Keeping them honest? Broad‐based employee ownership and earnings management

• Published date: 01 May 2024
• Author: Colin Birkhead
• Date: 01 May 2024
• DOI: http://doi.org/10.1111/corg.12554

ORIGINAL ARTICLE

Keeping them honest? Broad-based employee ownership and

earnings management

Colin Birkhead

Atkinson Graduate School of Management,

Willamette University, Salem, Oregon, USA

Correspondence

Colin Birkhead, Atkinson Graduate School of

Management, Willamette University,

315 Winter St. SE, Salem, OR 97301, USA.

Email: cbirkhead@willamette.edu

Funding information

This research is partially supported by the

Louis O. Kelso Fellowship for Research in

Employee Ownership.

Abstract

Research Question/Issue: Does broad-based employee ownership limit accrual earn-

ings management?

Research Findings/Insights: I run a series of random effect and fixed effect models

on a sample of S&P 1500 firms between 2008 and 2019 to show that managers at

employee-owned firms manipulate earnings less than managers at nonemployee-

owned firms. My findings suggest that employee ownership enhances financial trans-

parency and limits the opportunities for managers to misrepresent firm performance.

Theoretical/Academic Implications: This study develops and tests theory on

employee ownership as a form of internal corporate governance. Equity incentives

for executives are typically thought to reduce agency costs. The findings here sug-

gest awarding equity incentives broadly, in which the majority of employees receive

equity stakes, may be a more effective method of reducing agency costs.

Practitioner/Policy Implications: Earnings management and intentional financial mis-

reporting are often a result of siloed information within firms. Broad-based employee

ownership is generally associated with enhanced information flows through greater

mutual monitoringand information sharing. Corporategovernors interested in reducing

managerial malfeasance may find that widely awarding equity to employees is more

effective than financially incentivizingindividual managers to act in the firm's interests.

KEYWORDS

corporate governance, employee ownership, earnings management, ESOPs, information

asymmetries

1|INTRODUCTION

Information asymmetries between managers and stakeholders can make

traditional corporate governance mechanisms ineffective (Ndofor

et al., 2015). As such, managerial malfeasance is an evergreen topic in

academic research and in practice. For example, high-profile instances of

fraudcommittedbyexecutivesatEnronandWorldComarestillfounts

of research almost 20 years later, as investigators try to uncover more

about how such brazen acts of deceit can go undetected (Eckhaus &

Sheaffer, 2018; Maccarthy, 2017). More recently, Elizabeth Holmes and

Ramesh Balwani bilked investors and partners out of hundreds of million s

of dollars largely by isolating internal information keepers from one

another and by obfuscating the effectiveness of Theranos' products to

outsiders (Carreyrou, 2018). Much of the focus from the Theranos case

hasbeenontheconsequencesofboardsneglectingtheirrolesasmoni-

tors and only fulfilling their roles as purveyors of resources (Garg, 2020).

But the case also highlighted the importance of information flows within

the organization. Holmes and Balwani benefited (albeit only in the short

run) from significant information asymmetries within Theranos:

Employees had little idea what other employees working on the same

project were doing and even less information about how the organization

as a whole was performing (Carreyrou, 2018).Andinevenmorerecent

examples, information asymmetries contributed to financial deception at

Samsung and Nissan (Chozick & Rich, 2018;Sang-Hun,2020).

Received: 4 August 2022 Revised: 26 June 2023 Accepted: 6 July 2023

DOI: 10.1111/corg.12554

500 © 2023 John Wiley & Sons Ltd. Corp Govern Int Rev. 2024;32:500–521.wileyonlinelibrary.com/journal/corg

That information asymmetries contribute to managers acting self-

interestedlyis not a novel idea, of course. Researchersand practitioners

alike are concerned with asymmetries in information, motivations, and

incentives that advantage agents (e.g., managers) over principals

(e.g., sharehol ders) (Jensen & Mec kling, 1976). Given the examples

above, it is apparent, however, that identifying firm characteristics that

reduce information asymmetriesand agency costs remainsan important

task for researchersand practitioners.

This paper identifies one such characteristic: broad-based

employee ownership. Broad-based employee ownership refers to

stock ownership plans that grant equity to employees, as opposed to

narrow-based stock ownership plans that grant equity to managers or

executives only. My core contention is that employee owners are

“agentic principals”whose ownership improves transparency and

limits earnings management. I argue this occurs in two ways. First,

employee ownership encourages employees to monitor each other.

