Board Political Connection Effect on Downward Earnings
Management
Arniati
1
, AnAn Chiu
2
and Shaio Yan Huang
3
1
Department of Management Business, Politeknik Negeri Batam,
Ahmad Yani Street, Kota Batam, Kepulauan Riau, 29461, Indonesia
2
Department of International Business, Feng Chia University,
100, Wenhua Road, Xitun District, Taichung City, 40724 Taiwan
3
Department of Accounting & Information Technology, National Chung Cheng University,
168, Section 1, Daxue Road, Minxiong Township, Chiayi County, 62102 Taiwan
Keywords: board political connection, downward earning management, investor protection
Abstract: This study examined whether political connections effect on earnings management, in a new investigation of
political connection Indonesia's companies on downward real earnings management. Using data in two
periods President of Indonesia, this study provided empirical support that the connected firms tend to
underperform earning, using downward earnings management. This study also exhibits that the level of
earnings management for the connected firms before or after the President change in 2014 is different because
there have been changes in the minority investor protection policy.
1 INTRODUCTION
This study investigates the impacts of political
connection on earnings management strategy in
Indonesia. Political connections have more benefits to
the firm, especially to achieve outcomes that serve the
firm's perceived interests (Song, Nahm, & Zhang,
2017). One of the advantages is to manage profit,
which was identified by the lower quality of earnings
information on companies that have political
connections for countries with higher political
connection and corruption (Chaney, Faccio, &
Parsley, 2011). Agency conflicts in a politically
connected firm affect the reporting of poor-quality
accounting information (Chaney et al., 2011; Faccio,
2010; Ramanna & Roychowdhury, 2010). They
suggested that the firms perform earning management
activities to managing political cost, such as a
donation for an election and cost of debt if the firm
lender is a government-owned bank. Riahi Belkaoui
(2004) also suggested that firms dominated by
political influences tend to report lower quality
financial information to avoid intervention. The
protection from politicians leads to connected
1
Global Intelligence Alliance (GIA) is the partner for
organizations seeking to understand, compete and grow in
international markets.
companies to deliberately hide and obscure financial
information to benefit them at the expense of
investors (Leuz, Nanda, & Wysocki, 2003).
Utilize accrual, or real earnings management
would be maximized through coordinate the use of
both (Darrough & Rangan, 2005), especially if
managers of firms are aware of the rewards by
meeting the targets of earnings (Bartov, Givoly, &
Hayn, 2002). Variation in earnings management to
achieving the goals is not only for accrual-based
earnings management, but also for real earning
management (Kothari, Mizik, & Roychowdhury,
2016; Zang, 2012). However, there is a uniform
impact of political connection with earnings
management, while political and economic
conditions in each country are different.
Indonesia provides a particularly suitable setting
for examining the role of political connection for
earning management strategy. Indonesia is one of the
top five emerging market countries from 2012 to
2017 from Global Intelligence Alliance
(https://www.m-brain.com)
1
.
Political connections are commonplace in
Indonesia, and politicians tend to have a significant
Arniati, ., Chiu, A. and Huang, S.
Board Political Connection Effect on Downward Earnings Management.
DOI: 10.5220/0011312500003255
In Proceedings of the 3rd International Conference on Applied Economics and Social Science (ICAESS 2021), pages 155-165
ISBN: 978-989-758-605-7
Copyright
c
 2022 by SCITEPRESS – Science and Technology Publications, Lda. All rights reserved
155

