employee downsizing and accounting choices: evidence from … · 2017-09-20 · 1 employee...

DP2017-06

Employee Downsizing and Accounting Choices: Evidence from Japan

Keishi FUJIYAMA Makoto KUROKI

Revised September 20, 2017

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Keishi Fujiyama Kobe University

[email protected]

Makoto Kuroki Yokohama City University [email protected]

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Abstract: While employee downsizing is an important economic phenomenon at least in countries with inflexible employment practices, little is known about accounting practices around downsizing. The literature proposes two competing hypotheses regarding accounting practices around labor negotiations: earnings management hypothesis and informative accounting practice hypothesis. This study investigates accounting choices around employee downsizing, using data from Japan, where employee downsizing is constrained by social norms and case laws. Specifically, it focuses on accounting conservatism, which informs employees of firms’ real economic conditions, and discretionary accruals, which represents opportunistic management behaviors. We find that downsizing firms report more conservative earnings in years during and after downsizing than non-downsizing firms do. However, we find no evidence suggesting that managers engage in income-decreasing earnings management around downsizing. These results are consistent with informative accounting practice hypothesis, in which managers make accounting choices to inform their employees of the firm’s real economic conditions. Keywords: accounting conservatism, earnings management, employee, labor negotiation, downsizing JEL Classifications: G34, J51, M41

INTRODCTION

This study examines accounting choices around employee downsizing. Specifically, it uses

data from Japanese firms whose subsidiaries, if any, operate only in Japan—hereafter,

Japanese domestic firms—and focuses on two earnings attribute measures: discretionary

accruals, which represent an opportunistic accounting practice, and accounting conservatism,

which is assumed to enhance the informativeness of accounting numbers and represents the

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real economic conditions of a firm.

Employment practices substantially vary around the world. For example, the

“employment at will” norm prevails in the United States, while managers face the “lifetime

employment” norm in Japan. World Economic Forum (2014) reports that hiring/firing

flexibility in the US and Japan is ranked as 11th and 133rd out of 144 countries, respectively.

Moreover, the international variation in labor power affects management decision making on

employment adjustment (Atanassov and Kim 2009). Specifically, they find that firms in

countries with strong labor protection are less likely to downsize their employees. Therefore,

to the extent that financial statements are used during labor negotiations, how accounting

numbers are shaped around employment adjustment, i.e. downsizing, is an important issue

from an international perspective.

In the literature, two competing hypotheses are proposed regarding labor

negotiations, especially wage negotiation. Liberty and Zimmerman (1986) adopt agency

theory to hypothesize that managers manage earnings downward to enhance their bargaining

power when negotiating with employees or labor unions (hereafter, earnings management

hypothesis). Although the earnings management hypothesis is intuitively persuasive, previous

studies show mixed results. Recently, however, García Osma, Mora, and Sabater (2015)

propose an alternative hypothesis that managers make accounting choices to inform

negotiating parties of firms’ real economic conditions (informative accounting practice

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hypothesis). They show enhanced accounting conservatism during labor negotiations but not

decreased discretionary accruals. These results suggest that negative accruals recognized in

financial statements during employee negotiations are mainly due to economic losses.

Along with this line of research, we investigate the nature of accounting choices

around downsizing by exploiting data from Japanese firms. A Japanese setting provides an

opportunity to investigate accounting practices around downsizing. First, Japanese firms

emphasize relationships with employees. Contrary to the US, where the “employment at will”

norm prevails, stakeholders including managers, shareholders, and employees in Japan share

the “lifetime employment” norm. In addition, firms are required by case laws to demonstrate

the necessity of downsizing. Thus, Japanese firms need to communicate with their

stakeholders and accounting numbers can play a role in doing so and converging stakeholders’

interests. Second, case laws also require that managers talk with labor unions or employee

representatives before implementing downsizings. This results in negotiations with

employees. Third, a certain portion of Japanese firms downsize their employees when they

perform poorly. While the lifetime employment norm prevails in Japan, the two decades of

stagnation in the Japanese economy have caused a deterioration in Japanese firms’ financial

position and downsizing has increased.

The sample for this study consists of 7,217 firm-year observations during 2002-2015,

including 739 observations experiencing a 5 percent or more decrease in employees. The

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observations are firms that do not have subsidiaries or whose subsidiaries operate only in

Japan. Thus, when managers seek to downsize their employees at any level of a company

group, they face the norms and legal practices of Japanese society.

Consistent with García Osma et al.’s (2015) findings, we find that the degree of

accounting conservatism increases in years during and after downsizing. This result is robust

using several earnings measures. However, we do not find negative discretionary accruals

around downsizing years. Therefore, the results are consistent with the informative

accounting practice hypothesis that managers make accounting choices to inform negotiating

parties of the firm’s real economic conditions. Additionally, we examine whether labor unions

affect accounting practices around downsizing and find that for both the unionized and

non-unionized samples, the degree of accounting conservatism increases in the downsizing

year. Similar to the main results, we do not find a negative relationship between discretionary

accruals and downsizing in the years around downsizing. These results suggest that managers

record economic losses regardless of the existence of labor unions, further supporting the

informative accounting practice hypothesis.

This study contributes to the existing literature in four ways. First, it sheds light on

accounting practices around downsizing. In countries with inflexible employment practices,

personnel reduction impacts significantly on employees’ lives. In addition, managers in such

countries can face stronger resistance from employees. Our results suggest that managers do

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not deceive employees to obtain better bargaining positions, but inform employees of firms’

real economic conditions to gain concessions and cooperation from employees.

Second, it adds new evidence on accounting practices around labor negotiations.

Prior research proposes two competing hypotheses, the earnings management hypothesis and

informative accounting practice hypothesis. Although García Osma et al. (2015) propose the

informative accounting practice hypothesis and provide consistent evidence, their study is the

first to do so and their sample size is limited to 150 observations including matched

non-negotiation observations. This study complements their findings by focusing on a

different institutional setting, using a larger sample, and investigating a different employee

negotiation. García Osma et al. (2015) acknowledge that relatively small unionized employee

bases of US firms reduce management incentives to depress earnings in a “close-shop”

system, where (re-)negotiation outputs are applied only to unionized workers. In Japan,

managers are often forced to make efforts such as personnel relocation and temporary

assignment before downsizing and to demonstrate the necessity of downsizing, which

suggests that Japanese firms’ financial statements at a firm or business unit level can play a

greater role than those of US counterparts. Nevertheless, we do not find evidence consistent

with the earnings management hypothesis. Therefore, the use of a Japanese setting enhances

the plausibility of the informative accounting practice hypothesis.

Third, this study examines a new aspect of management behavior around downsizing.

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While prior research emphasizes the importance of trust around downsizing (e.g., Mishra and

Spreitzer 1998; Lee and Teo 2005), little is known about trust destroying behavior in terms of

accounting practices. Hillier, Marshall, McColgan, and Werema (2007) find negative stock

market reaction to layoff announcements and improved employee productivity after

permanent layoffs, which suggests that poor financial conditions drive permanent layoffs and

employee trust is not eroded to a greater extent. Our evidence is consistent with their findings

and suggests that managers do not behave in ways that destroy trust during downsizing.

Finally, this study contributes to prior research on Japanese accounting practices.

While Japan has one of the world’s largest economies and unique institutional characteristics

such as relational banking (main bank system), keiretsu, and stable block holders (e.g.,

Douthett and Jung 2001; Chung, Ho, and Kim 2004; Gramlich, Limpaphayom, and Rhee

2004; Habib, 2004; Baik and Choi, 2010; Shuto and Iwasaki, 2014),1 there is little known

about the context of lifetime employment, especially in the English accounting literature. To

our knowledge, Yamaji (1986) reports the only study examining the influence of Japanese

employees on accounting-related practices. His findings suggest that employee considerations

affect aggressiveness of management forecasts in Japan. This study extends prior research on

Japanese accounting practices by providing new evidence suggesting employee influences on 1 These three characteristics are discussed in management literature (see Yoshikawa and McGuire 2008). Previous studies also investigate accounting practices of Japanese firms and the capital market consequences without analyzing the effects of Japanese institutional characteristics or other factors affecting Japanese accounting practices (Jacobson and Aaker 1993; Inoue and Thomas 1996; Mande, File, and Kwak 2000; Herrmann, Inoue, and Thomas 2003; Skousen, Guan, and Wetzel 2004; Thomas, Herrmann, and Inoue 2004; Shuto 2007; Kato, Skinner, and Kunimura 2009; Shuto 2009; Cho, Hah, and Kim 2011; Higgins 2013; Guo, Huang, Zhang, and Zhou 2015; Goto and Yanase 2016).

