J. of Multi. Fin. Manag.

55 (2020) 100626

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Journal of Multinational Financial

Management
journal homepage: www.elsevier.com/locate/econbase

Political connections and income smoothing: Evidence of

institutional investors’ monitoring in Malaysia
Chwee Ming Tee
School of Business, Monash University, Jalan Lagoon Selatan, 46150, Bandar Sunway, Selangor, Malaysia

a r t i c l e i n f o a b s t r a c t

Article history: This study explores the association between politically connected firms (PCFs) and income
Received 18 August 2019 smoothing. Using a Malaysian dataset from 2002 till 2015, this study finds that PCFs are
Received in revised form 8 February 2020 more likely to engage in income smoothing activity, in comparison with non-PCFs. Further,
Accepted 1 March 2020
smoothing income in PCFs is encouraged by institutional investors, as it is perceived as an
Available online 3 March 2020
attempt to convey useful private information to investors. However, the moderating effect
of institutional investors are largely driven by domestic institutional investors. This study
Keywords:
extends prior literature on income smoothing, by suggesting that political connection is a
Income smoothing
key determinant in engaging in income smoothing activity, particularly in countries where
Politically connected firms
Institutional investors crony capitalism and political patronage is deeply entrenched.
Institutional investors domiciles © 2020 Elsevier B.V. All rights reserved.

1. Introduction

The accounting literature finds that a large number of firms smooth earnings. For example, Graham et al. (2005) high-
lighted that 97 % of the surveyed firms smooth earnings to enable shareholders, analysts and lenders to forecast permanent
future cash flows. Additionally, it also represents the managers’ attempts to meet bonus targets (Healy, 1985); protect their
careers (Fudenberg and Tirole, 1995); communicate useful private information to the capital markets (Kirschenheiter and
Melumad, 2002); improve earnings informativeness (Tucker and Zarowin, 2006); and reduce the cost of capital (Gebhardt
et al., 2001).
While prior studies have examined income-smoothing in widely held firms (Tucker and Zarowin, 2006) and family-
controlled firms (Prencipe et al., 2011); the relationship between political connections and income-smoothing is largely
unknown. In emerging capital markets such as Malaysia, politically connected firms (PCFs) are deeply rooted in the crony
capitalism and political patronage system2 . However, crony capitalism and political patronage literature presents two
perspectives on the impact of political connections on firm outcomes. The first finds that political connections confer benefits
to shareholders as they are associated with higher market valuation (Cooper et al., 2010); lower cost of equity (Boubakri
et al., 2012); lower cost of bank loans (Houston et al., 2014); and are more likely to receive government bail-outs (Duchin
and Sosyura, 2012; Johnson and Mitton, 2003). More importantly, older PCFs are reported to be efficient, with strong firm
governance (Fung et al., 2015). The second, however, shows that political connections can be a source of severe agency
problems to shareholders. As a result, PCFs are reported to have lower earnings quality and opaque financial reporting

E-mail address: tee.chwee.ming@monash.edu

2
In the 2016 crony capitalism index survey by The Economist, Malaysia ranks second. In 2017, it was included in the list of top ten kleptocratic nation in
the world (Asia Times, 2018). Consequently, prior studies document a large and well-documented PCFs (Fung et al., 2015; Gomez and Jomo, 1999; Gomez
et al., 2017; Johnson and Mitton, 2003; Tee et al., 2017)

https://doi.org/10.1016/j.mulfin.2020.100626
1042-444X/© 2020 Elsevier B.V. All rights reserved.
2 C.M. Tee / J. of Multi. Fin. Manag. 55 (2020) 100626

(Chaney et al., 2011). This facilitates managers’ (controlling shareholders) efforts to siphon corporate resources through
self-dealing and third-party related transactions (Chen et al., 2011; Guedhami et al., 2014).
Furthermore, prior literature which examines the motivation and effects of income smoothing did not consider the
rising trend in corporate ownership by institutional investors. For instance, IMF (2015) reports that corporate ownership
by institutional investors exceeded $1 trillion in 2014. As such, institutional investors are urged by international regulators
(OECD, 2009) to play an active monitoring role especially since institutional investor ownership is shown to impact firm
performance (Ferreira and Matos, 2008), firm governance (Aggarwal et al., 2011), and likelihood of earnings management
(Cornett et al., 2008; Kim et al., 2016; Liu et al., 2018). Since investors’ confidence in the inferred permanent component
of earnings can be reduced by fluctuations in reported earnings (Kirschenheiter and Melumad, 2002; Tucker and Zarowin,
2006); this study extends existing work to examine whether institutional investors can moderate a firm’s volatile earnings
in PCFs. Specifically, it contributes to the literature by using novel data from PCFs and institutional investors’ ownership in
an emerging economy.
Motivated by the above issues, the first research question explores whether PCFs are associated with income-smoothing,
and if so, whether the duration of political connections is a significant determinant. The second research question investigates
whether institutional investors’ ownership can moderate the association between political connections and income-
smoothing. Although institutional investors are reported to prefer a smooth income stream (Koh, 2005); their preference
depends on managerial motivation in PCFs. According to political patronage theory, one path involves conveying useful infor-
mation to investors and the other involves diverting corporate resources for the managers’ personal benefit. Institutional
investors prefer income- smoothing if it is assessed as a manager’s effort to relay useful information. Conversely, managers’
attempts to smooth income will be attenuated by institutional investors if it is perceived as rent-seeking. This study addresses
this gap by examining the moderating effects of institutional investors on income-smoothing in PCFs. Finally, another novel
research question investigates whether institutional investors’ domiciles affect income-smoothing in PCFs. This poses an
academically interesting question since prior literature suggests that institutional investors should not be viewed as a homo-
geneous group, but rather, are associated with different firm outcomes. On one hand geographical proximity theory argues
that higher domestic institutional investor ownership (IIDOM) deters opportunistic earnings management (Kim et al., 2016;
Liu et al., 2018); while business relationship theory posits that higher foreign institutional investor ownership (IIFOR) is
associated with stronger firm governance (Aggarwal et al., 2011), higher firm performance (Ferreira and Matos, 2008), and
higher premiums in mergers and acquisitions (Ferreira et al., 2010). Despite numerous studies on institutional monitoring,
none examines the moderating effects of institutional investors’ domiciles on income-smoothing in PCFs.
To examine all the research questions, this study uses Malaysian dataset comprising from 2002 to 2015. Based on several
findings, the contribution to the accounting and finance literature is discussed as follows. First, income-smoothing is likely to
be more prevalent in PCFs than in non-PCFs. PCFs smooth income to avoid unnecessary attention from the public, particularly
from institutional investors. Further, results reveal that the duration of political connections is positively associated with the
likelihood of income-smoothing. Specifically, older PCFs are more inclined to smooth income, supporting the institutional
theory of isomorphism that older firms tend to build and attach importance to their reputation and credibility in the long run.
Second, this practice is stronger in PCFs with higher institutional investor ownership. The implication is that the practice of
income-smoothing in PCFs serves as a channel to reveal useful private information to investors. It can be further deduced that
income-smoothing is encouraged by institutional investors when it is a genuine attempt to reduce high volatility in reported
earnings.3 Third, when institutional domiciles are considered, it is documented that the moderating effect by institutional
investors is largely driven by IIDOM. In line with the geographical proximity theory, IIDOM have unparalleled monitoring
advantages, therefore the proclivity to monitor PCFs.
The remainder of this paper is organized as follows. Section 2 reviews relevant literature and develops hypotheses. The
research method is discussed in Section 3, and Section 4 reports and discusses empirical findings. Section 5 concludes the
study and provides several implications.