influence on the firms (Faccio, 2010; Fisman, 2001).
Fisman (2001) proves that well-connected firms will
suffer more, relative to less-connected firms, in
reaction to a Suharto health rumor. It suggested that
more political connections in Indonesia with Suharto
in the Suharto era and after the fall of Suharto.
The relation between political officers and
business elites provides opportunities for businesses
to use political connections to extract economic rents.
Indeed expropriation of investor rights is carried out
by connected firms (Leuz et al., 2003). Previous
research discussing the political connection in
Indonesia uses the degree of political dependence on
the Soeharto family (e.g., Leuz and Oberholzer-Gee
(2006); Nys, Tarazi, and Trinugroho (2015)).
Political dynamics after Soeharto's era were changed
dramatically, become decentralized systems, multi-
party, and lost composition of parliament from the
military faction (Marcus Mietzner, 2013; Ruland &
Manea, 2013; Ziegenhain, 2016). It's exciting to study
political connection in Indonesia after Suharto's era,
especially since Yudhoyono's era because ideally,
civilian-military relation in national politics has been
since President Yudhoyono (Sebastian, 2013).
However, limited researches discuss the effect of
political connection on earning management in
Indonesia with a focus on earnings management.
Although Habib, Muhammadi, and Jiang (2017a)
investigated about political connections on earnings
management in Indonesia. However, they examined
the impact of the connections only on accrual
earnings management. Therefore, we will investigate
more detail using real earning management.
This study contributes to the political connections
literature. It extends previous researches to discuss
the effect of political connections on downward
earnings management in Indonesia in two presidential
periods, using real earning management. Downward
earning management is possible because companies
expect benefits from the government, such as subsidy
or tax incentives, form the government (Jiang, Hu,
Zhang, & Zhou, 2018).
This paper collects data of the Indonesia listed
firm through the Osiris database and Indonesia Stock
Exchange website from 2007 to 2017, where there are
different political and social environments through
two elections and one presidential change, i.e.,
Yudhoyono and Joko Widodo era. This research
suggests that firms with another kind of political
connections in Indonesia have a different impact on
accrual and real earnings management. The results
show that firms with political connections are more
likely to downward real earnings management.
The remainder of this paper was organized into
four following sections. In the second section, the
researchers describe the institutional background and
develop a hypothesis. The third section discusses the
sample and methodology. The fourth section presents
an empirical analysis results. The fifth section
presents the conclusion.
2 INSTITUTIONAL
BACKGROUND AND
HYPOTHESIS DEVELOPMENT
2.1 Political Connections in Indonesia
There is a famous and long political turmoil in
Indonesia starts from Suharto's time (1966-1998).
After that, there are short tenures of President
Habibie, President Abdurrahman Wahid, and
President Megawati that ended in 2004 (Indonesia-
Investments, 2017). Suharto constructed a secure
government, centralized, and military-dominated
government and Indonesia experienced significant
economic growth. Hence, the political condition in
Indonesia was strongly influenced by the President
Suharto era (Ruland & Manea, 2013). However,
Suharto is the most corrupt leader in modern history
(Transparency_International, 2004). Which caused
the economy and politics in Indonesia after Suharto
entered the reform era. Starting from Abdurrahman,
after that replaced by Megawati (Honna, 2003).
Political stability then appears to emerge under
President Yudhoyono from 2004 to 2014. To achieve
political stability, President Yudhoyono appointed
members of other parties to his cabinet. The new
political era after President Yudhoyono is President
Joko Widodo from 2014 to 2019. As a president in
the freedom of information era, President Joko
Widodo has implemented more corporate governance
issues, such as budget transparency, law enforcement,
and eradicating corruption (Indonesia-Investments,
2017).
The political connection may be changed in the
new president era because new policy from the
government will increase protection to investment in
Indonesia. The lower protection of investors
associated with lower quality of earning, indicated by
an increase of earnings management (Boonlert-U-
Thai, Meek, & Nabar, 2006; Houqe, van Zijl,
Dunstan, & Karim, 2012; Leuz et al., 2003).
Moreover, Enomoto, Kimura, and Yamaguchi (2015)
suggested that managers in countries with stronger
investor protections tend to engage in real earnings
ICAESS 2021 - The International Conference on Applied Economics and Social Science
156

