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

Purpose - 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. Design/methodology/approach - 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. Findings - 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. Research limitations/implications - Future research may expand this study by examining how the adverse consequences of the CEO compensation saliency disclosure can be mitigated. Practical implications - 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. Social implications - This study highlights the importance of understanding how employees’ social relationships with leaders may influence their behavior. Originality/value - 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.