2. Related literature and hypotheses development

2.1. Political connections and income smoothing

The crony capitalism and political patronage theory suggests that there are benefits and costs in establishing closer ties
with the ruling elites. Shefter (1977) argues that through an intricate political patronage system, politically connected busi-
nessmen can obtain numerous commercial benefits and political protection (Bunkanwanicha and Wiwattanakantang, 2009;
Cooper et al., 2010; Faccio, 2006). In exchange, politicians receive political donations, support and bribes (Shleifer and Vishny,
1993, 1994). Although shareholders may benefit from this connection, several findings find that PCFs are plagued by opaque
financial reporting, often associated with efforts by managers (controlling shareholders) to siphon corporate resources, via
third-party related and self-dealing transactions (Boubakri et al., 2012; Chaney et al., 2011; Guedhami et al., 2014). However,
political costs and agency theories posit that PCFs are subject to close monitoring and scrutiny by shareholders, analysts,

3
Conversely, the result would have shown that institutional investors’ ownership attenuate income-smoothing in PCFs, if it is viewed as opportunistic
behaviour by managers (controlling shareholders) to extract private benefits from the firm.
 C.M. Tee / J. of Multi. Fin. Manag. 55 (2020) 100626 3

regulators, media and politicians (Watts and Zimmerman, 1986). Therefore, managers in PCFs may smooth income to divert
attention from highly volatile reported earnings. Under this circumstance, income-smoothing in PCFs will adversely affect
other shareholders in the long-run, as it is motivated to conceal the managers’ rent-seeking activities which ultimately
destroy firm value.
However, the practice of smoothing can also be seen as an effort by PCFs to convey valuable private information to
investors, consistent with signalling theory. The reasons are not far-fetched. For example, in Malaysia, the PCF’s profitability
and valuation is associated with prospects of obtaining continuous government financial assistance and privileges (Gomez
and Jomo, 1999; Gomez et al., 2017). Johnson and Mitton (2003) attributed the fall in Malaysian PCFs’ market valuation
prior to the imposition of capital controls in 1998, to the perceived inability of the government to retain existing financial
assistance. However, these firms experienced a reversal in fortunes after the imposition of capital controls in 1998, as the
market perceived it as a government attempt to restore these privileges. In fact, governments were required to eliminate
privileges for PCFs (Faccio et al., 2006) as a pre-condition to receive bail-out money from the International Monetary Fund
(IMF). Further, Malaysian ruling elites comprise various competing political factions, although from 1957 till 2018, the nation
was governed by UMNO-dominated Barisan Nasional (BN). Therefore, the fortunes of Malaysian PCFs are highly dependent
on the political survival of the leaders they are linked to, consistent with the theory of political patronage (Bueno de Mesquita
et al., 2002; Shefter, 1977).4 Accordingly, managers may smooth income as a pre-emptive measure when the government
is unable to maintain privileges during financial crises or minimize the economic fallout when their political benefactors
are no longer in power. Subsequently, PCFs smooth income to relay more information to investors regarding its business
sustainability and political risks. Gebhardt et al. (2001) report that income smoothing reduced perceived risk by investors and
lenders alike, thus lowering the cost of capital. Regardless of the motivation to smooth income in PCFs, the first hypothesis
predicts the following:

H1. Politically connected firms are more likely to smooth income.

2.2. Duration of political connections and income smoothing

The institutional isomorphism and reputational theories argue that PCFs’ outcomes are influenced by the duration of
its political connections (DiMaggio and Powel, 1983; Rona-Tas, 1994). In contrast with firms with a shorter duration of
connections to the ruling elite, firms with longer ties use connections to build a strong reputation and network in local
and international capital markets (DiMaggio and Powell, 1983; Fung et al., 2015). In doing so, older PCFs tend to attract
managerial talent, therefore evolve to be a more self-sustaining firm in the long run (Donaldson, 2008).
Since 1970, the Malaysian government has maintained active participation in the economy and capital markets through
the affirmative New Economic Policy (NEP), and its investments in government-linked investment companies (GLICs). Prior
literature shows that political connections remain an important institutional setting in Malaysia as the government has
immense power to allocate the strategic resources it controls (Bliss and Gul, 2012; Fung et al., 2015; Gomez et al., 2017).
As such, controlling shareholders/managers of PCFs spend substantial effort and time to build credibility and adherence to
government policies. Gaining access to the informal network of the political elite also brings prestige in society (DiMaggio
and Powell, 1983; Donaldson, 2008) and this, in turn, enables connected firms to attract talented managers, thus indirectly
obtaining economic resources from the government and retaining high quality human capital. Based on reputational theory,
managers in older PCFs are more incentivized to smooth income to retain their privileges and good reputation in the capital
markets.
However, from the entrenchment effect perspective, firms with longer political connections or older PCFs are more likely
to smooth income in order to hide their efforts to divert and expropriate corporate resources. Prior literature suggests
that cultivating ties with Malaysian top politicians requires extensive efforts, funding and time (Brown, 2018; Gomez and
Jomo, 1999; Wright and Hope, 2018). When PCFs establish long-term relationships with top politicians in Malaysia, they
can influence the political systems, regulations and institutions. Consequently, due to career concerns, government officials
are reluctant to investigate the PCFs for financial irregularities (Kim and Zhang, 2016; Yu and Yu, 2011). This enables PCFs
to receive stronger political protection and avoid legal prosecution5 when they attempt to siphon corporate resources or
extract private benefits from the firm (Gomez and Jomo, 1999; Wright and Hope, 2018). Regardless of the positive and
negative perspectives of the duration of political connections, the second hypothesis is proposed as follows:

H2a. Firms with longer political connections are more likely to smooth income.

H2b. Older politically connected firms are more likely to smooth income.

4
Johnson and Mitton (2003) find that cronies of Anwar Ibrahim experience substantial losses in market valuation following his dismissal as Malaysia’
Deputy Prime Minister and Minister of Finance in 1998. Similar trend is repeated after the general election of 2018, when PCFs linked to Najib Razak and
UMNO party are reported to suffer substantial losses in market valuation and business contracts (The Edge, 2018).
5
The influence of political protection is stronger in Malaysia as power is centralized in the executive branch, while its law-making, civil administration
and judiciary institutions are beholden to the executive (1957-2018). For example, a panel to investigate the 1MDB financial fraud in can be summarily
dismissed by Najib Razak in 2015, when it was evident that he will be charged for corruption (Brown, 2018; Wright and Hope, 2018).
4 C.M. Tee / J. of Multi. Fin. Manag. 55 (2020) 100626

2.3. Political connections, income smoothing and institutional investors’ monitoring

The theory of large shareholders posit that institutional investors can partially mitigate a firm’s agency problems through
effective monitoring (Shleifer and Vishny, 1986). Institutional investors can either monitor through board representation
(“voice theory”) (Shin and Seo, 2011) or the threat of share sales in the open market to discipline the management (“exit
theory”) (Edmans, 2009). Both of the above monitoring mechanism are essential in protecting the scale of their invested
wealth.
Institutional investors rely on a firm’s financial statement to value, and subsequently allocate their capital (Balsam et al.,
2002). Accurate and stable earnings enhance the prediction of market valuation and dividend income streams of their
portfolio firms. Empirical findings by Tucker and Zarowin (2006) suggest that income-smoothing improves a firm’s earnings
informativeness, particularly in conveying useful information to investors. Thus, Carlson and Bathala (1997) argue that
managers smooth income to retain the interest of institutional investors because unpredictable firm performance will
influence institutional investors to divest their investments from the firm. Additionally, a smoothed and accurate stream of
reported earnings allows institutional investors to justify their investment as high quality in accordance to the prudent-man
laws (Del Guercio, 1996; Del Guercio and Hawkins, 1999).
Prior evidence shows that institutional investors prefer income-smoothing, provided it is aimed at reducing volatility
in income or relaying useful information to investors (Koh, 2005). When it comes to monitoring, PCFs attract the attention
of institutional investors since their earnings are expected to dip significantly during financial crises. This is due to the
government’s inability to maintain commercial privileges. Additionally, it could also be due to a financial fallout when their
political benefactors lose power (Leuz and Oberholzer-Gee, 2006). Therefore, PCFs smooth income to relay information to
institutional investors on its exposure to future political risks and business sustainability.
Conversely, income-smoothing in PCFs can mask attempts by managers (controlling shareholders) to siphon corporate
resources through self-dealings and third-party related transactions, as in the case of the Malaysian 1MDB financial fraud
(Brown, 2018; Wright and Hope, 2018). For example, PCFs’ earnings quality (Chaney et al., 2011) and analysts forecast accu-
racy are reported to be lower (Chen et al., 2010). Further, their rent-seeking activities are aided by political protection by top
politicians (Piotroski et al., 2015) and privileged access to credit financing (Houston et al., 2014; Khwaja and Mian, 2005; Tee,
2018). More importantly, political cost theory predicts that PCFs tend to attract greater attention from the media, analysts,
investors and politicians (Watts and Zimmerman, 1986). This in turn will reflect badly on the image of the institutional
investors, if they are perceived to be ineffective monitors. Hartzell et al. (2014) suggest that institutional investors are more
likely to experience increased fund outflow, when investors lose confidence in their inability to be effective custodians of
their investments. As such, Del Guercio (1996) fiduciary theory argues that institutional investors should increase their
monitoring efforts in firms which are known to experience severe agency problems, as in PCFs. In view of two competing
arguments on income-smoothing in PCFs, and based on overwhelming evidence that institutional investors do monitor their
investee firms, the third hypothesis is proposed as follows:

H3. Institutional investors strengthen (attenuate) the positive association between PCFs and income smoothing if it is used
to convey useful information (it is used to siphon corporate resources).

