Taking risks with financial reporting can drive up a company’s labor costs. | iStock/ryasick
The collapse of Enron in 2001 not only led to the demise of its auditor Arthur Andersen, it also raised questions about the quality of the once-respected accounting firm’s financial reporting. If it could sign off on the energy firm’s hidden debts and inflated profits, what else might it have missed?
After the scandal blew up, Andersen’s former clients issued more accounting restatements — revising or correcting their books to fix errors or omissions. After observing these public admissions of less-than-perfect bookkeeping, employees at these companies worried their jobs might be in danger. Consequently, they demanded higher wages to compensate for the increased uncertainty and risk of layoffs.
This case is detailed in a new study by Jung Ho Choi and Brandon Gipper, accounting professors at Stanford Graduate School of Business, and Sara Malik, PhD ’21, an assistant professor at David Eccles School of Business at the University of Utah. They find that there is a wage premium linked to accounting quality, with employees at companies with poor financial reporting commanding higher pay.
Taking risks with financial reporting can drive up a company’s cost of labor, a significant expense. The researchers find that a firm with significantly above-average-quality reporting can cut the cost of wages, taxes, benefits, and other employee-related expenses by $3 million. That’s equivalent to the cost of an audit from a big-name accounting firm.
What Employees Know
Choi, Gipper, and Malik find that the average worker’s wage is 0.9% to 2.8% higher at firms rated in the bottom quartile of reporting quality compared with companies in the top quartile. And when employees move from companies with higher-quality reporting to those with weaker accounting practices they receive higher wages, and vice versa.
The researchers argue that employees recognize the importance of accounting numbers for their compensation and prospects at a company. However, it’s unlikely that the average employee understands complex financial reporting. Yet they can deduce the quality of their employer’s reports from different sources, including news reports and reviews from current and former employees on job sites such as Glassdoor.
“If you read those reviews, they talk about whether or not they feel fairly compensated, relative to perceived performance,” Choi says. “They may not use the same technical terms, but how workers feel about how they are compensated is actually related to the quality of financial reporting.”
Choi, Gipper, and Malik find that lower quality financial reporting imposes several risks on employees. If performance measurement does not accurately reflect true worker output because of errors or inaccuracies, it introduces “noise” that can distort evaluations. That leads risk-averse workers to demand wage premiums, especially in industries where compensation packages are often structured to align performance with financial incentives, typically in the form of bonuses.
“If I can see a chunk of my pay is based on performance but the measurement system is not able to accurately assess my work, I won’t wait for a bonus which I may or may not get: I’ll ask for bigger base pay,” says Malik, who conducted this research while she was a PhD student at Stanford GSB.
Too Much Noise
Sloppy accounting could raise a company’s turnover risk because it may limit investor or board oversight. “If there is so much noise in the reports that stakeholders cannot accurately monitor a company, the lack of scrutiny could lead management to overinvest in people. When there is a slowdown, workers may lose their jobs,” Malik explains.
To complete their study, the researchers used absolute abnormal accruals, a widely used measure of financial reporting quality. In accrual accounting, revenue or expenses are booked when transactions occur rather than when cash is received or paid (cash basis accounting). By comparing a company’s actual adjustments to what would be considered normal for its industry and size, it’s possible to identify abnormal patterns that may indicate aggressive or risky accounting practices.
The researchers argue their findings strengthen the case for investments in financial reporting quality, which can also decrease the cost of capital, the expense associated with raising funds to finance operations or investments. “Firms may need to invest in new technology or software to improve their internal systems,” Choi says.
However, he adds there is a potential drawback: Increased transparency could put companies at a competitive disadvantage by providing rival firms with insights into their financial performance, strategies, or sensitive business information. Ultimately, though, Choi says the benefits of transparency, such as cheaper access to talent and capital, often outweigh the perceived drawbacks.
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