Rank and File Equity Compensation and Earnings Management: Economic incentives and the Robin Hood Effect
63 Pages Posted: 1 Jul 2016 Last revised: 8 Aug 2018
Date Written: May 9, 2018
The wide-spread use of rank and file equity-based compensation suggests that executives believe that rank and file employees can affect firm outcomes, and some research supports this view. If equity-based incentives influence rank and file employees’ productive efforts, they might also influence rank and file employees’ earnings management decisions as extant literature provides evidence that equity-based compensation creates earnings management incentives (economic incentive effect). Rank and file equity-based compensation may also influence executives’ earnings management decisions as psychology research suggests that individuals are better able to justify dubious behavior when the behavior can be rationalized as benefitting other, less-fortunate individuals. Consequently, firms that offer equity compensation to rank and file employees may provide executives with a built-in justification to manage earnings (the Robin-Hood effect). Our results provide evidence that increases in rank and file employees’ equity-based compensation are associated with increases in earnings management. Cross-sectional tests are more consistent with economic incentives of rank and file employees accounting for our results rather than the Robin Hood effect influencing executives’ propensity to rationalize earnings management.
Keywords: Earnings management; rank and file employees; compensation; equity incentives; stock options; financial reporting quality
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