2.4. Political connections, institutional investors’ domiciles and income smoothing

A new research stream suggests that institutional the investors’ domicile is significantly associated with monitoring
effectiveness (Aggarwal et al., 2011; Ferreira and Matos, 2008; Ferreira et al., 2010; Kim et al., 2016; Liu et al., 2018).
Further evidence shows that IIDOM have the tendency to monitor their investee firms, consistent with the geographical
proximity theory which argues that IIDOMs are more familiar with the local accounting rules (Kim et al., 2016; Liu et al.,
2018), political landscape (Tee et al., 2017), business environment, language and culture (Ayers et al., 2011; Chhaochharia
et al., 2012). Due to its proximity to PCFs, detailed information on the firm’s business operations, and other intangible
factors such as management culture can be obtained. Moreover, understanding the Malaysian political environment and
other local institutions is essential in determining the real motivation of income-smoothing in PCFs. Face-to-face meetings
with management can also be arranged to convey any suggestions or displeasure, particularly regarding firm performance
and financial reporting quality (Kim et al., 2016; Liu et al., 2018). As such, the costs of communication and information
gathering are substantially reduced in comparison with foreign institutional investors that are headquartered overseas. This
will facilitate domestic institutional investors’ quest to acquire firm-level specific information in PCFs, thus speeding up
their learning process6 . These factors ensure that domestic institutional investors can effectively monitor PCFs, particularly
in determining the real motivation for smoothing income. Therefore, the final hypothesis is written as follows:

H4. Domestic institutional investors strengthen (attenuate) the positive association between PCFs and income smoothing; if it is
used to convey useful information (if it is used to siphon corporate resources).

6
Unlike advanced capital markets, Malaysian capital markets have one of the lower levels of disclosure and transparency in the world due to its weak
legal protection for minority shareholders (Morck et al., 2000), and weak institutional structures i.e judiciary and parliament (Brown, 2018; Wright and
Hope, 2018).
 C.M. Tee / J. of Multi. Fin. Manag. 55 (2020) 100626 5

Table 1
Sample of study.

Panel A: Industry distribution

Industry Firm-year Observations Percentage (%)

Consumer 882 18.44

Industrial 1,527 31.93
Trading and Services 983 20.55
Property 599 12.52
Plantation 270 5.60
Construction 295 6.16
Technology 227 4.80
Total 4783 100

Panel B: Sample size

Description Firm-year observations

Total population of 750 listed firms in Bursa Malaysia from 2002 to 2015 after deleting financial firms 8736
Less: Firms with data unavailable to compute income smoothing measures and missing data for financial control variables 3953
Final sample 4783

3. Research method

3.1. Data and sample selection

To test all the hypotheses, this study selects a sample of 805 Malaysian firms listed in the Bursa Malaysia Malaysian Stock
Exchange from 2002 till 2015. In line with extant literature, 55 financial firms are deleted from the sample of study due to
different financial reporting structure. Based on this information, an unbalanced panel data of 8736 firm-year observations is
obtained for the period 2002-2015. Another 3953 firm-year observations are deleted due to missing data to compute income
smoothing measures and other financial control variables. This yields a final sample of 4783 firm year observations. The data
on PCFs and institutional investors’ ownership are hand-collected from each of the firm’s annual report in Bursa Malaysia
database, while financial data are extracted from Bureau Van Djik BVD database. Table 1 reports the sample selection process
for this study.

3.2. Income smoothing

As proposed by prior studies to classify firms into “smoothers” and “non-smoothers”, this study uses income-smoothing
ratio (ISR) (Carlson and Bathala, 1997; Prencipe et al., 2011). A firm is classified as “smoother” if the variability of its income is
lower than its variability of its sales. The ISR is obtained by dividing the coefficient of variation in income with the coefficient
in sales as shown in equation 1. An ISR less than 1 indicates that this firm’s income variability is lower than sales variability.
A firm classified as an “income smoother” (SMOOTH) is indicated as 1. Conversely, this firm is classified as “non-smoother”
if ISR is more than 1, as its firm’s income variability is higher than sales variability. In this case, it is indicated as 0.
CV I
ISR =
CV S
where: I = one period change in income,
S = one period change in sales,
where: CV = coefficient of variation = Standard Deviation
Mean

3.3. Political connected firm (PCF)

Following established methodology, a firm is identified as politically connected if at least one executive director (i.e., CEO)
or controlling shareholder7 is established to be closely connected to the Prime Minister or cabinet minister, through family
or informal business ties (Faccio, 2006; Johnson and Mitton, 2003). PCF is a dummy variable, which is indicated as one, if the
firm is identified as political connected to Malaysian top politicians, and zero otherwise. Additionally, government-linked
companies (GLCs)8 are included in the sample of PCFs to capture the institutional setting of the Malaysian capital markets.
Additionally, this study tabulates the shareholding of political connected director or controlling shareholder (PCFSHR) from
the firm’s annual reports. While identifying these connected firms during this period of study, changes in political connections
are considered.9

7
A shareholder is considered to have a controlling stake if he/she or a company maintains a minimum 10% voting rights in the firm (Faccio, 2006).
8
These are companies, whereby the Malaysian government is the dominant controlling shareholders. Its shareholding is maintained through Ministry
of Finance (MOF), via, Khazanah Nasional (Gomez et al., 2017).
9
This is due to establishment of a new tie with the ruling elite, resignation and death of these connected directors.
6 C.M. Tee / J. of Multi. Fin. Manag. 55 (2020) 100626

Next, this study computes the duration of political connections for each of the Malaysian PCFs (AGE PCF). This is followed
by the re-classification of PCFs into firms which are politically connected for long and short periods. For a firm to be classified
as PCF OLD, a minimum of ten years of connections to the ruling government is required. For example, a firm is labelled as
PCF OLD, if it satisfies both conditions: (i) politically connected for that particular year i.e., 2015, and (ii) maintain its political
connections for at least 10 years prior to the year of connection (i.e., 2005–2015).10 However, a PCF is classified as PCF NEW,
if it does not meet both of the requirements. The primary sources to identify a PCF and compute its duration of political
connections is obtained from the firm’s annual reports. Under section of substantial shareholders, the names of controlling
shareholders (individual, family or company) is listed. Additionally, these sources are cross-checked with prior studies on
Malaysian PCFs11 and The Edge Malaysia.

3.4. Institutional investors’ ownership

In line with extant literature, this study defines institutional investors as an organization, playing the role of fiduciary
duty, by exercising discretion over the investment of others (Del Guercio, 1996; Ferreira and Matos, 2008). In this study,
institutional investors operating in Malaysia include banks, insurance companies, mutual funds companies, government-
controlled investment fund, hedge funds, venture capitalist and private investment companies. Institutional ownership data
is collected from each firm’s annual report under the section top 30 largest shareholders. The variable institutional investors’
ownership (II) is computed as the number of shares owned by institutional investors scaled by total shares outstanding. Next,
institutional investors’ ownership is partitioned according to where the institutional investors are domiciled in. Since this
study focuses on Bursa Malaysia listed firms, institutional investors that are domiciled in Malaysia are classified as local
domicile institutional investors (IIDOM), while institutional investors that are domiciled outside of Malaysia are classified
as foreign domicile institutional investors (IIFOR).

3.5. Control variables

This study includes several control variables to isolate the effect of political connections and institutional ownership on
income smoothing. Prior studies find that firm attributes that may affect income smoothing are accounted and controlled
for by these control variables. First, a firm’s performance is controlled for, using return on asset (ROA) as proxy. Managerial
incentive to smooth income is reduced by a strong performance (Kothari et al., 2005). The second control variable is firm’s
size, computed as the natural logarithm of the firm’s total assets. Since larger firms are closely monitored and scrutinized
in comparison with smaller firms, Watts and Zimmerman (1986) argue that larger firms tend to smooth income to reduce
political attention. Since they are also likely to be mature firms, their revenues and profits tend to be more predictable
(Carlson and Bathala, 1997; Koh, 2005).
Past studies show a negative correlation between a firm’s income and growth. Growth opportunities is measured by the
growth in sales (Carey and Simnett, 2006; Prencipe et al., 2011). Further, the possibility of violating debt covenant by is
controlled for by including financial leverage in the model. The debt hypothesis posits that this possibility may incentivized
managers to manage earnings, rather than smooth income (Jaggi and Lee, 2002). Leverage is computed as total debt scaled
by total assets (Prencipe et al., 2011). Finally, cash flows from operations (CF) is introduced to control for the negative
association between cash flows and accruals management as part of the firm’s income smoothing strategy. CF is computed
as the ratio between cash flow from operations over total asset (Koh, 2005).

