Academics in Hong Kong have found that companies that have adopted executive compensation clawback provisions tend to substitute one type of earnings manipulation for another, and that this trend is more pronounced in companies with high growth or transient institutional ownership.
In an article published in the American Accounting Association’s journal, the authors analyzed companies from the Russell 3000 that voluntarily adopted clawback provisions of the type required by Section 954 of the Dodd-Frank Act. Because the Securities and Exchange Commission has not yet finalized the rules to implement this section, only some companies have adopted these measures. Section 954 is intended to deter financial misstatements.
By carefully matching about 250 companies that have adopted clawback provisions with those that have not, the authors investigated two main questions: (1) do clawbacks lead companies to substitute one type of earnings manipulation with another; and (2) which kind of company is more likely to engage in these substitutions: companies with high-growth opportunities or companies with high-transient institutional ownership?
The authors found that clawbacks reduce accruals management, or the manipulation of balance-sheet items that require some estimation, like bad debt reserves. However, clawbacks increase real transactions management, or the alteration of actual expenditures to increase temporary earnings, such as by reducing R&D costs. Thus, one type of manipulation is merely replaced with another that, according to the authors, is less likely to attract scrutiny from auditors or regulators.
This trend was more pronounced in high-growth companies, which are more likely to suffer a sharp drop in price if they miss forecasts, and in companies with high-transient institutional ownership, which focus on short-term earnings.
Ultimately, the authors conclude that clawbacks do not fully eliminate earnings manipulation. In addition, the increased reliance on real transactions management causes companies to sacrifice long-term value for a boost in short-term profits.
[eds. Lilian H. Chan, et al., “Substitution Between Real and Accruals-Based Earnings Management After Voluntary Adoption of Compensation Clawback Provisions,” The Accounting Review Vol. 90, No. 1 (Jan. 2015).]