How Accounting Employees’ Incentives Affect Financial Reporting Quality

An extensive body of literature that spans accounting, corporate finance, management, and other adjacent disciplines examines the relationship between senior executives’ contractual incentives (e.g., bonus plans, stock and option holdings) and various properties of their firms’ financial reporting and disclosures. The collective evidence that emerges from this vast literature is not only surprisingly mixed, but also largely neglects consideration of the contractual incentives of employees lower in the organizational hierarchy. This is a particularly conspicuous oversight since many of these subordinates (e.g., financial accountants, cost accountants, internal auditors, and other accounting and finance employees) have more direct access to, and more frequent involvement with, their firms’ accounting and control processes than senior executives do. In a recent study, we examine how the incentives that stem from rank-and-file accounting employees’ incentive-compensation contracts relate to their financial reporting decisions and, in turn, to the quality of their firms’ financial reports.

Why Should Rank-and-File Accountants Matter?

Even if a senior executive has incentives to manipulate earnings, one or more subordinates are typically required to make the necessary alterations – whether knowingly or unwittingly – to instantiate the executive’s intentions. However, accounting employees who become aware of attempts to misreport might have incentives to take remedial actions rather than participate. These include making a correcting adjustment, reducing the magnitude of the misstatement (e.g., rendering it “immaterial”), and, in more extreme or egregious cases, “blowing the whistle” by alerting the board, the firm’s external auditors, media outlets, or the Securities and Exchange Commission (SEC). Even if senior executives may have considerable motives to misreport, this will only occur if their actions are not impeded by the subordinates responsible for making the actual accounting entries.

Whether and how rank-and-file accountants’ incentives are related to their firms’ financial-reporting quality hinges largely on how their board’s audit and compensation committees set their incentive-compensation packages. If audit committees, which influence the staffing and compensation practices of their firms’ accounting functions, do so with shareholders’ interest in mind, they should provide accountants and other employees involved in the financial reporting and control processes with incentives that encourage more accurate reporting. Our research design is premised on the assumption that audit committees review and structure these employees’ incentive-compensation plans to discourage any attempted manipulation by their superiors (i.e., senior executives). However, if senior executives are solely – or even largely – responsible for setting these employees’ pay plans with little or no oversight from the board, then they may do so as to provide incentives to tolerate, if not participate in, any misreporting initiated at the senior level.

You Get What You Pay for, but It Depends on How You Pay

We study this question using proprietary data that include details about the incentive compensation of individual accounting and other employees from 384 publicly traded U.S. firms from 2000 through 2004. To the best of our knowledge, ours is the first paper to study this question with such detailed microdata. Our main analysis provides evidence of a positive relationship between accountants’ contractual incentives – measured using the amount or level of their total annual pay – and their firms’ financial reporting quality. We also find some evidence of a negative relationship between the extent to which accounting employees’ annual compensation is from contingent – rather than fixed – forms of pay (e.g., annual bonuses based on earnings and equity compensation based on stock price and implicit earnings), and the quality of their firms’ financial reports. These findings are consistent with the notion that accountants with stronger incentives to monitor their firms’ financial reporting processes contribute to the production of higher-quality accounting reports.

Rank-and-File Accountants Can Offset Misreporting Incentives by Senior Management

Most cases of financial misreporting involve both accountants with monitoring responsibilities and senior executives who have incentives to initiate the manipulation. This observation raises the question of whether accountants’ incentives to monitor, if any, are sufficient to mitigate any attempted manipulation by their superiors. We find evidence that accountants’ contractual incentives do seem to influence the efficacy of their oversight of the financial reporting process. In particular, the negative relationship between accountants’ contractual incentives and the frequency of misreporting as well as the positive relationship that exists when more of their pay is contingent are both more prominent when senior executives have stronger contractual motives to misreport. This evidence of the moderating relationship between these two distinct sets of employees – both of whom are closely involved with and collectively responsible for their firms’ reporting practices – highlights the importance of considering accountants’ incentive-compensation contracts in order to gain a more complete and accurate understanding of the forces that shape firms’ financial reporting and disclosure practices.

Rank-and-File Accountants and SOX

We conduct multiple sensitivity analyses to assess the strength of our evidence and enhance the credibility of our inferences. Nonetheless, an important concern with any observational study is that inferences drawn from the empirical evidence may be confounded by unobserved correlated omitted variables. In the context of our research question and setting, this could result from an unmodeled endogenous relationship between factors that jointly affect rank-and-file accountant compensation and financial reporting quality. To help assuage this concern, we examine the Sarbanes-Oxley Act of 2002 (SOX) as an alternative research setting. SOX mandated lower bounds on the quality of firms’ public financial reports and produced variation in reporting quality that associates with changes to individual firms’ employee compensation decisions. Consequently, we expect that non-compliant firms had to spend – and, in particular, pay their accountants – more in order to comply. Consistent with our conjecture, we find that SOX led to increased accountant salaries – as well as increased staffing of accounting departments overall – at firms that had lower-quality accounting prior to the mandate. We also find that the firms at which accountants’ pay increased the most had the largest improvements in financial reporting quality. These findings provide corroborating evidence that accounting employees’ contractual incentives influence their firm’s financial reporting quality.

Takeaways

Firms with relatively well-paid accounting employees tend to issue higher-quality financial reports, but their reports tend to be of lower quality when these employees’ compensation is contingent rather than fixed. These relationships are more pronounced at firms whose senior executives have stronger contractual incentives to misreport, which sheds light on when lower-level accounting employees have incentives to promote, discourage, or thwart financial misreporting.

This post comes to us from Christopher S. Armstrong, EY Professor of Accounting at the Wharton School; John D. Kepler; an assistant professor of accounting at the Stanford Graduate School of Business; David F. Larcker, the James Irvin Miller Professor of Accounting Emeritus at the Stanford Graduate School of Business; and Shawn X. Shi, a PhD student at Stanford Graduate School of Business. It is based on their recent paper, “Rank-and-File Accounting Employee Incentives and Financial Reporting Quality,” available here.

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