The Effects of Vertical Pay Dispersion: Experimental Evidence in a Budget Setting

Vertical pay dispersion is the difference in pay across different hierarchical levels within an organization (Milkovich and Newman 1996 ). While vertical pay dispersion may be useful in attracting, retaining, and motivating highly skilled employees (Lazear and Rosen 1981 ; Lazear 1995 ; Prendergast 1999 ), our study investigates a potential disadvantage; specifically, the negative impact of perceived unfairness of vertical pay dispersion on employees' budgeting decisions. We predict and find that high vertical pay dispersion motivates subordinates to misreport costs to a greater extent than low vertical pay dispersion. Furthermore, we predict and find that superiors, on average, exercise more lenient cost controls when vertical pay dispersion is high rather than low. Supplemental analysis indicates superiors are more lenient on average because of their aversion to inequity caused by vertical pay dispersion. Our results suggest that high vertical pay dispersion can compromise the overall corporate budgeting environment, where higher levels of misreporting by subordinates goes unchecked by superiors.     

Gambling Attitudes and Financial Misreporting

We investigate whether attitudes toward gambling help explain the occurrence of intentional misreporting. Similar to gambling, some financial reporting choices involve taking deliberate, speculative risks. We predict that in places where gambling is more socially acceptable, managers will be more likely to take financial reporting risks that increase the likelihood the financial statements will need to be restated. To test this prediction, we exploit geographic variation in local gambling attitudes and find that restatements due to intentional misreporting are more common in areas where gambling is more socially acceptable. This association is even stronger in situations where management is under greater pressure to misreport, including when the firm is close to meeting a performance benchmark, experiencing poor financial performance, or under investment‐related pressure. Furthermore, these results are robust to numerous tests to address omitted variables and endogeneity. Collectively, these findings suggest gambling attitudes help explain the incidence of intentional misreporting.     

Independence Threats,Litigation Risk,and the Auditor's Decision Process*

This study examines the effect of independence threats and litigation risk on auditors' evaluation of information and subsequent reporting choices. Using a Web‐based experiment, I tracked auditors' information gathering and evaluation leading to a going‐concern reporting decision. Specifically, 48 audit managers assessed client survival likelihood, gathered additional information, and suggested audit report choices. I found that auditors facing high independence threats (fear of losing the client) evaluated information as more indicative of a surviving client and were more likely to suggest an unmodified audit report, consistent with client preferences. In contrast, auditors facing high litigation risk evaluated information as more indicative of a failing client and were more likely to suggest a modified audit report. In addition, the association between risk and report choice was fully mediated by final information evaluation. This suggests that it is unlikely that different reporting choices resulted from a conscious choice bias, but rather that motivated reasoning during evidence evaluation plays a key role in the effect of risk in auditor decision making.     

Audit Strategies and Multiple Fraud Opportunities of Misreporting and Defalcation*

We examine how an auditor assesses the risk of fraud and formulates an audit plan when the auditee has the opportunity to commit various types of fraud. Unlike previous studies, the audi‐tee can misappropriate assets (defalcation), misreport financial information (fraudulent financial reporting), or misreport financial information in combination with defalcation. Our results identify four possible equilibria whose characteristics depend on the auditee's relative rewards and penalties from the various types of fraud, the cost of audit effort, and expectations about the auditee‐firm's performance. When the cost of audit effort is sufficiently small, fraud risk assessment depends on the auditee's rewards and penalties associated with each type of fraud, but not on the auditor's beliefs about firm performance. The auditor develops an audit plan that focuses on the type of fraud the auditee is most motivated to commit, and in turn, the audit plan deters all other types of fraud.     

Discussion of “The Effects of Vertical Pay Dispersion: Experimental Evidence in a Budget Setting”

Guo, Libby, and Liu (2017) (hereafter GLL), examine how pairs of experimental subjects interact in a game framed as a funding request from a privately informed subordinate to a superior. When the superior's pay is higher than the subordinate's, subordinates display more self‐serving dishonesty and superiors are more tolerant of it than when their pay is the same. In this discussion, I compare GLL's design with an ultimatum game, consider additional tensions that arise in pay‐level comparisons, address the applicability of their results, and suggest some extensions. I conclude by calling for new theory that regularizes GLL's surprising findings.     

