Political Connections and Related Party Transactions: Evidence from Indonesia

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Abstract

This paper examines whether politically connected firms use related party transactions as a tunneling mechanism in Indonesia. We further investigate whether the presence of tunneling compels managers to manage earnings to conceal such expropriation of resources. Our study is motivated by conflicting evidence in the extant literature about the role of political connections and related party transactions. Using data from Indonesia, we document that politically connected firms use related party loans to tunnel resources, and that this effect is more pronounced for firms with government connections. We further document that politically connected firms manage earnings to conceal their tunneling activities. By documenting the role of related party transactions as a specific channel through which connected firms expropriate resources, we enrich the political connection and related party transactions literature.

Introduction

This paper examines whether politically connected firms use related party transactions (hereafter RPTs) as a tunneling mechanism in Indonesia. We further investigate whether the presence of tunneling compels managers to manage earnings to conceal such expropriation of resources. This study is motivated by conflicting views on whether political connections are beneficial or detrimental to stakeholder interests. Evidence supporting the beneficial effects of political connections reveals that such connections enhance firms' value (Fisman, 2001), provide privileged access to lenders thereby reducing the cost of debt (Boubakri et al., 2012, Boubakri et al., 2012, Faccio, 2006, Houston et al., 2014, Khwaja and Mian, 2005, Leuz and Oberholzer-Gee, 2006), and lower the incidence of bankruptcy by ensuring government bailouts (Faccio, Masulis, & McConnell, 2006). On the other hand, political connections are deemed harmful to minority interests. Empirical research documents that politically connected firms usually have high leverage (Faccio, 2010, Hassan et al., 2012), low dividend payouts and profitability (Hassan et al., 2012), high rent-seeking activities (Boubakri et al., 2012, Boubakri et al., 2012, Faccio, 2006, Frye and Shleifer, 1997), and tunneling (Qian, Pan, & Yeung, 2011).

Despite the progress made in understanding the impact of political connections, the channel through which the effect, if any, manifests itself remains unexplored. We propose that the RPT is one such channel through which political connections can be exploited to take advantage of minority investors, e.g., tunneling. RPTs enable politically connected firms to achieve objectives for their own sake as they have a vast number of affiliates with which to conduct transactions. This is exacerbated by the poor investor protection and weak enforcement of regulations in Indonesia.

A related party transaction is a transfer of resources, services, or obligations between related parties, regardless of whether or not a price is charged (International Auditing Standards 24.9), where a related party is a person or entity related to the entity preparing its financial statements. These transactions are diverse and often complex business transactions between a firm and its own managers, directors, principal owners, or affiliates, and are reasons for concern because they violate arm's-length market transaction principles.

Conflicting evidence exists as to the value of RPTs in business transactions. Benefits include lower transaction costs and higher firm values (Chen et al., 2012, Jian and Wong, 2010, Khanna and Palepu, 2000), shortened negotiation processes (Jian & Wong, 2010), and realignment of firms' operations (Cheung, Jing, Lu, Rau, & Stouraitis, 2009). However, RPTs are also viewed as detrimental to the stakeholders, since RPTs might be utilized by controlling shareholders as tools for tunneling and earnings management (Cheung et al., 2009, Gordon and Henry, 2005, Jian and Wong, 2010, Johnson et al., 2000). Although literature often regards operating RPTs as efficiency enhancing1 (Liu & Liu, 2007), whereas RP loans are regarded as abusive or value-destroying2 (Berkman, Cole, & Fu, 2009), firms can tunnel resources using abnormal sales transactions, a form of operating RPTs. Wang and Yuan (2012), for example, find that earnings are less informative for firms with a high level of abnormal RP sales. Jian and Wong (2010) reveal that Chinese firms prop their affiliates with abnormal sales, but then tunnel resources out.

Faccio (2006) investigates political connections around the world, with samples from 47 countries including Indonesia. She investigates whether political connections enhance firms' value by using an event study approach around the announcement of entry of controlling shareholders and management into politics or the incorporation of politicians into the boards of firms. However, our research is different from that of Faccio (2006), as we explore a specific channel, RPTs, through which politically connected firms may tunnel resources. We also use a finer classification of connections into two different categories, namely, government connections and military connections.3