management instead of accrual earnings
management. Habib et al. (2017a), by using a more
specific type of political connection in Indonesia,
their study provided that connected companies in
Indonesia more likely to engage accrual earning
management through related party transactions.
2.2 Political Connections and Earnings
Management
Accrual earnings management occurs when managers
choose accounting policies to achieve earnings
objectives (Dechow, Sloan, & Sweeney, 1995; Jones,
1991). Real earnings management occurs when
managers perform actions that change the timing or
structuring of operation and diverge from regular
business activity, such as manipulating sales,
reducing discretionary expenditures, and
overproducing inventory to obtain certain earnings
(Roychowdhury, 2006). Earning management
strategy, i.e., accrual-based and real earnings
management can be implemented with various
conditions, such as investor protections in a country
(Boonlert-U-Thai et al., 2006; Degeorge, Ding,
Jeanjean, & Stolowy, 2013; Enomoto et al., 2015;
Irani & Oesch, 2016).
Real earnings management is considered to be
more expensive than accrual-based earnings
management (Graham, Harvey, & Rajgopal, 2005;
Kim & Sohn, 2013), and it has an impact on cash
flow (Gunny, 2010). Moreover, real earnings
management is more difficult to detect than accrual
earnings management because it affects cash flows,
not under an existing auditing system, and not subject
to extensive controls and external monitoring by
society (Kim & Sohn, 2013; Wongsunwai, 2013).
Therefore, the firms with lower investor protection
tend to engage accrual earning management because
less costly (Enomoto et al., 2015; Irani & Oesch,
2016). On the contrary, firms with high pressure from
internal and external factors are more likely to
employ real earning management because of more
confidentiality (Kim & Sohn, 2013).
Agency conflicts in a politically connected firm
affect the reporting of poor-quality accounting
information (Chaney et al., 2011; Faccio, 2010;
Ramanna & Roychowdhury, 2010). They suggested
that the firms perform earning management activities
to managing political costs, such as a donation for an
election and the cost of debt if the firm lender is a
government-owned bank. Riahi Belkaoui (2004) also
2
The Indonesia Stock Exchange is Indonesian capital
market located in Jakarta. Before 2007, Indonesia has two
suggested that firms dominated by political
influences tend to report lower quality financial
information to avoid intervention. Moreover,
utilization of accrual-based and real earnings
management would be maximized through the
coordinated use of both (Darrough & Rangan, 2005),
especially if managers of firms are aware of the
rewards by meeting the targets of earnings (Bartov,
Givoly, & Hayn, 2002). Variation in earnings
management to achieving the goals is not only for
accrual-based earnings management but also for real
earning management (Kothari et al., 2016; Zang,
2012).
Political connection in Indonesia is increasing
from the Soeharto era to Joko Widodo era, although
with different patterns. The increasing of
entrepreneurs involved in politics and the decline in
military function in politics in Indonesia in recent
years has caused different patterns and impact of
political connection in Indonesia firms (Fukuoka,
2013). This difference is expected to have a different
impact on earnings management in Indonesia. The
politically connected firm in Indonesia also provides
more benefit to the company, such as easy to get a
loan from a bank, tax rate treatments (Faccio, 2010;
Habib et al., 2017a; Leuz & Oberholzer-Gee, 2006;
Nys et al., 2015). Hence, this has an impact on lower
investor protection in Indonesia and no regulation
regarding the involvement of politicians in the
company business, and also there is no rule for
punishing earnings management. It is possible for the
firm decrease earning using downward earnings
management. Therefore, firms with political
connections more likely to underperform earnings
management compared to firms without political
connections. Therefore, the hypothesis that:
Ha: Firms with political connections are more likely
to downward earnings management than with non-
connected firms.
3 RESEARCH METHODOLOGY
3.1 Data and Sample
This study collects data of the Indonesian listed
companies from Osiris database and the firm's
financial reports downloaded from the Indonesia
Stock Exchange (http://www.idx.co.id/index-
En.html)
2
. We hand-collect the names and the number
of the board of commissioners, the board of director
capital market, i.e. Jakarta Stock Exchange and Surabaya
Stock Exchange. These capital market merge in 2007.
Board Political Connection Effect on Downward Earnings Management
157

