Political Connections and the Trade‐Off Between Real and Accrual‐Based Earnings Management*

Abstract

ABSTRACTWe provide evidence on the effect of political connections on the trade‐off between real and accrual‐based earnings management in the United States. This evidence is important because prior literature documents mixed evidence on whether political connections reduce the threat of SEC enforcement. By studying earnings management with a large sample, our study provides more generalizable insights into the effects of political connections on enforcement. We argue that politically connected firms face a lower threat of enforcement, which reduces the costs of accrual‐based earnings management and alters the trade‐off between real and accrual‐based earnings management. Consistent with our predictions, using a single‐step estimation method as well as a difference‐in‐differences test based on an exogenous shock, we find that connected firms engage in more accrual management and less real earnings management. Our results are driven by firms that have relatively high costs of real earnings management. Furthermore, we find that political connections mitigate the relation between SEC comment letters and earnings management. Overall, the evidence is consistent with politically connected firms facing a lower threat of regulatory enforcement and using this flexibility to increase accrual‐based earnings management and reduce real earnings management that is potentially value destructive. Our study complements and strengthens inferences in prior work that documents evidence of lax SEC enforcement for politically connected firms using small samples. Our findings should be of interest to policy‐makers, regulators, and other professionals that are interested in understanding the effects of political connections.