Subordinate external employment opportunities and corporate decision-making

Abstract

I examine the impact of the external labour market on subordinate executives' incentives and behaviour associated with firms' financial reporting quality and investment choices. Specifically, I test how the strength of the external employment opportunities facing subordinates influences focal firms' earnings management choices, overall investment level, the level of excess cash holdings and the likelihood of cutting committed resources following sales drops.

I find that firms whose subordinates face greater external employment opportunities, measured by the compensation difference between focal firms' subordinates and their peers, tend to engage more aggressively in income-increasing real and accrual-based earnings management. This result is robust to alternative methods of peer identification schemes, alternative measures of subordinate external pay gaps, suspect firm sample analyses and propensity score matched sample analyses. Further, the association between the subordinate external employment opportunities and focal firms' income-increasing real and accrual-based earnings management is stronger in years in which the likelihood of firms' engaging in earnings management is higher. I also show that on classifying subordinates according to their predominant functional roles (financial or operating), operating subordinates' incentives can significantly influence both accruals-based and real earnings management whereas financial subordinates do not seem to have independent effects on accruals management. One possible interpretation is that financial subordinates are held more responsible for focal firms' financial statements and may incur higher financial or reputational costs, such as legal punishments or fines, if financial misconduct is revealed.

With regard to the impact of the value of subordinates' external employment opportunities on focal firms' decisions regarding investment behaviour, I find that although the strength of such opportunities has a positive impact on focal firms' tendency to underinvest, it does not significantly affect firms' excess cash holdings. Further, firms with larger subordinate external pay gaps tend to cut less of resources they have committed following a decrease in sales. However, these findings are highly sensitive to peer identification schemes. Show more