from the profile of commissioners and directors
section on annual reports and financial statements.
We check the name of board members with political
connections to ensure the information of political
connections through other resources such as
government websites. For unavailable data, We
searching for news from online websites. This paper
obtains 3.625 firm-year observations or 427 firms
from 2007 to 2017, which the political connection
data and financial report data available complete in
published annual reports, with board profile and
database. The data exclude financial industry due to
the different operating system between financial and
nonfinancial industry. The data period includes Table
1 illustrates the sample collection process.
Table 1: Sample selection
Information Observations
All firm-year observation from 2007 to
2017
(
471 firms
)
4.721
Less:
Number of firms-year observations
financial secto
r
621
Number of firms-year observations
with a ne
g
ative book value
186
Number of firms-year observations
with missing data of dependent
variables
190
Number of firms-year observations
with missing data of other control
variables
97
Final Sample (firms-year) 3.625
Final Sample (firms) 427
Table 2 Panel A provides industry distribution of
the firm-year samples, revealing that manufacturing
industry accounts for 42.26 percent of the total firm-
year samples. SIC codes are used to classify industry.
Table 2 Panel A also reports the percentage of
political connection of the sample observations by
industry. The highest percentage is the construction
industry for 51.12 percent of total sample
observations. Table 2 Panel B shows the sample
distributions by year. Interestingly, the percentage of
political connections increase over time, from 32.62
percent in 2007 to be 42.67 percent in 2017, and
decline to be 41.87 percent in 2017 with average 39.7
percent firms-years have political connections.
Table 2: Sample distribution
Panel A: Sam
p
le Distribution b
y
Industr
y
Industry
Firm-
year
% of firm-
year/Total
fir
m
PC
Firm-
y
ea
r
% of firm-
year/indust
r
y
Agriculture,
Forestry, And
Fishin
g
128 3.53 54 42.19
Minin
g
311 8.58 156 50.16
Construction 178 4.91 91 51.12
Manufacturing 1532 42.26 460 30.03
Transportation,
Communicatio
ns, Electric,
Gas, and
Sanitary
Services
480 13.24 223 46.46
Wholesale
Trade
321 8.86 136 42.37
Retail Trade 359 9.9 179 49.86
Services 316 8.72 140 44.3
Total/Average 3625 100 1439 39.7
Panel B: Sam
p
le Distribution b
y
Yea
r
Years Firm
% of
firms/To
tal fir
m
PC
Firm
% of PC
firms/year
2007 233 6.43 76 32.62
2008 265 7.31 96 36.23
2009 281 7.75 105 37.37
2010 294 8.11 114 38.78
2011 328 9.05 131 39.94
2012 348 9.6 139 39.94
2013 367 10.12 148 40.33
2014 376 10.37 154 40.96
2015 382 10.54 163 42.67
2016 376 10.37 156 41.49
2017 375 10.34 157 41.87
Total/Average 3625 100 1439 39.7
3.2 Measuring of Political Connections
This paper measures the political conditions of
Indonesia following Faccio (2006), Fan, Wong, and
Zhang (2007) and (Cheng, 2013). The firm is defined
as politically connected (POLCON) if at least one
board of commissioner or board of director: (a) is a
current or former member of parliament or the party,
(b) is a former minister or directorate general (under
minister) or local government, and (c) is a former
army or police. This study use minister or directorate
general, because of this position has a durable power
of government. Moreover, this study uses the former
army and police as a military connection, because of
the base on history for police and army in Indonesia
came from the same institution (Marcus Mietzner,
2006; M. Mietzner, 2008).
ICAESS 2021 - The International Conference on Applied Economics and Social Science
158

3.3 Measuring of Earnings
Management
This study use real earning management as a
dependent variable. The characteristics of real
earning management are abnormally low cash flows
from operations, abnormally high production costs,
and abnormally low discretionary expenses. This
study follows Roychowdhury (2006) to estimate
abnormal levels of operating cash flows,
discretionary expenditures, and production in
equations (1), (2) and (3) as follows:
𝐶𝐹𝑂

