Does Earnings Management Relieve the Negative Effects of Mandatory Pension Contributions?

• Author: Hieu V. Phan,Joseph Golec,Hinh D. Khieu
• Published date: 01 March 2017
• DOI: http://doi.org/10.1111/fima.12139
• Date: 01 March 2017

Does Earnings Management Relieve the

Negative Effects of Mandatory Pension

Contributions?

Hieu V. Phan, Hinh D. Khieu, and Joseph Golec∗

Mandatory pension contributions (MCs) are negative shocks to a firm’s liquidity that can unfa-

vorably impact its cost of capital, financing, and investment plans. We examine whether firms

faced with MCs use both noncash (NEM) and cash-generating earnings management (CEM) to

partially offset their negative effects. Firms increase CEM, but not NEM, when they experience

MCs. We also find that earnings management associated with MCs does not substantially lower

the weighted cost of capital or boost external funding and investment. Our findings suggest that

MC firms use CEM as it directly generates cash to fund MCs, while NEM does not.

Mandatory pension contributions (MCs) are often unexpected negative shocks to a firm’s

liquidity that can raise its cost of capital (Campbell, Dhaliwal, and Schwartz, 2012) and lead to

reduced investment (Rauh, 2006). Linck, Netter,and Shu (2013) f ind that financially constrained

firms can use earnings management to signal prof itable investment opportunities and help attract

investor funds for those investments. Our paper examines whether firms faced with MC shocks

increase their earnings management to partially offset the rise in the cost of capital and the fall in

investment associated with MCs.

The accounting literature establishes two general forms of earnings management: 1) accrual-

based earnings management and 2) real earnings management. The more widely studied accrual-

based methods have little or no impact on cash. For example, if a firm reduces its estimate of

uncollectable accounts, reported earnings increase, but not cash flow. Conversely, real earnings

management impacts cash. For example, a firm could expand production to spread its fixed costs

and boost profit margins and earnings, even though this method of real earnings management

consumes cash.

In our study, we group the various methods of earnings management into two different cate-

gories: 1) cash-generating earnings management (CEM) and 2) noncash-generating earnings man-

agement (NEM).1Wedo this as we wish to study how managers cope with the negativecash shocks

caused by MCs. CEM can generate internal cash to relieve financing constraints directly, but can

also do so indirectly byboosting repor ted earnings to attract more investorsand external f inancing.

NEM relies solely on the indirect channel of boosting earnings to attract external financing.

We appreciate the helpful comments from Raghu Rau (Editor), an anonymous referee, session participants at the 2014

Financial Management Association International Annual Meetings, and participants at a PrairieView A&M University

College of Business research seminar. We thank Huong Doan, Dylan Mooney, and Bharadwaj Rachamadugubalaji for

excellent research assistance.All remaining errors are ours.

∗Hieu V. Phan is an Assistant Professor in the Department of Financein the Manning School of Business at the University

of Massachusetts Lowell, MA. Hinh D. Khieu is an Assistant Professor of Finance in the Department of Accounting,

Finance, and MIS in the College of Business at Prairie View A&M University, TX. Joseph Golec is a Professor in the

Department of Finance in the School of Business at the University of Connecticut in Storrs, CT.

1Wethank the referee for suggesting this g rouping of earnings management methods.

Financial Management •Spring 2017 •pages 89 – 128

90 Financial Management rSpring 2017

Whether MC firms use CEM, NEM, some combination, or neither, is an empirical issue and

depends upon their relative costs and effectiveness in boosting reported earnings and attracting

financing. In addition to generating cash directly, CEM has the advantage that it is more difficult

for investors and auditors to detect than NEM as changes in business operations are not required

to be disclosed. Indeed, Graham, Harvey, and Rajgopal (2005) and Cohen, Dey, and Lys (2008)

find that managers prefer it to NEM, especially after Congress passed the Sarbanes-Oxley Act

(SOX) in 2002. SOX requires managers to certify the integrity of their financial statements, but

not the soundness of their operating decisions.

However, both CEM and NEM have drawbacks. CEM can be costlier to implement than simple

accounting book adjustments as it involves changing, and perhaps disrupting, a firm’s physical

operations. The physical constraints of firm production could also make CEM a less flexible or

potent method to boost earnings than NEM. A corresponding drawback of NEM is that investors

must recognize the earnings signal and perceive it as a signal of good investment opportunity as

opposed to deception.

Defined benefit (DB) plans are substantial liabilities for US firms. During our sample period

from 1991 to 2013, the average DB plan’s assets represent 18.20% of firms’ book assets and

36.49% of their market value of equity.In a DB plan, the sponsoring f irm promises to make fixed

monthly pension payments to its retirees. When the present value of those payments exceeds the

DB plan’s asset value, the plan becomes underfunded and the sponsoring firm is required to make

MCs. Business media reports that the recent drop in interest rates has caused the value of US

corporate DB plans to reach their most underfunded levels on record. Although DB plans may be

costly and risky, they could be valuable if they attract and retain talented employees.