Indonesia offers an interesting setting to explore this research due to its unique institutional features. First, a vast majority of the Indonesian population is Muslim, i.e., followers of Islam. Islam requires business practices to be conducted in an honest and just manner, with fair treatment extended to those involved with the organization. It is expected in such a context that managers will refrain from engaging in transactions that violate the core Islamic values. This is based on the view that religion influences economic outcomes by fostering religious beliefs that affect personality traits, such as honesty and work ethics (Barro & McCleary, 2003). Second, political connections play a dominant role in determining the value of Indonesian firms. Fisman (2001) finds that firm value is highly influenced by political connections. By using an event study of rumors of the health of former President Suharto during 1995 to 1997, he finds that the stock returns of firms having a close relationship with Suharto were significantly lower than those of less connected firms. Leuz and Oberholzer-Gee (2006) document that the volatility of the performance of connected firms increases with changes in the fortune of their connections. Third, Indonesia has a high ownership concentration (Brown, 2006, Claessens et al., 2000), with an average 16.6% of market capitalization being confined within the hands of a single family. Such a high ownership concentration gives rise to type II agency problems, i.e., the risk of expropriation of resources of minority shareholders by their controlling owners. Fourth, RPTs are significant in Indonesia, as > 90% of listed firms in Indonesia conduct various forms of RPT. Fifth, Indonesia is traditionally deemed to have weak corporate governance (Juliarto, Tower, Zahn, & Rusmin, 2013), and this provides opportunities for connected firms to engage in abusive RPTs that siphon resources out of the minority stakeholders.

We categorize a firm-year observation as politically connected (PCON) if at least one large shareholder (controlling at least 10% of the votes directly or indirectly), or board member, or commissioner is: (a) a current or former Member of Parliament, (b) a Minister or head of local government, or (c) closely related to a politician or party. We further decompose PCON into GCON (government connection: a dummy variable coded 1 for government connected firms, and 0 otherwise) and MCON (military connection: a dummy variable coded 1 for military connected firms, and 0 otherwise). We consider abnormal RP net credit (net credit is the difference between RP lending and RP borrowing) and abnormal RP sales as potential instruments for tunneling resources by connected firms. (Section 4 provides a detailed measurement of these constructs.)

Using a panel data of 1775 firm-year observations from 2007 to 2013, we document that: (i) politically connected firms use abnormal RP net credits, but not abnormal RP sales, as the primary tool for tunneling resources, (ii) this effect is mainly confined to firms with government connections (GCONs), and (iii) politically connected firms using abnormal RP net credit but not abnormal RP sales to tunnel resources engage more in earnings management.

We contribute to the existing political connections and RPT literature in a number of important ways. First, RPTs are channels through which political connections affect firms' accounting information quality and firm value. Although a stream of literature has examined the role of political connections in the context of reporting behavior (e.g., Chaney et al., 2011, Chen et al., 2011), no published research has investigated a specific channel through which politically connected firms might conduct resource tunneling and mask their true financial performance. Second, we add further insights into the debate of the beneficial versus the detrimental effect of RPTs in an economy with poor investor protection and weak enforcement of regulations. The evidence presented in this paper supports the theory that RPTs are used as a tunneling mechanism by firms with political connections.

Our research question on whether politically connected firms conduct tunneling via RPTs addresses an issue different from those in the extant literature on state ownership and RPTs addressed by, e.g., Cheung et al. (2009), Cheung et al. (2005), and Jian and Wong (2010), all of whom used Chinese data. However, China and Indonesia exhibit significant institutional differences that have implications for our study.4 While state ownership offers a rich institutional environment for studying RPTs, political connection is a concept above and beyond state ownership. Firms without government shareholding often have incentives even stronger than those of state owned enterprises (SOEs) to build political connections in order to receive favorable economic and political treatment (Liu et al., 2016, Wang and Lin, 2016). In addition to this important difference, we outline and explain some additional institutional differences between Indonesia and China that have implications for our study (see Section 2 for detailed discussion of the differences).

First, we consider political connection in a country where the majority of the population is followers of Islam. The Islamic value system requires honest, just, and fair business transactions (Lewis, 2001). However, political connections that benefit a select group at the expense of minority stakeholders goes against Islamic business ethics. We cannot provide empirical evidence as to whether the extent of exploitation varies with the religious beliefs of managers conducting the transactions because of the homogeneity of Indonesian religious beliefs.5 However, we are able to document that religious value systems are compromised by powerful entities and individuals. This is all the more disturbing because the State, as per Islamic values, is responsible for protecting the investment of Muslim shareholders due to the trust (amanah) given to them. In addition, managers need to guarantee that the firm conducts business only in permissible (halal) activities, and that those business activities must be carried out in a transparent and ethical manner based on the principles of justice (‘adl), equity (qist), and benevolence (ihsan) (Hassan & Harahap, 2010). Using political connections to deceive minorities is a direct violation of this ethos.

