Sword of Damocles: Job Security and Earnings Management
2019-12-26 17:04:19
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To navigate the chaos of the financial world, it is crucial to have high-quality information. Yet managers often have incentives to influence reported earnings, undermining the quality of a firm's financial information. Why do they choose to manipulate it? PHBS Assistant Professor Li Di and coauthors wanted to know, and their research landed them the Best Paper prize by Wharton Research Data Services (WRDS) during its first Advanced Research Scholar Program.

As the world's leading business intelligence, data analytics and research platform, WRDS launched the program in 2018 for international scholars to gain an in-depth understanding of empirical research practices and insights into the latest innovations in academic research. The inaugural program's participants were selected following paper submissions from 22 leading academic institutions in China.

Li, along with Cai Chen, assistant professor, Cleveland State University, and Fang Xiaohua, assistant professor, Florida Atlantic University, examined a large sample of U.S. public firms to study the relationship between CEO dismissal hazard and earnings management, following up prior studies showing that a potential reason for “earnings management” is a manager's concern about job security. However, according to Li and colleagues, the empirical evidence is mixed.

According to their paper “Job Security and Earnings Management,” when a change in CEO job security does not immediately cause a turnover, CEOs in such situations face a variety of options: take action to improve real firm performance (being disciplined) or distort earnings information (opportunism). Li's study shows that the “disciplinary effect of CEO job security is dominant, especially for income-inflating manipulation. In contrast, the opportunistic effect exists, only when the dismissal risk is extremely high.” In short, Li remarked, “The hanging sword of Damocles can make CEOs work diligently and properly, though sometimes they may react opportunistically when they perceive the ‘sword’ is too close.”

Their findings contribute to the emerging literature about the effect of CEO job security on corporate policies and deepen the understanding about the channel of the disciplinary effect by studying certain real corporate decisions. Further, the study provides evidence to support the view that forced turnover is an effective corporate governance measure that motivates CEOs to undertake rightful actions.

By Annie Jin 
Edited by Priscilla Young