Political freedom and earnings management

We hypothesize that a deteriorated political freedom environment increases firms’ incentive to undertake earnings management. Using country-level political freedom data for 42 countries collected over the period from 1990 to 2017, we document a significantly positive relationship between a deteriorated political freedom environment and earnings management. Tests based on the instrumental variable and difference-in-differences frameworks provide evidence of a causal link between political freedom and earnings management. We further show that the effect of political freedom on earnings management is more pronounced for firms with external financing needs as well as for firms with stronger precautionary incentives, and that the effect is reduced if corporate governance improves. Our findings suggest that a deterioration in political freedom is an important obstacle to investors when accessing a firm’s performance.