𝐴


=𝑘


1
𝐴



+𝑘


𝑅𝐸𝑉
𝐴



+𝑘


∆𝑅𝐸𝑉
𝐴



+𝜀
.....(1)
𝐷𝐼𝑆𝑋

𝐴


=𝑘


1
𝐴



+𝑘


𝑅𝐸𝑉
𝐴



+𝜀
…………………………..(2)
𝑃𝑅𝑂𝐷

𝐴


=𝑘


1
𝐴



+ 𝑘


𝑅𝐸𝑉
𝐴



+ 𝑘


∆𝑅𝐸𝑉
𝐴



+𝑘


∆𝑅𝐸𝑉

𝐴


+𝜀
..(3)
The CFO is operating cash flows; A is total assets;
REV is net sales; ΔREV is the change in net sales;
DISX is the sum of research and development
expenses, sales expenses, general and administrative
expenses, and advertising expenses, and PROD is the
sum of the costs of goods sold and the change in
inventories. Equations (1) – (3) estimated for each
industry and year to be real earning management from
operating cash flow (REM_CFO), real earnings
management from the cost of production
(REM_PROD), and real earning management from
general discretionary (REM_DISX).
These studies follow Cohen, Dey, and Lys (2008),
Cohen and Zarowin (2010) and Braam, Nandy,
Weitzel, and Lodh (2015) to capture the aggregate
effects of real earnings management. This study
combined the three individual real earnings
management measures to create comprehensive
measures of real earnings management. The
aggregate real earning management is the amount of
the standardized variables of REM_CFO,
REM_DISX, and REM_PROD to make REM_CPD.
The higher the amount of REM_CPD exhibit that the
firm is engaged in real activities manipulation. To
investigate downward real earning managament, this
study use dummy variable. The value is 1 if a firm has
negative REM_CPD, with notation DEM.
3.4 Empirical Model
This research implements Heckman two-stage
procedure to avoid potential endogeneity of the
diversification decision. Heckman's self-selection
model without valid instrumental variables can
produce unreliable results. In the first stage of the
Heckman model, this study use the firm location
(HQ_Capital), a dummy variable coded 1 if the firm
located in the capital city Guedhami, Pittman, and
Saffar (2014). The following equation (4) is the
Heckman first-stage probit regression:
𝑃𝑂𝐿𝐶𝑂𝑁
,
=𝛼

+ 𝛽

𝐻𝑄_𝐶𝑎𝑝𝑖𝑡𝑎𝑙
,
+ 𝛽

𝑆𝑖𝑧𝑒
,
+𝛽

𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒
,
+𝛽

𝐶𝑎𝑝𝑖𝑛𝑡
,
+𝛽

𝐺𝑟𝑜𝑤𝑡ℎ
,
+𝛽

𝑇𝑜𝑝𝑠ℎ𝑎𝑟𝑒
,
+𝛽

𝐹𝑜𝑟𝑜𝑤𝑛
,
+𝛽

𝐼𝑛𝑑𝑒𝑝𝑏𝑜𝑎𝑟𝑑
,
+𝛽

𝐵𝑖𝑔4
,
+ 𝑖𝑛𝑑𝑢𝑠𝑡𝑟𝑦 𝑎𝑛𝑑 𝑦𝑒𝑎𝑟 𝑑𝑢𝑚𝑚𝑖𝑒𝑠
+ 𝜀……………………………(4)
POLCON equals to 1 if the firm has a political
connection and 0 otherwise. The next equation is the
Original Least Squares regression. The following
model (5) is used to estimate political connections
and earning management:
𝐷𝐸𝑀
,
=𝛼

+ 𝛽

𝑃𝑂𝐿𝐶𝑂𝑁
,
+ 𝛽

𝑆𝑖𝑧𝑒
,
+𝛽

𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒
,
+𝛽

𝐶𝑎𝑝𝑖𝑛𝑡
,
+𝛽

𝐺𝑟𝑜𝑤𝑡ℎ
,
+𝛽

𝑇𝑜𝑝𝑠ℎ𝑎𝑟𝑒
,
+𝛽

𝐹𝑜𝑟𝑜𝑤𝑛
,
+𝛽

𝐼𝑛𝑑𝑒𝑝𝑏𝑜𝑎𝑟𝑑
,
+𝛽

𝐵𝑖𝑔4
,
+ 𝑖𝑛𝑑𝑢𝑠𝑡𝑟𝑦 𝑎𝑛𝑑 𝑦𝑒𝑎𝑟 𝑑𝑢𝑚𝑚𝑖𝑒𝑠
+ 𝜀……….…………………(5)
The next equation is Heckman's second-stage
regression. This study use coefficient estimates from
the equation (6) to construct the Inverse Mills Ratio
of POLCON as a control variable in the equations (6).
The equation is:
𝐷𝐸𝑀
,
=𝛼

