Research in Action Fall 2021 by UCI Paul Merage School of Business

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IN ACTION Tenth Edition | Fall 2021

INSIDE THIS ISSUE

How Transparency Triggers Ethical Behavior The Disciplinary Effect of Social Media On Corporate Policies Can Employee Turnover Predict the Future of a Firm? Awards and Honors

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Research Highlights

How Transparency Triggers Ethical Behavior by Keith Giles

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In the field of quantum physics, there’s a strange scientific phenomenon where the act of observing an electron can change how it behaves called “the observer effect.” As Radhika Lunawat, assistant professor of accounting at The UCI Paul Merage School of Business has discovered, the same phenomenon appears to occur in the case of humans and financial reports.

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The results of Lunawat’s research, conducted with A morality game Professor Timothy Shields of Chapman University’s To test this theory, Lunawat and her colleagues created George L. Argyos School of Business and Economics a lab experiment in the form of a game. “We recruited and Professor Gregory Waymire of the Emory University subjects to participate in a computerized investment Goizueta Business School, are summarized in their game where they play the role of either a manager or an article “Financial Reporting and Moral Sentiments” investor,” she says. “The investors give an investment which is forthcoming from amount to the other subject—the the Journal of Accounting & manager—who oversees that Economics. “Our experiment proves that investment over six growth periods. Drawing inspiration from If you are the investor who invests financial reporting plays a very ten dollars, for example, there’s a Adam Smith random multiplier in the game that When famed economist Adam fundamental role by activating will randomly return either the same Smith published his Theory of amount, or double the amount, Moral Sentiments, he surmised these moral sentiments.” or triple. The manager in the that human psychology played an experiment can choose how much, undeniably pivotal role in the way if any, of that amount to pay back industrial capitalism worked. “Smith suggests that our to the investor as dividend, or how much to take as a actions are not motivated solely by selfish maximization,” fee, and how much to reinvest into the next period. After says Lunawat. “The other factor is that we care about six periods the manager decides on the final payout to the moral evaluations of others,” she says. “Both factors keep, or to pay the investor.” tend to guide our actions. Our premise, therefore, was that financial reporting can actuate that kind of sentiment within managers.” Simply put, people want to be seen by others as moral, trustworthy, and fair. Our desire to convey these qualities to others means that even an impartial spectator can lead us to modify our own actions as we evaluate ourselves through the eyes of someone else.

This final stage of the experiment—the liquidation phase—is the most important one. After this, the game ends. “We found that, when financial reporting is made available, the managers in our experiment returned a much greater portion of the investment to the investor,” she says. What explains the difference? As Lunawat explains, it’s not the manager’s desire to retain the investor as a future customer. “Once the game begins, the investor has no power over the manager at any point in the game. They are totally at the mercy of the manager,” she says. “The manager cannot be fired or replaced if the investor doesn’t like how the manager handles the payouts. Still, the manager knows they will be observed and will be morally evaluated by the investor. This pushes the manager to behave more ethically and leads to a greater good for the investor.”

The power of symmetry When the two parties to a transaction have different access to information, the outcome can unfairly favor 4

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the party with the information advantage. Economists call this phenomenon information asymmetry. It is absent from the work of many influential theoreticians, including Adam Smith’s, perhaps because it adds a surprising degree of complexity to otherwise relatively simple models. Financial reporting serves to mitigate the information asymmetry between portfolio managers and their investors. Lunawat and her colleagues were interested in exploring how this mechanism might spark what Adam Smith would call the manager’s moral sentiment, by better aligning the manager’s incentives with those of the investor.

Transparency creates moral incentives As their research suggests, transparency in financial reporting results in better reinvestment and resourcesharing actions on behalf of investor interests, even when the investor can impose no penalty or confer no reward on the manager. What’s more, the evidence strongly suggests that the real value of financial reporting is how it plays on the manager’s deeply held need to be perceived by investors as moral and fair. “Even when the investor can confer no reward on the manager for a desirable action, nor exact any cost or penalty upon the manager for an undesirable action, the manager will still work in the best interests of the investor, simply because they desire to be seen as moral,” says Lunawat. “The transparency of the reporting actuates the moral sentiment of the manager who deeply cares about the investor’s moral evaluation of them.”

