Section 3.3 to describe the testingmethodology and the measurement of variables. The discussion in Section 3.3 is represented as follows (please see page 8-10):
“3.3. Methodology of testing model
Based on Khan and Watts’ [70], our measure of conservative financial reporting is firm-year-specific asymmetric timeliness score. First, we establish Basu’s [48] asymmetric timeliness measure, which regresses earnings on return and allows the return coefficient to vary with the sign of the return.
(1)
where, for firm i and period t: NI is the net income before extraordinary items are deflated by the market value of the equity at the beginning of the period; RET is the buy-and-hold return over the fiscal year; and NEG is an indicator variable coded to one when RET is negative, and zero otherwise. In Equation (1), β1 captures the timeliness of earnings with respect to positive returns, and β1 + β3 capture the timeliness of earnings with respect to negative returns. If β1 + β3>β1 (or β3> 0), it will be conservative reported earnings; that is, a positive and significant β3 represents earnings that reflect bad news more quickly than good news and, hence, is the measure of conservatism (i.e., the asymmetric timeliness coefficient).
Second, we develop an estimation of the timeliness of good news (G_Score) and the incremental timeliness of bad news (C_Score) as linear functions of size, market-to-book value, and financial leverage [Marzuki and Wahab, 68].
(2)
(3)
where, for firm i and period t: MVE is the natural logarithm for the market value of the equity; MTB is the market value of the equity divided by the book value of the equity; LEV is the total liabilities divided by total assets; and the empirical estimators of μ1~μ4 andλ1~λ4, are constant across all firms, but vary over time. After estimating β1and β3 in Equations (2) and (3), we place them into Equation (1) to yield Equation (4) as follows:
(4)
Following Khan and Watts [70], we include an additional term in the last parenthesis of Equation (4) to control for the firm’s characteristics separately (the main effect). We first estimate Equation (4) in annual cross-sections to obtain the coefficient estimates for λ1~λ4, which we then apply to Equation (3) to calculate the C_Score: a higher C_Scorerepresents a higher degree of conservatism.
To test the hypothesis, we apply the firm-specific timeliness measure of conservatism in the following regression:
(5)
where, for firm i and period t,C_Score is the firm-specific measure of conservatism; PC is the political connections indicator; and CONTROLS is a vector of control variables. This vector includes: PCOWN, the politician ownership; OUTOWN, the fractional equity ownership of the outside largest shareholder; INST, the fractional equity ownership of the institutional shareholder; SIZE, the natural logarithm for the book value of total assets; LEV, the total liabilities divided by total assets; MTB, the market value of the equity divided by the book value of the equity; CFO, the cash flows from operating activities scaled by lagged total assets;LAGNI, prior net income scaled by market value of equity; AGE, the number of listedfirm years; VOLRET, the standard deviation for the daily stock returns; LINC, the depreciation expense scaled by lagged total assets; and LIT, an indicator variable set to one if the firm is in a technology industry, otherwise zero .
The control variables are identified from prior literature. For ownership structure, we add politician ownership (PCOWN) as control variable. Prior studies suggest that politician-owned firms are less likely to implement conservative financial reporting due to lenders being less concerned with downside default risk and protection from public scrutiny [Bona-Sanchez et al. 69]. In addition, we control for the ownership of outside shareholders (OUTOWN) and institutional shareholders (INST) since external monitoring mechanism could exhibit a higher degree of accounting conservatism [71]. For firm specific characteristics, we control for firm size (SIZE) as previous studies suggest that larger firms have a lower asymmetric timeliness of earnings [71]. Ahmed et al. [70] find that firms with greater bond holder–shareholder conflicts exit a higher demand for conservative financial reporting; thus, we also control for financial leverage (LEV) in the regression. In addition, we include growth opportunities (MTB) as prior study finds a negative relation between growth and conservatism [72]. We control for profitability using operating cash flow (CFO) as a proxy as well since Ahmed and Duellman [71] find that profitable firms tend to use conservative accounting practices. Moreover, Khan and Watts [70] suggest that the characteristics of a firm’s information environment could affect conservatism, which increases with firm-specific uncertainty and decreases with firm age; thus, we include prior net income (LAGNI), return volatility (VOLRET), and firm age (AGE) to control for this effect. Furthermore, Khan and Watts [70] find that conservative financial reporting is positively related to investment uncertainty; therefore, we include the length of the investment cycle (LINC) in the model. Because high technology firms face greater risks of shareholder litigation and greater discretionary expenditures affected by accounting standards, such as the recognition of research and development (R&D) costs and potential loss of patent litigation [74,75], such firms can use conservative accounting to reduce anticipated litigation costs from shareholders; thus, we include an indicator variable to control for firms facing high litigation risks (LIT). Finally, we control for yearly and industry sector fixed effects, which both account for the systematic time period and controls for any omitted industry factor.
In Equation (5), the primary coefficient of interest is q3. We expect the sign of q3 is negative (or positive) if political connections weaken (strengthen) the incentive in family firms to engage in conservative financial reporting.”
(4)Comment of the Reviewer
Finally, about the conclusions, it could be improved.I miss: Implications for scholars Implications for family firms Limitation.
Authors’ Response
We agree with the reviewer’s comment that we should re-think how to summarize our findings in the conclusion and what the contributions to the further studies. In this manuscript, we address the issue we would like to investigate and then discuss the findings, implication for the contribution and the limitation. The partial discussion is reproduced as follows (please see page 21):
“5. Conclusions
This study examines how political connections affect conservative financial reporting, which is how the political connections affect the timely recognition of economic loss and gain for family firms. This study analyzes the role of conservative financial reporting and contract decisions of family firms. Unlike prior research that investigate the effect of corporate governance in earnings conservatism [34, 80], we not only provide the evidence on the impact of specific family firm features on accounting conservatism but also reveal the significant moderating effect of political connections as an important determinant of accounting conservatism. We expand the research field on the relation between the political economy and the quality of accounting information, which mainly focuses on a setting in whichagency conflict stems from family members and other stakeholders. It indicates that the government and capital market regulatory authorities easily neglect the supervision and regulation of politically connected firms and weaken the punishment upon their improper behaviors of earnings disclosure. It supports that politically connected family firms are less likely to release bad news in a timely manner as compared with good news.
Further analysis suggests that family firms with founder or descendentCEOs who have political connections are also less likely to engage in conservative financial reporting. After checking the robustness of these findings, we control for sample-selected problems and endogeneity, consider an alternative definition of political connections, and use another accounting conservatism measurement; however, the results are still robust to all of these sensitivity examinations.Therefore, this study contributes the academy literature on how political connections affect the family owners’ reporting incentives. Policy makers may consider political connections as an essential factor with respect to establishing governance practice in family firm.
A potential limitation of this study is the measure of political connection, because our measure of political connections only captures a shelter of business riskand identify for pursuing politician personal benefits. There still exists another proxy for a shelter of business risk and future research can further explore the shelter of business risk. In fact, this study still provides several avenues for future research. It would be interesting for future studies that compare the economic consequences of the family firms inherited by the founders’ descendants and those managed by outsiders. While few family firms have currently passed their ownership and control to outsiders, this new issue can create a better research field of how the family succession process serves as a specific factor in accounting quality and information transparency of family firms.”
Author Response File: Author Response.docx
Round 2
Reviewer 3 Report
I think the paper could be published by the journal.