In comparison, Chinese do not have strong religious beliefs6 due to the long political dominance of the Communist Party, which upholds ideology of Marx, who contended that political revolution started with religious criticism. During the rules of Mao and Deng, religious movements were oppressed. As a result, several generations of Chinese born after 1949 were not exposed to religious freedom.

Another institutional difference that is pertinent to our study is the difference in the roles of military business connections in these two countries. Political connections were established with military officers in Indonesia following the seizure of political and economic power by the military (see Section 2.1 for a discussion on the value of military connections in Indonesia). In contrast, the military in China does not enjoy the same privilege as it does in Indonesia, as a result of a series of institutional reforms utilized by the central Communist Party designed to strengthen its control over armies. To accomplish political stability, central government strategically reined in the scope of the domestic political, economic, and social roles of the People's Liberation Army (PLA). Therefore, in contrast to Indonesia, military-business connections are absent in China (Hsu, 1999).7

Last but not least, investigating RPTs and political connections in a different institutional setting is important, as prior Chinese RPT studies focus predominantly on state ownership as an important explanation for RPTs because the Communist Party of China, being a ruling party, determines all civilian, political, and economic issues. However, Indonesia has a multi-party system resulting in competition for political power and economic resources. Our study of political connections and RPTs using Indonesian data enables us to unfold the differential effects of various types of political connections and, thus, provides rich insights beyond the extant literature using US and Chinese data.

The remainder of the paper proceeds as follows. Section 2 provides an overview of the institutional environment of Indonesia pertinent to our research questions. Section 3 reviews the relevant literature and develops hypotheses. Section 4 describes the research design followed by the sample selection procedure, and we report the descriptive statistics in Section 5. The following section explains the main test results and Section 7 concludes the paper.

Section snippets

Religion and financial reporting in Indonesia

Indonesia has a population of around 252 million, and 87% of those are Muslims. Islam occupies a central role in the value system of the Indonesian people. Islamic principles and norms (sharia) offer guidance to followers in dealing with all aspects of human life, including economic, political, religious, and social affairs (Alsaadi et al., 2013, Hassan and Harahap, 2010, Lewis, 2001). Sharia has the ultimate goal of accomplishing success in both this world and in the hereafter, seeking

Literature review and hypotheses development

Connections between politicians and firms are triggered by the mutual need of both parties. There are many reasons for entrepreneurs entering into politics. First, when the markets are not functioning well in supporting business in terms of excessive regulations, tax burdens, and poor protection of property rights, entrepreneurs rely on political connections to alleviate these concerns (Li et al., 2008, Li et al., 2006). Second, firms tend to build political connections because the government

RPTs and political connections

To test H1, we develop the following regression model.ABN_RPT=γ0+γ1PCON+γ2OCON+γ3FOWN+γ4GOWN+γ5LN_SEG+γ6ROA+γ7AUDIT+γ8AC+γ9BSIZE+ε

Our dependent variable is the following two categories of abnormal RPTs: (i) abnormal RP net credit (ABN_CREDIT) and (ii) abnormal RP sales (ABN_SALE) (a proxy for propping). In our sensitivity test we also use abnormal RP loans (ABN_LOAN), abnormal operating RPTSs (ABN_OPRPT), and abnormal other RPTs (ABN_OTH).

RPTs may constitute normal business and, thus, to

Sample selections and descriptive statistics

Data on the number and amounts of RPTs are hand-collected from audited financial reports downloaded mainly from the website of the Indonesia Stock Exchange (http://www.idx.co.id/index-En.html). If not available, the data are derived from the websites of Indonesian listed firms. In addition, the following corporate governance data are also manually collected from audited financial statements or annual reports: board of directors, board of commissioners, independent commissioners, audit

Political connections and RPT

Table 3 presents regression results for H1, which tests whether politically connected firms tunnel resources through opportunistic RPTs. We use ABN_CREDIT and ABN_SALE as two of our primary RPT instruments likely to be employed by connected firms (we explained the detailed measurement techniques for these variables in 4.1). In Column (1) we find the coefficient on PCON, our main variable of interest, to be positive and significant (coefficient 0.008, t-statistic 2.11, significant at p < 0.05),

Conclusion

Although much has been learned about political connections and their effect on firm value, the channel through which this relationship manifests itself is unexplored. This paper aims to fill this void by proposing RPTs as the mechanism used by politically connected firms to tunnel corporate resources. Indonesia is a particularly suitable setting for this investigation because both political connections and RPTs are pervasive and, thus, are expected to play significant roles in shaping

Acknowledgments

We appreciate helpful comments from four anonymous reviewers. We also thank the Editor, Rashad Abdel-khalik for helpful comments.

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