Academic journal article Academy of Accounting and Financial Studies Journal

Earnings Management, Executive Compensation and Layoffs

Academic journal article Academy of Accounting and Financial Studies Journal

Earnings Management, Executive Compensation and Layoffs

Article excerpt

INTRODUCTION

We study the accounting choices managers make to manage reported earnings during layoff announcements. Prior studies (Groshen and Potter, 2003; Farber and Hallock, 2008) suggest that layoff announcements after the 1990s were generally considered efficiency-improving, wealth-increasing events, whereas layoff announcements before that time were viewed as negative news events (Worrell, Davison, and Sharma, 1991; Chen, Mehrotra, Sivakumar, and Yu, 2001). In addition, prior research finds that CEOs of firms announcing layoffs receive significantly more stock-based compensation and more total pay in the subsequent year relative to CEOs of non- layoff companies. However, little is known about whether external pressures or contracts explicitly tied to accounting numbers affect the accounting choices by managers in layoff firms.

To our knowledge, only one study, Hall, Stammerjohan, and Cermignano (2005), addresses how managers make accounting choices around layoff announcements. Covering the years 1976 through 1995, Hall et al. descriptively examine the accrual behavior of layoff firms and document that companies appear to use accruals to decrease reported earnings in the layoff announcement year. They proffer that their findings are consistent with several theories of earnings management, including the "big bath hypothesis and the bonus hypothesis. These hypotheses posit that earnings performance is poor, managers further reduce earnings to save income for increased earnings in future years (the "big bath hypothesis) or to increase the likelihood of management bonuses in future years (the bonus hypothesis). Hall et al. did not attribute their findings to either of these hypotheses as the singular motive for earnings manipulation.

Our study differs from Hall et al. in that, first, to determine whether their findings are robust over time and in later years when layoffs appear to be more dynamic, we examine layoffs in a ten- year period, 1997-2006. Second, we add explanatory variables to capture the impact of executive compensation and characteristics of the firm, CEO and governance. Third, we analyze whether accounting choices differ based on the stated reason for the layoff. Finally, we include control variables for the size of the layoff, state of the economy, fiscal quarter and industry.

Using a sample which includes more than 2,100 layoff firm-year observations, our empirical analysis shows that firms tend to have higher intensity of earnings management (measured by discretionary accruals) during the year of a layoff announcement, and that executive compensation structures economically impact the intensity. We argue these findings support both the "big bath" and bonus hypotheses.

Our paper contributes to the literature on layoffs, earnings management, and incentive- based compensation by providing analyses of how managers of layoff firms use accrual-based earnings management to respond to external pressure, and to serve self-interests in firms' stock prices. In addition to examining a more recent time period of layoffs than prior evidence, we incorporate characteristics of corporate governance and layoff reasons for sample and control firms within a multivariate setting. We thus provide new evidence on the impact of the external pressure and self-interested motives on the accounting choices made by managers of layoff firms.

The next section provides background and reviews the relevant literature. In the third section, we present the research design and describe the sample and data. The fourth section contains our results. Finally, we provide concluding remarks in section five.

LITERATURE REVIEW

Managerial Incentives and Earnings Management

Considerable evidence suggests that incentive compensation can motivate managers to make superior decisions (e.g., Baker, Jensen, and Murphy, 1988). However, managers can also exert their influence and power on the design of compensation arrangements (e. …

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