Abstract

This paper argues that prior studies investigating the determinants of profit sharing plan adoption fail to consider the effect of current earnings changes on future expected compensation payments under profit sharing that underlie the success of profit sharing in motivating employees. When current earnings changes are caused by factors that make earnings too volatile then the payments under profit sharing are volatile and their predictability is reduced. In this situation, profit sharing is not expected to be successful in motivating employees and would not be a preferred means of compensation. In contrast, if earnings changes are caused by factors that produce more sustainable effects on earnings, rendering them more reliable and predictable, then compensation payments under profit sharing will be more predictable and representative of employees' efforts. In this case, profit sharing would be more successful in motivating employees and is more likely to be adopted as a preferred compensation scheme. Accordingly, it is hypothesized that a positive association exists between the level of permanence of current earnings changes and the adoption of profit sharing plans. Permanence of earnings changes is measured by the level of earnings persistence which is computed using two alternative time-series models: IMA (1,1) and ARIMA (2,1,0). A Logit model is used to evaluate the effect of earnings persistence and control variables on the probability of adoption of employee profit sharing plans. Profit sharing data is extracted from the U.S. IRS 5500 Form while financial data for the sample firms are retrieved from Compustat. The final sample includes 298 firms that are equally split between profit sharing and non-profit sharing firms. The test results indicate that information about persistence of earnings innovations is a significant determinant of profit sharing plan adoption. Earnings persistence is positively associated with the probability of profit sharing plan adoption. This result is robust when the alternative measure of earnings persistence is used and the control variables are included. These results should lead to a richer model of employee profit sharing plan adoption and use.