+ 𝛽

𝑃𝑂𝐿𝐶𝑂𝑁
,
+ 𝛽

𝑆𝑖𝑧𝑒
,
+𝛽

𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒
,
+𝛽

𝐶𝑎𝑝𝑖𝑛𝑡
,
+𝛽

𝐺𝑟𝑜𝑤𝑡ℎ
,
+𝛽

𝑇𝑜𝑝𝑠ℎ𝑎𝑟𝑒
,
+𝛽

𝐹𝑜𝑟𝑜𝑤𝑛
,
+𝛽

𝐼𝑛𝑑𝑒𝑝𝑏𝑜𝑎𝑟𝑑
,
+𝛽

𝐵𝑖𝑔4
,
+ 𝛽

𝐼𝑀𝑅_𝑃𝑂𝐿𝐶𝑂𝑁
,
+ 𝑖𝑛𝑑𝑢𝑠𝑡𝑟𝑦 𝑎𝑛𝑑 𝑦𝑒𝑎𝑟 𝑑𝑢𝑚𝑚𝑖𝑒𝑠
+ 𝜀……….…………………(6)
Board Political Connection Effect on Downward Earnings Management
159

This research controls following variables: firm
size (Size), capital structure (Leverage), capital
intensity (Capint), and firm growth (Growth) (Chen,
Firth, & Xu, 2009; Muttakin, Monem, Khan, &
Subramaniam, 2015; Wu, Wu, Zhou, & Wu, 2012).
This study added ownership as a control variable,
such as a proportion of top shareholder (Topshare)
and foreign ownership (Forown). Topshare and
forown are essential roles in mitigating real earning
management (Guo, Huang, Zhang, & Zhou, 2015).
Researchers add a proportion of independent boards
(Indepr) and the number of the board (Board). The
Independent board provides active monitoring of
earning management and mitigated family-controlled
firms (Jaggi, Leung, & Gul, 2009). Xie, Davidson,
and DaDalt (2003) suggested that Board size related
to earnings management. We also control audit
quality using the big audit firm (Big4) because high
audit
quality reduces earning management
(Guedhami et al., 2014; Habib, Muhammadi, & Jiang,
2017b). This study also included industry dummies
and year dummies variable in the models to control
for the industry effect and year. The completion of a
variable definition explained in Table 3.
Table 3: Variable definition
Variable Definition
Dependent Variable (earning management proxies):
DEM 1 if the firm has a negative real earning
mana
g
ement and 0 otherwise;
Independent Variable:
POLCON 1 if board formerly or currently from
the army or police, minister, deputy,
director, or head of the division,
parliament (central or local
g
overnment
)
, and 0 otherwise;
Control Variables:
Size market capital value, log-transformed;
Leverage long-term debt divided by total assets in
y
ear t-1;
Capint Property and equipment divided by
total assets in year t-1;
Growth total sales divided by total sales in year
t-1;
Topshare percentages of the top shareholder in
the com
p
an
y
;
Forown percentages of foreign ownership in the
company;
Indepboard percentages of independent boards in
the company;
Big4 1 if the firm uses the big four public
accountants, 0 otherwise;
Year 1 if firm i is a member of year j;
Industry 1 if firm i is a member of industry j;
Selection Model Variable:
HQ_Capital 1 if the firm located in the capital city,
0 otherwise;
4 EMPIRICAL ANALYSIS
4.1 Descriptive Analysis
Table 4 presents the results of descriptive statistics.
The mean value of downward real earning
management (DEM) is 0.551. Averagely, political
connection (POLCON) is 39,7 percent of total
observations. The mean of POLCON almost the same
with corresponding data of Habib et al. (2017a).
Table 4: Descriptive statistics
Variable N
Mea
n
Media
n
Std
De
v
Min
Ma
x
DEM 3625 0.551 1 0.497 0 1
POLCON 3625 0.397 0 0.489 0 1
Size 3625 21.237 21.237 1.657 17.091 25.05
9
Growth 3625 0.232 0.106 0.795 -0.792 6.195
Leverage 3625 0.584 0.558 0.327 0.045 2.11
0
Capin
t
3625 0.406 0.358 0.303 0.002 1.59
0
MTB 3625 3.814 1.511 8.2562 0.125 62.69
6
Topshare 3625 0.515 0.510 0.221 0 1
Forown 3625 0.236 0.100 0.287 0 0.990
0
Indepboa
rd
3625 0.217 0.200 0.109 0 0.625
0
Big4 3625 0.3630 0 0.480 0 1
Notes: This table contains summary statistics for the raw
variables in our analysis. All the continuous independent
variables and control variables are winsorized at the 1
p
ercent level.
Source: SAS Output – SAS 9.4
4.2 Political Connections and
Downward Earnings
Management
Table 5 exhibits the results of equation (5) that
political connections (POLCON) have significant
