Assistant professor Sara Malik has a forthcoming paper in the Journal of Accounting Research entitled “Financial Reporting Quality and Wage Differentials: Evidence from Worker-level Data.”
Accounting researchers have known for a long time that the quality of a public firm’s financial reporting (i.e., the value relevance and accuracy of the financial statements) is important to firm’s cost of capital. When firm financial information is opaque, investors tend to demand a higher risk premium for a given investment amount; investors are trying to protect themselves from the firm’s uncertain condition. Relatedly, when investors are better informed about a company’s financial performance, they demand a smaller risk premium. But investors aren’t the only group that interacts with firms. In fact, financial reporting quality plausibly could matter to anyone who has a stake in a firm. In new co-authored research, Malik asks how employees respond to their employers’ financial reporting quality. More specifically, Malik tests if employees demand a wage premium when their employers’ have firm financial reporting quality. The answer to this question isn’t obvious: investors know to distinguish between a firm’s fundamental performance and the quality of its information. Do employees do the same?
In fact, they do. Malik finds that employees demand a wage premium for their employers’ poor financial reporting quality. They appear to do so for two reasons. First, poor financial reporting quality is linked to cycles of over and under investment, which are associated with painful layoffs and corporate reorganizations. Second, poor financial reporting quality suggests that the firm does a bad job of tracking internal metrics, which are relevant to employee compensation. These results are among the first to establish that financial reporting quality engenders a cost of labor, a corollary to the cost of capital.
Why does this matter? Regulators are perennially debating if they should mandate improvements to financial reporting quality of public firms. All recommendations are evaluated using a cost-benefit calculus. Until now, almost all of that assessment was based on the costs and benefits borne by investors. Malik’s research suggests that there are heretofore unstudied costs of bad financial reporting quality. If regulators keep these costs in mind, we might see some different recommendation in the coming years.
Sara Malik is an Assistant Professor in the David Eccles School of Business School of Accounting.