Broadly-Distributed Equity-Based Compensation and Earnings Management: The Robin-Hood Effect or Economic Incentives

• In Event: Financial Accounting and Reporting 3

Abstract

Prior research provides evidence that linking executive compensation to the value of the firm’s equity results in greater earnings management in financial reports, but has not examined the impact of granting equity compensation broadly to rank-and-file employees on earnings management. There are two reasons to suspect that broad-based plans will increase earnings management. First, psychology research suggests that individuals are better able to justify dubious behavior when it benefits others. Consequently, firms that offer broad-based plans may unwittingly provide executives with a built-in justification to manage earnings (i.e., to increase the value of employees’ equity-based compensation). Second, economic theory suggests that broad-based plans provide employees with greater incentives to engage in earnings management to increase the value of their equity-based compensation. Our results suggest that broad-based plans increase executives’ willingness to rationalize earnings management, leading to increased earnings management. We also find that broad-based plans increase rank-and-file employees’ earnings management activities. Overall, we find compelling evidence that both psychological and economic factors influence changes in firms’ earnings management activities accompanying the adoption of broad-based compensation plans and as equity-compensation is granted more extensively throughout the organization.

Authors

• Darin Kip Holderness, West Virginia University

• Melissa F Lewis, University of Utah