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accounting numbers in financial statements.

The reminder of this paper is as follows. In section 2, we discuss the prior research

and the Japanese institutional setting, and develop our hypothesis. Section 3 describes the

empirical design and sample. We present the results in Section 4. Section 5 presents

conclusions.

BACKGROUND AND HYPOTHESIS DEVELOPMENT

Accounting Practices around Labor Negotiations

While the earnings management hypothesis predicts that managers manage earnings

downward in the face of labor negotiations, previous studies of US firms and wage

negotiations show mixed results. Liberty and Zimmerman (1986) propose the earnings

management hypothesis, but do not provide evidence consistent with it. They interpret their

results in three ways: first, managers do not need to manage earnings downward due to firms’

poor real operating performance; second, labor unions’ ability to undo managers’

opportunistic accounting choices prevents downward earnings management; and third, their

research design is inappropriate. Subsequent studies also do not find evidence consistent with

the earnings management hypothesis (Mautz and Richardson 1992; Cullinan and Knoblett

1994). DeAngelo and DeAngelo (1991) report one exception, showing that during the 1980s,

US companies in the steel industry record a large amount of restructuring charges during

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negotiations with labor unions. As they argue, managers can choose the timing of the

recognition of those charges and the recognition during labor negotiations may be

opportunistic.2

D’Souza, Jacob, and Ramesh (2001) exploit the adoption year of the Statement of

Financial Accounting Standards No. 106, Employer’s Accounting for Postretirement Benefits

Other Than Pensions, and find that highly unionized firms are more likely to choose an

accounting method that reduces earnings. However, they do not find that firms with higher

costs of debt covenant violations do not make such an accounting choice. Bova (2013) shows

that unionized firms are more likely to miss analysts’ earnings expectation partly by

managing earnings downwards; however, the likelihood of this practice does not increase in

the face of wage negotiations with labor unions. In addition, firms with strong labors increase

information asymmetry (Hilary 2006; Chung, Lee, Lee, and Sohn 2016; Ji and Tan 2016).

These studies suggest that labor considerations affect firms’ accounting practices. The

earnings management hypothesis, however, does not sufficiently predict accounting practices

around labor negotiations.

García Osma et al. (2015) offer several criticisms of the assumptions of

agency-based prior research: (1) negotiation outcomes are mainly determined by the

bargaining power of just one negotiating party (management or labors/labor unions) and (2)

2 Note that DeAngelo and DeAngelo (1991) describe that the losses result from managers’ real operating decisions.

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the bargaining is a one-shot game. The industrial relations literature views the bargaining

relationship between firms and labors as a repeated game (Espinosa and Rhee 1989; Kahn

1993; Sestini 1999). Given the repeated nature of firm-labor interactions, both parties

consider future interactions and cooperate to achieve efficient outcomes. Therefore, both

parties make concessions when firms perform poorly.

From the above explanation, García Osma et al. (2015) propose an alternative

hypothesis, in which managers make accounting choices around labor negotiations to inform

their employees of the firm’s real economic conditions (informative accounting practice

hypothesis). They find that firms with wage renegotiations report more conservative earnings

than non-negotiating firms do, but fail to find decreased discretionary accruals around labor

negotiations. These results suggest that accrual choices around wage renegotiations reflect

managers’ motivation to reflect economic losses in the firm’s financial statements, which can

promote communication between firms and labors.

Employment Practices in Japan

Japanese employment practices include lifetime employment, the seniority wage system, and

enterprise labor union (Yamaji 1986; Hamaaki, Hori, Maeda, and Murata 2012). Lifetime

employment is a norm at the core of those practices, in which an employee works at a same

company until a certain age stipulated by the company, resulting in a long-term relationship.

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One of the most important aspects of the lifetime employment norm is that it is an implicit

contract, and trust among the related parties is crucial for the practice to work. This also

significantly constrains Japanese firms’ decision making. For example, combined with banks’

influence,3 Japanese firms attempted to maximize sales growth rather than earnings or

shareholder value until only recently (Ahmadjian and Robbins 2005). This enables stable

employment because sales are the first pie for distribution among stakeholders such as

shareholders, banks, and employees. In another example, Japanese firms are less likely to

restructure their businesses and downsize a smaller proportion of employees than their US

counterparts (Kang and Shivdasani 1997). Therefore, managers of Japanese firms may make

accounting choices that avoid undermining employee trust but promote cooperation.

In addition to the lifetime employment norm, judicially created doctrines set four

guidelines for collective dismissals: (1) necessity, (2) duty to implement dismissal avoidance

efforts, (3) selection adequacy, and (4) procedural adequacy. The first and forth guidelines are

relevant to the present study.4 The first guideline requires managers to demonstrate the

necessity of collective dismissal. For example, two consecutive losses are a traditional

indicator of the necessity of collective dismissal, suggesting that losses are one of the ways

3 Similar to employees, banks face asymmetry payout. In other words, while they receive reduced interest in case of borrowers’ insolvency, they do not receive increased interest in case of borrowers’ high performance. Therefore, banks prefer borrowers’ stable growth of sales to maximization of earnings. See Faleye, Mehrotra, and Morck (2006) for incentives of banks and employees. 4 The second guideline requires managers to make efforts such as personnel relocation and temporary assignment before collective dismissals. The third guideline requires reasonable and fair selection of employees dismissed.

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managers demonstrate the necessity for collective dismissal.5 If accounting numbers play a

role, they can have certain attributes around collective dismissals. According to the forth

guideline, managers must set conversations with labor unions or employee representatives,

indicating that managers negotiate with them before downsizing. Note that most downsizing

activities are not resorted to courts. Those guidelines, nevertheless, are influential in that

firms try to avoid litigation and behave with reference to them.

In sum, Japanese firms are constrained by a trust-based lifetime employment system,

which leads to a long-term relationship between firms and employees, as well as judicially

created doctrines that suggest a role for accounting numbers and labor negotiations around

downsizing. Therefore, a Japanese setting provides an appropriate opportunity to investigate

accounting practices around employee downsizing.

Hypothesis

Repeated game theory assumes that a firm interacts with employees or labor unions

repeatedly, and employees/labor unions incorporate the firms’ behavior in their response. It

also assumes that cooperation among related parties results in efficient outcomes. Thus,

concessions from related parties are predicted when the firm has poor performance. García

Osma et al. (2015) hypothesize, based on repeated game theory, that managers make

5 Note that doctrines change as social norms change. Two-consecutive-year criterion is changing and firms recently tend to downsize their employees regardless of such losses (Noda 2013).

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accounting choices to enhance the informativeness of the firm’s financial statements instead

of opportunistic earnings management.

In Japan, the lifetime employment norm results in a long-term relationship, and

active, repeated interactions between firms and employees. It is costly for managers to break

and re-establish trust from employees. For example, Japanese managers are viewed as

intermediaries between shareholders and employees (Aoki 1984) and evaluated by both

capital providers (stable shareholders and banks) and employees (Dore 2000). Moreover, the

lifetime employment norm itself is an implicit contract. Thus, trust from employees is

important for managers.

On the other hand, firms need to gain concessions from employees when their

performance is deteriorating. Since the collapse of the economic babble in 1991, Japanese

firms have experienced a two-decade downturn and deteriorating financial positions, causing

a decline in firms’ capacity to protect employment. Employee downsizing is a type of

concession from employees. Thus, managers persuade employees to accept it. At the same

time, they must take the relationship with employees after downsizing into account because

most employees will remain within the firm. If earnings management becomes manifest

ex-post and erode trust in management, managers will not engage in costly opportunistic

accounting choices. Instead, they will enhance the informativeness of accounting numbers

and show their future outlook.

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Accounting conservatism occurs when managers “anticipate no profits and provide

for all probable losses” (Bliss 1924, 110); and conditional conservatism is “an equivalent bias

conditional on firms experiencing contemporaneous economic losses” (Ball and Shivakumar

2005, 89). Conditionally conservative accounting, by definition, records losses based on

economic losses, which occur in effect but whose related transactions are not yet realized or

whose related accrual accounting standards do not yet require their recognition. Therefore,

conservative earnings are not derived from non-existent losses and can show firms’ future

outlook (García Osma et al. 2015). The above discussion leads to our hypothesis:

H1: Firms report more conservative earnings around employee downsizing.

