Employee Cash Profit-Sharing and Earnings Management

Abstract

This paper examines how a firm’s employment policy, particularly employee cash profit-sharing plans, affects its financial reporting. We find that firms with employee cash profit-sharing programs are more likely to engage in downward earnings management to reduce labor costs, especially with decreasing performance. This effect is more evident in firms with higher labor costs and human-capital reliant firms. Our findings are robust to a variety of model specifications and endogeneity problems.

Keywords:

• Employee
• Stakeholder
• Earnings Management
• Cash Profit Sharing

JEL classification:

• G34

Acknowledgements

We sincerely thank Thorsten Sellhorn (editor) and two anonymous reviewers for their insightful suggestions, which have significantly improved our paper. We also thank Rui Shen, and seminar participants at the Southwestern University of Finance and Economics and the 29th Asian FA Annual Conference for helpful comments. We wish to thank Yumiao, Wang, Hao Wang, Chengzhe Han, and Haoran Chu for their excellent research assistant. Part of the work was done during Prof. Jian Zhang’s visiting at Chinese University of Hong Kong, Shenzhen. All remaining errors are ours.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1 A cash profit-sharing plan gives employees a share in their company’s profits based on its quarterly or annual performance. Managers decide how much of a firm’s profit they would like to share. An employer has full discretion over how and when it makes contributions. In a cash profit-sharing plan, contributions are paid directly to employees in the form of cash, checks, or stock. The shared cash profit is taxed as ordinary income when distributed. A cash profit-sharing plan does not discriminate in favor of highly compensated employees. (Employee Benefit Research Institute, 2009).

2 Based on differences in states’ trade secret case laws and statutes, Png (2017) constructs a state-level index to measure the strength of the legal protection of trade secrets under the Uniform Trade Secrets Act (UTSA). Specifically, Png (2017) rates the strength of the legal protection of trade secrets from three broad aspects: substantive law, civil procedure, and remedies. The index represents the average score of all three aspects. A higher index score indicates stronger legal protection of trade secrets.

3 As mentioned in OECD (1995), executives’ bonus plans are excluded from CPS programs.

4 For detailed information on the CPS plans in our sample, please see Appendix 2.

5 The KLD Database is widely used in academic research to evaluate a firm’s relations with its employees (Bae et al., 2011; Cronqvist et al., 2009; Ertugrul, 2013; Faleye & Trahan, 2011; Landier et al., 2009; Verwijmeren & Derwall, 2010). It is constructed from multiple data sources, such as company filings, government data, media information, and direct communication with company officers. Once KLD collects the information, its sector-specific analysts adopt a proprietary framework to rate the firms.

6 See Bergstresser & Philippon, 2006; Burns & Kedia, 2006; DeFond & Jiambalvo, 1994; Erickson & Wang, 1999; Holthausen et al., 1995; Perry & Williams, 1994; Shivakumar, 2000; Teoh et al., 1998a; 1998b; Yu, 2008.

7 Panel C of Table 1 is based on firm-level observations instead of firm-year observations.

8 As we find CPS does not lead to more income-increasing earnings manipulation, to save space, we do not show the results here, the detailed results are available upon request. In addition, we still find that firms adopting CPS plans are more likely to manipulate earnings downward if we exclude firms with a transition of CPS plans. To further address concerns over the impact of switching firms, we define a dummy variable to measure whether a firm opts in to a CPS plan (denoted by Switch_in). We define another dummy variable to measure whether a firm opts out of a CPS plan (denoted by Switch_out). We rerun our baseline regression by adopting Switch_in and Switch_out as independent variables. Our results show that neither Switch_in nor Switch_out plays an important role in earnings management. To save space, we did not report this table, and the results are available if request.

9 See http://www.census.gov/manufacturing/asm/index.html.

10 To ensure that ‘switching’ firms do not bias our findings, we rerun the regression for firms that do not switch. Our findings are not changed. To save space, we do not report the results, which are available on request.

Additional information

Funding

This work was supported by the National Natural Science Foundation of China under [grants number 71802160 and 71772178]; and the Humanities and Social Science Fund of Ministry of Education of China under [grant number 18XJC630008].