When There’s A Cap on SEC Pay, Firms Will Play With Their ROA

Abstract

We document that firms engage in opportunistic short-term ROA enhancing when they conduct business in an environment with a low probability of detection of financial misconduct. To proxy for a lax monitoring environment, we compute the percentage of local Securities and Exchange Commission (SEC) employees earning the exogenously imposed maximum salary, as these employees lack the monetary incentives to increase their monitoring efforts. We find that the percentage of local SEC employees at the salary cap correlates negatively with the detection rate of financial misconduct, and positively with the attrition rate of SEC employees. We also show that in environments with apparent lax SEC monitoring, firms engage in short-term ROA enhancements, principally by increasing their discretionary accruals, and the magnitude of the effect increases when peers of the focal firms also engage in financial misconduct.