3.6. Model specification

To examine these hypotheses, a probit model is used, where the standard errors are adjusted for heteroskedasticity and
clustered at the firm and year level. This study controls for industry-level differences and year variation by including industry
and year dummies. The the top and bottom of 1% of the distribution of all continuous variables are winsorized to reduce the
influence of extreme outliers. Hypothesis 1 is tested by the following equation:
SMOOTH i,t = ˛ + ˇ1 PCFi,t-1 +ˇ2 ROAi,t-1 +ˇ3 ASSETi,t-1 +ˇ4 GROWTHi,t-1 +ˇ5 LEVERAGEi,t-1

+ˇ6 CFi,t-1 (YEAR)i,t +(IND)i,t +εi,t (1a)

SMOOTH i,t = ˛ + ˇ1 PCFSHR i,t-1 +ˇ2 ROAi,t-1 +ˇ3 ASSETi,t-1 +ˇ4 GROWTHi,t-1 +ˇ5 LEVERAGEi,t-1 +ˇ6 CFi,t-1 (YEAR)i,t-1

+(IND)i,t +εi,t (1b)

where:

10
This study adopts Fung et al.’s (2015) criterion of classifying Malaysian old and new PCFs.
11
(Gomez and Jomo, 1999; Gomez et al., 2017; Tee et al., 2017).
 C.M. Tee / J. of Multi. Fin. Manag. 55 (2020) 100626 7

the subscripts i and t – represent firm and year, respectively,

SMOOTH – a dummy variable, indicates 1, if the firm is classified as a “smoother” and 0, otherwise based on ISR mea-
surement,
PCF - a dummy variable, indicates 1, if the firm is classified as a politically connected firm, and 0 otherwise,
PCFSHR - percentage shareholding held by politically connected directors or controlling shareholders,
ROA – net profit scaled by total assets,
ASSET – natural log of total assets
SALES – natural log of sales,
GROWTH – the growth rate of sales, computed as the sales in year t minus sales in t – 1 and scaled by sales in year t – 1,
LEVERAGE – total debt scaled by total assets.
The second hypothesis is tested by the following equation:
SMOOTH i,t = ˛ + ˇ1 AGEPCFi,t-1 +ˇ2 ROAi,t-1 +ˇ3 ASSETi,t-1 +ˇ4 GROWTHi,t-1 +ˇ5 LEVERAGEi,t-1

+ˇ6 CFi,t-1 +(YEAR)i,t +(IND)i,t +εi,t (2a)

SMOOTH i,t = ˛ + ˇ1 PCFOLDi,t-1 +ˇ2 PCFNEWi,t-1 +ˇ3 ROAi,t-1 +ˇ4 ASSETi,t-1 +ˇ5 GROWTHi,t-1 +ˇ6 LEVERAGEi,t-1

+ˇ7 CFi,t-1 +(YEAR)i,t +(IND)i,t +εi,t (2b)

SMOOTH i,t = ˛ + ˇ1 PCFSHROLDi,t-1 +ˇ2 PCFSHRNEWi,t-1 +ˇ3 ROAi,t-1 +ˇ4 ASSETi,t-1 +ˇ5 GROWTHi,t-1

+ˇ6 LEVERAGEi,t-1 +ˇ7 CFi,t-1 +(YEAR)i,t +(IND)i,t +εi,t (2c)

where:
AGE PCF – The duration of political connection,
PCF OLD – a dummy variable indicated as one if it is identified as old politically connected firm, and zero otherwise,
PCF NEW – a dummy variable indicated as one if it is identified as new politically connected firm, and zero otherwise,
PCF OLDSHR - percentage shareholding held by older politically connected firms’ directors or controlling shareholders,
PCF NEWSHR – percentage shareholding held by new politically connected firms’ directors or controlling shareholders,
The definition of other variables is described above.
The third hypothesis is tested by the following equation:
SMOOTH i,t = ˛ + ˇ1 PCFi,t-1 +ˇ2 IIi,t-1 +ˇ3 PCFi,t-1 xIIi,t-1 +ˇ4 ROAi,t-1 +ˇ5 ASSETi,t-1 +ˇ6 GROWTHi,t-1

+ˇ7 LEVERAGEi,t-1 +ˇ8 CFi,t-1 +(YEAR)i,t +(IND)i,t +εi,t (3a)

SMOOTH i,t = ˛ + ˇ1 PCFSHR i,t-1 +ˇ2 IIi,t-1 +ˇ3 PCFSHR t-1 xIIi,t-1 +ˇ4 ROAi,t-1 +ˇ5 ASSETi,t-1 +ˇ6 GROWTHi,t-1

+ˇ7 LEVERAGEi,t-1 +ˇ8 CFi,t-1 +(YEAR)i,t +(IND)i,t +εi,t (3b)

where:
II- Percentage of shares held by institutional investors scaled by total shares outstanding
The definition of other variables is described above.
The fourth hypothesis is tested by the following equation:
SMOOTH i,t = ˛ + ˇ1 PCFi,t-1 +ˇ2 IIDOMi,t-1 +ˇ3 PCFi,t-1 xIIDOMi,t-1 +ˇ4 IIFOR i,t-1 +ˇ5 PCFi,t-1 xIIFOR i,t-1 +ˇ6

ROAi,t-1 +ˇ7 ASSETi,t-1 +ˇ8 GROWTHi,t-1 +ˇ9 LEVERAGEi,t-1 +ˇ10 CFi,t-1 +(YEAR)i,t +(IND)i,t +εi,t (4a)

SMOOTH i,t = ˛ + ˇ1 PCFSHR i,t-1 +ˇ2 IIDOMi,t-1 +ˇ3 PCFSHR i,t-1 xIIDOMi,t-1 +ˇ4 IIFOR i,t-1 +ˇ5 PCFSHR i,t-1 xIIFOR i,t-1

+ˇ6 ROAi,t-1 +ˇ7 ASSETi,t-1 +ˇ8 GROWTHi,t-1 +ˇ9 LEVERAGEi,t-1 +ˇ10 CFi,t-1 +(YEAR)i,t +(IND)i,t +εi,t (4b)
where:
II- Percentage of shares held by institutional investors scaled by total shares outstanding,
IIDOM- Percentage of shares held by domestic institutional investors scaled by total shares outstanding,
IIFOR- Percentage of shares held by foreign institutional investors scaled by total shares outstanding
The definition of other variables is described above.
8 C.M. Tee / J. of Multi. Fin. Manag. 55 (2020) 100626

Table 2
Descriptive statistics.

Panel A SMOOTH = 1 N = 1151 NON-SMOOTH = 0 N = 3632 t-test

Mean Std.Dev. 25 % 50 % 75 % 95 % Mean Std.Dev. 25 % 50 % 75 % 95 %

PCF 0.476 0.499 0.00 1.00 1.00 1.00 0.029 0.169 0.00 0.00 0.00 1.00 −59.029***
PCFSHR 25.11 29.53 0.00 0.00 54.79 74.35 1.447 9.035 0.00 0.00 0.00 60.48 −35.789***
PCF OLD 0.421 0.493 0.00 0.00 1.00 1.00 0.012 0.112 0.00 0.00 0.00 0.00 −37.02***
PCF NEW 0.054 0.226 0.00 0.00 0.00 1.00 0.017 0.129 0.00 0.00 0.00 0.00 −7.062***
PCFSHR OLD 22.63 29.28 0.00 0.00 52.05 74.32 0.677 6.584 0.00 0.00 0.00 0.00 −33.70***
PCFSHR NEW 2.470 11.20 0.00 0.00 0.00 13.81 0.770 6.270 0.00 0.00 0.00 0.00 −6.570***
II 12.996 19.776 0.00 4.42 17.63 65.94 7.856 10.943 0.00 3.26 13.54 34.86 −11.253***
IIDOM 10.493 17.243 0.00 1.97 13.53 61.35 6.105 9.186 0.00 1.04 9.70 25.45 −11.058***
IIFOR 2.503 4.105 0.00 0.00 1.97 12.20 1.750 3.940 0.00 0.00 1.10 10.15 −3.459***
ROA 2.827 13.363 −0.63 3.54 8.51 18.27 5.353 9.876 0.94 4.78 9.78 18.88 7.085***
ASSET (LN) 13.538 1.746 12.26 13.38 14.58 16.90 12.590 1.2506 11.81 12.60 13.53 15.32 −20.460***
GROWTH 34.565 8.840 −9.762 2.899 18.29 72.49 19.901 2.163 −6.29 4.41 19.20 73.73 −0.658
LEVERAGE 72.145 10.341 8.99 43.78 89.44 554.5 51.135 6.516 9.55 33.7 72.28 184.05 −7.747***
CF 0.006 0.119 −0.013 0.00 0.024 0.115 0.010 0.325 −0.014 0.000 0.029 0.113 0.829

