The Effect of Managerial Horizontal Pay Disparity on Earnings Management

Abstract

Earnings management has been a threat to the financial health of corporations and the financial market as a whole. It continues to be a significant concern for stakeholders such as investors, creditors, regulators, and accounting researchers. Many researchers attribute earnings management to the level and design of managerial compensation. This dissertation adds to the literature by studying how the level of managers’ compensation relative to their peers affects their financial reporting decisions. The current study investigates whether horizontal pay disparity and the availability of pay disparity justification influence managers’ likelihood to engage in earnings management. The study also investigates whether managers’ equity sensitivity affects their tendency to manage earnings and whether it moderates the relationship between horizontal pay disparity and earnings management. This study uses an experimental research method and manipulates two independent variables between participants: (1) high horizontal pay disparity or no horizontal pay disparity; and (2) justified or unjustified pay disparity. The third independent variable, equity sensitivity, is measured through some post-experimental questions. The study recruited participants with managerial and accounting experience through Prolific crowdsourcing platform. The findings show a significant positive effect of horizontal pay disparity on managers’ likelihood to engage in earnings management. The results demonstrate that the two groups of equity sensitivity (high and low) show different reactions to horizontal pay disparity. The high equity sensitivity group shows an increased likelihood of managing earnings only when the pay disparity is not justified. In contrast, the low equity sensitivity group shows an increased tendency to engage in earnings management, whether or not the pay disparity is justified. Further, managers’ equity sensitivity has a significant negative effect on the likelihood of earnings management when the horizontal pay disparity is unjustifiable.