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

The purpose of this study is to examine the possibility of adverse consequences regarding the recently enacted Dodd–Frank Act (DFA) pay-equity disclosure requirement in the USA, which will likely lead to lower levels of perceived Chief Executive Officer (CEO) pay fairness by subordinates. Specifically, the study examines whether the pay-equity disclosure leads to increased earnings management when business-unit managers have friendship ties with the CEO.

An experiment is conducted wherein participants assume the role of a business-unit manager and are asked to provide an estimate for future warranty expense, which is used as a proxy for earnings management. The study manipulates friendship between the CEO and a business-unit manager and the saliency of CEO compensation pay-equity.

CEO friendship ties, which are associated with lower levels of social distance, result in less earning management in the absence of the DFA CEO pay-equity ratio disclosure. However, CEO friendship may result in negative repercussions in terms of higher earnings management in the post-DFA environment when managers are provided with the pay-equity disclosure.

Future research may expand this study by examining how the adverse consequences of the CEO compensation saliency disclosure can be mitigated.

Management, audit committees and internal auditors should consider the possibility of unintended consequences of the increased transparency of CEO pay-equity while designing management control systems.

This study highlights the importance of understanding how employees’ social relationships with leaders may influence their behavior.

Unlike prior research, which focuses on senior executives’ direct incentives to manipulate earnings and subsequently increase their compensation, this study provides evidence regarding the earnings management behavior of business-unit managers.