Panel B PCF = 1 N = 646 PCF = 0 N = 4137 t-test

Mean Std.Dev. 25 % 50 % 75 % 95 % Mean Std.Dev. 25 % 50 % 75 % 95 %

SMOOTH 0.831 0.375 1.00 1.00 1.00 1.00 0.169 0.349 0.00 0.00 0.00 1.00 −59.03***
II 19.12 23.37 0.00 10.99 26.61 75.12 7.501 10.70 0.00 2.40 11.87 29.45 −16.78***
IIDOM 15.47 9.222 0.00 7.52 21.49 71.12 5.83 9.22 0.00 0.71 9.09 24.88 −16.30****
IIFOR 3.65 4.84 0.00 0.35 3.11 14.49 1.67 3.80 0.00 0.00 0.98 9.93 −8.27***
ROA 4.716 10.43 0.91 4.74 9.74 18.81 5.645 12.44 1.24 4.94 10.10 20.66 2.307**
ASSET (LN) 14.26 1.663 13.11 14.10 15.34 17.44 12.53 1.226 11.71 12.43 13.27 14.65 −32.016***
GROWTH 46.61 10.71 −6.40 3.75 17.35 72.49 19.21 9.458 −6.28 4.55 19.49 73.75 −0.818
LEVERAGE 76.85 10.74 14.35 49.47 94.30 269.47 52.08 6.962 9.11 31.71 68.69 171.81 −7.711***
CF 0.004 0.122 −0.013 0.00 0.024 0.104 0.010 0.313 −0.014 0.000 0.029 0.115 1.275

Variables definition is described in Appendix A. The superscripts ***,**, and * denote the 1%, 5%, and 10 % levels of significance, respectively.

4. Empirical findings and discussion

4.1. Descriptive statistics

Table 2 reports the results from two sub-samples, namely: (i) income and non-income smoothing firms (Panel A), and (ii)
PCFs and non-PCFs (Panel B). Panel A shows that PCF are significantly more likely to smooth income than non-PCF. 47.6 % of
PCF smooth income, while only 2.9 % PCF do not smooth income. Further, firms that are classified as “income-smoother” have
significantly higher politically connected shareholding (PCFSHR), higher institutional ownership (II), domestic institutional
ownership (IIDOM) and foreign institutional ownership (IIFOR). 42.1 % PCF OLD smooth income, as opposed to only 1.2 %
which do not smooth income, while only 5.4 % PCF NEW smooth income. Additionally, it shows that larger firm (ASSET)
and higher leverage (LEVERAGE) increase the likelihood of smoothing income, while higher ROA reduces the likelihood of
smoothing income. As reported in Panel B, 83.1 % of PCFs are classified as “income smoother” as opposed to only 16.9 % in
non-PCFs. Further, PCFs have higher institutional shareholding, lower firm performance, bigger in firm size and have higher
financial leverage, in comparison with non-PCFs.

4.2. Correlation

Table 3 presents correlation matrix. A firm classified as “income-smoother” is positively associated with PCF, PCFSHR,
PCF OLD, PCF NEW, PCFSHR OLD, PCFSHR NEW, II, IIDOM, IIFOR, larger firm and higher financial leverage.

4.3. Political connections and income smoothing

Table 4 presents the results for Eqs. (1a and 1b). The PCF coefficient in column 1 is positive and significant (2.17, p <
0.01), suggesting that PCFs are more likely to smooth income than non-PCFs, lending support to Hypothesis 1. In fact, higher
shareholding by politically connected directors or shareholders PCFSHR is associated with higher likelihood of income-
smoothing as shown in column 2 (3.685, p < 0.01). ROA coefficient is negative and significantly associated with income-
smoothing. Firms that are profitable are less likely to smooth income as high profits are enough to meet the expectation of
all stakeholders.
Further, this section also examines whether there is any association between the length of political connections and
income smoothing. Evidence from column 3 supports Hypothesis 2a, showing that the duration of political connection is
positively associated with income-smoothing (0.207, p < 0.01). As a further test, PCFs are partitioned into PCF OLD and PCF
Table 3
Correlation coefficient.

N = 4783 SMOOTH PCF PCFSHR PCF OLD PCF NEW PCFSHR OLD PCFSHR OLD II IIDOM IIFOR

SMOOTH 1.000
PCF 0.554*** 1.000
(0.000)
PCFSHR 0.524*** (0.000) 0.929***(0.000) 1.000
PCF OLD 0.556*** 0.886*** 0.850*** 1.000

C.M. Tee / J. of Multi. Fin. Manag. 55 (2020) 100626

(0.000) (0.000) (0.000)
PCF NEW 0.099*** 0.412*** 0.328*** −0.056*** 1.000
(0.000) (0.000) (0.000) (0.000)
PCFSHR OLD 0.519*** 0.825*** 0.912*** 0.932*** −0.052*** 1.000
(0.000) (0.000) (0.000) (0.000) (0.000)
PCFSHR NEW 0.092*** 0.362*** 0.362*** −0.052*** 0.932*** −0.049*** 1.000
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
II 0.152*** (0.000) 0.281***(0.000) 0.286***(0.000) 0.252***(0.000) 0.110***(0.000) 0.261*** (0.000) 0.098***(0.000) 1.000
IIDOM 0.158*** 0.280*** 0.293*** 0.255*** 0.100*** 0.271*** 0.096*** 0.944*** 1.000
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
IIFOR 0.037*** 0.104*** 0.076*** 0.078*** 0.071*** 0.062*** 0.043*** 0.485*** 0.182*** ‘1.000
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
ROA −0.096***(0.000) 0.013 (0.222) 0.009 (0.379) −0.004 (0.745) 0.039***(0.000) −0.013 (0.237) 0.052***(0.000) 0.123***(0.000) 0.122***(0.000) 0.094***(0.000)
ASSET 0.273*** (0.000) 0.419***(0.000) 0.423***(0.000) 0.394***(0.000) 0.125***(0.000) 0.411*** (0.000) 0.l09*** (0.000) 0.406***(0.000) 0.345***(0.000) 0.313***(0.000)
GROWTH −0.010 (0.436) −0.011(0.428) −0.004(0.747) −0.025*(0.067) 0.025* (0.071) −0.020 (0.15) 0.029** (0.034) −0.001 (0.996) −0.023*(0.090) 0.065***(0.000)
LEVERAGE 0.105*** (0.000) 0.112***(0.000) 0.103***(0.000) 0.113***(0.000) 0.018* (0.093) 0.104*** (0.000) 0.012 (0.126) 0.050***(0.000) 0.043***(0.000) 0.031***(0.000)
CF −0.012 (0.278) −0.013(0.223) −0.013(0.268) −0.026*(0.020) 0.022** (0.049) −0.024**(0.029) 0.024** (0.031) 0.007 (0.517) 0.003 (0.735) 0.007 (0.517)

ROA ASSET GROWTH LEVERAGE CF

ROA 1.000
ASSET 0.154***(0.000) 1.000
GROWTH 0.072***(0.000) 0.092***(0.000) 1.000
LEVERAGE 0.243***(0.000) 0.259***(0.000) 0.044***(0.001) 1.000
CF 0.178***(0.000) −0.016 (0.143) 0.031** (0.02) −0.041***(0.000) 1.000

Variables definition is described in Appendix A. The superscripts ***,**, and * denote the 1%, 5%.

9
 10
Table 4
Political connections and income-smoothing.

