12 May 2008  Research & Ideas

Accounting Information as Political Currency

Corporate donors that gave at least $10,000 to closely watched races in the U.S. congressional elections of 2004 were more likely to understate their earnings, say Harvard Business School's Karthik Ramanna and MIT colleague Sugata Roychowdhury. Such "downward earnings management" may have functioned as a political contribution. In this Q&A, Ramanna explains how accounting and politics influence each other. Key concepts include:

  • Firms manage accounting numbers to avoid regulatory scrutiny. The implication is that firms manage accounting numbers to influence political decisions.
  • Accrual accounting gives managers some flexibility to make estimates about the future.
  • The data used to construct these measures are available for the larger companies in most developed and fast-developing nations.

 

Corporate donations to political campaigns reveal a lot about mutual back-scratching in the political and business arenas. Now new research from Harvard Business School reveals that corporate giving may consist of more than monetary contributions.

The evidence shows that firms involved in potentially controversial business activities—outsourcing, for example—understate their earnings if it might boost a candidate's chances of election.

The research by HBS professor Karthik Ramanna and a colleague from MIT, Professor Sugata Roychowdhury, suggests that accounting information itself may function as an important political contribution. In a study of 573 Democratic and Republican candidates in the 2004 congressional races, 338 corporate donors that gave at least $10,000 to closely watched races—those races with greater uncertainty and higher visibility, involving 95 candidates of the total—were more likely to understate their earnings in the two quarters prior to the election.

Such "downward earnings management," as it is known in accounting, seems to have been motivated by the desire of contributing firms to not taint preferred candidates with association to the political red flag of 2004—outsourcing—as well as to ensure future benefits and avoid future costs in regulatory matters.

As Ramanna and Roychowdhury write in their working paper [PDF] "Accounting Information as Political Currency": "While corporate donors in general do not exhibit evidence of downward earnings management, corporate donors to candidates in closely watched races exhibit significant evidence of downward earnings management in the second and third calendar quarters of 2004."

Ramanna agreed to an e-mail interview about the relation between accounting and the political process, with implications for the U.S. presidential election this November.

Martha Lagace: What led you to think about accounting information as political currency?

Karthik Ramanna: There is evidence in the academic literature that firms manage accounting numbers to avoid regulatory scrutiny. The implication is that accounting can be used to influence political decisions. We wanted to take this a step further and see if accounting can be used to manage the information environment in an election, and thus influence voters’ decisions. 

Q: Did your findings surprise you?

A: The results are consistent with established economic theories of accounting. That said, the results suggest that accounting has a broader political role than was previously thought. What surprised us was the significance of our estimates. We were skeptical going in: We weren’t sure our tests had enough power, and we expected the accounting effect on election outcomes to be minor. When we ran the tests, we found that even a one standard-deviation change in our measure of earnings management could affect election outcomes in some cases.

Q: Were you able to see whether these firms’ efforts at downward earnings management were "well spent"? Does other work document a relationship between donorship and political favors?

A: There is evidence in the paper that the downward earnings management is associated with favorable election outcomes. So, to the extent that the (re)elected politician is likely to support the firm in the future (the politicians and firms have a good history together), one can argue that the earnings management is "well spent."

It is ambiguous, however, whether earnings management or other forms of political contributions actually "buy" favorable votes in Congress. While there is evidence in the academic literature to suggest an association between political contributions and, say, legislators’ votes on bills, there is little evidence to suggest this relation is causal. The problem is that firms tend to contribute to politicians who are predisposed to supporting them.

Q: On the basis of this study, could it be suggested that any given candidate desired that a company manage earnings downward? Or can it be assumed that these were unsolicited "gifts"?

A: The data we have cannot establish with certainty that the earnings management was actively solicited. I suppose one would need tape recordings or sworn testimony for that.

Q: If you were doing a similar study of accounting as political currency for the upcoming U.S. presidential election in November, what keywords would you use?

A: I suppose outsourcing is still likely to be an issue. Relations with oil companies can also be a liability for politicians in some districts. Perhaps, contributions from financial institutions perceived to have benefited from the mortgage crisis will also be sensitive.

Q: In layman’s terms, what does it mean to manage earnings downward? Why would companies otherwise understate their earnings?

A: Accrual accounting gives managers some flexibility to make estimates about the future. These estimates are usually verifiable by auditors, and on average, they provide information about future cash flows. The estimates are also usually predictable based on the economic circumstances of the firm (e.g., its growth in sales).

Accounting researchers have built models to estimate "discretionary" accruals, which are accruals not predictable by recent economic changes in the firm. These discretionary accruals can be used opportunistically (but almost certainly aren’t always used so). In general, earnings management refers to this discretionary component of accruals.

In an average firm, earnings management is likely to be used to convey meaningful information on future cash flows. In the absence of appropriate incentive alignment, earnings management can be used to mislead financial-statement users, including shareholders, debt holders, regulators, and so on.

Q: Would your methods apply in countries other than the United States?

A: The data used to construct earnings management measures are available for the larger companies in most developed and fast-developing nations. Data on legislative-election vote shares are also likely available for many jurisdictions. The data on cash contributions from companies to politicians will be tricky—the United States has relatively better disclosure regulation in this regard.

Q: What are you working on next?

A: My research interests are at the intersection of accounting, economics, and politics. I am working on several projects on how political forces shape accounting standards. One project, with HBS professor Arthur Daemmrich, compares the differential role of lobbying in setting information standards in accounting (through the Financial Accounting Standards Board) and in food labeling (through the Food and Drug Administration). There are likely lessons for both regulatory agencies in such a comparative analysis.

About the author

Martha Lagace is the senior editor of HBS Working Knowledge.