Political alignment and corporate fraud: evidence from the United States of America

Abstract

Purpose The paper investigates whether political geography, as measured by the degree of alignment of state politicians with the party of the USA President, has an impact on corporate fraud convictions. Design/methodology/approach Prior research shows that the degree of alignment between state politicians and the president's political party is positively correlated with measures of earnings management for firms headquartered in the state. Political alignment is conducive to earnings management because it affects a firm's information and enforcement environment by increasing policy risk and promoting lenient regulatory oversight. The paper posits that this environment is also conducive to corporate fraud and tests this hypothesis using pooled ordinary least squares (OLS) and panel regressions with annual state-level data for 2003–2018. Findings The paper documents a positive and statistically significant relationship between political alignment and corporate fraud conviction rates by state. Research limitations/implications The conclusions are tempered by data limitations. First, the conviction data are available at the state level only. Second, the true level of fraud is inherently unobservable and the conviction data may not reflect the actual number of frauds that are committed. Practical implications Fraud examiners might benefit from considering the role of political connectedness in determining fraud risk. Although additional research is needed before making concrete recommendations, the initial indications clearly point to political connections as a potential concern. Originality/value The findings build on evidence that political connections influence earnings management. Rather than focusing on direct measures of connectedness, such as lobbying expenditures, the paper examines a plausibly exogenous measure: political geography.