positive impacts on downward real earning
management (coefficient 0.084, t-statistic 2.29, 0.05
significant). This results support the hypothesis (Ha).
The result indicates that political connection effect on
earning management practices than those without
political connections.
The political connection is available to help the
firms in many business fields, in the form of policy or
access. The firms with political connections have
more access to financial funding, contracts with the
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government, and preferential tax treatments
(Claessens, Feijen, & Laeven, 2008; Faccio, 2010;
Goldman, Rocholl, & So, 2013; Wu et al., 2012). The
marginal benefit for the connections is substantial to
the firm to engage in earning management (Zang,
2012). Hence, the connection is able to drive firm to
underperform their earnings. Therefore, firms with
political connections may do downward earnings
management than firms without political connections.
Table 5: Political connection and earnings management
Variable DEM
POLCON 0.084**
(
2.29
)
Size 0.067***
(
5.7
)
Growth 0.0234**
(
2.01
)
Leverage -0.379***
(
-8.25
)
Ca
p
int 0.327***
(
6.78
)
Topshare 0.100
(
1.23
)
Forown -0.026
(
-0.43
)
Indepboard -0.06
(
-0.42
)
Bi
g
4 0.024
(
0.57
)
Interce
p
t -0.853***
(
-3.33
)
Industr
y
& Year FE Y
R S
q
uare 0.1861
Num. of observation 3625
Notes: Values in parentheses are t-values clustered at
each industry year. *, **, and *** indicate significance
at the 0.10, 0.05, and 0.01 levels, respectively. All VIF
Less than 10, All continuous variables are winsorized
1 percent at each end of the distribution.
Source: SAS Output – SAS 9.4
4.3 Test of Endogeneity
This paper presents the results of Heckman first-stage
probit regression from the equation (4) and the
Heckman second-stage regression from the equation
(6) in Table 6 and 7. The results show that capital city
as headquarter (HQ_Capital) is positive with
politically connected (coefficient 0.149, t-statistic
2.24, 0.05 significant). Thus, the firm locations are
good predictors of the political connection.
Table 6: First-stage Heckman test
Variable POLCON
HQ
_
Ca
p
ital 0.149**
(
2.24
)
SIZE 0.193***
(
11.85
)
Growth -0.070***
(
-2.95
)
Levera
g
e 0.133*
(
1.88
)
Ca
p
int 0.091
(
1.14
)
To
p
share 0.589***
(
5.78
)
Forown -0.248***
(
-3.10
)
Inde
p
boar
d
0.939***
(
4.56
)
A
g
e 0.395***
-6.37
Interce
p
t -5.583***
(
-15.31
)
Industr
y
& Year FE Y
R S
q
uare 0.1058
Num. of observation 3625
Notes: Values in parentheses are t-values clustered at
each industry year. *, **, and *** indicate significance
at the 0.10, 0.05, and 0.01 levels, respectively. All VIF
Less than 10, All continuous variables are winsorized 1
p
ercent at each end of the distribution.
Source: SAS Output – SAS 9.4
After fixing the potential self-selection bias by
applying the Heckman test, the result remains the
same. Table 7 shows that political connections have
an impact on downward real earning management.
The results support (H. Fan, 2017) because the
politically connected firms have more advantages
from the connections, such as subsidy from the
government.
Table 7: The Second-stage Heckman test of Political
connection and earnings management
Variable DEM
POLCON 0.058*
(
1.79
)
IMR
_
POLCON -0.062***
(
-5.97
)
Control Variable Y
Industr
y
& Year FE Y
R S
q
uare 0.1867
Num. of observation 3625
Notes: Values in parentheses are t-values clustered at
each industry year. *, **, and *** indicate significance
at the 0.10, 0.05, and 0.01 levels, respectively. All VIF
Less than 10, All continuous variables are winsorized 1
p
ercent at each end of the distribution.
Source: SAS Output – SAS 9.4
Board Political Connection Effect on Downward Earnings Management
161