SMOOTH
Coefficient(1) Z-Statistic Coefficient(2) Z-Statistic Coefficient(3) Z-Statistic Coefficient(4) Z-Statistic Coefficient(5) Z-Statistic

C.M. Tee / J. of Multi. Fin. Manag. 55 (2020) 100626

PCFt -1 2.171*** 41.69
PCFSHRt -1 3.685*** 39.50
AGE PCFt -1 0.207*** 10.79
PCF OLDt -1 2.666*** 37.16
PCF NEWt -1 1.142*** 13.83
PCFSHR OLDt -1 0.443*** 26.36
PCFSHR NEWt -1 0.232*** 13.92
ASSETt -1 0.036** 1.90 0.043** 2.03 0.028** 1.95 0.007 0.39 0.017 0.78
GROWTHt -1 −0.002 −0.20 −0.001 −0.10 −0.002 −0.18 0.002 0.17 0.000 0.05
ROAt -1 −0.024*** −6.73 −0.021*** −6.17 −0.019*** −5.28 −0.023*** −6.66 −0.020*** −5.52
LEVERAGEt -1 0.004 1.43 0.065** 2.11 0.000 1.09 0.000 1.23 0.067** 2.17
CFt -1 0.763* 1.71 0.737 1.59 0.803* 1.87 0.956** 2.07 0.812* 1.74

Industry dummy Included Included Included Included Included

Year dummy Included Included Included Included Included
Pseudo R2 0.340 0.316 0.332 0.366 0.331
Obs. 4783 4783 4783 4783 4783
Wald Chi-Square 1438.08 710.98
(0.000) (0.000)

Variables definition is described in Appendix A. The superscripts ***,**, and * denote the 1%, 5%.
 C.M. Tee / J. of Multi. Fin. Manag. 55 (2020) 100626 11

NEW. The reported results in column 4 and 5 suggest that both PCF OLD and PCF NEW are associated with higher likelihood
of income-smoothing. However, the coefficient magnitude for PCF OLD is larger than PCF NEW as documented in column
4 and 5. This result is consistent with institutional theory of isomorphism argument that PCFs exploit their privileges it
received from the ruling elite to build a good reputation over a long period of time (DiMaggio and Powell, 1983). Since, older
PCFs place emphasis on its prestige and reputation, they are more likely to smooth income than new PCFs.

4.4. Institutional investors’ ownership, political connections and income smoothing

In this section, the motivation to smooth income in PCFs is revealed by the moderating effect of institutional investors’
ownership. If the motivation is to expropriate firm’s wealth, institutional investors through monitoring and voting rights can
attenuate this agency problem. Likewise, if income smoothing in PCFs is regarded as an effort to convey useful information
about its business sustainability and exposure to political risk in Malaysia, it would be encouraged by institutional investors.
The positive and significant interaction coefficient in column 2 and 4, Panel A of Table 5 indicates that the positive association
between PCFs and income-smoothing is strengthened by higher institutional investors’ ownership. It is likely that institu-
tional investors regard income-smoothing as a channel by managers in PCFs to reveal useful future information to investors.
In addition, institutional investors tend to avoid firms with higher variation in income. Thus, capital markets incentivize
managers to smooth income to retain institutional investors’ ownership in PCFs. Particularly, institutional investors’ prefer-
ence for income-smoothing is stronger for PCF OLD (see column 3 and 5 of Panel B). This supports the reputational hypothesis
that older PCFs place a premium on their reputational capital, thus avoid volatile earnings. Also, income-smoothing in PCF
OLD is unlikely to be motivated by rent-seeking activities, since it would be detected by institutional investors, and damage
its prestige and reputation in the eyes of investors.
Next, the heterogeneous effect of institutional monitoring is examined by partitioning the total institutional ownership
data into domestic (IIDOM) and foreign institutional ownership (IIFOR). Column 2 of Table 6 shows that higher ownership by
IIDOM strengthens the association between PCFs and income-smoothing (1.821, p < 0.01), while higher ownership by IIFOR
weakens income-smoothing practices in PCFs. Although findings in column 4 indicate that both PCF x IIDOM and PCF x IIFOR
are positive and significant, the former’s interaction coefficient is larger in magnitude. Overall, both results suggest that
effective monitoring is largely driven by IIDOM, consistent with geographical proximity theory. Clearly, IIDOM’s proximity
to local firms, confer upon them an unparalleled advantage and proclivity to monitor PCFs.

4.5. Self-selection issue

PCFs which choose to smooth income as a mean to siphon off corporate resources may attempt to establish close ties with
key politicians in Malaysia to reduce the possibility of been detected and prosecuted by the law. To mitigate this issue of self-
selection in PCFs, this study employs propensity-score matching method to match the sample of PCFs and non-PCFs. Next,
income-smoothing variable is regressed on the experimental and other control variables to determine matched sample’s
outcome is consistent with the unmatched sample. Following Rosenbaum and Rubin (1983), the nearest-neighbourhood
technique is used as an optimal match to control for differences in characteristics between PCFs and non-PCFs. This can
reduce the potential problem of selection bias (Boubakri et al., 2012). Propensity scores are computed based on a set of firm
characteristics that capture the probability of a firm establishing political connections with top politicians. Consistent with
prior studies, leverage, ROA, and firm size (Asset) are the selected variables (Bliss and Gul, 2012; Boubakri et al., 2012). The
reported results in Table 7 show that all of the experimental variables produce the same coefficient sign and significance
level as those in Tables 4 and 5. This indicates that our results are not affected by self-selection bias. For brevity purpose,
control variables’ results are not reported.

4.6. Endogeneity

An issue of concern is that institutional investors’ ownership is endogeneously determined. For example, it is possible that
firms which smooth income may attract higher institutional investments (Liu et al., 2018). To mitigate this concern, this study
applies two-stage least squares (2SLS) tests to isolate the effect of institutional ownership on income-smoothing in PCFs. In
using the instrumental-variable (IV) method, this study closely follows the procedures proposed by Aggarwal et al. (2011).
To begin with, instrument variables which are correlated to II, IIDOM and IIFOR, are identified. However, these instruments
should not be correlated with income-smoothing, except indirectly through other independent variables. Following prior
findings, the selected instrument variables for II are: Bursa Malaysia index-linked share (BMI) and PCFSHR. Ferreira and
Matos (2008) find that shares which are index-linked are associated with higher institutional investments. In this study, a
dummy variable is created, where an index-linked share is indicated as one, and zero otherwise (BMI). In addition, prior
evidence finds that PCFs in Malaysia tend to receive higher institutional investments. This indicates that numerous privileges
granted to PCFs outweigh the agency costs of such investments (Tee et al., 2017). For IIDOM, dividend yield (DY) is selected
as an IV, while for IIFOR, Morgan Stanley Capital Index-linked share (MSCI) is selected (Aggarwal et al., 2011). Ferreira and
Matos (2008) find that dividend-paying share is preferred by domestic institutional investors, while MSCI-index linked share
attracts investments from foreign institutions (Ferreira and Matos, 2008).
 12
Table 5
Political connections, institutional investors and income-smoothing.

Panel A:SMOOTH Coefficient(1) Z-Statistic Coefficient(2) Z-Statistic Coefficient(3) Z-Statistic Coefficient(4) Z-Statistic

PCFt -1 2.156*** 42.58 1.984*** 22.44

PCFSHRt -1 3.652*** 40.10 3.269*** 20.73
IIt -1 0.286* 1.81 −0.002 −0.81 0.477** 2.61 −0.000 −0.21
PCFt -1 x IIt -1 1.248*** 2.83
PCFSHRt -1 x IIt -1 2.843*** 3.07
ASSETt -1 0.023 0.95 0.024 0.99 0.022 0.78 0.023 0.82
GROWTHt -1 −0.002 −0.19 −0.001 −0.10 −0.001 −0.09 0.000 0.01
ROAt -1 −0.024*** −6.85 −0.023*** −6.72 −0.021*** −6.28 −0.021*** −6.14
LEVERAGEt -1 0.004 1.60 0.004 1.60 0.075** 2.37 0.073** 2.28

C.M. Tee / J. of Multi. Fin. Manag. 55 (2020) 100626

CFt -1 0.765* 1.71 0.764* 1.66 0.733 1.58 0.729 1.52

Industry dummy Included Included Included Included

Year dummy Included Included Included Included
Pseudo R2 0.340 0.342 0.317 0.320
Obs. 4783 4783 4783 4783

Panel B: SMOOTH Coefficient(1) Z-Statistic Coefficient(2) Z-Statistic Coefficient(3) Z-Statistic Coefficient(4) Z-Statistic Coefficient(5) Z-Statistic

AGE PCFt -1 0.206*** 12.27

PCF OLDt -1 2.651*** 37.55 3.777*** 17.47
PCF NEWt -1 1.115*** 14.26 2.059*** 7.96
PCFSHR OLDt -1 4.336*** 26.44 3.755*** 16.90
PCFSHR NEWt -1 2.225*** 14.37 2.049*** 7.50
IIt -1 0.791*** 4.58 0.395** 2.07 0.001 0.54 0.594*** 2.78 0.043 0.14
PCF OLDt -1 x IIt -1 0.046*** 3.73
PCF NEWt -1 x IIt -1 0.017* 1.87
PCFSHR OLDt -1 x IIt -1 0.048*** 3.60
PCFSHR NEWt -1 x IIt -1 0.018* 1.76
ASSETt -1 −0.006 −0.30 −0.009 −0.37 −0.012 −0.40 −0.008 −0.26 −0.009 −0.29
GROWTHt -1 −0.003 −0.21 0.002 0.18 0.002 0.17 0.000 0.07 0.002 0.17
ROAt -1 −0.020*** −5.46 −0.023*** −6.81*** −0.020*** −5.51 −0.020*** −5.60 −0.020*** −5.50
LEVERAGEt-1 0.005* 1.65 0.000 0.44 0.079** 2.50 0.079** 2.44 0.078** 2.36
CFt -1 0.079* 1.83 0.963** 2.08 0.088* 1.66 0.813* 1.73 0.810* 1.66

Industry dummy Included Included Included Included Included

Year dummy Included Included Included Included Included
Pseudo R2 0.335 0.366 0.337 0.332 0.337
Obs. 4771 4782 4782 4782 4782

Variables definition is described in Appendix A. The superscripts ***,**, and * denote the 1%, 5%.
Table 6
Political connections, institutional investors domiciles and income-smoothing.