RESEARCH DESIGN

Model for Conservatism Test

To test our hypothesis, we run the following regression based on Basu (1997) and with

control variables proposed by Khan and Watts (2009):

𝑂𝑂𝑂𝑂𝑖𝑖,𝑘𝑘 = 𝛼𝛼0 + 𝛼𝛼1𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘 + 𝛼𝛼2𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘𝑅𝑅𝑖𝑖,𝑘𝑘 + 𝛼𝛼3𝑅𝑅𝑖𝑖,𝑘𝑘 +𝛼𝛼4𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡 + 𝛼𝛼5𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡 + 𝛼𝛼6𝑅𝑅𝑖𝑖,𝑘𝑘𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡 + 𝛼𝛼7𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘𝑅𝑅𝑖𝑖,𝑘𝑘𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡 +𝛼𝛼8𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑖𝑖,𝑘𝑘−1 + 𝛼𝛼9𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑖𝑖,𝑘𝑘−1 + 𝛼𝛼10𝑅𝑅𝑖𝑖,𝑘𝑘𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑖𝑖,𝑘𝑘−1 + 𝛼𝛼11𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘𝑅𝑅𝑖𝑖,𝑘𝑘𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑖𝑖,𝑘𝑘−1 +𝛼𝛼12𝑀𝑀𝑀𝑀𝑀𝑀𝑖𝑖,𝑘𝑘−1 + 𝛼𝛼13𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘𝑀𝑀𝑀𝑀𝑀𝑀𝑖𝑖,𝑘𝑘−1 + 𝛼𝛼14𝑅𝑅𝑖𝑖,𝑘𝑘𝑀𝑀𝑀𝑀𝑀𝑀𝑖𝑖,𝑘𝑘−1 + 𝛼𝛼15𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘𝑅𝑅𝑖𝑖,𝑘𝑘𝑀𝑀𝑀𝑀𝑀𝑀𝑖𝑖,𝑘𝑘−1 +𝛼𝛼16𝐿𝐿𝑆𝑆𝐿𝐿𝑖𝑖,𝑘𝑘−1 + 𝛼𝛼17𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘𝐿𝐿𝑆𝑆𝐿𝐿𝑖𝑖,𝑘𝑘−1 + 𝛼𝛼18𝑅𝑅𝑖𝑖,𝑘𝑘𝐿𝐿𝑆𝑆𝐿𝐿𝑖𝑖,𝑘𝑘−1 + 𝛼𝛼19𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘𝑅𝑅𝑖𝑖,𝑘𝑘𝐿𝐿𝑆𝑆𝐿𝐿𝑖𝑖,𝑘𝑘−1 +𝜀𝜀𝑖𝑖,𝑘𝑘, (1)

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where OIi,k is ordinary income (keijo rieki), deflated by the market value of equity (MVE) at

three months after the fiscal year end k−1; Ri,k is annual stock return ([MVEi,k −

MVEi,k-1]/MVEi,k-1); NEGi,k takes one if Ri,k is negative and zero otherwise; Sizei,k-1 is the

natural logarithm of MVE at the end of fiscal year k−1; MTBi,k-1 is the market-to-book ratio at

the end of fiscal year k−1, defined as MVE/equity capital (jikoshihon); and Levi,k-1 is the debt

ratio at the end of fiscal year k−1, defined as short-term plus long-term debt scaled by the

MVE at three months after the fiscal year end k−1. k represents fiscal year t−1, t, or t+1.

Downi,t is a proxy for downsizing. It takes one if firm i experiences a five-percent

decrease in employees or more in year t and zero otherwise (Ahmadjian and Robinson 2001;

Ahmadjian and Robbins 2005). We hypothesize that managers enhance the informativeness

of accounting numbers in the face of employee downsizing to elicit concession from

employees, and earnings are more conservative around downsizing. Therefore, we expect a

positive coefficient on α7.

Model for Earnings Management Test

We hypothesize that firms report more conservative earnings around employee downsizing.

While we do not explicitly describe earnings management around downsizing, prior research

proposes the competing earnings management hypothesis. Therefore, in addition to

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conservative accounting practices, we analyze earnings management around downsizing,

following García Osma et al. (2015).

Discretionary Accrual Measure

We estimate non-discretionary accruals by running the following regression based on

Kasznik’s (1999) model in cross-section for all industry-year combinations (DeFond and

Jiambalvo 1994):6

𝐴𝐴𝐴𝐴𝐴𝐴𝑖𝑖,𝑘𝑘 𝐴𝐴𝐴𝐴𝐴𝐴𝑆𝑆𝐴𝐴𝐴𝐴𝑖𝑖,𝑘𝑘−1⁄ = 𝛽𝛽0 + 𝛽𝛽1 1 𝐴𝐴𝐴𝐴𝐴𝐴𝑆𝑆𝐴𝐴𝐴𝐴𝑖𝑖,𝑘𝑘−1⁄ + 𝛽𝛽2 �∆𝑅𝑅𝑁𝑁𝑅𝑅𝑖𝑖,𝑘𝑘 − ∆𝑅𝑅𝑁𝑁𝐴𝐴𝑖𝑖,𝑘𝑘� 𝐴𝐴𝐴𝐴𝐴𝐴𝑆𝑆𝐴𝐴𝐴𝐴𝑖𝑖,𝑘𝑘−1�

+𝛽𝛽3 𝑃𝑃𝑃𝑃𝑁𝑁𝑖𝑖,𝑘𝑘 𝐴𝐴𝐴𝐴𝐴𝐴𝑆𝑆𝐴𝐴𝐴𝐴𝑖𝑖,𝑘𝑘−1⁄ + 𝛽𝛽4 ∆𝐴𝐴𝐶𝐶𝑂𝑂𝑖𝑖,𝑘𝑘 𝐴𝐴𝐴𝐴𝐴𝐴𝑆𝑆𝐴𝐴𝐴𝐴𝑖𝑖,𝑘𝑘−1⁄ + 𝜀𝜀𝑖𝑖,𝑘𝑘 (2)

where ACCi,k is total accruals in year k, defined as ordinary income after taxes minus cash

flows from operations;7 ΔREVi,k is the change in revenues from year k−1 to k; ΔRECi,k is the

change in accounts receivable from k−1 to k; PPEi,k is gross property, plant, and equipment in

year k; ΔCFOk is the change in cash flows from operations from year k−1 to k; and Assetsi,k-1

is total assets in year k−1.

6 García Osma et al. (2015) examine the relationship of abnormal working capital accruals and cash flows with labor negotiations. We do not employ those measures of opportunistic management behavior because we assume that discretionary total accruals affect ordinary income as a whole and the conservatism measure captures accrual practices. We do not find negative relationships between discretionary accruals and Downi,t from year t−1 to t+1 when we exclude 𝑃𝑃𝑃𝑃𝑁𝑁𝑖𝑖,𝑘𝑘 𝐴𝐴𝐴𝐴𝐴𝐴𝑆𝑆𝐴𝐴𝐴𝐴𝑖𝑖,𝑘𝑘−1⁄ from equation (2) based on García Osma et al. (2015). 7 Ordinary income after taxes is the net income after taxes less special profits plus special losses.

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Empirical Model

To test earnings management around downsizing, we examine the association between

discretionary accruals and downsizing by estimating the following equation similar to Becker,

DeFond, Jiambalvo, and Subramanyam (1998) and García Osma et al. (2015):

𝐷𝐷𝐴𝐴𝑖𝑖,𝑘𝑘 = 𝛾𝛾0 + 𝛾𝛾1𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡 + 𝛾𝛾2𝐿𝐿𝐷𝐷𝐴𝐴𝐴𝐴𝐴𝐴𝑆𝑆𝐴𝐴𝐴𝐴𝑖𝑖,𝑘𝑘−1 + 𝛾𝛾3𝑅𝑅𝑂𝑂𝐴𝐴𝑖𝑖,𝑘𝑘 + 𝛾𝛾4𝐴𝐴𝐶𝐶𝑂𝑂𝑖𝑖,𝑘𝑘 + 𝛾𝛾5𝐷𝐷𝑆𝑆𝐷𝐷𝐴𝐴𝑖𝑖,𝑘𝑘−1 +𝛾𝛾6𝑀𝑀𝑀𝑀𝑀𝑀𝑖𝑖,𝑘𝑘−1 + 𝛾𝛾7𝑂𝑂𝐴𝐴𝐴𝐴𝐷𝐷𝑁𝑁𝑀𝑀𝑀𝑀𝑖𝑖,𝑘𝑘 + 𝛾𝛾8𝑂𝑂𝐴𝐴𝐴𝐴𝑁𝑁𝐼𝐼𝑖𝑖,𝑘𝑘 + ∑𝐶𝐶𝑆𝑆𝐹𝐹𝑆𝑆𝐹𝐹𝑁𝑁𝐹𝐹𝐹𝐹𝑆𝑆𝐹𝐹𝐴𝐴𝐴𝐴 + 𝜀𝜀𝑖𝑖,𝑘𝑘 (3)

where DAi,k is discretionary accruals computed as total accruals less non-discretionary

accruals estimated from equation (2); LnAssetsi,k-1 is the natural logarithm of total assets in

year k−1; ROAi,k is return on assets in year k−1; Debti,k-1 is the debt ratio; and MTBi,k-1 is

market-to-book ratio at the end of fiscal year. According to García Osma et al. (2015), we

incorporate IssDEBTi,k (IssEQi,k) as a proxy for debt (equity) issuances. IssDEBTi,k (IssEQi,k)

takes one if firm i experiences a 10% increase in outstanding debt (capital stock) or more in

year k and zero otherwise. If managers engage in income-decreasing earnings management

around downsizing, the γ1 will be negative.