Observation, then, really does change the outcome of the experiment. If we know that someone is watching what we do, we will behave in ways that others perceive as moral and praiseworthy. “We really do care what others think of us and how they see us,” says Lunawat. “Our experiment proves that financial reporting plays a very fundamental role by activating these moral sentiments. We create a greater alignment between the actions of the managers and what’s best for the investors. The investors are better off because the managers take better care of their investments when they know they’re being observed. This leads to greater financial reward, in the end, for the investor.”

Professor Radhika Lunawat’s research focus is on financial reporting and disclosure and its effects on investment decisions and price formation. More specifically, she looks at the role information, particularly accounting information, plays in investment efficiency at the individual decision-making level and price efficiency and other trade characteristics at the aggregate level. Professor Lunawat earned her PhD from the University of Minnesota in 2009 and joined UCI in 2013 after having taught at Chapman University, University of St Thomas and Carnegie Mellon University. She has published her research in top accounting journals and top field journals in economics.

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The Impact of Social Media: How Glassdoor Reviews Improve Corporate Policy by Keith Giles

When Professor Chenqi Zhu of The UCI Paul Merage School of Business wanted to measure the influence of social media on corporate policy, she decided to study how firms respond to the increased transparency of sites like Glassdoor. com, which collects reviews on employee satisfaction and publishes these reviews online. She reports her findings in a paper, cowritten with Assistant Professor Svenja Dube of the Fordham University Gabelli School of Business and forthcoming from the Journal of Accounting Research, titled “The disciplinary effect of social media: Evidence from firms’ responses to Glassdoor reviews.”

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“I’ve always been interested in the different ways that social media has changed our life, work and society as a whole,” says Zhu. “We’ve seen a lot of conversations about how companies can use social media to extend their reach, control their branding and so on. But social media aggregates and disseminates everyone’s opinion, beyond the ones initiated by companies, and I believe those opinions can in turn shape how companies operate.”

Uncharted Territories While previous research has centered on the role social media plays in the way companies communicate information about themselves to customers and potential employees, relatively little research has examined the real impact of social media on corporate policies. “In recent years we’ve seen a large number of news articles about how social events are facilitated by social media,” Zhu says. “Mostly as a bottom-up approach—to organize events and ‘change the world’ to some extent. So given all this, my co-author Svenja Dube and I were curious about the real consequences of social media on the world.”

Their idea was to see how the Glassdoor platform impacted a company’s internal environment by looking at the impact the site had on companies since the site launched in 2008. “We compared company workplace policies around the time of its first Glassdoor review,” says Zhu. “Our goal was to measure workplace environment changes both before and after the emergence of Glassdoor. We collected thousands of reviews and identified when each firm was reviewed for the first time. We measured a firm’s workplace policies and friendliness to employees using KLD rating, which quantifies the social responsibility performance of companies and gives very specific performance indicators in areas like employee relations, diversity, inclusion, environmentally-friendliness and the like.”

A powerful incentive With the emergence of more transparency-focused social media platforms, companies are forced to take their employee policies more seriously. “As you would imagine it’s important for the companies to improve their public image on the platform,” says Zhu. “Some sources suggest that CEOs are the closest readers of these reviews are reviews’”

To narrow things down, Zhu and Dube focused on a few specific issues: workplace culture and employee health, along with diversity and inclusion. “We wanted to measure how social media affects the workplace environment,” says Zhu, “Because “and we also wanted to be as clear as possible about the scope of that now publicly impact.”

available,

That pressure raises concerns that some businesses will try to manipulate Through a glass door… companies are now the system. “They could push To quantify the impact of social media employees to give a positive review or pressured to improve on corporate policies and culture, Zhu write a fake testimonial,” Zhu says, “but and Dube zeroed in on the influence their workplace policies.” Glassdoor—and other social media of one website in particular: Glassdoor. platforms—have programs in place “We turned to Glassdoor because to mitigate disingenuous reviews. So, we wanted to get a clear picture of while it’s very hard to eliminate false how employee reactions and ratings on social media reviews completely, even using sophisticated AI to impacted a company—either positively, negatively or not detect and eliminate them, the relative number of fake at all.” testimonials is very low.” 8

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By looking at company policies prior to the launch of Glassdoor and studying policy changes made after the website began collecting reviews, Zhu and Dube clarified the impact of the site on those companies. “To identify the impact of workplace transparency, we exploited the firms’ staggered exposure to Glassdoor reviews using a generalized difference-in-differences (DID) research design,” says Zhu.