Honor Among Thieves: Open Internal Reporting and Managerial Collusion

Firms have increasingly adopted open work environments. Although openness is thought to have benefits, it could also expose firms to an unanticipated cost. An open (closed) internal reporting environment makes it more (less) likely that managers will observe a colleague's communications with senior executives. This increase in what one manager knows about another manager's communication to senior executives could facilitate employee collusion to extract resources from the firm. To test whether internal reporting openness results in more collusion, we conduct an experiment in which two managers each make separate reports to the firm about cost information they know in common but that remains unknown by the firm. Because both managers face the same truth‐inducing contract, conventional economic theory predicts that they will not collude to misreport costs regardless of reporting openness. However, using behavioral theory involving trust and reciprocity, we predict and find that managers honor their nonbinding collusive agreements and successfully collude more often in an open versus closed internal reporting environment, leading to lower firm welfare in the open environment. These results suggest that firms should consider how the cost of collusion compares to the benefits of openness.     

Equilibrium Earnings Management,Incentive Contracts,and Accounting Standards*

In this paper, we model earnings management as a consequence of the interaction among self‐interested economic agents ‐ namely, the managers, the shareholders, and the regulators. In our model, a manager controls a stochastic production technology and makes periodic accounting reports about his or her performance; an owner chooses a compensation contract to induce desirable managerial inputs and reporting choices by the manager; and a regulatory body selects and enforces accounting standards to achieve certain social objectives. We show that various economic trade‐offs give rise to endogenous earnings management. Specifically, the owner may reduce agency costs by designing a compensation contract that tolerates some earnings management because such a contract allocates the compensation risk more efficiently. The earnings‐management activity produces accounting reports that deviate from those prescribed by accounting standards. Given such reports, the valuation of the firm may be nonlinear and s‐shaped, thereby recognizing the manager's reporting incentives. We also explore policy implications, noting that (1) the regulator may find enforcing a zero‐tolerance policy ‐ no earnings management allowed ‐ economically undesirable; and (2) when selecting the optimal accounting standard, valuation concerns may conflict with stewardship concerns. We conclude that earnings management is better understood in a strategic context that involves various economic trade‐offs.     

The Role of Narcissistic Hypocrisy in the Development of Accounting Estimates

In an experiment including experienced managers, we investigate how supervisor and subordinate narcissism influence a supervisor's review of a subordinate's accounting estimate. While narcissistic supervisors express greater liking for narcissistic subordinates (narcissistic tolerance), they nonetheless reject and revise the accounting estimates of narcissistic subordinates to a greater extent than they reject estimates of non-narcissistic subordinates (narcissistic hypocrisy), even when doing so inhibits the supervisor's ability to reach a profit target. Our findings contribute to extant research in accounting and psychology. We demonstrate that narcissistic hypocrisy extends beyond the evaluation of others and alters narcissists' willingness to rely on other narcissists in a meaningful financial reporting decision. We also find that narcissistic hypocrisy is robust across age, gender, and supervisory experience.     

Why Are People Honest? Internal and External Motivations to Report Honestly

We create and validate measures capturing internal and external motivations to report honestly as trait-like characteristics. Both measures have high levels of reliability, as well as convergent and divergent validity. To test their predictive validity, we conduct two experiments. In the first experiment, MTurk participants have the opportunity and incentive to misreport with no immediate consequences, and in the second experiment, participants with management experience report how they would make a hypothetical accounting allocation decision. In both experiments, we find that participants who are higher in internal motivations to report honestly are more likely to report honestly than those lower in internal motivations, confirming this measure's predictive validity. Both experiments also provide limited support for the predictive validity of our external measure, finding that those who are higher in external motivation do not report differently than those who are lower in external motivations in the absence of controls. Our study also reveals that individuals who are higher in internal motivations have a diminished reaction to different management controls: MTurk participants to a control that punishes misreporting, and manager participants to a control that rewards honest reporting. Results suggest that management and those charged with governance should consider that some employees can react negatively to controls that are perceived as constraining. Our measures are useful to researchers who investigate honest reporting by allowing them to identify, ex ante, individuals who want to be honest versus wanting to appear honest.     

Do ‘Boss Effects’ Exist in Japanese Companies? Evidence from Subordinate–Supervisor Matched Panel Data*

This article investigates whether supervisors can significantly enhance their subordinates' performance using a five‐waves panel dataset from a medium‐sized Japanese firm comprising around 400 employees. The dataset includes all regular non‐managerial employees working in one manufacturing company. About 40 supervisors were matched to their subordinates, and the evaluation outcomes were used to evaluate the worker performance. The results showed that supervisor effects were heterogeneous, displayed a one‐year lag, and lasted for two years. We proved the existence of the supervisor effect on current performance, by using current supervisor dummies or past supervisor dummies. Irrespective of the supervisor being switched, the effect of the past supervisor on workers’ current performance continues to exist. It was also found that these effects remained significant, even when workers were assigned new/different supervisors.     