Rauh (2006) suggests that MCs are substantial enough to adversely affect a firm’sinvestments

and competitive position. He finds that, on average, a firm’s capital expenditures decrease by

$0.60 to $0.70 per dollar of MCs and that industry competitors take advantage by increasing their

investments. Franzoni (2009) argues that MCs lead to subsequent negative stock returns, while

Campbell et al. (2012) report that MCs increase firms’ cost of debt, cost of equity, and weighted

average cost of capital (WACC). These studies imply that MCs can impose financial constraints

on firms with underfunded DB plans.

Linck et al. (2013) argue that a financially constrained firm with valuable investment projects

can manage earnings to help attract additional external capital for its investments. Francis, Olsson,

and Schipper (2004) find that smoothed earnings help f irms reduce the implied costs of equity.

For these reasons, MC firms may be more willing to engage in costly earnings management if it

lessens the negative effects of MCs on their financing and investment plans.2

Our sample includes only firms with DB plans, some of which experience cash flow shocks

from MCs and others that do not. Rauh (2006) and Campbell et al. (2012) find that MCs are

driven bythe arbitrar y and nonlinear structure of pension contribution rules that cause unexpected

MC jumps that are unlikely to be endogenous to firms’ investment prospects, costs of capital, or

external funding opportunities. Specifically, Rauh (2006) argues: “ . . . [t]he function that relates

funding status to investment opportunities does not have precisely the same kinks, jumps, and

2Earnings management can also be costly in several ways. It can increase tax expenses, divert management and staff

attention to unproductive activities, and bring on costly litigation from regulatorsand investors. For example, Cohen and

Zarowin (2010) find that firms manipulate earnings prior to seasoned equity offerings to help boost offering proceeds,

but firms’ future operating performance suffers. Teoh, Welch, and Wong (1998) conclude that three-year aftermarket

stock returns are 20% lower for IPO issuers that aggressively manage earnings compared to those that are conservative.

DuCharme, Malatesta, and Sefcik (2004) note that managers are able to send false signals about their firm’s health prior

to stock issues, but they later face litigation. McInnis (2010) finds that investors see through earnings smoothing, and

that smoothing firms enjoy no decrease in implied costs of equity.

Phan, Khieu, & Golec rMandatory Pension Contributions and Earnings Management 91

asymmetries as the function that relates pension funding status to required pension contributions.”

(2006, 34-35). In our case, the function that relates pension funding status to MCs does not have

the same exact kinks, jumps, and asymmetries as the function that relates funding status to NEM

or CEM. Therefore, MCs provide a relativelyclean way to identify whether earnings management

helps to counteract the burdens imposed by liquidity shocks, such as MCs. Those burdens can

include higher costs of capital, less available external funding, and consequently, less investment.

Webegin our analysis by examining the relation between earnings management and MCs while

controlling for DB plan funded status and other factors that could explain earnings management.

Based on a panel of 1,283 unique firms that sponsor DB plans from 1991to 2013, we find that

firms that are required to make MCs resort to CEM, but not NEM.

Having established that MC firms resort to managing earnings, we next examine whether this

earnings management impacts the cost of capital, external financing, and investment. We use

MCs interacted with various measures of NEM and CEM as explanatory variables in the cost

of capital, external financing, and investment regressions to measure the effects of earnings

management conditioned on MCs. Our analysis indicates that earnings management associated

with MCs increases the cost of debt, although it can marginally reduce the cost of equity and

WACC. In addition, we do not find evidence that earnings management associated with MCs

helps firms raise more debt or equity. Intuitively, external creditors would be concerned that any

new debt proceeds would go to fund MCs rather than to finance profitable investment projects.

Even if the larger managed earnings signal the firm’s attractive investment opportunities (Linck

et al., 2013), creditors are less likely than stockholders to benefit from them as their payments are

fixed and the new investment returns are uncertain. Consequently, creditors raise their required

rate of return on new debt and refuse to lend more to these firms.

CEM associated with MCs may be viewed positively by equity holders as it can generate cash

to fund MCs without diluting their holdings. While like Campbell et al. (2012), we find that MCs

raise the costs of debt, equity, and WACC, on average,we also determine that CEM can mitigate

a small amount of the increase in the cost of equity and overall WACC. However, we find no

evidence that CEM increases investment, and some evidence that it actually reduces investment.

We also find that MC firms that employ CEM contribute more to their DB plans. Overall, our

results can be interpreted as indicating that firms faced with MCs tend to engage in more CEM,

but that does not help increase external funding for their profitable investments. Rather, CEM

generates internal cash to fund their MCs, and that this is likely to placate their equity holders to

some degree.

Our paper contributes to both the pension literature and the earnings management literature.

It adds to the pension literature by examining whether firms cope with sudden MCs associated

with their underfunded DB pension plans by increasing their earnings management. In addition,

it studies whether this earnings management favorably impacts their cost of capital, corporate

financing, and investment. Our evidence indicates that firms respond to MCs by managing

earnings. We contribute to the earnings management literature by using MCs as exogenous

shocks to a firm’s liquidity to better identify the potential benefits of earnings management for

financially constrained firms. Prior ear nings management studies use conventional measures

of financial constraints based on fir m-level variables, such as size, that can be endogenous to

corporate decisions and, as such, may provide biased estimates of the potential benefits (Duchin,

Ozbas, and Sensoy, 2010; Hadlock and Pierce, 2010). The only significant benef it of earnings

management associated with MCs that we find is that CEM provides cash that firms can use to

help fund MCs.