With transparency comes growth

social goals. We find that companies are already proactive in responding to negative reviews on platforms like Glassdoor, for example. What’s more, companies tend to prioritize those policies that are more visible on social media. This suggests the alignment between the information content and corporate policies seems to critical for a real effect to take place.” In other words, despite the downsides, corporate transparency is good for us.

What they found wasn’t as surprising as it was comforting. “Real improvements translated into better reviews on Glassdoor,” says Zhu. “Most companies had improved ratings and saw a very strong increase in that change due to the influence of this social media platform.” When asked why such positive changes in company policies were observed, Zhu says there were two main factors at play: “First, some company information was not widely available to outsiders seeking a job at a firm prior to the emergence of Glassdoor. Secondly, even if outsiders can find additional information elsewhere, Glassdoor makes this sort of information easier to access. Because reviews are now publicly available, companies are now pressured to improve their workplace policies.” Zhu feels that her research has wide-reaching implications for how social media positively influence corporations. “We can learn some general lessons from our study on Glassdoor,” she says. “What we discovered is that Glassdoor is a decentralizing market-based mechanism that enhances transparency and promotes

Chenqi Zhu is an assistant professor of accounting at The UCI Paul Merage School of Business. She received a BA in finance & BS in mathematics from Renmin University of China, a master’s in economics from the Chinese University of Hong Kong, and a PhD in accounting from New York University. Her current research interests primarily lie in the intersection of information and innovation. She has studied knowledge diffusion, information dissemination and price discovery in product, technology and capital markets, as well as information frictions in the peer-to-peer lending market. She is also interested in exploring big data and applying natural language processing techniques to study the decision making of market participants such as managers and different groups of investors. RESEARCH IN ACTION

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Can Employee Turnover Predict the Future of a Firm? by Keith Giles

The SEC does not require firms to disclose employee turnover data to investors. But many have questioned whether this information might be an indicator of the future performance of a business, and therefore have relevance for investors.

Professors Terry Shevlin and Ben Lourie of The UCI Paul Merage School of Business, together with their colleagues Qin Li of Hong Kong Polytechnic University School of Accounting and Finance and a graduate of the doctoral accounting program at UCI, and former UCI faculty member Alex Nekrasov of the University of Illinois at Chicago, took a deep dive into the question of whether employee turnover is an essential human capital metric for investors to consider. Their paper, Employee Turnover and Firm Performance: Large-Sample Archival Evidence, is forthcoming in Management Science.

analytics, who provided us with ten years of data gathered from employee profiles on LinkedIn,” says Lourie. “Using this we could see how long someone was at a firm and aggregate who was at the company in a given month.”

Of course, they had to take into account that the data “As the SEC considers requiring the disclosure of human wasn’t always completely accurate. “For one thing, not capital information like this everyone updates their in the future, we wanted LinkedIn profiles,” says to examine the impact that “The high cost of retention and recruiting Shevlin. “We also had to employee turnover might consider that LinkedIn makes employee turnover rate relevant to is mostly for white-collar have,” says Lourie. “Is it material information? employees. And white-collar future performance.” Because the collection employees are typically and reporting of this harder and more costly to information does carry a replace than blue-collar cost for the firm, it’s important to know in advance how workers.” much employee turnover informs about a firm’s future Another factor was the size of the company. “Smaller performance.” and younger firms tend to suffer the most from high

Going in search of deep data With this question in mind, Lourie, Shevlin and their team set out to find sources that might provide answers. “Because the SEC does not require this information, finding the data was not easy,” says Lourie. Prior studies on how employee turnover impacted future performance tended to use very small samples. Lourie and Shevlin were looking for a more robust sample of data for their study. “We talked to Revelio Labs, a leading provider of labor market 12

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turnover,” says Lourie. “They’re not as adept at handling turnover compared to larger firms who can absorb the costs a little better.”