The Influence of Corporate Social Responsibility Measures on Investors' Judgments when Integrated in a Financial Report versus Presented in a Separate Report

This study examines the effect on investors' judgments of corporate social responsibility (CSR) measures when integrated with financial information in a single report versus when presented in a separate CSR report. Advocates for integrated reports argue that CSR information will be perceived as more relevant and have a greater impact on users when observed in an integrated report. However, we provide experimental evidence that CSR measures have greater influence on investors' judgments when investors observe the CSR information and financial information depicted in separate reports. We also provide evidence that this greater influence of CSR measures is caused by investors' evaluations taking on a “multidimensional perspective” that includes both a social responsibility and a financial dimension, which is triggered by observing the separate CSR report. Activating a social responsibility dimension elevates the perceived relevance of CSR measures, increasing their influence on investors' judgments. Our study contributes to practice by highlighting a potential unintended consequence of issuing integrated versus separate CSR reports: that investors incorporate CSR information less when it is integrated with financial information versus separately reported.     

Home Country Investor Protection,Ownership Structure and Cross‐Listed Firms' Compliance with SOX‐Mandated Internal Control Deficiency Disclosures

We examine whether home country investor protection and ownership structure affect cross‐listed firms' compliance with SOX‐mandated internal control deficiency (ICD) disclosures. We develop a proxy for the likelihood of cross‐listed firms' ICD misreporting during the Section 302 reporting regime. For cross‐listed firms domiciled in weak investor protection countries, we have three main findings. First, firms whose managers control their firms and have voting rights in excess of cash flow rights are more likely to misreport ICD than other firms during the Section 302 reporting regime. Second, there is a positive association between the likelihood of ICD misreporting and voluntary deregistration from the SEC prior to the Section 404 effective date. Third, for firms that chose not to deregister, there is a positive association between the likelihood of ICD misreporting and the reporting of previously undisclosed ICDs during the Section 404 reporting regime. We do not find similar evidence for cross‐listed firms domiciled in strong investor protection countries. Our findings are consistent with the hypothesis that, for cross‐listed firms domiciled in weak investor protection countries, managers who have the ability and incentive to expropriate outside minority shareholders are reluctant to disclose ICDs in order to protect their private control benefits. The results of our study should be of interest to regulators who wish to identify noncompliant firms for closer supervision, investors who wish to identify ex ante red flags for poor financial disclosure quality, and researchers who wish to understand the economic forces governing cross‐listed firms' financial disclosure behavior.     

Cherry Picking,Disclosure Quality,and Comprehensive Income Reporting Choices: The Case of Property‐Liability Insurers*

Statement of Financial Accounting Standards No. 130: Reporting Comprehensive Income encourages enterprises to report comprehensive income on a performance statement rather than on a statement of equity. We investigate the reporting decisions of 82 publicly traded property‐liability insurers that are fairly evenly split in their choice. Our results demonstrate that insurers with a tendency to manage earnings through realized securities' gains and losses (that is, cherry pickers), as well as insurers with a reputation for poor disclosure quality, are more likely to report comprehensive income in a statement of equity. Apparently, these insurers face the highest cost of transparency. We do not find a relation between the reporting decision and the volatility of comprehensive income relative to the volatility of net income. Our findings that insurers' comprehensive income reporting choices are a reflection of their proclivity toward cherry picking as well as their level of disclosure quality should be of interest to standard‐setters because of the controversy over standard‐setters' preference for mandating all firms to report comprehensive income in a performance statement.     

Managing Perceptions of Technical Competence: How Well Do Auditors Know How Others View Them?*

We investigate factors that influence an auditor's accuracy in knowing how subordinates, peers, and superiors view his or her own technical competence (metaperception). Extant literature on reputation management in auditing contexts depicts preparers of audit workpapers as strategic agents (subordinates) who stylize workpapers and engage in behaviors that enhance their reputations with reviewers (superiors). These superiors, in turn, are represented as strategically engaging in coping behaviors in response to such stylization attempts. One of the necessary conditions for auditors to enhance their reputations on a sustainable basis is accurate metaperception. We report the results of an experiment that investigates determinants of auditors' metaperception accuracy. Our participants comprise teams of audit partners, managers, and seniors who work together in the field. Each auditor performs two tasks of varying complexity and then predicts whether other team members can accurately perform the task and how other team members assess his or her performance on the tasks. Results show that accuracy in knowing what others think of one's technical proficiency (metaperception) is generally high, particularly when the predictor auditors are partners and managers; however, metaperception accuracy is asymmetric and varies depending on the predictor auditor, the target auditor being predicted, and task complexity. Implications are discussed.     

