Operating Flexibility and Earnings Manipulation

I examine the relationship between operating flexibility and firms’ accounting quality. I use the staggered adoption of wrongful discharge laws across U.S. states as a plausibly exogenous increase in firms’ dismissal costs. These laws protect employees against unfair dismissals, increasing the rigidity of firms’ cost structure. I hypothesize that when regulation makes it more costly to cut labor costs, managers manipulate accruals in lieu of terminating employees in order to increase reported income. I find that regulated firms engage in more income-increasing accrual manipulation than their unregulated peers in response to decreases in demand following the adoption of these laws. This result is strongest for sub-samples of firms that experience larger increases in expected firing costs and for firms with enough flexibility left to engage in more accrual manipulation. My findings shed light on the unintended consequences of prolabor regulations and contribute to the emerging literature on how firms’ cost structures shape reporting incentives.

This seminar is organised by the Erasmus Accounting Research Group.