We investigate the employment consequences of earnings management. Using audit firm consolidation as an exogenous shock impacting earnings management, we find a positive casual effect of firm-level earnings management on employment growth. The effect is concentrated in privately owned enterprises and firms with higher operational risk, consistent with earnings management affecting labor dynamics by influencing employees’ perceptions of job security and subsequent career decisions. We further document a crowding out effect in local labor market, where a firm’s earnings management negatively influences the employment growth of local peer firms.

Using a difference-in-differences approach, we examine the effect of industry-specific knowledge transfer on audit performance after a merger of two Chinese audit firms with different levels of expertise in an industry. For clients in an industry audited by both merging audit firms, those audited by the audit firm less specialized in that industry belong to the treatment group, while all other clients belong to the control group. We find an economically-significant improvement in audit quality (as reflected in a reduction in financial misstatements) for the treatment group relative to the control group in the same merged audit firm. We show that the treatment effect is not driven by changes in auditor incentives or personnel movement and is more pronounced when we expect stronger communication between the less and more specialized auditors after the merger. We caution that our findings are specific to China and may not generalize to other countries.