Hypotheses development

Previous documents (discussed in the literature review section) report evidence that political connections are associated with the difference in these firms’ performance. However, Faccio (2010) argues that it is not possible to infer any causality from the reported results; but she mentions two possible interpretations of these results: 1) It could be true that political connections lead to the differences in performance; or 2) it could also be true that these types of firms are more likely to establish a political connection. As a starting point, this study analyses how connected firms differ from non-connected firms in

their accounting ratios in annual financial reports, their market price and their corporate governance performances. This study will discuss the causality question later in section 3.6.3 (time patterns). To organise these comparisons, this study employs the following hypotheses.

Hypothesis 1: There is a systematic difference in accounting ratios between firms with political connections and firms without such connections.

Accounting ratios are a persistent and traditional standard that investors use to assess firm performance. Faccio (2010) investigates the difference between politically connected and non-connected firms by focusing on leverage, taxation, market power and productivity, return on assets, and market-to-book ratio. Motivated by Faccio (2010), this study examines the following items on the firms’ balance sheet.

To measure the level of operating current assets this study uses cash & cash equivalents, net other receivables and total current assets (as a percentage of total assets) to measure the impact of a political connection on a firm’s liquidity structure. Boubakri, Cosset, and Saffar (2009) suggest that these ratios are particularly important when firms face large amounts of short-term debt. This study also uses the net fixed asset ratio to indicate the operating capital investment level. Charumilind, Kali, and Wiwattanakantang (2006) report that the political connection helps firms gain access to long-term bank credit. They suggest that firms with political ties are treated favourably in the credit market because of less collateral is required for loans (such as fixed assets). Leuz and Oberholzer-Gee (1982)

use the ratio of fixed assets to total assets as a proxy for financing needs. Therefore, this study tests whether firms with connections to government or military have lower fixed assets than firms without such connections.

This study also uses the net investments ratio to test possible political relationships. It defines net investment as the short-term net investment plus the long-term net investment. To the best of our knowledge, no other study examines whether the net investment of connected firms is different from that of their counterparts. This study has included this in the study for the purpose of completeness of coverage.

On the liability side this study uses short-term debts, long-term debts, payables for special projects, other liabilities and IPM (interest protection multiples, EBIT/finance expense33).

Prior research (Cull and Xu, 2005; Faccio, 2006; Johnson and Mitton, 2003; Khwaja and Mian, 2005) shows that connected firms have preferential access to credit. However, Qian, et al (1995) argue that political connections help firms secure bank financing and evade capital market punishment. This study scale their ratios against total assets (except the IPM) to analyse their status.

Boubakri, et al (2009) use the change in the ratio of long-term debt and short-term debt to assess the impact of political connection on debt maturity. Furthermore, Chaney, et al.(2011) use the interest coverage ratio as a control variable when they study the link between earning quality and cost of debt for connected firms. Similarly, this study uses interest protection multiples to measure their relative capacity of meeting debt payment requirements. The higher this ratio is, the easier it is to obtain a loan.

Finally, to test how connected firms differ from non-connected firms in terms of equities, this study includes share capital, capital reserves, surplus reserves, retained earnings and minority interests divided by total assets. Although this study includes most of the accounting ratios from the balance sheet, it excludes Other Current Assets and some of the other non-current assets (such as Long-term Prepayments and Deferred Tax Assets), so there is no perfect linear relation among the included accounting ratios.

As explained in the previous section, the sample is of firms of the “princelings” type, which is a strong indication that these firms are selected by the most powerful group of investors. These investors are powerful not only in political influence, but also in economic capacity. Although these investors are not necessarily well educated, they have all of the professional resources and inside information. Most of the time they are not actively involved in operational decision making, but they are definitely keen on receiving greater returns. The fundamental force of having better returns is of advantage in operating the business, and this advantage should be shown in the selected firms’ accounting figures.

33_{In the Chinese accounting report system, interest expense is included in the finance expenses, and reported}

This study uses the terms “Golden hens” vs. “Chickens” to describe this expectation. Golden hens will be raised for a long time to harvest more eggs, while chickens are kept for a much shorter period. To test the “Golden hens” hypothesis, this study has developed hypotheses 1a, 1b and 1c.

Hypothesis 1a: Politically connected firms of the princelings type are relatively advantaged in operating revenue and/or operating profits.

Hypothesis 1b: Politically connected firms of the princelings type are relatively less motivated to accept cash tunnelling.

Hypothesis 1c: Politically connected firms of the princelings type pay relatively lower dividends and so show a higher retained earnings ratio.

Hypothesis 1a proposes that princelings-connected PCFs are more efficient in operation and more profitable; they are good choice for harvesting future eggs. Due to good future opportunities, this is a better use of the “hens” than producing current meat products. However, cash tunnelling behaviour has a damaging effect on future business incomes. It is proposed that these PCFs have much less motivation to accept cash tunnelling, which is to be tested in hypothesis 1b. Consistent with the lower levels of cash tunnelling, the PCFs of the “Golden hens” type will keep more of their profits as re-investment so that their “hens” can be more productive in the production of future “eggs”. The re-investment effect is indicated in the ratio of retained earnings, which is tested in hypothesis 1c.

