CFO Incentive Compensation Not a Key Factor in Accounting Fraud

This last week, the Harvard Law School Forum on Corporate Governance and Financial Regulation published an interesting paper entitled “Why Do CFOs Become Involved in Material Accounting Manipulations?.  The research was conducted by four professors from the University of Pittsburg and the University of Washington.

The professors started with 2,261 Accounting and Auditing Enforcement Releases (AAERs) issued by the SEC from May 17, 1982 through June 10, 2005.  After eliminating (i) AAERs that did not involve annual accounting misstatements, and (ii) AAERs with insufficient data, the professors were left with 409 firms with alleged annual accounting manipulations.  These AAERs were then compared to a control group in the same industry and with total assets in the range of 80 percent to 120 percent of the manipulation firm’s total assets in the year prior to the start of the manipulation period.  The professors use a matched pair methodology, and ran a regression analysis to determine what factors were statically significant.

The existence of a dominant CEO was one of the variables studied, and (not surprisingly) ended up being a key consideration.  The professors measured CEO power in three ways:

  1. The CEO’s percentage of the aggregate of the top five executives’ total compensation – Compensation includes salary, bonus, other annual pay, stock/stock option grants, and all other compensation.  Consistent with previous studies by others, the professors found that (i) CEO pay slice is higher for firms with weaker shareholder rights and more management entrenching provisions, and (ii) CEO turnover occurs less frequently for firms with a high CEO pay slice.
  2.  Whether the CEO is Chairman of the Board, and
  3. Whether the CEO is a company founder.

The paper’s conclusions include the following:

Taken together, our findings suggest that CFOs are likely to become involved in material accounting manipulations because they succumb to CEO pressure, rather than because they seek immediate financial benefit. … Our findings suggest that CFOs are typically not the instigator of accounting manipulations.  Instead, it appears that CEOs, especially powerful CEOs with high equity incentives, exert significant influence over CFOs’ financial reporting decisions. In other words, CFOs’ role as watchdog over financial reports is compromised by the pressure from CEOs.”

In response to this finding, the professors suggest that Boards of Directors or their audit committees provide greater involvement in CFO employment matters.  The professors indicate as unnecessary actions taken by many boards to reduce CFO incentive compensation because of the belief that CFO incentive compensation was a key factor in causing accounting fraud.  The professors found no statistical connection between CFO incentive compensation and the propensity to accounting fraud.

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