Ignorance is Bliss: Effects of Real Earnings Management by Rank-and-File Employees and the Role of Managers

Abstract

This study uses an interactive experiment to investigate the effects of real earnings management by rank-and-file employees to meet internal performance targets on their performance. We also examine whether this effect is moderated by managers’ awareness of employees’ opportunity to manage earnings. We predict and find that when managers’ awareness is low, employees use real earnings management to restore their effort incentives under a suboptimally set target, resulting in an increase in employee performance. However, when managers have higher awareness of employees’ real earnings management opportunity, they overattribute observed employee performance to earnings management, resulting in a decrease in employee performance as well as a more confrontative and less trustful employee-manager relation. Overall, these findings suggest that, contrary to conventional wisdom, employees’ opportunity to engage in real earnings management can motivate higher employee performance, but increasing managers’ awareness of this comes at the cost of negative performance and relational effects.