Investor Sentiment,Misstatements, and Auditor Behavior*

High investor sentiment has been linked with opportunistic managerial behavior in the face of more optimistic investors and analysts. We extend this line of work by documenting that the likelihood of misstatements is higher when sentiment is high. Although this would suggest elevated audit risk, we posit that a contemporaneous reduction in auditors' litigation cost could drive down audit fees and going concern opinion (GCO) reporting conservatism in order to please clientele. Consistent with this notion, we document that auditors charge lower fees and report GCOs less conservatively when sentiment is high. However, this reduction in reporting conservatism is unwarranted; results reveal that auditors are less likely to issue GCOs to clients which subsequently file for bankruptcy during high sentiment periods. We conduct additional tests to examine whether auditors' litigation costs indeed vary with sentiment and document that auditors are less likely to be sued and the market reacts less negatively to misstatement announcements when sentiment is high. Collectively, our findings suggest that, although misstatement risk is increasing with sentiment, auditors' litigation risk actually declines.     

Disability Reporting Choices by Married Couples: Evidence from Census Data

The purpose of this paper is to analyze determinants of the decision to self-report health impairments that limit or prevent work. Its particular focus is on joint reporting behavior by married couples, with a view toward potential interdependence of spouses' reporting decisions. The model is based on a large sample of married couples taken from the 1990 Public Use Microdata Sample of the U.S. Census. Empirical analysis is based on a simultaneous probit model of spouses' reports. Results of the analysis show evidence of an association between spouses' reports, after controlling for important background variables. The extent of association appears to be more pronounced among low earners and among older wives.     

Common Institutional Ownership and Earnings Management*

This study examines the relation between earnings management and block ownership of same‐industry peer firms by a common set of institutional investors (common institutional ownership). This relation is important given the tremendous growth of common institutional ownership and the significant influence of blockholders on financial reporting. We hypothesize that common institutional ownership mitigates earnings management by enhancing institutions' monitoring efficiency and by encouraging institutions to internalize the negative externality of a firm's earnings management on peer firms' investments. Consistent with our hypothesis, we find that higher common institutional ownership is related to less earnings management. Analyses of a quasi‐natural experiment based on financial institution mergers show that this negative relation is unlikely to be driven by the endogeneity of common institutional ownership. Cross‐sectional tests provide evidence that the negative relation is stronger among firms for which common institutional ownership is likely to generate a greater reduction in institutions' information acquisition and processing costs, and among firms whose severe financial misstatements are more likely to distort co‐owned peer firms' investments, supporting both mechanisms underlying our hypothesis. Our findings inform the ongoing debate on the costs and benefits of common institutional ownership by highlighting an important benefit: the enhanced monitoring of financial reporting.     

Lenders’ Response to Peer and Customer Restatements

We investigate whether restatements announced by economically related firms influence the contract terms a borrower receives from lenders. A restatement by a major customer firm increases the loan spread of a borrower by 11 basis points, on average. The contagion effects of customer restatements are higher (45 basis points) when a borrower's switching costs are high. Restatements by peer firms in the same industry also increase a borrower's loan spread, and this increase occurs regardless of restatement severity. Moreover, the sensitivity of loan spread to peer restatements is significantly greater when the restating peer firms are also in the bank's lending portfolio, suggesting that a lender's personal experience with restatements in an industry makes it more attuned to the potential implications of these restatements for the borrowing firm. Finally, our results suggest that lenders utilize information from peer restatements to anticipate future restatements by the borrowing firm.     

Do Shareholders Assess Managers' Use of Accruals to Manage Earnings as a Negative Signal of Trustworthiness Even When Its Outcome Serves Shareholders' Interests?*

We examine how shareholders' trust in managers is affected by (i) the outcome of earnings management (inconsistent vs. consistent with shareholders' interests) and (ii) the method of earnings management (accruals vs. real methods). Using a controlled experiment, we predict and find that trust is impaired when the outcome of earnings management suggests that managers have put their interests above shareholders' interests and/or when the method of earnings management suggests that managers misreported the firm's economic performance. We argue that shareholders assess managers putting their interests above shareholders' interests as a signal of untrustworthiness because it involves a transfer of the firm's resources away from shareholders to managers. We argue that shareholders also assess managers' use of accruals to manage earnings as a signal of untrustworthiness because, in this instance, managers misreport the firm's economic performance. Finally, we show that trust mediates the combined effects of the outcome of earnings management and the method of earnings management on investment decisions. Our study incrementally contributes to the literature by highlighting the adverse implications of managers' use of accruals to manage earnings even when its outcome serves shareholders' interests.