Prior literature documents that asymmetric timely recognition of losses versus gains (also known as conditional conservatism) can induce management to make more efficient investment decisions by mitigating information asymmetry between management and investors and providing early signals about the profitability of projects that are undertaken. In this paper, we investigate the impact of conservatism on an important investment decision that has been overlooked, namely, investment in labor. We find that conservatism is negatively associated with labor investment inefficiency; more specifically, conservatism reduces inefficient investment practices on the labor market, including over-hiring, under-firing, under-hiring, and over-firing. Our results hold after controlling for managerial ability, corporate governance, and other investments.

Introduction

In Basu’s (1997) seminal work, conditional conservatism (hereafter, conservatism) is interpreted as companies reporting earnings reflecting “bad news” more quickly than “good news”, implying systematic differences in earnings reports for bad news and good news periods.1 Prior literature documents that conservatism can induce management to make more efficient investment decisions in the capital market by mitigating the information asymmetry between management and investors and providing early signals about the profitability of projects that are undertaken (García Lara et al., 2016). We extend this line of research by investigating the impact of conservatism on another important investment decision that has been overlooked, namely, investment in the labor market. We posit that conservatism improves labor investment efficiency by reducing information asymmetry and moral hazard. First, although labor costs are traditionally considered variable, labor investment also involves significant fixed components such as severance pay, training costs, and hiring costs, and thus financing frictions caused by information asymmetry can hamper labor investment. Conservatism would mitigate labor inefficiency by reducing financing frictions through enabling the writing of better contracts and/or reducing the information asymmetry between managers and capital providers regarding a firm’s optimal level of labor investment. Second, by imposing timely recognition of losses, conservatism would act as a disciplining mechanism to prevent or deter inefficient investments by providing early warning signals about the profitability of projects that are undertaken. Labor investment efficiency is worth studying for three reasons. First, labor is a significant cost component of business operations. Improving labor investment efficiency would reveal much about a firm’s overall investment behavior. Labor costs typically represent two-thirds of economy-wide value added (Bernanke, 2004). For example, in the 2016 Annual Survey of Manufactures, the U.S. Census Bureau (2017) reports that payroll and employee benefits in the U.S. manufacturing sector totaled $839 billion in 2016, compared to $168 billion in capital expenditure. Despite the significance of labor investment in inefficient managerial resource allocation, the literature on the impact of financial reporting quality on investment efficiency focuses on more salient but infrequent investments such as capital, R&D expenditures, and mergers and acquisitions (Biddle et al., 2009; García Lara et al., 2016), while ignoring ongoing investments in labor. Furthermore, human capital plays an increasingly important role as the information and technology industries dominate the world economy (Pfeffer, 1996; Zingales, 2000), which makes this study more relevant to the changing economic landscape. Second, labor investment provides a powerful setting for investigating the effect of conservatism on investment efficiency. Due to their variable nature, labor costs can vary significantly from year to year. Additionally, the fixed portion of labor costs is subject to much lower adjustment costs than capital expenditures (Dixit and Pindyck, 1994; Jung et al., 2014), making it less costly for managers to exercise their discretion in labor investments. Both these characteristics contribute to greater variation in labor investments, providing a more powerful setting for testing the impact of conservatism on investment efficiency. Third, since all firms have employees, a broad cross-sectional sample of firms is available, allowing research questions to be tested in a more general setting.