Earnings Management of Chemical Firms in Response to Political Costs from Environmental Legislation

Abstract

This paper examines the earnings management of chemical firms at the end of 1979 when Congress was considering legislation leading to the Comprehensive Environmental Response, Compensation, and Recovery Act of 1980. This legislation gave the U.S. government the authority to remediate hazardous chemical waste sites and set up a Superfund, funded largely by the chemical industry, to cover cleanup costs. Unlike prior studies that use single, often crude, measures of political costs, we employ seven different measures of the firms' exposure to costs arising from Superfund. Additionally, using factor analysis, we construct a composite measure of political costs. There is some evidence from time-series tests that chemical firms took income-decreasing accruals in 1979 at the height of the Superfund debate but, as expected, they did not in the prior or preceding year. Cross-sectional tests show that the size of the earnings response is correlated negatively with four of the seven individual proxies for political costs. Also, the common factor for political cost is related significantly to the earnings response. Overall, the evidence is consistent with the political cost hypothesis.