Data

Our sample consists of firms operating only in Japan to investigate accounting practices

around downsizing constrained by Japanese employment practices. Our sample period is

18

2002-2015 because Japanese firms disclosed consolidated cash flow statements since 2000.

Table 1 summarizes the sample selection process. First, we use firms with fiscal

years ending in March because approximately 70 percent of Japanese firms use this practice

and this treatment can control for macro-economic effects on financial performance and stock

prices. Second, according to Kimura (2016), we identify Japanese domestic firms by defining

them as firms whose foreign currency translation adjustment account is zero from year t−2 to

t+1, assuming that those firms do not have any subsidiaries or their subsidiaries are located

only in Japan. Thus, the downsizing activities implemented by our sample firms are subject to

Japanese employment practices. Third, we eliminate firms with less than 200 employees. This

process is more likely to prevent us from capturing unintended decreases in employees as

downsizing. Fourth, we eliminate firms with insufficient financial and price data. Fifth, we

exclude financial institutions. Sixth, we exclude firms that downsize their employees in year

t−1 because we are interested in accounting practices in both year t−1 and t, and including

these firms can compound the effects of downsizing in year t on accounting practices in year

t−1. Finally, we include industries comprising 15 firms or more on an annual basis to

compute non-discretionary accruals.

< Insert Table 1 about here >

The result of the above selection process yields a sample of 7,217 firm-year

observations. Table 2 presents the number of firms by industry. The manufacturing industry

19

represents 30.82 percent of the sample. In general, the unionization rate is higher for

manufacturing industries compared to non-manufacturing industries, especially the service

industry (Ministry of Health, Labour and Welfare 2015). Therefore, our sample includes

industries with various unionization rates. A variation in employee influences across firms

enhances the power of empirical test (Bova 2013).


Table 3 reports the descriptive statistics for the conservatism and earnings

management tests in Panels A and B, respectively. Each continuous variable is winsorized at

its 2nd and 98th percentiles.8 In Panel A, the mean value of Downt is 0.1024 indicating that

on average, 10.24 percent of the sample firms experience downsizing. In Panel B, the median

value of LnAssetst-1 (pre-converting total assets) is 10.260 (JPY 25,323 million9). Our sample

consists of relatively small firms, though does include some large firms. Table 4 presents the

Pearson correlations. Downt is negatively correlated with ROAt, suggesting that downsizing

firms face deteriorating performance.

<Insert Table 3 about here>

RESULTS

8 We set the 2nd and 98th percentiles because the results yield extreme values of annual stock returns in the conservatism test when we winsorize the variables at its 1st and 99th percentiles. The 99th criterion results in an extremely high R-requared for the conservatism test. Ball, Kothari and Robin (2000) employ 2nd and 98th percentile criteria. We obtain similar results of the earnings management tests by winsorizing the variables of the earnings management test at the 1st and 99th percentiles. 9 The amount is US$ 230 million (US$ 1 = JPY 110).

20

Results of Conservatism Test

Table 5 reports the results of the conservatism test. The coefficient of NEGk*Rk*Downt, α7, is

the main interest. The coefficient on year t−1 is insignificant (coefficient = 0.0573; t = 1.32),

while those on years t and t+1 are positive and statistically significant at the 1% and 5%

levels (coefficient = 0.2165 and 0.1234; t = 4.65 and 2.72), respectively. These results suggest

that Japanese domestic firms report more conservative earnings in the years during and after

downsizing, consistent with Hypothesis 1. Interestingly, the coefficients on Rk*Downt in

years t and t+1 are significantly negative (coefficient = -0.0790 and -0.0428; t = -2.76 and

-2.13), indicating that downsizing firms report lower earnings than non-downsizing firms,

even when they earn economic gains. The results are also consistent with the informative

accounting practice hypothesis.


In Table 5, the coefficient on NEGk*Rk is insignificant. To test the validity of the

empirical model, we run a baseline regression using Basu’s (1997) model. Model (1) in Table

6 presents the baseline results. In Model (1), the coefficient on NEGk*Rk in year t is positive

and statistically significant at the 1% level (coefficient = 0.0645; t = 3.94), confirming the

validity of the models. In Models (2) and (4), the coefficients on NEGk*Rk*Downt remain

statistically significant (coefficient = 0.2519 and 0.2653; t = 5.58 and 5.75), indicating that

the results of the main analysis are robust.

21


We also confirm the robustness of the main results in two ways. First, we use other

earnings measures: ordinary income plus fixed asset impairment losses10 and net income.

Because Japanese firms disclose financial statements in accordance with Japanese accounting

standards, which require different earnings classifications from US GAAP, it is not possible

to compute the same earnings as employed in US-based studies. The results are qualitatively

the same as in the main analysis except for the coefficient on Rk*Downt in year t

(untabulated), which is insignificant for the model using ordinary income plus fixed asset

impairment losses as the earnings measure.

Second, we employ a continuous downsizing measure, CDownt, that takes a positive

percentage change in employees, multiplied by −1, if the pre-multiplication value is −5

percent or less and zero otherwise. 11 The magnitude of downsizing may affect the

conservativeness of downsizing firms’ earnings. Table 7 presents these results, which are

similar to the main analysis.


Results of Earnings Management Test

10 Accounting for fixed asset impairment is introduced as mandatory in 2006. Impairment losses are reported as a special loss, below ordinary income. We employ ordinary income in the main analysis to use a uniform earnings measure. 11 The variable is winsorized at the 98nd percentile.

22

Table 8 presents the results of the earnings management tests. The coefficient on Downt in

year t−1 is negative but not statistically significant (coefficient = -0.0000; t = -0.04), while

those in year t and t+1 are positive and statistically significant (coefficient = 0.0025 and

0.0016; t = 2.93 and 1.66), suggesting that managers of downsizing firms seek to record

larger profits in the years during and after downsizing. Those results are inconsistent with

earnings management hypothesis.


Table 9 shows the results using a continuous downsizing measure, which are similar to those

in Table 8. The coefficients on CDownt in years t and t+1 are significantly positive

(coefficient = 0.0246 and 0.0253; t = 2.56 and 2.41), while that on Downt in year t−1 is

negative but insignificant (coefficient = -0.0056; t = -0.57). Firms with a larger downsizing

may have stronger incentives to report higher earnings.


Finally, we test the conservatism and earnings management hypotheses by dividing

the sample based on the median value of debt ratio at the end of year t−1. In Table 8, the

positive coefficient on Downt in year t is opposite to the earnings management prediction. It

is possible that downsizing firms experience poor underlying performance and do not need to

depress earnings (Liberty and Zimmerman 1986). Consistently, D’Souza et al. (2001) find

that highly unionized firms with higher costs of debt covenant violations do not make an

23

income-decreasing accounting choice. If downsizing firms face poor performance and

financial position, we expect that income-increasing earnings management is observed for

downsizing firms with a high debt ratio. The results are shown in Table 10. The results in

Panel A indicate that downsizing firms with both high and low debt ratios report conservative

earnings, confirming the informative accounting practice hypothesis. The results in Panel B,

however, reveal that downsizing firms with a high debt ratio engage in income-increasing

earnings management, while this is not the case for those with a low debt ratio. These results

are consistent with Liberty and Zimmerman’s (1986) interpretation of their results and our

expectation.


Additional Analysis

In this section, we report an exploratory investigation of the effect of labor unions on the

earnings attributes around downsizing. The role of labor unions is to protect employees, and

managers of firms with labor unions may face more difficult negotiations than those of firms

without labor unions. If this is the case, managers of downsizing firms without labor unions

face a relatively lower necessity to communicate with employees through accounting

numbers.

Alternatively, managers of downsizing firms both with and without labor unions

24

have incentives to communicate with employees through accounting numbers. In Japan, the

lifetime employment norm and legal doctrines constrain employment practices. Therefore,

Japanese managers, regardless of labor unions, may follow the doctrines and inform their

employees of the firm’s real economic conditions to avoid needless conflicts with them. If

this is the case, managers of downsizing firms both with and without labor unions report

more conservative earnings than those of non-downsizing firms.

