CFOs, CEOs and Earnings Management

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday September 2, 2009 at 9:18 am
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(Editor’s Note: This post comes from John (Xuefeng) Jiang, Kathy Petroni, and Isabel Wang of the Eli Broad College of Business, Michigan State University.)

In our paper, CFOs and CEOs: Who Have the Most Influence on Earnings Management?, which was recently accepted for publication in the Journal of Financial Economics, we investigate whether Chief Financial Officer (CFO) equity incentives are associated with earnings management. Extant research has primarily focused on how chief executive officer (CEO) equity incentives affect earnings management (Bergstresser and Philippon 2006; Cheng and Warfield 2005). However, both commentators and policymakers have expressed a concern that CFO equity-based compensation might also contribute to earnings management. As described by Katz (2006), during testimony before the Senate Finance Committee IRS Commissioner Mark Everson expressed that the temptations of stock appreciation demand “heroic” virtue to keep managers from wrongdoing. He suggested that CFOs who are in charge of “minding the cookie jars” should not be paid by stock options, but by “generous but fixed compensation for specified contract periods.” Echoing concerns over CFO compensation, the SEC recently amended its disclosure rules on executive compensation by requiring that firms report their CFO pay. One analyst claims that the mandatory disclosure of CFO compensation is “a major benefit” of the amended SEC disclosure rule (Harris 2007).

Because CFOs’ primary responsibility is financial reporting, we argue that CFO equity incentives should play a stronger role than those of the CEO in earnings management. We separately and jointly examine the association between CFO and CEO equity incentives and earnings management. We consider two settings (accrual management and the likelihood of beating analysts’ expectations) and utilize methodologies similar to those used in prior research that has documented an association between CEO equity incentives and earnings management. We find that the magnitude of accruals and the likelihood of beating analyst forecasts are more sensitive to CFO equity incentives than to those of the CEO. For example, our results suggest that if a CFO equity incentive moves from the first quartile to the third quartile of the distribution of our sample CFO equity incentives, the absolute total accruals as a percent of total assets would increase almost 75 percent more than the increase associated with a similar move of CEO equity incentives. Similarly, the change in odds ratio of beating analysts’ expectation is 5 percent more when CFO’ equity incentives increase from the first quartile to the third quartile than when CEO’ equity incentives have a similar move.

Our results suggest future research should consider compensation of CFOs when investigating incentives for earnings management. More importantly, our results confirm policymakers’ concerns over CFO compensation and thus provide indirect support for the SEC’s new requirement for disclosures of CFO compensation. The disclosure of CFO compensation should be useful for investors and analysts to assess the quality of firms’ financial reporting.

The full paper is available here.


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