Managers’ rank & file employee coordination costs and real activities manipulation

Abstract

We predict that managers’ rank & file employee coordination costs constrain decentralized real activities manipulation (RAM). We test this prediction using 99 state adoptions of wrongful dismissal laws (WDLs) between 1967 and 2004. WDLs increase managers’ rank & file employee coordination costs because WDLs strengthen rank & file employees’ motive and ability to resist manager pressure to engage in myopic activities. We find decentralized RAM declines when managers’ rank & file employee coordination costs increase. In contrast, coordination costs neither affect centralized RAM nor accrual-based earnings management, both of which are less likely to require rank & file employee coordination. Corroborating tests demonstrate that the effect of coordination costs on decentralized RAM varies predictably in event-time, with firms’ earnings management incentives, and across states and WDL subtypes. Our primary inference is that managers’ rank & file employee coordination costs constrain decentralized forms of earnings management.