Why Do CFOs Become Involved in Material Accounting Manipulations?

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday December 20, 2010 at 10:02 am
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Editor’s Note: The following post comes to us from Mei Feng of the Department of Accounting at the University of Pittsburgh; Weili Ge of the Department of Accounting at the University of Washington; Shuqing Luo of the Department of Accounting at the National University of Singapore; and Terry Shevlin, Professor of Accounting at the University of Washington.

In the paper, Why Do CFOs Become Involved in Material Accounting Manipulations? we investigate why CFOs become involved in material accounting manipulations. To address this research question, we examine two possible explanations. CFOs might instigate accounting manipulations for immediate personal financial gain, as reflected in their equity compensation. Alternatively, CFOs could manipulate the financial reports under pressure from CEOs.

Using a comprehensive sample of material accounting manipulations disclosed between 1982 and 2005, we investigate the costs and benefits associated with intentional financial misreporting for CFOs. We find that CFOs bear substantial legal costs when involved in accounting manipulations. We also document that these CFO equity incentives (measured by pay-for-performance sensitivity) are not significantly different from those of CFOs of control firms. However, CEOs of the manipulation firms have significantly higher equity incentives and power than CEOs of the control firms. Moreover, CFO turnover is significantly higher within three years prior to the occurrences of material accounting manipulations for manipulation firms than control firms, consistent with CFOs facing significant costs (loss of job) for saying no to CEO pressure. Finally, our AAER content analyses suggest that CEOs of manipulation firms are more likely than CFOs to be described as having orchestrated the manipulation and to be requested to disgorge financial gains from the manipulation. 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.

Some caveats are in order. First, we assume that CFOs of accounting manipulation firms are aware of or are involved in misreporting. We believe this assumption is reasonable given that one of the main job responsibilities of CFOs is to watch over the financial reporting process and make related decisions. However, in some unusual cases accounting manipulations could occur without the knowledge of CFOs (e.g., CEOs collude with divisional managers to create fictitious sales and hide the manipulation from CFOs). These cases are likely to add noise instead of introducing a systematic bias to our empirical results. Second, we assume that the companies identified by the SEC have indeed manipulated financial statements. This assumption seems reasonable given that the SEC spends effort and resources to establish evidence for the alleged manipulations. However, the SEC likely does not identify all the companies with accounting manipulations; as a result, some of our control firms might have “undetected” manipulations. This issue would be a concern if the SEC systematically pursues companies with characteristics examined and found significant in our empirical tests, but we are not aware of any evidence supporting this possibility.

While subject to these caveats, our paper contributes to the understanding of CFOs’ incentives when they face accounting manipulation decisions. 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. Overall, the findings of this study suggest a corporate governance failure for the accounting manipulation firms, and have important implications for current corporate governance reform. While researchers, practitioners, and regulators have generally concluded that stock-based compensation has provided managers with incentives to misstate accounting numbers, our results indicate that re-designing compensation packages for CFOs is not necessarily the only remedy. Improving CFO independence by alleviating the pressure of CEOs on CFOs could be critical to improving financial reporting quality. One possible way to achieve this would be to have boards or audit committees more involved in CFO performance evaluation and in hiring and retention decisions (Matejka, 2007).

The full paper is available for download here.

  1. [...] 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 University of Pittsburg and the University of [...]

    Pingback by Between the Numbers » CFO Incentive Compensation Not a Key Factor in Accounting Fraud — December 27, 2010 @ 11:47 am

 

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