4.4 Additional Analysis
4.4.1 Political Connection and Earnings
Management in Different Political
Environment
This section splits the analysis to be two sub-periods
presidential, 2007 to 2014, as represented the
previous presidential era before the 2014 election,
and after 2014 as represented the new presidential era
after the 2014 election. It is to investigate whether the
differences in the political environment effect on
earnings management. Table 8 proves that there is a
significant impact political connection (POLCON) on
downward real earning management in Yudhoyono
era (2007-2014). However, there is no impact of
political connections in Joko Widodo era (2014-
2015).
This result suggested that the connected firms in
the new political environment are more likely to less
earning management activity because difficult to the
previous political connection to connect with the new
political era (new President and parliament) (Leuz &
Oberholzer-Gee, 2006), especially if there is a change
of President and the coalition party. Therefore,
managers with previous political connections do not
take advantage of their relation. Besides that, investor
protection in Indonesia after the 2014 election is
increasing, indicated by increasing ease of doing
business (EODB) Indonesia rank is very significant
from 120 to 72 levels from 190 countries. Therefore,
the connected firm might reduce the earning
management level after the change of investor
protection or the managers will the changes in earning
management type to accrual earning management
(Enomoto et al., 2015; Leuz et al., 2003).
Table 8: The Second-stage Heckman test of Political
connection and earnings management for two periods of
President
Variable
DEM (2007-
2014)
DEM (2015-
2017)
POLCON 0.063* 0.024
(1.68) (0.62)
IMR_POLCON -0.672*** -0.563***
(-5.847) (-4.57)
Control Variable Y Y
Industry & Year FE Y Y
R Square 0.1890 0.1728
Num. of observation 2509 1116
Notes: Values in parentheses are t-values clustered at
each industry year. *, **, and *** indicate significance at
the 0.10, 0.05, and 0.01 levels, respectively. All VIF
Less than 10, All continuous variables are winsorized 1
p
ercent at each end of the distribution.
Source: SAS Output – SAS 9.4
4.4.2 Political Connection and Real
Earnings Management
Table 9 proves that political connection significantly
impacts on negative real earning management. This
regression proves that the firm with the political
connection may engage negative real earning
management as an effort to shows lower accounting
performance.
Table 9: The Second-stage Heckman test of Political
connection and earnings management
Variable REM
POLCON -0.465***
(
-2.55
)
IMR
_
POLCON 1.593***
(
2.91
)
Control Variable Y
Industr
y
& Year FE Y
R S
q
uare 0.1977
Num. of observation 3625
Notes: Values in parentheses are t-values clustered at
each industry year. *, **, and *** indicate significance
at the 0.10, 0.05, and 0.01 levels, respectively. All VIF
Less than 10, All continuous variables are winsorized 1
p
ercent at each end of the distribution.
Source: SAS Output – SAS 9.4
5 CONCLUSIONS
This study investigates the impact of political
connections on earnings management in the
Indonesia context. The research proves that political
connections associated with earning information
quality in Indonesia. The connected firms have an
impact on downward real earning management. The
firm expects that the firm will obtain benefits from
lower-earning, i.e., tax incentives, and subsidy from
the government (Jiang et al., 2018).
Moreover, there are political environment effects
on the role of political connection with earning
management activity that is before or after the 2014
election. The political connections perform
downward earnings management in the Yudoyono
era. After 2014 election, Indonesia entered in a new
phase with new President from civilian, after 10-year
ICAESS 2021 - The International Conference on Applied Economics and Social Science
162

President from the military. The policy to increase
investor protection through law enforcement,
increasing pers freedom is able to reduce earning
management level. Hence, the manager connected
firm may reduce earning management. Other reasons
are including the cost of earning management
activities and benefit from the connection for
business.
This study implies that shareholders can consider
the advantages of having the board with good
government connections when they are selecting the
board members. Boards with good government
connections can benefit firms in several ways, such as
taxes, financing, cost strategy, or business strategy.
As for future research, researchers can further explore
different measures of political connections in
Indonesia, such as position in executive or military or
using the independent board connections. In addition,
researchers can also investigate interaction effects
that potentially influence the choices for different
earnings management strategies, such as public
monitoring, new regulation, board power, and board
ability.
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