Just how bad is turnover? The team needed to take into consideration the variety of reasons why a business might experience employee turnover. “Turnover could be a sign that a company is doing badly and need to cut staff to remain profitable,” says Shevlin. “Or it could simply be that the employee had to be fired, or that they discovered a better opportunity at another firm. Not all turnover is necessarily bad, nor is it always an indication of a company’s future performance.” They identified a data set that almost no one has looked at before and what they found was eye-opening. “As one might expect, turnover is bad for the firm,” says

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Lourie. “But only at higher levels. For example, even up to the 50 percentile, most firms were still performing well in subsequent quarters over the ten-year time frame of our study.” Still, even a small turnover rate could be bad for the company if it comes during a single quarter. “The median turnover rate was .03 per quarter,” Shevlin explains. “One could interpret this to say that if turnover is greater than 3 percent in a single quarter, giving due consideration to industrywide trends, future performance suffers. When you look at tech firms, for example, they are competing for essentially the same employees. This involves perks, salary increases, equity grants, signing bonuses, and so on, which makes employee turnover extremely costly.”

Accounting for the cost of good people The high cost of retention and recruiting makes employee turnover rate relevant to future performance. “It’s not just about not having enough staff. It’s the fact that turnover is very costly to these firms,” Lourie says.

“When you’re constantly increasing salaries, onboarding new talent, training and investing in their skills, the money lost when that employee leaves is significant.” When a firm must replace multiple employees in a year, these costs can severely impact profitability. The bottom line is that employee turnover is a key metric of human capital. “In our study, we found that turnover is directly associated with lower future financial performance,” says Lourie. So disclosure of this data would be of great use to investors and also to the company. “What our research shows is that investing in employee retention is very important for firms,” says Shevlin. “The disclosure of this data can predict one quarter ahead the sales and stock returns of a firm. That strongly suggests that, aside from what it might costs the firms to disclose it, the data would be very useful for investors to consider.”

Terry Shevlin is a professor of accounting and Paul Merage chair in business growth at the Merage School. He earned his PhD from Stanford University in 1986 and joined the faculty at the University of Washington where he worked for 26 years until joining UCI in 2012. He has served as editor on three academic journals and on numerous editorial boards. He has published over 55 articles in the very top accounting and finance journals. His research interests are broad and include the effect of taxes on business decisions and asset prices, capital markets-based accounting research, earnings management, employee stock options, research design and statistical significance testing issues.

Ben Lourie is an assistant professor of accounting at the Merage School. His research interests are broad and include financial reporting and disclosure, capital markets, financial analysts and human capital. His work examines, among other issues, equity analysts’ conflicts of interest, psychological biases and the informativeness of human capital measures. Lourie has published in top-tier journals such as The Accounting Review, Journal of Financial Economics, Management Science, Review of Accounting Studies and Review of Finance. His research has been covered by the Wall Street Journal, Financial Times, Business Insider, Bloomberg and International Business Times. He has taught at the master and PhD levels. He currently teaches financial statement analysis and SAS and STATA boot camp. Lourie earned his PhD from the UCLA Anderson School of Business and his bachelor’s degree in economics from Tel Aviv University. He worked as a senior consultant in Deloitte Management Consulting. RESEARCH IN ACTION

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Awards, Honors and Books Professor Emeritus Richard McKenzie published The Selfish Brain: A Layperson’s Guide to a New Way of Economic Thinking. The book, which has been written with non-economists in mind, expands on Richard McKenzie’s development of “brain-centric economics,” which provides a new way of assessing and reconciling (albeit partially) the growing conflict between conventional or neoclassical economics (represented by the work of Nobel Laureates Milton Friedman and Gary Becker) and behavioral economics (represented by the work of Nobel Laureates Daniel Kahneman and Richard Thaler).

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Professor Ed Coulson was honored with the GSSI Best Paper award at the Asian Real Estate Association/American Real Estate and Urban Economics Association International Meeting in July for his published work Housing Wealth, Fertility, and Child Quality. Co-author: Ming-zhe Tang Accepted at: International Real Estate Review Description: We use changes in wealth due to house price changes to test the effect of wealth on fertility and child quality in the context of Chinese fertility policies. We find, even in those situations where the one-child policy is not in effect, that wealth increases do not lead to increased fertility in urban areas, and have only a tiny effect in rural. However, a rise in housing wealth does lead to increased expenditure on a child’s education for households in both rural and urban areas (although of different types of expenditure) and increased child’s height in rural areas. In terms of Becker (1960), increased wealth tilts the tradeoff between child quality and quantity in favor of the former.

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