Why do investors not punish politically connected firms for financial misrepresentation?

Abstract

PurposeThe purpose of this paper is to examine whether the political connections of listed firms in China affect how the market reacts to cases of financial misrepresentation investigated by the regulatory authorities.Design/methodology/approachThe authors use an event study method and the financial misrepresentation events in China stock markets as research setting and empirically test the association between market reactions to the announcement of financial misrepresentations and the presence of political connections.FindingsThe results show that on average, there is no significant market reaction to financial misrepresentation for politically connected firms. In contrast, however, there is a significantly negative market reaction for non-connected firms, which suggests that investors do not punish politically connected firms for financial misrepresentation. The authors argue that politically connected companies use the altered financial information to gain legitimacy and obtain benefits from the government. Consistent with the argument, the authors find that in the years after they disclose their financial misrepresentation, firms with political connections are more likely to increase their bank loans than firms without political connections.Originality/valueThe authors provide a new explanation for the low-earnings quality of politically connected firms.