Firms’ exposure to political risk and financial reporting quality

• Published date: 01 January 2024
• Author: Lukas Timbate,Dereje Ferede Asrat
• Date: 01 January 2024
• DOI: http://doi.org/10.1002/jcaf.22653

Received: 21 February2023Revised: 16 July 2023Accepted: 24 July 2023

DOI: 10.1002/jcaf.22653

RESEARCH ARTICLE

Firms’ exposure to political risk and financial reporting

quality

Lukas Timbate1Dereje Ferede Asrat2,3

1School of Global Studies, Kyungsung

University, Busan, South Korea

2Faculty of Economics and Management,

Cote D’AzurUniversity, Nice, France

3Department of Accounting and Finance,

Bahir Dar University, Bahir Dar, Ethiopia

Correspondence

Lukas Timbate, School of Global Studies,

Kyungsung University,Busam, South

Korea.

Email: lukas@ks.ac.kr

Abstract

We examine the effects of political risk at the firm level on the integrity of finan-

cial reports between 2009 and 2019 using a data from U.S. firms. We provide

evidence that, as evaluated by quarterly earnings conference call transcripts of

companies with analysts that focus on political risk or uncertainty, political risk

at the firm level is inversely related to the quality of accounting information.

This effect is more likely to happen to firms with a higher agency problem, faster

growth, and greater reliance on outside finance. The results persist after con-

trolling macroeconomic variables. Our findings are also robust to alternative

financial reporting quality criteria and endogeneity tests, and are economically

significant.

KEYWORDS

agency costs, financial reporting, firm-level political risk, U.S., accounting information

JEL CLASSIFICATION

G38, P16, P26, M41, M43

1 INTRODUCTION

Recent global changes have resulted in a sharp increase

in political uncertainty; for example, the Russian–Ukraine

war and the trade war between the United States and

China demonstrate the rise of political uncertainty around

the world. Since 2000, the U.S. has experienced a violent

period of political uncertainty because of the structure and

systems of its political organization. Anecdotal evidence

also supports this notion. According to The New York

Times (2019), the U.S. government blackouts in October

2013 and December 2018 concerning the national budget

are just some of the typical examples of incidents that

increase political uncertainty. Theoretical studies suggest

that during times of high political uncertainty, economic

agents take precautionary actions to protect themselves;

for example, investors become more prudent and demand

greater transparency in financial reporting. Managers

must respond to this request, especially when they need

to access external capital (Boubakri et al., 2010).

Political uncertainty also reduces corporate investment

(Gulen & Ion, 2016; Julio & Yook, 2012, 2016) and inno-

vation (e.g., Gad et al., 2020; Hassan et al., 2019), slows

employment growth (Baker et al., 2016), and raises default

risk (Kelly et al., 2016;Pástor&Veronesi,2013). Moreover,

political uncertainty also affects stock prices (Gorbatikov

et al., 2020). However, research on the link between

firms’ exposure to political uncertainty and the quality of

accounting information is still scarce, and less is known

about the effect of firm-level political uncertainty on firm

behavior. Therefore, this paper aims to fill the gap by

attempting to examine how different firms’ exposure to

political risk affects corporate financial reporting quality

across U.S. firms.

Uncertainty around major policies such as govern-

ment and institutional reforms and monetary and taxation

policies exerts an influence on different firms’ business

outputs. As a result, Hassan et al. (2019) created an empir-

ical index of firm-level political risk by conducting textual

analyses of conference call transcripts of publicly traded

110 © 2023 Wiley Periodicals LLC.J Corp Account Finance. 2024;35:110–127.wileyonlinelibrary.com/journal/jcaf

TIMBATEand ASRAT111

firms in the United States. This empirical index built by

Hassan et al. (2019) accounts for around 70% of the total

variations in political risk compared to other measures

such as Baker et al. (2016), which account for only 1% of

the aggregate political risk over time. As data were unavail-

able, prior studies did not consider the effect of political

risk at the firm level. Thus, taking advantage of the new

measure, this paper investigates the effect of firms’ expo-

sure to political uncertainty on the quality of accounting

information.

Financial reporting quality studies have a long history

(Dechow & Skinner, 2000;Healy&Wahlen,1999). We

stress accounting information quality for three reasons.