We test the conservativeness of earnings, dividing the full sample into samples with

and without labor unions. A firm is unionized if it has a labor union at the end of fiscal year

t−1.12 The results indicate that both unionized and non-unionized downsizing firms report

more conservative earnings in year t than non-downsizing firms do (Panels A and B of Table

11). The coefficient of NEGk*Rk*Downt in year t−1 is positive and statistically significant at

the 10% level for the unionized sample (coefficient = 0.0996; t = 1.72), while that in year t+1

is positive and significant at the 1% level for the non-unionized sample (coefficient = 0.1764;

t = 2.77). This suggests that labor considerations affect the timing of accounting

communication with employees.


We also test earnings management around downsizing, incorporating a union dummy,

Uniont-1, and its interaction term with Downt. In Table 12, the coefficients on Downt are

12 We obtain labor union data from Nikkei Kihon data database.

25

insignificant in years t−1 and t+1 (coefficient = 0.0003 and -0.0010; t = 0.19 and -0.63). That

in year t is positive and statistically significant at the 10% level (coefficient = 0.0025; t =

1.70). The results suggest that downsizing firms without labor unions do not behave

opportunistically around employee negotiations from the view point of employees. The

coefficients on Downt*Uniont-1 are insignificant in year t−1 and t (coefficient = -0.0006 and

-0.0000; t = -0.32 and -0.01), while that in year t+1 has the positive sign and is statistically

significant at the 5% level (coefficient = 0.0042; t = 2.27). The combinations of Downt and

Downt*Uniont-1 are positive and statistically significant at the 5% and 1% level in years t and

t+1 (coefficient = 0.0025 and 0.0032; t = 2.44 and 2.89), respectively. The result reveals that

downsizing firms with labor unions have incentives to report higher earnings. In summary,

regardless of the existence of labor unions, we do not find evidence suggesting that

downsizing firms engage in opportunistic income-decreasing earnings management before or

during employee negotiations.


Note, however, that this study does not investigate the difference in conservative

financial reporting around downsizing between unionized and non-unionized firms. However,

we do show that both types of firms report conservative earnings in the downsizing year.

Nevertheless, the analyses in this section is important because the evidence reveals that

downsizing firms make more or less similar accounting choices that incorporate economic

26

losses regardless of labor unions.

CONCLUSIONS

While employee downsizing is an important economic phenomenon at least in countries with

inflexible employment practices, little is known about accounting practices around

downsizing. Prior accounting research proposes two competing hypotheses of accounting

practices around labor negotiations: the earnings management hypothesis and the informative

accounting practice hypothesis. This study exploits the Japanese setting and investigates

earnings attributes around downsizing. We find that downsizing firms report more

conservative earnings in the downsizing year than non-downsizing firms do. On the other

hand, we find no evidence suggesting that downsizing firms engage in opportunistic

income-decreasing earnings management around downsizing. Instead, the results indicate that

downsizing firms make income-increasing accounting choices more often than

non-downsizing firms do when their debt ratio is high. The results are robust using a

continuous downsizing measure. Overall, the evidence is consistent with the informative

accounting practice hypothesis, similar to García Osma et al. (2015).

In addition, we examine the effect of labor unions on accounting choices around

downsizing. The results indicate that both unionized and non-unionized downsizing firms

report more conservative earnings than their counterparts and do not engage in

27

income-decreasing earnings management around downsizing.

This paper contributes to the literature in four ways. First, it sheds light on a new

labor negotiation i.e. employee downsizing. Second, it complements prior research on

accounting choices around labor negotiations by providing evidence consistent with the

informative accounting practice hypothesis and investigating an institutional setting and

negotiations that differ from those in prior research. Third, this study examines a new aspect

of management behavior around downsizing in terms of destruction of employee trust. Our

results suggest that managers do not make accounting choices that destroy trust. Fourth, this

study highlights accounting practices related to employees, another major stakeholder of

Japanese firms, while most previous studies focus on relational banking (main bank system),

keiretsu, and stable block holders.

A caveat of this study is that it excludes many large Japanese firms because it

focuses on firms that operate only in Japan. The lifetime employment norm is common

among large Japanese firms and extends to smaller firms (Cole 1979; Brown, Nakata, Reich,

and Ullman 1997; Ahmadjian and Robinson 2001). Thus, large firms are constrained to a

greater extent by the social norm. Moreover, labor unions of large firms can be more

sophisticated because their larger number of employees gives them more resources to spend

during negotiations. A study including large Japanese firms may provide clearer insights.

29

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Table 1. Sample Selection Process 1. Fiscal year end is March, with 12 months in the fiscal year; 2. Foreign currency translation adjustment is zero from year t-2 to t+1; 3. The number of employees in year t-1 is 200 or more; 4. Necessary financial and price data are available; 5. Firms in the financial industry are excluded; 6. Firms in industries with less than 15 peers on an annual basis are excluded; 7. Firms implementing a downsizing in year t-1 are excluded.

34

Table 2. Number of Observations by Industry # of Obs. Proportion Cumulative

Food 406 5.63% 5.63% Chemicals 258 3.57% 9.20% Pharmaceuticals 82 1.14% 10.34% Ceramics 65 0.90% 11.24% Steel 79 1.09% 12.33% Non-ferrous metal 338 4.68% 17.02% Machinery 459 6.36% 23.38% Electronics 264 3.66% 27.03% Other manufacturing 273 3.78% 30.82% Construction 924 12.80% 43.62% Trading 1072 14.85% 58.47% Retail 680 9.42% 67.90% Real estate 31 0.43% 68.32% Rail road and bus 261 3.62% 71.94% Land transportation 184 2.55% 74.49% Services 1,841 25.51% 100.00%

35

Table 3. Descriptive Statistics (n = 7,217) Panel A: Variables for the Conservatism Test in year t Mean SD Min 25 %ile Median 75 %ile Max

OIt 0.1274 0.1140 -0.3581 0.0647 0.1175 0.1834 0.7511

NEGt 0.4959 0.5000 0.0000 0.0000 0.0000 1.0000 1.0000

Rt 0.0594 0.3810 -0.6487 -0.1533 0.0029 0.1800 3.3169

Downt 0.1024 0.3032 0.0000 0.0000 0.0000 0.0000 1.0000

Sizet-1 9.2356 1.2623 6.5212 8.3517 9.0619 9.9755 13.0341

MTBt-1 1.0680 0.8382 0.2016 0.5386 0.7992 1.2731 5.8207

Levt-1 0.7948 1.0976 0.0000 0.0410 0.3622 1.0914 7.0912

Panel B: Variables for the Earnings Management Test in Year t Mean SD Min 25 %ile Median 75 %ile Max

DAt 0.0001 0.0269 -0.0737 -0.0163 0.0004 0.0167 0.0755

LnAssetst-1 10.2604 1.1015 7.8694 9.4688 10.1395 10.9058 13.5125

ROAt 0.0304 0.0320 -0.0713 0.0123 0.0259 0.0458 0.1411

CFOk 0.0533 0.0547 -0.1100 0.0213 0.0512 0.0836 0.2354

Debtt-1 0.1834 0.1729 0.0000 0.0220 0.1445 0.2990 0.6588

MTBt-1 1.0555 0.8502 0.1949 0.5268 0.7864 1.2553 6.7251

IssEQt 0.3410 0.4741 0.0000 0.0000 0.0000 1.0000 1.0000

IssDEt 0.0317 0.1753 0.0000 0.0000 0.0000 0.0000 1.0000

Note: Panels A and B report descriptive statistics of variables for the conservatism and earnings

management tests, respectively. OI is ordinary income, scaled by lagged market capitalization. NEG takes

one if a firm has a negative annual stock return and zero otherwise. R is the annual stock return. Down is a

dummy variable that takes one if a firm experiences a 5% decrease in employees or more and zero

otherwise. Size is the natural logarithm of market capitalization. MTB is the market-to-book ratio. Lev is

total debt, scaled by market capitalization. DA is discretionary accruals. LnAssets is the natural logarithm

of total assets. ROA is the return on assets. CFO is cash flows, scaled by lagged assets. Debt is the debt

ratio. IssEQ (IssDE) takes one if the positive change in capital stock (total debt) is more than 10% and

zero otherwise.

