Policy Uncertainty, Presidential Elections and Earnings Management: Evidence from South Korea

Abstract

This study investigates South Korean firms’ earnings management (EM) practices when policy uncertainty increases during the presidential election period. We adopt the Economic Policy Uncertainty (EPU) index, a recent development in economics research, as a proxy for policy uncertainty. A heightened EPU contracts economic activity, thereby restricting a firm’s real activity-based earnings management (RM) rather than its accrual-based earnings management (AM). Nonetheless, we argue that South Korean firms become more reluctant to use AM than RM when EPU rises during a presidential election period due to their unique political environment. The constitution stipulates a single five-year presidential term, and it is common for an incoming government to conduct a series of inspections of the economic policies of the outgoing government. In this political system, South Korean firms can be easily entangled with political scandals such as allegations of bribery or corruption, which will increase the cost of AM because it is easier to detect than RM. Results show that South Korean firms are less likely to use AM as EPU increases in the presidential election period, while they are less likely to use RM when EPU rises during the non-election period.