Rank and File Equity Compensation and Earnings Management: Economic Incentives and the Robin Hood Effect

Abstract

Executive compensation is often linked to firm performance with equity-based compensation. One consequence of executives’ equity compensation is that it can create incentives for earnings management. Rank and file employees are also granted equity compensation and there are at least two reasons to suspect that rank and file equity compensation will influence earnings management. First, a substantial literature provides evidence that performance-based compensation creates earnings management incentives (economic incentive effect). Second, psychology literature suggests that individuals are better able to justify dubious behavior when the behavior can be rationalized as benefitting other, less-fortunate individuals. Consequently, firms that offer rank and file plans may unwittingly provide executives with a built-in justification to manage earnings (the Robin-Hood effect). Our results provide evidence that increases in rank and file employees’ equity-based compensation are associated with increases in earnings management. Cross-sectional tests are more consistent with economic incentives accounting for our results rather than the Robin Hood effect.