SMOOTH Coefficient(1) Z-Statistic Coefficient(2) Z-Statistic Coefficient(3) Z-Statistic Coefficient(4) Z-Statistic

C.M. Tee / J. of Multi. Fin. Manag. 55 (2020) 100626

PCFt -1 2.147*** 42.90 2.011*** 21.31
PCFSHRt -1 3.647*** 41.27*** 0.034 0.11
IIDOMt -1 0.452*** 3.59 −0.277 −0.93 0.521*** 3.31 0.001 0.48
IIFORt -1 −0.540 −0.79 −0.029 −0.04 0.004 0.78 −0.004 −0.73
PCFt -1 x IIDOMt -1 1.821*** 4.10
PCFt -1 x IIFORt -1 −1.996** −2.13
PCFSHRt -1 x IIDOMt -1 1.985*** 2.53
PCFSHRt -1 x IIFORt -1 0.907** 1.97
ASSETt -1 0.027 0.99 0.026 0.99 0.021 0.70 0.020 0.67
GROWTHt -1 −0.001 −0.17 −0.001 −0.11 −0.000 −0.09 0.000 0.02
ROAt -1 −0.023*** −6.76 −0.023*** −6.41 −0.021*** 6.29 −0.021*** −6.19
LEVERAGEt -1 0.004* 1.65 0.005 1.55 0.076** 2.40 0.074** 2.38
CFt -1 0.783* 1.73 0.763 1.60 0.734 1.56 0.726 1.50

Industry dummy Included Included Included Included

Year dummy Included Included Included Included
Pseudo R2 0.340 0.344 0.317 0.321
Obs. 4783 4783 4783 4783

Variables definition is described in Appendix A. The superscripts ***,**, and * denote the 1%, 5%.

13
14 C.M. Tee / J. of Multi. Fin. Manag. 55 (2020) 100626

Table 7
Propensity-score matching.

Panel A SMOOTH Coefficient(1) Z-Stat. Coefficient(2) Z-Stat.

PCFt-1 2.351*** 22.06

PCFSHRt-1 3.581*** 19.50

Control variables Included Included

Industry dummy Included Included
Year dummy Included Included
Pseudo R2 0.488 0.495
Obs. 1308 1308

Panel B SMOOTH Coefficient(1) Z-Stat. Coefficient(2) Z-Stat. Coefficient(3) Z-Stat. Coefficient Z-Stat.

PCFt-1 2.336*** 21.65 2.004*** 14.76 2.309*** 21.41 2.009*** 14.68

IIt-1 0.319 1.20 1.752*** 2.43
PCFt-1 x IIt-1 2.606*** 3.62
IIDOMt-1 0.511** 2.03 2.222** 2.55
IIFORt-1 −0.963*** −0.95 −1.163 −0.80
PCFt-1 x IIDOMt-1 3.481*** 3.92
PCFt-1 x IIFORt-1 −0.168 −0.10

Control variables Included Included Included Included

Industry dummy Included Included Included Included
Year dummy Included Included Included Included
Pseudo. R2 0.488 0.495 0.489 0.498
Obs. 1308 1308 1308 1308

Panel C SMOOTH Coefficient(1) Z-Stat. Coefficient(2) Z-Stat. Coefficient(3) Z-Stat. Coefficient Z-Stat.

PCFSHRt-1 3.548*** 19.16 2.944*** 13.09 3.542*** 18.90 2.865*** 12.52

IIt-1 0.728*** 2.74 0.917** 1.95
PCFSHRt-1 x IIt-1 4.488*** 4.33
IIDOMt-1 0.755*** 2.94 −0.633 −1.27
IIFORt-1 0.673 0.75 −2.653** −1.95
PCFSHRt-1 x IIDOMt-1 2.762*** 2.66
PCFSHRt-1 x IIFORt-1 0.169 1.55

Control variables Included Included Included Included

Industry dummy Included Included Included Included
Year dummy Included Included Included Included
Pseudo R2 0.424 0.433 0.424 0.439
Obs. 1308 1308 1308 1308

Variables definition is described in Appendix A. The superscripts ***,**, and * denote the 1%, 5%.

Column 1, Panel A of Table 8 presents the results of the first-stage regressions that use II, IIDOM, and IIFOR as the dependent
variables. II, IIDOM, and IIFOR variables are regressed on selected IVs, and other control variables12 . The first-stage regression
results support prior findings that BMI and PCFSHR are positively associated with institutional investors’ ownership. Column
2 and 3 show that DY and MSCI are positively associated with IIDOM and IIFOR, respectively. The reported significant F-test
results suggest that the instruments are strong, thus rejecting the hypotheses that these instruments can be excluded from
the first-stage regressions.
Panel B reports the coefficients of the second-stage regression that uses income-smoothing as the dependent variable.
The main results offer the same conclusion as Tables 4 and 5. After accounting for the possibility that institutional, domestic
and foreign institutional ownership is endogenous, evidence significantly supports the conclusion that there is a causal
link from institutional investors’ ownership to income-smoothing in PCFs. Therefore, it can be concluded that institutional
investors’ preference, particularly domestic institutional investors for income-smoothing in PCFs are unlikely affected by
endogeneity.

4.7. Institutional investors and firm governance

Prior literature suggests that institutional investors have the expertise to detect opportunistic earnings management
(Balsam et al., 2002). There are various channels to determine the real motivation of income-smoothing, particularly in PCFs.
Among the commonly used mechanism is to institute a strong internal governance structure within the firm. Following
prior studies, this study examines the association between institutional investors’ ownership with various types of internal
governance structure such as audit committee and board independence, auditor choice and CEO duality (Chung and Zhang,

12
Results on PCF and other control variables are not reported due to brevity purpose.
 C.M. Tee / J. of Multi. Fin. Manag. 55 (2020) 100626 15

Table 8
Two-stage least squares.

First Stage Regression II T-Stat. IIDOM T-Stat. IIFOR T-Stat.

Panel A Coefficient Coefficient Coefficient
(1) (2) (3)

BMIt-1 3.256*** 2.77

PCFSHRt-1 8.155*** 8.58
DYt-1 0.045*** 2.89
MSCIt-1 5.773*** 7.26

Control variables Included Included Included

Industry dummy Included Included Included
Year dummy Included Included Included
Adj. R2 0.287 0.248 0.130
F-Test (IV) 33.14 22.15 20.56
Obs. 4783 4783 4783

Second Stage Regression Coefficient Z-Stat. Coefficient Z-Stat. Coefficient Z-Stat. Coefficient Z-Stat.
SMOOTH Panel B (1) (2) (3) (4)

PCFSHRt-1 3.657*** 30.79 3.675*** 32.06 3.656*** 30.83 3.682*** 32.67

PRE IIt-1 0.026* 1.66 −0.000 −0.23
PCFSHRt-1 x PRE IIt-1 0.015* 2.38
IIDOMt-1 0.239** 2.36 −0.181 −0.56
IIFORt-1 0.001 0.43 0.000 0.16
PCFSHRt-1 x IIDOMt-1 1.759** 2.43
PCFSHRt-1 x IIFORt-1 0.008 0.33

Control variables Included Included Included Included

Industry dummy Included Included Included Included
Year dummy Included Included Included Included
Pseudo R2 0.345 0.345 0.345 0.345
Obs. 2921 2921 2921 2921

Variables definition is described in Appendix A. The superscripts ***,**, and * denote the 1%, 5%.

