Political connections, institutional monitoring and earnings quality in Malaysia

This study builds on political economy theory to examine the association between politically connected firms and earnings quality in Malaysia. Since Shleifer and Vishny (1986) theory of large shareholders suggests that a firm’s agency problems can be partially alleviated through monitoring by institutional investors, this study also investigates the effect of institutional investors’ ownership on the association between politically connected firms and earnings quality. Further, this study also investigates whether the domiciles of institutional investors have any influence on the association between politically connected firms and earnings quality, since the theory of institutional investor heterogeneity suggests that a firm’s outcome will differ according to different types of institutional investors (example local or foreign institutions). This study is motivated by the following factors. First, a cross-country study conducted by Chaney, Faccio, and Parsley (2011) find that politically connected firms are associated with poor earnings quality. While cross-country findings can be generalised within countries in the same region or cluster, it cannot capture the unique or special institutional setting of a particular country in terms of political, economic and social structure. In addition, econometric problems such as omitted variables and endogeneity issues are more severe in research that is based on cross-country data (Miller, 2004). In order to mitigate these potential problems, this study takes a single country approach by focusing on Malaysia. By focusing on a single country, the researcher can construct variables that capture the unique or special institutional setting of Malaysia. This will further enrich the political economy literature (Gul, 2006), particularly in emerging economies or capital markets. Second, prior studies document conflicting results on the association between politically connected firms and firm outcomes. For example, Bliss and Gul (2012a) show a positive association between politically connections and the cost of debt in Malaysia, but a study by Houston, Jiang, Lin, and Ma (2014) document a negative association between politically connected firms and the cost of bank loans in the United States (U.S.). This could be attributed to the institutional, cultural and behavioural differences that exist between emerging and developed economies (Fan, Wei, & Xu, 2011). This study, by examining the link between politically connected firms and earnings quality attempts to shed some light on this controversy. Third, the literature on institutional investor suggests that institutional monitoring is associated with higher firm performance and better firm governance (Aggarwal, Erel, Ferreira, & Matos, 2011; Chung & Zhang, 2011; Cornett, Marcus, & Tehranian, 2008; Cronqvist & Fahlenbrach, 2009; Ferreira & Matos, 2008; Hartzell & Starks, 2003; Shin & Seo, 2011). Therefore, it is not surprising that international regulators have frequently called upon institutional investors to play an active monitoring role in the firm, particularly after the global financial crisis 2008-2009 (OECD, 2009). This call is justified on the premise that several studies have documented an increasing trend in global institutional ownership in the corporate sectors and capital markets (Aggarwal et al., 2011; Ferreira & Matos, 2008; Gillan & Starks, 2003; IMF, 2013; Leuz, Lins, & Warnock, 2010). However, no evidence has yet been found on the effect of institutional monitoring in politically connected firms, particularly in the area of earnings quality. Therefore, this study attempts to fill this gap in the literature of political economy and institutional investor. Fourth, the theory of institutional investor heterogeneity suggests that institutional investors should not be seen as homogenous, but should be viewed as heterogeneous i.e. as different types of institutional investors such as banks, insurance companies, mutual funds and public pension funds. A recent stream of research suggests that the domicile of an institutional investor is significantly associated with firm governance and performance (Aggarwal et al., 2011; Ferreira & Matos, 2008; Leuz et al., 2010; Tee, Gul, Foo, & Majid, 2014). Therefore, this study also considers whether the domicile (local versus foreign) of an institutional investor can produce different monitoring outcomes on the association between politically connected firms and earnings quality. This study has several contributions to the policy makers and market participants in the Malaysian capital markets. First, this study documents strong evidence that institutional investors can play an effective monitoring role in a firm. Thus, it provides a strong basis for the Securities Commission of Malaysia to include institutional investors as one of the major component of corporate governance best practices. Second, regulators such as Bursa Malaysia (Malaysian Stock Exchange) and Securities Commission of Malaysia should increase their surveillance and monitoring effort, particularly on firms with close ties to the government. Finally, in view of poor earnings quality and weak earnings persistence in Malaysian politically connected firms, institutional investors, individual investors and auditors should increase their scrutiny on the accounting information provided by these connected firms. Institutional investors should intensify their monitoring to reduce opportunistic earnings management by controlling shareholders or top managers. Additionally, individual investors should be more vigilant over the financial information provided by politically connected firms. Finally, auditors as the gatekeepers of the quality of financial reporting should intensify their audit effort in order to provide more reliable accounting information to investors and regulators.