DO POLITICAL CONNECTIONS MITIGATE THE DETRIMENTAL EFFECT OF EARNINGS MANAGEMENT? EVIDENCE FROM COST OF DEBT

Abstract

This study investigates the conditional impact of political connections on the relationship between earnings management and the cost of debt. The theoretical framework is grounded in resource dependence and agency perspectives. The sample comprises non-financial firms listed on the Indonesia Stock Exchange from 2010 to 2020. We observe a positive correlation between earnings management and the cost of debt. Political connections alleviate the adverse effects of earnings management, with an estimated reduction of US$1.375 million in interest paid, aligning with the resource dependence theory. Additional tests indicate that the mitigating effect of political connections is more pronounced in firms experiencing inferior financial performance, establishing connections to higher-ranking politicians, and securing debt solely from bank loans. Furthermore, we observe that debtholders may be less adept at detecting real operations-based earnings management in their lending decisions. Our results remain robust to various measures of earnings management and political connections, as well as different estimation methods to address endogeneity issues.