A new working paper from Stanford Graduate School of Business professors Christopher Armstrong, John Kepler, and David Larcker, and Shawn Shi, Ph.D. ’23, of the University of Washington’s Foster School of Business has found a connection between how well low-ranking accountants are paid and the quality of their work. This is a new area for researchers as they are usually focused on CEOs, CFOs, and other such golden parachute-eligible executives when researching a connection between pay (including bonuses) and financial reporting quality. Won’t someone think of the grunts?? Someone finally did.
Here’s the TL;DR:
An extensive literature examines whether senior executives’ contractual incentives influence their financial reporting decisions. However, little is known about whether — and how — the incentives of lower-level (or “rank-and-file”) employees, who are perhaps even more directly involved in the financial reporting process, influence their behavior. We use a proprietary database with detailed, employee-specific information about these employees’ incentive-compensation plans and find that although firms with relatively well-paid accounting employees tend to issue higher quality financial reports, their reports tend to be of lower quality when these employees’ compensation is contingent rather than fixed. We also find that 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.
The researchers say that focusing only on the relationship between senior executive incentives and financial reporting is a mistake because it’s the low level “subordinates” (e.g., financial accountants, cost accountants, internal auditors, and other accounting and finance employees) that have more direct access to, and more frequent involvement with, their company’s accounting and control processes than their superiors. In other words, it’s the people in the trenches who you might want to look at if you are analyzing the battlefield.
Any evidence based on only a handful of senior executives—typically the chief executive officer (CEO), chief financial officer (CFO), or the five highest-paid executives—can lead to misleading or, at best, incomplete inferences about how employees’ contractual incentives shape their firm’s financial reports and disclosures, and financial misreporting in particular. One reason is that even if a CEO has incentives to manipulate earnings, one or more subordinates are typically required to make the necessary alterations—whether knowingly or unwittingly—to instantiate the CEO’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. Therefore, at best, it is difficult to draw complete inferences from the relationship between senior executives’ incentives and accounting manipulation alone without also considering the incentives of certain subordinate (e.g., accounting) employees.
They looked at proprietary data that include details about the incentive compensation of individual accounting and other employees from 384 publicly traded U.S. companies from 2000 through 2004 and found evidence of a positive relationship between accountants’ contractual incentives—measured using the amount or level of their total annual pay—and their firm’s financial reporting quality.
They also found 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 that are a function of earnings, and equity compensation that is a function of stock price and implicit earnings), and the quality of their firms’ financial reports. This suggests that bonuses and the like that are tied to company performance may incentivize the grunts to look the other way when it comes to questionable accounting in the company books. “The prospect of losing that additional bit of income over their career can outweigh any gains from turning a blind eye to misreporting or errors,” said Armstrong, noting that “police officers are more likely to take bribes if they are underpaid.”
These findings are consistent with the notion that accountants with stronger incentives to monitor their company’s financial reporting processes contribute to the production of higher-quality accounting reports, say the researchers.
They also found that SOX had a positive effect on salaries (remember, the researchers were looking at data from 2000 to 2004):
SOX mandated lower bounds on the quality of firms’ public financial reports and produced variation in reporting quality that associates with changes with respect 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.
Pretty interesting paper and definitely a topic worth further study. You can check out the whole paper here.