36

Table 4. Peason Correlation for the Earnings Management Test in Year t (n = 7,217) (1) (2) (3) (4) (5) (6) (7) (8) (1) DAt 1.0000 (2) Downt 0.0047 1.0000 (3) LnAssetsk-1 0.0085 -0.0459 1.0000 (4) ROAk 0.1681 -0.2109 -0.0581 1.0000 (5) CFOk -0.4176 -0.1290 -0.0704 0.5359 1.0000 (6) Debtk-1 -0.0280 0.1297 0.1158 -0.2594 -0.0359 1.0000 (7) MTBk-1 -0.0148 -0.0360 0.0238 0.2978 0.1927 0.1992 1.0000 (8) IssDEk-1 0.1231 -0.0636 -0.1118 0.1263 -0.0965 -0.3472 0.0323 1.0000 (9) IssEQt-1 0.0167 -0.0090 0.0127 0.0764 0.0297 0.0893 0.1782 -0.0085

Note: This table reports Pearson correlation coefficients of the variables for the earnings management test

in year t. DA is discretionary accruals. Down is a dummy variable that takes one if a firm experience a 5%

decrease in employees or more, zero otherwise. LnAssets is the natural logarithm of total assets. ROA is

the return on assets. CFO is cash flows, scaled by lagged assets. MTB is the market-to-book ratio. Debt is

the debt ratio. IssEQ (IssDE) takes one if the positive change in capital stock (total debt) is more than 10%,

zero otherwise. Bold represents statistical significance at the 5% level.

37

Table 5. Conservatism Test Results Year t-1 Year t Year t+1

Coef. t-value Coef. t-value Coef. t-value Intercept 0.2190 *** 8.24 0.1731 *** 6.43 0.1763 *** 6.70 NEGk -0.0458 -1.79 -0.0443 -1.60 -0.0741 ** -2.58 NEGk * Rk 0.0997 1.02 0.0979 0.88 0.1306 1.08 Rk 0.1338 * 2.84 0.2134 *** 4.67 0.1165 ** 2.45

Downt -0.0598 *** -6.15 -0.0298 *** -2.93 -0.0370 *** -4.29 NEGk * Downt 0.0133 1.06 0.0004 0.03 0.0187 1.52 Rk * Downt -0.0247 -0.83 -0.0790 *** -2.76 -0.0428 ** -2.13 NEGk * Rk * Downt 0.0573 1.32 0.2165 *** 4.65 0.1234 *** 2.72

Sizek-1 -0.0093 *** -3.36 -0.0048 * -1.74 -0.0060 ** -2.19 NEGk * Sizek-1 0.0031 1.08 0.0022 0.73 0.0055 * 1.77 Rk * Sizek-1 -0.0025 -0.48 -0.0104 ** -2.11 0.0005 0.11 NEGk * Rk * Sizek-1 -0.0105 -1.05 -0.0086 -0.76 -0.0163 -1.31 MTBk-1 -0.0146 *** -4.80 -0.0185 *** -5.04 -0.0169 *** -4.31 NEGk * MTBk-1 0.0063 * 1.66 0.0106 ** 2.37 0.0035 0.81 Rk * MTBk-1 -0.0251 *** -4.46 -0.0263 *** -3.74 -0.0336 *** -5.31 NEGk * Rk * MTBk-1 0.0120 1.16 0.0092 0.75 0.0061 0.43 Levk-1 0.0094 *** 2.77 0.0069 * 1.87 0.0027 0.75 NEGk * Levk-1 -0.0050 -1.23 -0.0022 -0.48 0.0047 1.06 Rk * Levk-1 -0.0018 -0.35 0.0017 0.40 0.0061 1.60 NEGk * Rk * Levk-1 0.0180 1.04 0.0353 * 1.94 0.0510 *** 3.11

Year Yes Yes Yes Industry Yes Yes Yes

# of Obs. 7,217 7,217 7,217 adjR2 0.2999 0.3139 0.2628

Note: This table reports estimation results of the conservatism tests.

𝑂𝑂𝑂𝑂𝑖𝑖,𝑘𝑘 = 𝛼𝛼0 + 𝛼𝛼1𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘 + 𝛼𝛼2𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘𝑅𝑅𝑖𝑖,𝑘𝑘 + 𝛼𝛼3𝑅𝑅𝑖𝑖,𝑘𝑘 + 𝛼𝛼4𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡 + 𝛼𝛼5𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡

+𝛼𝛼6𝑅𝑅𝑖𝑖,𝑘𝑘𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡 + 𝛼𝛼7𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘𝑅𝑅𝑖𝑖,𝑘𝑘𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡 + 𝐴𝐴𝐷𝐷𝐷𝐷𝐴𝐴𝐶𝐶𝐷𝐷𝐶𝐶𝐴𝐴 + 𝜀𝜀𝑖𝑖,𝑘𝑘

The dependent variable, OI, is ordinary income, scaled by lagged market capitalization. NEG takes one if

a firm has a negative annual stock return and zero otherwise. R is the annual stock return. Down is a



total debt, scaled by market capitalization. ***, **, and * represent significance at the 1%, 5%, and 10%

levels (two-tailed), respectively. Standard errors are clustered at the firm level.

38

Table 6. Model Validity Test Using Data in Year t Model (1) Model (2) Model (3) Model (4)

Coef. t-value Coef. t-value Coef. t-value Coef. t-value

Intercept 0.1025 *** 10.73 0.1092 *** 11.68 0.1382 *** 6.39 0.1554 *** 7.44

NEGk -0.0120 *** -3.41 -0.0137 *** -3.88 -0.0126 *** -3.59 -0.0148 *** -4.21

NEGk * Rk 0.0645 *** 3.94 0.0206 1.31 0.0461 *** 2.72 -0.0007 -0.05

Rk 0.1069 *** 13.85 0.1105 *** 14.21 0.1049 *** 14.13 0.1070 *** 14.57

Downt -0.0169 * -1.68 -0.0232 ** -2.35 NEGk * Downt -0.0097 -0.75 -0.0051 -0.39 Rk * Downt -0.0798 *** -2.97 -0.0781 *** -2.95 NEGk * Rk * Downt 0.2519 *** 5.58 0.2653 *** 5.75

Sizek-1 -0.0029 -1.39 -0.0042 ** -2.07 MTBk-1 -0.0113 *** -4.73 -0.0117 *** -5.06 Levk-1 0.0015 0.54 0.0036 1.35

Year Yes Yes Yes Yes Industry Yes Yes Yes Yes

# of Obs. 7,217 7,217 7,217 7,217 adjR2 0.2515 0.276 0.2594 0.2876

Note: This table reports estimation results of model validity tests of the main conservatism tests, using data

in year t.


+𝛼𝛼6𝑅𝑅𝑖𝑖,𝑘𝑘𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡 + 𝛼𝛼7𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘𝑅𝑅𝑖𝑖,𝑘𝑘𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡 + 𝜀𝜀𝑖𝑖,𝑘𝑘







39

Table 7. Conservatism Test Results Using a Continuous Downsizing Measure Year t-1 Year t Year t+1 Coef. t-value Coef. t-value Coef. t-value Intercept 0.2188 *** 8.24 0.1732 *** 6.44 0.1760 *** 6.68 NEGk -0.0461 * -1.81 -0.0434 -1.57 -0.0754 *** -2.63 NEGk * Rk 0.0901 0.92 0.1112 0.99 0.1305 1.08 Rk 0.1349 *** 2.87 0.2112 *** 4.59 0.1140 ** 2.40

CDownt -0.7395 *** -6.74 -0.3584 *** -2.81 -0.3563 *** -3.46 NEGk * CDownt 0.1798 1.28 -0.0583 -0.37 0.1894 1.34 Rk * CDownt -0.0484 -0.17 -0.8147 ** -2.42 -0.4192 * -1.95 NEGk * Rk * CDownt 0.0770 0.18 1.5752 *** 3.24 1.3565 *** 3.05

Sizek-1 -0.0093 *** -3.36 -0.0048 * -1.74 -0.0061 ** -2.21 NEGk * Sizek-1 0.0032 1.12 0.0021 0.71 0.0057 * 1.83 Rk * Sizek-1 -0.0024 -0.46 -0.0103 ** -2.09 0.0007 0.15 NEGk * Rk * Sizek-1 -0.0093 -0.93 -0.0091 -0.80 -0.0164 -1.32 MTBk-1 -0.0142 *** -4.69 -0.0183 *** -4.99 -0.0163 *** -4.13 NEGk * MTBk-1 0.0062 1.64 0.0104 ** 2.34 0.0030 0.69 Rk * MTBk-1 -0.0258 *** -4.53 -0.0252 *** -3.56 -0.0334 *** -5.25 NEGk * Rk * MTBk-1 0.0124 1.21 0.0075 0.60 0.0062 0.43 Levk-1 0.0102 *** 3.00 0.0071 * 1.95 0.0026 0.73 NEGk * Levk-1 -0.0058 -1.43 -0.0018 -0.39 0.0047 1.07 Rk * Levk-1 -0.0035 -0.67 0.0022 0.52 0.0064 * 1.66 NEGk * Rk * Levk-1 0.0196 1.15 0.0379 ** 2.10 0.0502 *** 3.07


# of Obs. 7,217 7,217 7,217 adjR2 0.3015 0.3138 0.2618

Note: This table reports estimation results of the conservatism tests, using a continuous downsizing

measure.

