by Christos A. Makridis and Yuqing Zhou
Intangible capital is becoming an increasingly important determinant of firm value. For example, the ratio of intangible capital to the United States’ GNP is totaling 1.7, according to McGrattan and Prescott (2010).[1] Companies are further prioritizing their brand and perception among consumers and the media, which can affect the way they do business by influencing corporate strategy and investment. In this sense, how employees and/or the general public think about a company can ultimately influence the company’s ability to retain and attract talented employees, which is an integral determinant of firm value.[2]
While there are many different circumstances that firms find themselves in, some can be particularly damaging. For example, the public revelation of a cyber security breach can have lasting reputational effects when a company prides itself on privacy and security, as was the case with Equifax and their 2017 breach.[3] Much like data breaches, the public revelation of an accounting fraud can have a lasting effect on a company’s reputational capital. If employees and/or the public do not trust senior leadership, then employee engagement and retention will quickly dwindle. No one wants to work for an infamous company, especially skilled workers, given their ability to find alternative options in the labor market.
Our recent working paper investigates the effects public revelations of financial misconduct have on employee perceptions about their firm. Drawing on detailed individual-level ratings data, in partnership with Glassdoor.com, we find that the public revelation of financial misconduct is associated with a 0.32 standard deviation decline in overall company ratings. These results hold even after controlling for differences in characteristics across individuals and for various measures of the companies’ financial performances, suggesting that the decline in the employee’s rating of the company does not simply reflect the indirect effect of financial misconduct on the supply of credit, which has been documented before.[4] We also find that these effects are strongest among employees with less education and with greater tenure. These results build upon a large series of theoretical contributions about hierarchies and communication within the firm.[5]
A potential concern associated with our results is that the decline in perceptions about a company might simply reflect an immediate decline that subsequently returns to trend, or that it reflects a decline in productivity resulting from the financial misconduct. However, we find that, despite a 0.20 standard deviation decline in overall company ratings during the actual years that the misconduct was committed, these factors cannot account for the entirety of our main result. In this sense, at least some of the decline in how employees think about the company must be a result of the aftermath—that is, how the company brand adapts to the changed economic landscape. More importantly, we find that the ratings decline during the misconduct committing period is concentrated among employees with higher educations and among employees who work in the state in which a company’s headquarters locates. Both of these groups of employees are more likely to hold managerial positions and therefore they are exposed to more private information while the misconduct is taking place. This further indicates that the 0.20sd decline is not driven by a decline in firm productivity, but perhaps driven instead by private information leakage among employees who have inside information at the headquarters.
Furthermore, we examine the impact of misconduct on employees’ salaries. We find that employees have 5.9 percent higher salaries in the years that financial misconduct is being committed. After the public revelation of misconduct, we find no significant effects on salary, which could reflect a change in composition among employees. However, in the short run, employees with low education and short work experience, who are non-regular workers, younger than 30 years old, and working in a non-headquarter state, do experience a reduction in their salaries. These patterns indicate that these employees have lower bargaining power in the labor market and experience wage declines after frauds are released.
Finally, we also analyze whether employee ratings data can help predict potential misconduct in a firm. For example, might employee reviews of Wells Fargo, during the years that they were engaging in financial misconduct, have predictive power? Indeed, we find that these ratings hold significant predictive power over conventional sources of financial data. For example, while we can only predict about 4% of the cases of misconduct with standard financial data, we can predict 37% of the cases with the inclusion of these ratings. In this sense, our results showcase the applicability of non-financial data for public accounting, namely how employee rhetoric and perceptions can serve as a signal for the integrity of a company.
Footnotes
[1] McGrattan, Ellen R. and Prescott, Edward C., “Unmeasured investment and the puzzling boom in the 1990s”, American Economic Journal: Macroeconomics 2, 4 (2010), pp. 88-123.
[2] Merz, Monika and Yashiv, Eran, “Labor and the market value of the firm”, American Economic Review 97, 4 (2007), pp. 1419-1431.
Christos A. Makridis and Yuqing Zhou
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