Political Incentives to Suppress Negative Financial Information: Evidence from State-Controlled Chinese Firms

This paper examines the impact that political forces have on the financial reporting practices. Using a unique sample of listed Chinese firms ultimately controlled by local and/or provincial government entities, we test the proposition that the incentives of politicians and the local government shape financial reporting practices, especially with respect to the release of information about bad outcomes. We propose that politicians and managers of firms operating in regions with strong economic performance prospects, strong pro-market institutions and significant levels of foreign investment face the greatest political cost to reporting ex post bad news. In contrast, politicians implementing policies to reduce unemployment rates or to restructure underperforming assets face smaller penalties for releasing negative financial news. Similarly, the political/reputation cost to an individual manager for reporting bad news is likely to be smaller in those regions with poor expected performance or minimal foreign investment. We find that firms operating in provinces characterized by strong investor protections, minimal regulation and broadly seeking to maximize value (as opposed to full employment or social objectives) are more likely to experience negative stock price crashes. We also find that these same firms incorporate economic losses into accounting earnings in a less timely manner than firms domiciled in provinces with weak institutions. Further tests reveal that the level of suppression, as proxied by price crashes and a lack of timely loss recognition practices, is positively related to the extent of foreign direct investment in the province. The heightened level of suppression documented in these provinces is consistent with our predictions that managers and local politicians face large penalties if they report adverse outcomes in these settings.