Employee welfare and earnings management

Abstract

This study examines the association between employee welfare and corporate earnings management. Existing literature suggests that firms with better employee welfare are more productive and hence have less incentive to engage in accrual earnings management. At odds with this incentive view, this paper finds that firms with high welfare levels actually substitute accrual earnings management with real earnings management based on a sample of China A-share listed firms. Beyond the scope of incentives, this research proposes that employee welfare also proxies for operating flexibility, which facilitates managers’ ability to use real earnings management relative to accrual earnings management. Consistent with this agency theory-based view, further evidence demonstrates that the positive (negative) relation between employee welfare and real (accrual) earnings management is more pronounced for firms faced with lower ability of real-activity manipulation and higher likelihood of employee whistleblowing. The mediation model results consistently confirm operating flexibility as the channel through which employee welfare affects earnings management strategy. Besides, the impact of employee welfare on earnings management increases with CEO power and managerial horizon, but can be curbed by high-quality corporate governance. Lastly, the relationship between employee welfare and earnings management demonstrates a counter-cyclical nature, strengthening the argument of agency theory.