To test hypothesis 1a, this study uses operating revenue and net income values in both direct pairwise comparison and controlled regression models.The previous study of Fan et al. (2007) on political connections compares sales growth, earning growth and changes in return on sales to measure firms’ profitability at the time of IPO. They find firms with connected CEOs fail to perform as well as their counterparts post-IPO, which is linked to a lack of managerial skills by those CEOs who are appointed on the basis of their connections. Based on Fan et al. (2007),this study uses operating revenue and net income over the total assets to test the hypothesis that firms are more profitable if they are politically connected.

Additionally, these advantages should be reflected in their market value; this study uses the Market-to-book ratio for this test. Specifically, this study uses the market value of total assets over the book value of total assets as a proxy for the market value ratio. Cheung, Jing, Rau, and Stouraitis (2005) and Faccio (2010) find that there is no significant difference in market value performance between connected firms and unconnected firms.

A key feature of the Chinese stock market is the highly concentrated ownership structures. There are six types of shares; state, legal person, foreign, executive, employee, and individual, according to Shareholding Experience and Regulatory Opinion on Joint Stock Companies. The degree of ownership concentration determines which kind of agency problems firms face. For instance, a diffused ownership structure generally has agency problems between managers and a diffused group of shareholders (M. Jensen and Meckling, 1976) while a concentrated ownership structure leads to conflicts between controlling shareholders and minority shareholders (Porta, LopezϋdeϋSilanes, and Shleifer, 2006).

The unique ownership pattern of Chinese firms has triggered substantial academic study on links between earnings quality and ownership structure. High concentration ownership could have a positive effect on alignment (J.P.H. Fan and Wong, 2002) or a negative effect on tunnelling (Jiang et al., 2010). For instance, some controlling shareholders have other wholly-owned business interests and so opportunities exist to transfer resources to these other businesses. In these circumstances the controlling shareholders may force the listed companies to adopt less informative accounting so as to help camouflage the “expropriation” activities.

This study compares the ownership structure of PCFs to that of their non-connected peers by including two shareholder type variables; state, and largest ownership. The different ownership structure has implications for different incentives to control and monitor the firm’s management (Shleifer and Vishny, 1986). For instance, firms with state ownership have preferential access to new capital or bailouts in the event they fall into financial distress (Q. Wang, T. J. Wong, and L. Xia, 2008). This study expects that PCFs should have more concentrated ownership.

One of the most important factors influencing a firm’s performance is the board of directors, since it is charged with monitoring and disciplining senior management. Beasley (1996) suggests that directors’ expertise and occupations might have an impact on managerial decision-making and thereby influence firms’ performances. Byrd and Hickman (1992) indicate that the expertise and objectivity of independent directors help firms to reduce the problem of managerial tunnelling. Empirically, Chaney, Faccio, and Parsley (2011) find that, in firms where politics matter more, outside directors with a politician or lawyer status are more important. For example, companies in industries with larger government dealings tend to have a larger number of political directors. During the sample period in this study, the board members of listed firms are usually appointed by the state-owned controlling shareholder. Non-executive directors of connected firms come from social organisations and institutions, universities, industry associated committees, etc. (Xiao Chen et al., 2003).

Fan et al. (2007) argue that political connections have an effect not just in terms of accounting and stock market performance, but also in terms of the qualifications of the managers and directors that are appointed to connected firms. They include several variables to measure the governance and the degree of professionalism of PCFs’ directors on boards and find firm-level evidence that weaker corporate governance is associated with PCFs. Thus, following Fan et al. (2007), this study includes the percentage of female directors, age of directors, educational level of directors, background1 (accounting, law or finance background) and background2 (academic background), to test the differences between PCFs and politically unconnected firms. This study expects that PCFs are not significantly different from politically non-connected firms in board structure.

Chinese listed firms have a two-tier internal governance structure including an executive board and a separate supervisory board. Supervisory boards, comprised of at least three members, are intended to provide a monitoring role and help to reduce conflicts of interest between owners and managers. Furthermore, the supervisory board is responsible for accounting informativeness. Previous corporate governance literature on supervisory boards has shown mixed results. Dahya, Karbhari, and Xiao (2002) argue that the appointment of supervisory board members has not been a transparent process and is, therefore, not necessary when a company performs well, and cannot help when the company performs poorly (Schneider-Lenné, 2011). Nevertheless, Xiao, Dahya, and Lin

(2004), through a series of interviews in Chinese listed companies, find that supervisory boards perform as either advisors or watchdogs. Consistently, Firth, Fung, and Rui (2007) find that a larger supervisory board with greater expertise in monitoring management and accounting quality will improve firms’ performances. Analysing the weakness of Chinese corporate governance, Braendle, Gasser, and Noll (2005) conclude that business-to- government networks, in particular, can harm the independence of the supervisory board. Therefore, this study constructs two variables to assess the differences in supervisory board structure between connected firms and non-connected firms; the number of members on the supervisory board, and supervisory meeting frequency. This study expects that supervisory board structures of PCFs are significantly different from those of politically non-connected firms.

This study also tests how connected firms differ from their peers on stock returns. In brief, we use abnormal returns (subtract equal-weighted annual market return with cash dividend reinvested, from the annual stock return with cash dividend reinvested) to compare the difference in stock returns between connected and non-connected firms. Therefore, this study use null hypothesis to expect that stock returns of PCFs are not different from those of non-connected firms.