The effect of CEO friendship and perceived pay equity on the earnings management behavior of business-unit managers

Summary

The research paper, "The effect of CEO friendship and perceived pay equity on the earnings management behavior of business-unit managers," by Gouldman and Victoravich (2020), explores the intricate relationship between social ties, compensation transparency, and managerial accounting decisions. The central purpose of this study was to examine potential adverse, unintended consequences stemming from the Dodd-Frank Act's (DFA) requirement for CEO pay-equity disclosure. Specifically, the authors investigated whether this increased transparency regarding CEO-to-employee pay ratios might paradoxically lead to more earnings management, especially when business-unit managers share a friendly relationship with the CEO. To address this question, the researchers conducted an experiment. Participants were placed in the role of a business-unit manager and tasked with providing an estimate for future warranty expense, a decision used as a proxy for earnings management behavior. The experimental design manipulated two key variables: the presence or absence of a friendship between the CEO and the business-unit manager, and the saliency of CEO compensation pay-equity, which mimicked the conditions of the DFA disclosure. This methodology allowed for a controlled environment to observe how these factors, both independently and interactively, affected managers' reporting tendencies. The findings revealed a nuanced impact of CEO friendship and pay equity disclosure on earnings management. In situations where the DFA's CEO pay-equity ratio disclosure was absent, CEO friendship, which the authors associate with lower social distance, was linked to *less* earnings management. This suggests that positive interpersonal relationships can foster more ethical reporting when compensation details are not explicitly highlighted. However, the study uncovered a significant and concerning reversal in the post-DFA environment. When managers were provided with the pay-equity disclosure, CEO friendship actually resulted in *higher* levels of earnings management. This implies that the increased transparency intended by the DFA might have unintended negative repercussions on reporting behavior, particularly when existing social bonds between top executives and their subordinates are present.