Friendships to Perish and Friendships to Cherish: Corporate Political Tactic and Earnings Management Method

Abstract

Critical of a literature which examines corporate political connections with scant attention to their dynamic nature, we blend political theory with inter-organizational exchange research to propose and test a framework based on which firms’ earnings management (EM) method can vary predictably with their political tactic. Using hand-collected data on political money spent by US firms, we reveal an unknown dichotomy. Firms taking a transactional approach to politics tend to use the least costly EM method, substituting accruals-based EM (AEM) for real EM (REM). Conversely, firms following a relational approach, concerned that possible detection may alienate career-focused politicians, substitute REM for AEM. Consistent with the goodwill trust in the firm–politicians relationship moderating the EM trade-off, firms revert to AEM when the trust is impaired and they no longer perceive the need to insulate politicians from reputational damage. Notwithstanding the firm's political tactic, the total EM remains unaffected, suggesting perfect substitution. As a refined and dynamic lens for examining firm–politicians exchanges, our framework reconciles the conflicting evidence of prior studies on how political connections affect reported earnings and is generalizable to other third-party affiliations that may have important reputational stakes but no monitoring capacity over the production of financial information.