Firms have a choice about how they report their earnings – they can adjust the timing of what they report, or they can alter their actual business activities to change their annual bottom line. In new research, Antonios Kallias, Konstantinos Kallias, Jia Liu, Kamran Malikov and Song Zhang examine the relationship between how firms manage their earnings and their political relationships. They find that firms with more transactional political relationships focus on low-cost short-term earnings manipulation. By contrast, firms that have high-value, long-term, political relationships are more willing to change their actual business activities to maintain those relationships, potentially protecting their political allies from reputational risk.
The idea that firms influence politics through behavior like lobbying is nothing new, but firms can also influence political connections through less well-known practices such as how they report on their earnings. In new research, we explore how firms strategically align their financial reporting with the nature of their political connections. We investigate how the characteristics of a firm’s political ties—whether transactional or relational—determine how it chooses between two major methods of earnings management: accruals-based earnings management and real earnings management. Our work introduces a framework that explains not only how political connections influence corporate behavior, but also why firms make the reporting choices they do.
What exactly is Earnings Management?
At its core, Earnings Management (EM) is the practice of presenting a company’s financial results in a way that looks smoother or stronger than they might otherwise appear. Firms do this to meet market expectations, reassure investors, or avoid regulatory attention. There are two main methods firms use to present their financial results:
- Accruals-based earnings management (AEM): These are accounting adjustments that change reported profits without altering operations—for example, delaying expense recognition or recording sales early. AEM is relatively cheap but easier to detect because accruals reverse in later periods.
- Real earnings management (REM): Adjusting actual business activities—for example, cutting R&D, reducing investment, or offering steep discounts to boost sales. REM, disguised as routine operational choices, is harder to detect yet detrimental to long-term performance.
A simple example: Suppose a company expects $95 million in profit but wants to show $100 million (it could be to impress investors or influence its share price). It could use AEM by shifting the timing of expenses, recording $5 million of this year’s costs into next year’s accounts. The expense is already there; it is just to be recognized later. Or it could use REM by skipping a planned $5 million investment in essential equipment. In this case, the cost never occurs, but the firm sacrifices an important investment, achieving higher profit by cutting back on real activity. Both approaches get the company to the $100 million profit figure, but one manipulates when costs are reported, while the other avoids them at the expense of future performance.
Political connections and earnings management
Earnings Management (EM) has long been a concern in business research. Political ties can provide firms with contracts, lighter regulation, and reputational buffers. But while several studies explore the link between political ties and EM, they treat political connections as static. Some studies claim that political ties embolden firms to manipulate earnings, assuming that such connections will shield them from regulatory consequences. Others argue the opposite: that politically connected firms are more cautious, fearing that detection would jeopardize their political goodwill. Our research moves beyond this dichotomy by posing a deeper, more contextual question: what kind of political relationship does a firm have—and how does that shape its financial behavior?
To answer this, we have developed a range, drawn from contract law theory and organizational studies, which covers the full spectrum from transactional to relational political strategies. At one end of the spectrum are transactional political strategies, whereby firms make short-term, issue-specific money contributions to politicians in exchange for immediate, clearly defined policy favors. These are instrumental relationships—more like one-off trades than lasting partnerships. Firms in this category tend to treat their political allies as expendable and show little concern for shielding them from reputational harm. Relational political strategies are at the other end of the spectrum, distinguished by repeated, long-term contributions and the formation of durable, trust-based alliances. In these, firms see politicians as strategic partners whose reputation matters and who must be protected from any fallout from unethical corporate behavior. It is this distinction, we argue, that fundamentally reshapes the earnings management trade-off.
Earnings management practices and firms’ approaches to political giving
Our analysis is based on a large dataset of US firms’ political money contributions. We use the duration of uninterrupted contributions to Political Action Committees (PACs) to politicians as a proxy for the nature of the political relationship—longer durations indicating relational strategies, and shorter or intermittent ones reflecting transactional approaches. We then examine how these different tactics correlate with the two main forms of EM.
Our findings reveal a systematic pattern: firms that follow a transactional approach to political giving rely heavily on accruals-based earnings management (AEM). They are less concerned with the reputational damage their accounting practices may cause to affiliated politicians and more focused on short-term, low-cost manipulation. Conversely, firms that adopt a relational approach substitute AEM with real earnings management (REM), opting for a more camouflaged form of EM that protects their political allies from public scandal or electoral backlash. Importantly, we find that this shift does not result in less EM overall. Instead, we see a perfect substitution: as AEM declines, REM rises by an equivalent amount, and vice versa. The method changes, but the magnitude of manipulation remains stable.
Previous studies that focused solely on one EM method—typically AEM— seem to have misread declines in accrual manipulation as signs of enhanced financial reporting quality. Our findings suggest that such reductions may simply reflect a shift toward REM rather than a genuine decline in overall EM.
Photo by Jakub Żerdzicki on Unsplash
Firms change their earnings management to protect their political relationships
Digging deeper, we explore whether the shift from AEM to REM is driven by the firm’s own characteristics or by the stature and influence of the politicians they support. Using detailed information on the political profiles of PAC recipients—including their congressional rank and the relevance of their committee assignments to the donor firm’s industry—we find that the substitution is more pronounced when the affiliated politicians are especially powerful or industry-relevant. In contrast, firm-level prestige, such as being listed among the most admired companies, does not significantly moderate the effect. This strongly suggests that the reputational risk to politicians, rather than to firms, is the primary driver of the EM trade-off. Firms bear the higher cost of REM specifically to protect high-value political relationships—not merely to burnish their own image.
To further support our argument that goodwill trust underlies these patterns, we examine what happens when political trust breaks down. First, we study firms that abruptly end their political giving, signaling the end of a relational tie. In such cases, we observe a reversion from REM back to AEM—once the relationship is no longer worth preserving, firms return to the cheaper, more visible method. Second, we analyze the fallout from the Jack Abramoff lobbying scandal, which severely damaged trust in the US political scene. Our analysis found that firms exposed to the scandal reversed their EM methods in the same direction: away from costly REM and back toward AEM. These shifts confirm that trust, not just relationship duration, is the critical mechanism at play.
Looking behind the numbers
Beyond financial reporting, our study contributes to a broader conversation about corporate accountability and reputational risk. The logic we uncover—that firms behave more cautiously when they are embedded in trust-based, long-term relationships—naturally extends to other domains, such as environmental practices, supply chain management, and joint ventures. When external stakeholders—whether politicians, customers, or partners—lack monitoring capacity but have reputational capital, firms may choose costly concealment over visible misconduct.
For regulators, these findings underscore the need to look beyond headline numbers and instead focus on the methods of earnings management. Since real earnings management is harder to detect and more disruptive to operations, it poses unique challenges for enforcement and oversight. Disclosures about political contributions, particularly their continuity and objectives, could offer valuable clues for anticipating firms’ financial reporting behavior. Investors, too, should be alert to the EM implications of a firm’s political strategy—not all connections are alike, and some may come with hidden financial costs. Finally, managers should reflect carefully on the strategic value of their political ties; while relational strategies offer longer-term benefits, they also demand a greater degree of reputational stewardship and financial transparency.
Our work shifts the debate from whether political connections affect EM to how and why. By illuminating the trust-driven calculus behind the EM method, we offer a dynamic and theory-informed explanation of corporate behavior that aligns political economy with earnings reporting. The relationships that firms choose to cherish—and those they allow to perish—ultimately determine not just their political fortunes, but the form and integrity of their financial disclosures.