Table 9
Institutional investors and firm governance.

Panel A Full sample

AUDIT T-Stat. BIND T-Stat. AUDITOR Z-Stat. DUALITY Z-Stat.

IIt-1 0.092*** 6.31 0.047*** 5.55 0.472*** 5.25*** −0.591*** −4.82

Control Included Included Included Included

Industry dummy Included Included Included Included
Year dummy Included Included Included Included
Adj. R2 0.231 0.111
Pseudo R2 0.088 0.01
Obs. 5969 5969 5969 5969

Panel B Full sample

AUDIT T-Stat. BIND T-Stat. AUDITOR Z-Stat. DUALITY Z-Stat.

IIDOMt-1 0.124*** 6.97 8.353*** 20.64 0.994*** 8.24*** −1.049*** −7.21

IIFORt-1 0.073* 1.86 0.199*** 4.31 2.052*** 7.34*** 1.955*** 4.90

Control Included Included Included Included

Industry dummy Included Included Included Included
Year dummy Included Included Included Included
Adj. R2 0.233 0.116
Pseudo R2 0.088 0.017
Obs. 5969 5969 5969 5969

Variables definition is described in Appendix A. The superscripts ***,**, and * denote the 1%, 5%.

2011; Cornett et al., 2008). Panel A of Table 9 document a positive association between institutional ownership and audit
and board independence. Additionally, firms with higher institutional ownership are more likely to hire big four auditors,
and less likely to appoint CEO to chair the board. With the assistance of strong internal governance structure to assist
monitoring by institutional investors, it is likely that income-smoothing in PCFs is due to the need to reduce volatile earnings,
while at the same time conveying useful private information to investors. Apparently, Panel B shows that this positive and
significant association is largely driven by IIDOM. In the case of IIFOR, their ownership is associated with lower audit and
board independence, and CEO duality.
16 C.M. Tee / J. of Multi. Fin. Manag. 55 (2020) 100626

4.8. Structural effects

Finally, this study considers two major events that may influence income smoothing practices in PCFs, as well as insti-
tutional investors’ monitoring. First, the effect of 2008 global financial crisis is examined. The financial performances of
PCFs tend to decline during the period of financial crisis, since the government’s ability to provide financial assistance is
constrained (Johnson and Mitton, 2003; Leuz and Oberholzer-Gee, 2006). As such, PCFs are likely to smooth income, while
institutional investors adopt a more vigilant monitoring role during financial crisis period. Therefore, there is a possibility
that effect of global financial crisis drives main results. For this purpose, the study’s sample is divided into pre-crisis period
(2002–2008) and post-crisis period (2008–2015). The untabulated results are similar in outcomes as those in Tables 5 and 6.
Second, within this study period, Malaysia was led by three PMs, namely: the administration of: Mahathir Mohammed
(2002–2003), Abdullah Badawi (2004–2008) and Najib Razak (2009–2015). Although, all of them are from the BN govern-
ment, they may have different style of administering Malaysia. However, despite partitioning into sub-samples covering
three periods under different PMs, main results (unreported) do not diverge from results in Table 4 till 6.

5. Conclusion

Prior evidence from accounting literature suggests that income-smoothing is associated with compensation incentives,
cost of capital, CEO tenure, and the dissemination of useful private information to investors. This study introduces another
dimension, i.e., political connections and income-smoothing. The focus is whether political connections, one of the key
institutional settings of an emerging economy such as Malaysia’s, is associated with the likelihood of income-smoothing.
Understanding the relationship between income-smoothing and political connections in a deeply entrenched crony capi-
talism and political patronage system is crucial as income alterations can be a double-edged sword. While it can be used to
bring to the fore useful private information to all investors about the PCFs’ business sustainability and their future exposure
to political risks, it can be also being adversely used to divert corporate resources towards rent-seeking activities which
reduce the firm’s value. One of the ways to determine the real motivation of smoothing income in PCFs is to investigate the
moderating effect of institutional investors.
The findings of this study offer both theoretical contributions to the accounting literature, and practical implications to
the industry. Theoretically, it addresses several gaps in the literature by providing new empirical evidence that PCFs are
more likely to smooth income than non-PCFs. The results are consistent with the political cost hypothesis which posits
that PCFs prefer a corporate strategy that reduces political attention (Watts and Zimmerman, 1986), due to scrutiny by the
media, investors, analysts, politicians and regulators (Chaney et al., 2011). This study considers income-smoothing to be
one such strategy. Second, the duration of political connections is positively associated with income-smoothing; thus, it
is only prevalent in older PCFs. This lends support to the institutional isomorphism theory, which argues that older PCFs
do evolve over time to be more efficient and remain conscientious of their hard-earned prestige. Third, in line with their
fiduciary duty and monitoring hypothesis, institutional investors are reported to prefer predictable streams of earnings in
PCFs. However, this is only encouraged if institutional investors view income-smoothing as a means of conveying useful
information about earnings stability to investors. This study validates this proposition by showing that institutional investors’
ownership strengthens the association between income-smoothing in PCFs. More importantly, the positive moderating effect
is largely driven by the monitoring advantages enjoyed by domestic institutional investors, consistent with the argument
of geographical proximity theory that they have the proclivity to monitor investee firms.
The findings are of practical interest to investors, analysts, auditors and regulators. The likely prevalence of income-
smoothing in PCFs should remind investors, analysts, and auditors to be cautious in their use and interpretation of financial
statements, and understand their exposure to political risks, particularly for older PCFs. In fact, income-smoothing is closely
related to the firm’s earnings quality, which is the ability of income to reflect the firm’s current performance. This points to
an implicit need for investors to better understand the institutional factors that affect the accuracy of data at their disposal.
Overall, these findings enrich our understanding of income-smoothing practices in countries where institutional struc-
tures, such as the judiciary, are weak and political connection is an important institutional feature. However, beyond this
study, there is still room for future research. First, future studies can explore the relationship between capital markets
incentives with income-smoothing practices in PCFs. Second, it would be interesting to investigate whether the effect of
institutional monitoring is heterogeneous. For example, as in the literature, institutional investor ownership can be short-
term and long-term horizons or business relationships with their investee firms. These compelling directions are left for
future research.

Acknowledgements

I acknowledge the financial support by Monash University Malaysia Seed Grant (B-10-17 andB-7-17) and research
assistants for their data collections work.
 C.M. Tee / J. of Multi. Fin. Manag. 55 (2020) 100626 17

Appendix A. Variables definition

Variables Definition

SMOOTH A dummy variable, indicates one, if the firm is classified as a “smoother” and zero, otherwise based on Income
Smoothing Ration (ISR)
PCF A dummy variable, indicates 1, if the firm is classified as a political connected firm, and zero otherwise
PCFSHR Percentage shareholding held by political connected directors or controlling shareholders
AGE PCF Duration of political connection
PCF OLD A dummy variable indicated as one if it is identified as old political connected firm, and zero otherwise
PCF NEW A dummy variable indicated as one if it is identified as new political connected firm, and zero otherwise
PCFSHR OLD Percentage shareholding held by older political connected firms’ directors or controlling shareholders
PCFSHR NEW Percentage shareholding held by new political connected firms’ directors or controlling shareholders
II Percentage of shares held by institutional investors scaled by total shares outstanding
IIDOM Percentage of shares held by domestic institutional investors scaled by total shares outstanding
IIFOR Percentage of shares held by foreign institutional investors scaled by total shares outstanding
Return on Asset (ROA) Net profit scaled by total assets
Return on Equity (ROE) Net profit scaled by shareholders equity

ASSETS Natural log of total assets

SALES Natural log of sales
GROWTH The growth rate of sales, computed as the sales in year t minus sales in t – 1 and scaled by sales in year t – 1
LEVERAGE Total debt scaled by total assets
BMI A dummy variable, indicated as one if the stock is linked to Bursa Malaysia index, and zero otherwise
DY Annual dividend yield
MSCI A dummy variable, indicated as one if the stock is linked to Morgan Stanley Capital I index, and zero otherwise
PRE II Predicted total institutional ownership
PRE IIDOM Predicted domestic institutional ownership
PRE IIFOR Predicted foreign institutional ownership.
AUDIT Ratio of independent director in audit committee
BIND Ratio of independent director in board of director
AUDITOR A dummy variable, indicated as one if the firm’s financial statement is audited by a big four audit firm, and zero
otherwise
DUALITY A dummy variable, indicated as one if the firm’s CEO is also the chairman of the board, and zero otherwise

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