This mutual monitoring makes employees more aware of what their

colleagues are doing and how they and their business units are per-

forming. Second, in efforts to boost performance, financial informa-

tion is more readily shared throughout employee-owned firms. Thus,

managers are simultaneously pushed to produce more accurate finan-

cial reports via greater mutual monitoring while they are also pulled to

disclose more information to employees to improve performance.

These elements of employee ownership—greater oversight from peers

and greater voluntary disclosure—make it more difficult for managers

to falsify the economic status of their firms.

The novelty of this research is in the linking of these mechanisms

and broad-based employee ownership to earnings management, a

topic of particular importance for external shareholders. Previous

research has identified the relationship between executive ownership

and earnings management. Yang et al. (2008), for example, conclude

that manager owners reduce earnings management and its associated

agency costs. In contrast, other studies have shown that equity incen-

tives for managers, intended to prevent managers from acting self-

interestedly, often have the opposite effect and can induce executives

to manage earnings more (Bergstresser & Philippon, 2006; Cheng &

Warfield, 2005). Previous research has also shown that employee

ownership incentivizes firms to voluntarily release more guidance

about financial performance when it may benefit them in capital mar-

kets (Bova et al., 2015). I extend this work and theorize that the push

and pull mechanisms of employee ownership make the financial infor-

mation provided by employee-owned firms more accurate, not just

when firms are strategically releasing or withholding information.

I propose that broad-based equity grants to employees likely dif-

fer from equity incentives to managers in two principal ways. First,

equity grants to employees are significantly smaller than equity grants

to managers, with employees holding about $27K while managers

hold roughly $2.2M, on average (Bergstresser & Philippon, 2006;

Kim & Ouimet, 2014). The relative diminutive nature of broad-based

equity grants for employees lessens hypothetical rewards from, and

therefore likelihood of, earnings manipulations. Second, recipients of

employee stock ownership plan (ESOP) shares may not sell their

shares until retirement or otherwise severing their relationship with

the firm, a proposition that may be unpalatable given the relative pau-

city of shares held by an ESOP participant (Ghoshal, 2005). This con-

trasts with equity grants to managers (awarded outside of the ESOP)

that can be exercised and sold at regular intervals after a specified

vesting period. I test my argument using quarterly financial statements

from S&P 1500 firms between 2008 and 2019.

My findings have important implications for theories on corporate

governance. Existing research on internal monitoring mechanisms

focuses almost exclusively on the functions of boards of directors,

audit committees, and “insider owners,”a group that primarily con-

sists of equity-incentivized executives and directors (Dalton

et al., 2007; cf. Wezel & Ruef, 2017). This work contends that

principal-agent problems can be avoided by aligning the interests of

managers with the interests of shareholders and prescribes that

boards construct executive compensation packages that will induce

executives to behave in accordance with shareholders (Jensen &

Meckling, 1976). This top-down approach to internal monitoring, in

which executives answer to boards, can still produce information

asymmetries within firms, giving executives the opportunity to act in

their own interests (Ndofor et al., 2015). I theorize that firm-wide

monitoring, in which information about performance is shared widely

throughout the firm and workers are generally aware of what others

are doing and how their work fits in the larger picture, reduces asym-

metries that lead to executives acting in their interests instead of the

interests of other stakeholders. The mutual monitoring and informa-

tion sharing that occurs in employee-owned firms makes information

more uniformly distributed throughout the firm and gives less oppor-

tunity for executive malfeasance.

2|THEORETICAL BACKGROUND

2.1 |Employee ownership and information

asymmetries

Employee ownership is commonly discussed in the context of agency

theory. Financial stakes alignfirm interests with employeeinterests and

give employees incentive to work more productively. Even in highly

bureaucratized organizations, workers have some level of discretion

over their efforts,their cooperation with coworkers and managers, and

whether they try to improve processes and systems (McNabb &

Whitfield, 1998). This discretion over work can lead to principal-agent

problems in which workers, the agents, shirk their duties while share-

holders or other stakeholders, the principals, bear the costs. Managers

mayrelyonprescriptionsfromTaylor's(

1911) scientific management

theory and addressthe principal-agent problem with“carrots or sticks.”

Managers may create incentive systems that reward individual produc-

tivity. Individual rewards based on productivity may be difficult to

implement; however, as measuring, assessing, and otherwise rationaliz-

ing individuals'efforts may be more costly to the firm than the original

principal-agent problem (Alchian& Demsetz, 1972).

Managers may also closely monitor worker behavior and disci-

pline unproductive workers. Processes for monitoring too can be

BIRKHEAD 501