Does the Executive Labor Market Discipline? Labor Market Incentives and Earnings Management

Abstract

This paper investigates the role of outside options in the executive labor market on earnings management decisions. To proxy for executives’ outside options, we use the number of times other firms cite the executive’s firm as a compensation peer. We find that executives with more citations conduct less earnings management. Exploiting the 2006 SEC requirement for compensation peer disclosure as a quasi-natural shock to executives’ awareness of outside options, we show that the executives who should be more responsive to outside options significantly reduce earnings management. Cross-sectional tests support a labor market discipline channel of outside options. Finally, we exploit state-level recognition of Inevitable Disclosure Doctrine and enforcement of non-compete agreements as cross-sectional restrictions on labor mobility and show that the impact of peer citations on reducing earnings management is stronger when there are fewer restrictions on mobility.

Keywords: Executive Incentives, Earnings Management, Compensation Peers

JEL Classification: G34, J31, J34, M41