First, financial reporting improves investors economic

judgments. Accounting information quality reduces infor-

mation asymmetry and adverse selection, according to

research. Hence, it boosts market liquidity and lowers

equity capital costs ( Pastor & Stambaugh, 2003; Shroff

et al., 2013). Accounting information quality affects com-

pany investment and resource use. Quality accounting

information feeds back into the firm’s decision-making

process, improving managerial decisions (Lambert et al.,

2007), investment efficiency (Cheng et al., 2013), and eco-

nomic activity. Second, uncertainty is a major driver of

aggregate economic growth and business cycles, according

to Baker et al. (2016). Firm-level policy uncertainty affects

company operations and performance and creates infor-

mation asymmetry that affects earnings manipulation and

accounting information transparency (Julio & Yook, 2016;

Khan & Watts, 2009). Consequently, investigating how

firm-level policy uncertainty affects financial reporting

quality makes sense. Third, earnings manipulation may be

done to build credibility with the capital market, main-

tain or increase stock prices, improve the management

team’s external reputation, communicate future growth

prospects, improve management’scompensation, decrease

the likelihood of violating lending agreements, and avoid

regulatory interventions (Graham et al., 2005;Healy&

Wahlen, 1999). Dichev et al. (2013) found that 20% of

public businesses manage earnings and that the average

management is 10% of earnings per share.

The accounting information and disclosure practices

of businesses are significantly influenced by political

uncertainty.1When confronted with a sizable amount of

firm-level political ambiguity from legislators and regula-

tors, outside investors and businesses modify their actions.

In light of growing political division and the shifting eco-

nomic role of the government, worries about firm-level

political uncertainty have risen in recent years. On the

1For a few previous studies on the effect of political uncertainty on firm

reporting, see, for example, Jiang et al. (2021),Nagar et al. (2019), and Bird

et al. (2017).

one hand, company managers can easily restrict earnings

management during a high level of firm-level political

uncertainty since shareholders and other stakeholders

might be puzzled by erratic policy changes and actions.

On the other hand, in times of intense political unpre-

dictability, managers’ ability to manage earnings without

becoming tangled may be hampered by increased pub-

lic scrutiny from market participants, the public media,

and regulatory agencies. An empirical research question

is how various firms’ exposure to political uncertainty

impacts managerial incentives to participate in quality

accounting information because there is generally no clear

evidence on the impact of firms’ exposure to political risk

on financial reporting quality.

Our sample consists of 13,922 firm-year observations

in the U.S. from 2009 to 2019. We find that firms facing

higher firm-level political risk indeed have lower financial

reporting quality. In particular, a one-standard deviation

increase in firm-level political risk leads to a 2.13% decrease

in the firm’s earnings. Thus, the effect of firm-level polit-

ical risk is economically meaningful. We also find that

the firm-level political risk impact is more magnified for

companies with agency problems. Besides, the associa-

tion between firm-level political risk and the quality of

financial reporting is more simplified for companies with

higher growth opportunities that rely on external capital.

We conduct additional tests as well. First, we investigate

the impact of political risk at the firm level on the quality

of financial reporting in relation to firm size. We divided

our sample into two groups, classifying companies larger

than the median size as large and the remainder as small.

The result demonstrates that smaller firms are more sen-

sitive to political risk than larger firms, confirming that

different firms’ exposure to political risk reduces the qual-

ity of financial reporting, particularly for smaller firms.

Second, we test how the eight specific components of polit-

ical risk are related to firms’ financial reporting quality.

All eight topic-specific components show a negative rela-

tionship. Finally, we use propensity score matching to

minimize the endogeneity problem. The results obtained

using a matched sample are still consistent with our main

finding.

The current study makes substantial contributions.

First, this study contributes to the growing importance of

political unpredictability in the context of corporationsand

demonstrates a compelling need to investigate whether

firm-level political risk influences business decisions. Pre-

vious research has focused mostly on political risk at the

aggregate level in order to uncover the implications of

political risk on corporate funding (Çolak et al., 2017;Fran-

cis et al., 2014; Gao et al., 2019). In spite of this, Hassan

et al. (2019) discover that the majority of the variation in

political risk occurs at the firm level as opposed to the