𝑂𝑂𝑂𝑂𝑖𝑖,𝑘𝑘 = 𝛼𝛼0 + 𝛼𝛼1𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘 + 𝛼𝛼2𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘𝑅𝑅𝑖𝑖,𝑘𝑘 + 𝛼𝛼3𝑅𝑅𝑖𝑖,𝑘𝑘 + 𝛼𝛼4𝐴𝐴𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡 + 𝛼𝛼5𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘𝐴𝐴𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡

+𝛼𝛼6𝑅𝑅𝑖𝑖,𝑘𝑘𝐴𝐴𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡 + 𝛼𝛼7𝑁𝑁𝑁𝑁𝑁𝑁𝑖𝑖,𝑘𝑘𝑅𝑅𝑖𝑖,𝑘𝑘𝐴𝐴𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡 + 𝐴𝐴𝐷𝐷𝐷𝐷𝐴𝐴𝐶𝐶𝐷𝐷𝐶𝐶𝐴𝐴 + 𝜀𝜀𝑖𝑖,𝑘𝑘


a firm has a negative annual stock return and zero otherwise. R is the annual stock return. CDown takes a

positive percentage change in employees, multiplied by −1, if the pre-multiplication value is −5 percent or

less and zero otherwise. Size is the natural logarithm of market capitalization. MTB is the market-to-book

ratio. Lev is total debt, scaled by market capitalization. ***, **, and * represent significance at the 1%, 5%,

and 10% levels (two-tailed), respectively. Standard errors are clustered at the firm level.

40

Table 8. Earnings Management Test Results

Year t-1 Year t Year t+1 Coef. t-value Coef. t-value Coef. t-value Intercept -0.0065 * -1.65 0.0031 0.82 0.0040 1.05 Downt -0.0000 -0.04 0.0025 *** 2.93 0.0016 * 1.66 LnAssetsk-1 0.0007 ** 1.99 0.0001 0.41 0.0002 0.60 ROAk 0.5481 *** 36.74 0.5401 *** 37.32 0.5164 *** 36.83 CFOk -0.3944 *** -51.02 -0.3815 *** -47.17 -0.3820 *** -46.52 Debtk-1 0.0176 *** 7.60 0.0186 *** 7.92 0.0179 *** 7.68 MTBk-1 -0.0024 *** -5.50 -0.0026 *** -5.34 -0.0026 *** -5.16 IssDEk 0.0015 ** 2.40 0.0009 1.42 0.0014 ** 2.13 IssEQk 0.0015 1.02 0.0007 0.40 0.0000 -0.03

Industry Yes Yes Yes Year Yes Yes Yes

# of Obs. 7,217 7,217 7,217 adjR2 0.4677 0.4559 0.4494

Note: This table reports estimation results of the earnings management tests.

𝐷𝐷𝐴𝐴𝑖𝑖,𝑘𝑘 = 𝛾𝛾0 + 𝛾𝛾1𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡 + 𝐴𝐴𝐷𝐷𝐷𝐷𝐴𝐴𝐶𝐶𝐷𝐷𝐶𝐶𝐴𝐴 + 𝜀𝜀𝑖𝑖,𝑘𝑘 The dependent variable, DA, is discretionary accruals. Down is a dummy variable that takes one if a firm

experience a 5% decrease in employees or more, zero otherwise. LnAssets is the natural logarithm of total

assets. ROA is the return on assets. CFO is cash flows, scaled by lagged assets. Debt is the debt ratio.

MTB is the market-to-book ratio. IssEQ (IssDE) takes one if the positive change in capital stock (total

debt) is more than 10% and zero otherwise. ***, **, and * represent significance at the 1%, 5%, and 10%


41

Table 9. Earnings Management Test Results Using a Continuous Downsizing Measure

Year t-1 Year t Year t+1 Coef. t-value Coef. t-value Coef. t-value Intercept -0.0064 -1.61 0.0031 0.84 0.0036 0.96 CDownt -0.0056 -0.57 0.0246 ** 2.56 0.0253 ** 2.41 LnAssetsk-1 0.0007 ** 1.96 0.0001 0.41 0.0002 0.67 ROAk 0.5472 *** 36.62 0.5397 *** 37.24 0.5171 *** 36.94 CFOk -0.3945 *** -50.97 -0.3814 *** -47.15 -0.3820 *** -46.45 Debtk-1 0.0176 *** 7.63 0.0185 *** 7.91 0.0177 *** 7.62 MTBk-1 -0.0024 *** -5.48 -0.0026 *** -5.35 -0.0026 *** -5.2 IssDEk 0.0015 ** 2.41 0.0009 1.40 0.0014 ** 2.16 IssEQk 0.0015 1.03 0.0006 0.38 -0.0001 -0.03

Industry Yes Yes Yes Year Yes Yes Yes

# of Obs. 7,217 7,217 7,217 adjR2 0.4414 0.4292 0.4259

Note: This table reports estimation results of the earnings management tests using an alternative

downsizing variable.

𝐷𝐷𝐴𝐴𝑖𝑖,𝑘𝑘 = 𝛾𝛾0 + 𝛾𝛾1𝐴𝐴𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡 + 𝐴𝐴𝐷𝐷𝐷𝐷𝐴𝐴𝐶𝐶𝐷𝐷𝐶𝐶𝐴𝐴 + 𝜀𝜀𝑖𝑖,𝑘𝑘 The dependent variable, DA, is discretionary accruals. CDown takes a positive percentage change in

employees, multiplied by −1, if the pre-multiplication value is −5 percent or less and zero otherwise.

LnAssets is the natural logarithm of total assets. ROA is the return on assets. CFO is cash flows, scaled by

lagged assets. Debt is the debt ratio. MTB is the market-to-book ratio. IssEQ (IssDE) takes one if the

positive change in capital stock (total debt) is more than 10% and zero otherwise. *** and ** represent

significance at the 1% and 5% levels (two-tailed), respectively. Standard errors are clustered at the firm

level.

42

Table 10: Results of conservatism and earnings management tests dividing the sample based on the median value of debt ratio at the end of year t−1 Panel A: Conservatism test in year t Debtt-1 >= median Debtt-1 < median Coef. t-value Coef. t-value Intercept 0.1347 *** 3.50 0.2037 *** 5.84 NEGt -0.0607 -1.56 -0.0474 -1.20 NEGt * Rt 0.1545 1.01 -0.0303 -0.20 Rt 0.1708 ** 2.41 0.2204 *** 4.29

Downt -0.0446 *** -3.22 -0.0154 -1.23 NEGt * Downt 0.0129 0.72 -0.0086 -0.50 Rt * Downt -0.0213 -0.57 -0.1322 *** -3.55 NEGt * Rt * Downt 0.1541 *** 2.63 0.2717 *** 4.12

Sizek-1 0.0001 0.03 -0.0097 *** -2.76 NEGk * Sizek-1 0.0011 0.27 0.0046 1.10 Rk * Sizek-1 -0.0090 -1.22 -0.0089 -1.52 NEGk * Rk * Sizek-1 -0.0170 -1.10 0.0056 0.36 MTBk-1 -0.0234 *** -5.01 -0.0078 -1.37 NEGk * MTBk-1 0.0196 *** 3.08 0.0016 0.28 Rk * MTBk-1 -0.0139 -1.64 -0.0389 *** -3.11 NEGk * Rk * MTBk-1 0.0148 0.86 0.0106 0.58 Levk-1 0.0069 1.41 0.0558 *** 3.29 NEGk * Levk-1 0.0047 0.78 -0.0481 * -1.91 Rk * Levk-1 0.0058 0.80 -0.0127 ** -2.00 NEGk * Rk * Levk-1 0.0400 * 1.69 0.0440 0.36

Year Yes Yes Industry Yes Yes

# of Obs. 3,609 3,608 adjR2 0.3088 0.3402

43

Panel B: Earnings management test in year t

Debtt-1 >= median Debtt-1 < median

Coef. t-value Coef. t-value

Intercept 0.0034 0.64 -0.0001 -0.01

Downt 0.0024 ** 2.28 0.0023 1.61 LnAssetsk-1 0.0003 0.66 0.0000 0.07 ROAk 0.5473 *** 25.40 0.5285 *** 28.75 CFOk -0.3924 *** -33.67 -0.3708 *** -35.64 Debtk-1 0.0216 *** 5.45 0.0223 ** 2.17 MTBk-1 -0.0033 *** -5.19 -0.0017 ** -2.20 IssDEk-1 0.0002 0.23 0.0014 * 1.64 IssEQk-1 0.0029 1.46 -0.0030 -1.04

Industry Yes Yes Year Yes Yes

# of Obs. 3,609 3,608 adjR2 0.439 0.4212

Note: Panels A and B report estimation results of the conservatism and earnings management tests, using

samples with high and low debt ratio firms, respectively.



