The Sheep Watching the Shepherd: Employee Representation on the Board and Earnings Quality

Posted by ARC Commitee - Jul 05, 2021

The Sheep Watching the Shepherd: Employee Representation on the Board and Earnings Quality

Can employee representatives, i.e. directors on corporate boards appointed by employees, have an effect on earnings quality? Yes, probably. This is what Conny Overland and Niuosha Samani document in a recent article in the European Accounting Review (EAR).

Several European countries have put in place legislation that allows employees to be represented on the boards of directors. Recently the introduction, or strengthening, of such rights has been the topic of mounting debate – also in countries known for putting a stronger emphasis on shareholder interests, such as the US and the UK.

Legislation on employee representation principally aims to protect worker interests, and based on the assumption of a conflict between labor and capital it is a commonly believed that such worker rights are detrimental to shareholder interests. However, the evidence on any value effects is mixed, which calls for a better understanding of how employee representatives affect board decision making.

In that spirit we investigate to what degree employee representatives contribute to the board’s monitoring of earnings quality. Although the relationship between other aspects of board structure and earnings quality has been treated in previous literature, the effects of employee representatives on earnings quality is less understood. There are several reasons to why employee representatives could have a positive effect on earnings quality:

  • Employees have incentives to prevent earnings manipulations motivated by negotiation considerations,
  • employees have a long-term interest in the firm and are more exposed to firm-specific risk, and improved earnings quality can reduce such risk,
  • employees possess firm-specific knowledge, which in turn can be used in the board room to improve the monitoring of  earnings quality, and
  • employee representation increases the functional diversity on the board, which can enhance the board’s internal communication and monitoring.

Our study is based on a sample of firms listed on the Stockholm Stock Exchange (2006-2014). In Sweden employees have the option, through the Act on Board Representation, to appoint two (three) directors to the board of directors in all companies with collective agreements and at least 25 (1,000) staff. Employee representatives are appointed from inside the company, through their local trade unions, and no consent from owners or management is needed. However, once appointed employee representatives face the same duties, rights and responsibilities as the shareholder elected directors, as stipulated by the Company Act. This means that they must promote the interests of the company at large, while facing an increased personal litigation risk. The fiduciary duty paired with the litigation risk likely explains in part why employee representatives are absent in more than half of our observations.

We find that firms with employee representation show lower abnormal accruals as well as less excessive R&D cuts, controlling for alternative model specifications and potential sample selection bias. Also, for the 2010-2011 collective bargaining period, a period where manager and employee interests should be particularly divided, we document less income-decreasing abnormal accruals in firms with employee representatives. We also report that the effect on earnings quality varies with the characteristics of employee representatives, as employee representatives with shorter tenure, having white-collar jobs, or holding company shares seem to have a greater impact on earnings quality.

This study contributes to the literature on how board monitoring is related to financial reporting quality, as it examines a less noticed aspect of board structure, i.e., employee representation. In doing so the study also contributes to a greater understanding of how a moderate employee representation on company boards can affect company decision making, and that this effect can be distinct from more indirect forms of employee influence, such as labor union negotiations or work councils.

Discover more about our study at:

To cite this article: Conny Overland & Niuosha Samani (2021) The Sheep Watching the Shepherd: Employee Representation on the Board and Earnings Quality, European Accounting Review