Managing the Numbers Smartly: Rewards and Reputation from the Managerial Labor Market and Strategic Disclosure Choices

Abstract

A top executive’s reputation and potential rewards from the managerial labor market are at least partly determined by the financial information conveyed by her firm to the capital markets. We thus examine whether incentives from the managerial labor market affect firms’ choices in such information transmission. We measure a CEO’s labor market incentives by the gap between her pay and the maximal or near-maximal pay of CEOs at industry peer firms, which essentially captures the size of the prize of an industry tournament for CEOs. We find that firms whose CEOs face a larger pay gap are more like to distort reported financial information by managing earnings upward through income-increasing accruals and are more likely to meet or narrowly beat consensus analyst forecast. However, these firms are less likely to commit accounting irregularities that trigger earnings restatements later. These empirical patterns are concentrated in firms where CEOs stand a better chance of winning the industry tournament and have more mobility within the industry. Our findings are consistent with the hypothesis that CEOs facing greater incentives from the managerial labor market tend to engage in within-GAAP earnings management to boost their firms’ reported performance to burnish their reputation in the labor market and enhance their chance to move up the industry hierarchy. At the same time, these CEOs are more careful not to commit GAAP-violating earnings management, which, if discovered, will severely damage their reputation and undermine their future employment prospect as top executives. Overall, our evidence portrays a nuanced picture of how CEOs make strategic choices in firms’ financial disclosure in response to their labor market incentives and career concerns.