𝐷𝐷𝐴𝐴𝑖𝑖,𝑘𝑘 = 𝛾𝛾0 + 𝛾𝛾1𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡 + 𝐴𝐴𝐷𝐷𝐷𝐷𝐴𝐴𝐶𝐶𝐷𝐷𝐶𝐶𝐴𝐴 + 𝜀𝜀𝑖𝑖,𝑘𝑘 The dependent variable, OI, is ordinary income, scaled by lagged market capitalization. NEG takes one if




total debt, scaled by market capitalization. The dependent variable, DA, is discretionary accruals. LnAssets

is the natural logarithm of total assets. ROA is the return on assets. CFO is cash flows, scaled by lagged

assets. Debt is the debt ratio. IssEQ (IssDE) takes one if the positive change in capital stock (total debt) is

more than 10% and zero otherwise. ***, **, and * represent significance at the 1%, 5%, and 10% levels

(two-tailed), respectively. Standard errors are clustered at the firm level.

44

Table 11: Effect of Labor Unions on Conservatism around Downsizing Panel A: Unionized Sample Year t-1 Year t Year t+1 Coef. t-value Coef. t-value Coef. t-value Intercept 0.2092 *** 5.97 0.1785 *** 4.64 0.1730 *** 4.79 NEGk -0.0515 -1.45 -0.0592 -1.48 -0.0684 * -1.75 NEGk * Rk 0.0479 0.31 0.1187 0.69 0.1476 0.92 Rk 0.1314 ** 2.20 0.1727 ** 2.20 0.0959 1.22

Downt -0.0563 *** -5.29 -0.0226 * -1.78 -0.0267 ** -2.33 NEGk * Downt 0.0114 0.74 0.0040 0.25 -0.0014 -0.09 Rk * Downt -0.0390 -1.29 -0.0866 ** -2.29 -0.0400 -1.23 NEGk * Rk * Downt 0.0996 * 1.72 0.3153 *** 4.51 0.0684 1.03

Sizek-1 -0.0102 *** -2.81 -0.0076 * -1.92 -0.0085 ** -2.24 NEGk * Sizek-1 0.0048 1.25 0.0055 1.26 0.0057 1.35 Rk * Sizek-1 -0.0017 -0.25 -0.0050 -0.62 0.0020 0.24 NEGk * Rk * Sizek-1 -0.0020 -0.13 -0.0058 -0.33 -0.0150 -0.92 MTBk-1 -0.0186 *** -4.65 -0.0181 *** -3.38 -0.0167 *** -2.96 NEGk * MTBk-1 0.0057 1.02 0.0030 0.43 0.0035 0.55 Rk * MTBk-1 -0.0171 ** -2.16 -0.0297 ** -2.47 -0.0268 ** -2.57 NEGk * Rk * MTBk-1 -0.0164 -0.87 -0.0211 -0.86 -0.0044 -0.19 Levk-1 0.0111 ** 2.46 0.0053 1.02 -0.0004 -0.07 NEGk * Levk-1 -0.0123 ** -2.40 -0.0060 -0.95 0.0073 1.14 Rk * Levk-1 -0.0133 * -1.90 0.0040 0.59 0.0105 * 1.68 NEGk * Rk * Levk-1 -0.0054 -0.21 -0.0037 -0.16 0.0383 1.48


# of Obs. 3,906 3,906 3,906 adjR2 0.264 0.283 0.2345

45

Panel B: Non-unionized Sample Year t-1 Year t Year t+1 Coef. t-value Coef. t-value Coef. t-value Intercept 0.2174 *** 6.00 0.1501 *** 4.09 0.1638 *** 4.45 NEGk -0.0268 -0.72 -0.0093 -0.24 -0.0629 -1.39 NEGk * Rk 0.0929 0.74 0.0276 0.19 0.0920 0.47 Rk 0.1548 ** 2.48 0.2813 ** 4.84 0.1574 ** 2.54

Downt -0.0562 *** -3.45 -0.0380 ** -2.43 -0.0469 *** -3.47 NEGk * Downt 0.0151 0.73 0.0046 0.22 0.0414 ** 2.23 Rk * Downt -0.0174 -0.38 -0.0669 -1.60 -0.0457 * -1.73 NEGk * Rk * Downt 0.0370 0.59 0.1467 ** 2.45 0.1764 *** 2.77

Sizek-1 -0.0056 -1.44 0.0014 0.37 0.0000 0.01 NEGk * Sizek-1 0.0000 -0.01 -0.0034 -0.78 0.0032 0.66 Rk * Sizek-1 -0.0050 -0.73 -0.0194 *** -2.99 -0.0040 -0.59 NEGk * Rk * Sizek-1 -0.0118 -0.89 -0.0044 -0.28 -0.0147 -0.70 MTBk-1 -0.0134 *** -3.32 -0.0216 *** -4.26 -0.0211 *** -3.86 NEGk * MTBk-1 0.0069 1.44 0.0177 *** 2.97 0.0063 1.07 Rk * MTBk-1 -0.0296 *** -4.59 -0.0203 ** -2.28 -0.0331 *** -4.02 NEGk * Rk * MTBk-1 0.0264 ** 2.18 0.0239 1.59 0.0123 0.61 Levk-1 0.0138 *** 3.08 0.0119 ** 2.56 0.0083 * 1.86 NEGk * Levk-1 -0.0008 -0.13 -0.0001 -0.02 -0.0013 -0.24 Rk * Levk-1 0.0010 0.16 -0.0020 -0.38 0.0013 0.27 NEGk * Rk * Levk-1 0.0515 ** 2.21 0.0748 *** 3.14 0.0606 *** 2.91


# of Obs. 3,311 3,311 3,311 adjR2 0.3534 0.3579 0.3029

Note: Panels A and B report estimation results of the conservatism tests, using samples with unionized and

non-unionized firms, respectively.









46

Table 12: Effect of Labor Unions on Earnings Management around Downsizing Year t-1 Year t Year t+1 Coef. t-value Coef. t-value Coef. t-value Intercept -0.0064 -1.61 0.0033 0.89 0.0044 1.18 Downt 0.0003 0.19 0.0025 * 1.70 -0.0010 -0.63 Downt*Uniont-1 -0.0006 -0.32 0.0000 -0.01 0.0042 ** 2.27 Uniont-1 0.0023 *** 3.10 0.0021 *** 2.87 0.0025 *** 3.61 LnAssetsk-1 0.0005 1.45 0.0000 -0.14 -0.0001 -0.16 ROAk 0.5523 *** 37.28 0.5438 *** 37.68 0.5208 *** 37.19 CFOk -0.3944 *** -50.84 -0.3814 *** -46.99 -0.3814 *** -46.44 Debtk-1 0.0177 *** 7.65 0.0188 *** 7.96 0.0183 *** 7.83 MTBk-1 -0.0023 *** -5.45 -0.0026 *** -5.27 -0.0026 *** -5.16 IssDEk 0.0017 *** 2.68 0.0011 * 1.68 0.0016 ** 2.49 IssEQk 0.0015 1.04 0.0008 0.45 0.0000 0.01


# of Obs. 7,217 7,217 7,217 adjR2 0.4425 0.4304 0.4283

Downt + Downt*Uniont-1 -0.0003 -0.29 0.0025 ** 2.44 0.0032 *** 2.89

Note: This table reports estimation results of the earnings management tests, incorporating a union dummy

and its interaction with Down. The dependent variable, DA, is discretionary accruals. Down is a dummy

variable that takes one if a firm experience a 5% decrease in employees or more, zero otherwise. Union is

a dummy variable that takes one if a firm has a labor union at the end of fiscal year t−1 and zero otherwise.

LnAssets is the natural logarithm of total assets. ROA is the return on assets. CFO is cash flows, scaled by

lagged assets. Debt is the debt ratio. MTB is the market-to-book ratio. IssEQ (IssDE) takes one if the

positive change in capital stock (total debt) is more than 10% and zero otherwise. ***, **, and * represent

significance at the 1%, 5%, and 10% levels (two-tailed), respectively. Standard errors are clustered at the

firm level.

employee downsizing and accounting choices: evidence from … · 2017-09-20 · 1 employee...

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