In this study, we examine the relationship between employee effort within the firm and earnings management, using data on working hours and discretionary accruals. With higher employee effort, we find less earnings management among U.S. firms. This result is stronger when earnings are more predictable and persists after we control for endogeneity. We also find smaller earnings discontinuities with higher employee effort. Our domestic results remain the same with a global sample. Our results suggest that earnings management enables benchmark beating with greater precision than can high employee effort alone, but also that high-effort firms may be misclassified as earnings manipulators.
According to Dichev, Graham, Harvey, and Rajgopal (2013), surveyed financial managers in the United States believe that 20% of firms manage their earnings to misrepresent economic performance and reach earnings benchmarks, such as earnings above zero. Despite the dishonesty of such practices (Graham, Harvey, & Rajgopal, 2005; McGuire, Omer, & Sharp, 2012), it is rational that managers use discretion embedded in accounting standards to meet benchmarks based on prospect theory (Kahneman & Tversky, 1979). In addition, managers failing to meet earnings expectations may be punished with lower compensation or even dismissal (Farrell & Whidbee, 2003; Matsunaga & Park, 2001). While accounting and finance researchers have focused on earnings management as the primary way to meet or beat earnings benchmarks, they have largely neglected the role of reference-dependent effort (see Allen, Dechow, Pope, & Wu, 2017). In this paper, we investigate whether higher employee effort is a substitute for earnings management.
Researchers commonly use agency theory to explain earnings management, arguing that it results from various conflicts of interest and information asymmetries between managers and owners (Jensen & Meckling, 1976). While managers may act out of self-interest, they simultaneously realize that their individual destinies depend on the performance and the survival of the firm in its competition with other firms. Fama (1980) emphasizes that individual managers are disciplined by the labor market for managers. Hence, managers monitor other managers both above and below themselves, to ensure that policies send the most positive signals to that market. Policy choices that send negative signals (such as accounting choices that include earnings management) will impose private costs on managers, namely, opportunity wage decreases. To avoid such costs, managers should seek an alternative to earnings management, even if the alternative has its own costs. While Dichev et al. (2013) suggest that earnings management is widespread, Dechow, Richardson, and Tuna (2003) stress that the first-choice way to meet or beat earnings benchmarks is to set targets and motivate employees to work harder. The second choice would be earnings management. In this paper, we examine how these strategies are related.
Empirically, we follow the audit effort literature that uses auditor working hours (Caramanis & Lennox, 2008; Che, Langli, & Svanström, 2017), by using the working hours of employees at U.S. publicly listed firms as a proxy for employee effort. We use annual hours worked by an average employee according to data from the Occupational Safety and Health Administration (OSHA) for 2002–2011. We follow previous researchers (Kothari, Leone, & Wasley, 2005; Peasnell, Pope, & Young, 2000) in measuring earnings management.