Are there external factors that might lead companies to fail to protect the integrity of their financial statements, to put it euphemistically? Some recent articles in CFO.com discuss studies that posit various theories.
Even though the SEC has yet to fulfill the Dodd-Frank mandate requiring adoption of clawback policies, this article reports that the vast majority of companies in the S&P 1500 have voluntarily adopted clawback policies that enable companies to recover compensation that executives received on the basis of misstated financial reporting. Some early studies suggested that clawback policies were likely to cause executives subject to those policies “to push back against auditors proposing accounting restatements” that would trigger the clawbacks. That would seem to suggest that the clawback concept might be, well, counterproductive perhaps?
As you may recall, Section 954 of Dodd-Frank required the SEC to direct the securities exchanges to require each listed company to develop and implement a policy for recouping executive compensation that was paid on the basis of erroneous financial information, the theory being that it is compensation to which the executives were never really entitled in the first place. Under Dodd-Frank, the policy would apply in the event the company were required to prepare an accounting restatement due to the company’s material noncompliance with any financial reporting requirement under the securities laws. The policy must provide that the company will recover from any current or former executive officer an amount of incentive-based compensation (including options awarded as compensation) equal to the excess, if any, of the amount that was paid to the executive officer, in the three years preceding the date on which the company was required to prepare the restatement, over the amount that would have been paid to the executive officer based on the accurate financial data.
However, contrary to the results of those previous studies, the CFO.com article reports, a new peer-reviewed study in The Accounting Review concludes that clawbacks do function as intended—companies with clawback policies “generally seek to protect accounting integrity. And they do so while maintaining, and even enhancing, the advantages of performance-based CFO pay.”
In another academic study from MIT Sloan and Wharton, reported here, the study authors considered the level of public spotlight and public information that were most likely to result in a company’s engaging in earnings management. For example, high-profile companies are subject to substantial regulatory oversight and media glare, but also more pressure from investors and analysts to beat quarterly expectations. Are these companies more or less likely to engage in earnings management? The authors concluded that regs “‘designed to improve transparency and provide more information can sometimes have unintended adverse consequences.’”
How does management weigh the costs and benefits engaging in earnings management, which the study authors argue are “mainly the probability and consequences of getting caught in an accounting scandal against the potential for a higher stock price”? The study authors contended that “the key to the puzzle lies in the ‘quality of the information environment’ surrounding a company.” They evaluated over 300 restatements resulting from fraud or an SEC investigation that occurred between 2004 and 2012. To test their theory and gauge the quality of the information available, for each company evaluated, the study authors looked at the number of institutional shareholders, the number of industry analysts that followed the company and the number of articles about the company that appeared in mainstream media during the year. They found that it’s the “middle ground” that’s the most susceptible in this regard. The study authors:
“found that as the quality of the information environment improves, misreporting first increases, reaches an inflection point, and then decreases. Consequently, earnings management is greatest in a medium-quality environment and is lowest in both high- and low-quality environments. ‘When executives operate in closed corporate environments—meaning there’s not much information or media coverage about what the leadership team is doing and why— we found that they are not particularly inclined to exaggerate earnings….In [that] type of environment, the weight that investors place on earnings in valuing the company also tends to be low, and so exaggerating earnings is not that beneficial.’…The advantages of earnings management grow as investor interest, analyst coverage, and media attention increase. Managers then become more inclined to misstate earnings. But at a certain threshold—… about 17 media articles per year and just over 6 dedicated analysts—executives become less likely to overstate performance. ‘It’s only when the company has reached a certain level of interest that a manager’s incentive to overstate performance decreases—likely because the cost of getting caught is much higher.’”
As if those conclusions weren’t depressing enough, here’s another study from 2015 that’s likely to drive your cynicism score off the charts entirely. This article reports on academic research showing that managers who hire accounting professionals are “overwhelmingly” biased toward candidates that appeared likely to engage in earnings management: “That’s right: in a landslide, study participants were in favor of hiring people who appear predisposed to take actions that in extreme forms could land company officials in prison.”
The study authors conducted a survey that posited two candidates, one of whom had traits that led participants to conclude the candidate was “most likely to initiate efforts to manage earnings” (e.g., “results-oriented and willing to rewrite the rules if necessary to achieve goals”). The other “process-oriented” candidate (e.g., believed that rules “should not be circumvented to achieve goals”) was also generally considered to have better managerial skills. Other survey participants experienced in hiring (executives and recruiters) then evaluated which candidate a company would most likely hire, using a “technique called indirect questioning, whose efficacy has been supported by decades of psychology research.”
The stunning results showed that 88% of the executives rated the probable earnings manager as the candidate “more likely to be hired,” while 81% of the recruiters were certain that that candidate would “be a good fit for the job.” Only 35% held that view of the process-oriented candidate. One of the study authors observed that the study should be viewed as only a starting point and cautioned “against drawing firm conclusions from the results. ‘It’s not possible for any single study to put an issue to rest in one fell swoop,’” Given the conclusions of the study, let’s hope not