A large body of prior literature examines the relation between managerial equity incentives and financial misreporting but reports mixed results. This literature argues that a manager whose wealth is more sensitive to changes in stock price has a greater incentive to misreport. However, if managers are risk-averse and misreporting increases both equity values and equity risk, managers face a risk/return tradeoff when making a misreporting decision. In this case, the sensitivity of the manager’s wealth to changes in stock price, or portfolio delta, will have two countervailing incentive effects: a positive “reward effect” and a negative “risk effect.” In contrast, the sensitivity of the manager’s equity portfolio to changes in risk, or portfolio vega, will have an unambiguously positive incentive effect. Accordingly, when managers are risk-averse, it is important to jointly consider both portfolio delta and portfolio vega when assessing the relation between equity incentives and misreporting.

In our paper, The Relation Between Equity Incentives and Misreporting: The Role of Risk-Taking Incentives, forthcoming in the Journal of Financial Economics, we show that jointly considering both portfolio delta and portfolio vega substantially alters inferences reported in the literature. Specifically, we find inferences in studies reporting either a positive relation or no relation between portfolio delta and misreporting are not robust to controlling for vega.

…continue reading: The Relation between Equity Incentives and Misreporting

Recently, the SEC’s Enforcement Division has brought three matters focused on alleged flaws (and fraud) in connection with valuation issues. Together these actions make clear that the SEC is and will be looking hard at how public companies as well as financial firms make difficult and subjective valuation decisions. Specifically, the SEC will be looking to see whether firms, and individuals, followed proper processes and applied the correct inputs in reaching these judgments. These cases also make clear that, even in times of significant market disruption, firms cannot ignore or substantially discount market inputs in making valuation judgment.

KCAP Financial

In November 2012, the SEC filed and settled In The Matter of KCAP Financial, Inc. This was the first action in which the SEC alleged that a public company had violated the provisions of Financial Accounting Standard (FAS) 157 by failing to properly value certain assets. FAS 157 requires expanded disclosures and incorporates a strong preference for market inputs to determine fair value. According to FAS 157, “[e]ven in times of market dislocation, it is not appropriate to conclude that all market activity represents forced liquidations or distressed sales.”

…continue reading: SEC Enforcement Focusing on Valuation Issues

I. High Quality, Independent Auditing is Critical to Our Economic Success.

As I have learned in this job, getting the accounting right is indeed not the same thing as getting the auditing right. My sense from accountants I talk to is that auditing is receiving well-deserved attention in its own right.

Our economic success depends on the confidence of the users of capital and the providers of capital alike. Corporate managers hire internal accountants — many of you here today — to ensure they have accurate and detailed information on which to base management decisions. Managers ignore opportunities to glean trends and insights from this data at their peril.

Mistakes in this information can send a company into a business line or market that squanders resources. We now know that the true cost of financial misstatement is much greater than stock market fallout, concomitant lawsuits and insurance claims.

…continue reading: Enhancing the Relevance, Credibility and Transparency of Audits

In the paper, Mandatory Clawback Provisions, Information Disclosure, and the Regulation of Securities Markets, forthcoming in the Journal of Accounting and Economics, I discuss the potential pitfalls of mandating that compensation be recouped from the executives of firms that are found to have engaged in material accounting misstatements. My discussion is motivated by recent evidence in the literature that the voluntary adoption of such clawback provisions by firms is followed by a reduced incidence of accounting restatements, lower auditing fees and a reduced auditing lag, and stronger earnings response coefficients. It is tempting to conclude from this evidence that government attempts to mandate such provisions, most recently through Section 954 of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, will increase the accuracy of information disclosure by firms and thereby enhance the integrity of the capital market. I argue that such a conclusion is premature at best.

…continue reading: Mandatory Clawback Provisions, Information Disclosure, and the Regulation of Securities Market

In our paper Why Do CEOs Survive Corporate Storms? Collusive Directors, Costly Replacement, and Legal Jeopardy, which was recently made publicly available on SSRN, we consider new explanations for the puzzling result that a majority of misreporting CEOs retain their jobs.  We extend the literature by investigating the role of directors’ both personal and reputational incentives in the CEO retention decision.  Overall, our analysis improves our understanding of the CEO retention decision by 30 to 40% relative to a benchmark model based on the severity of the misreporting, the firm’s performance and risk characteristics, and traditional measures of the strength of corporate governance.

We show that two types of personal benefits make conventionally independent directors less likely to remove CEOs: loss avoidance on equity-contingent wealth and increased compensation. First, we find that in firms where independent directors emulate CEOs’ trading behavior and also engage in abnormal insider selling over the misreporting period, CEOs are 13.6% more likely to be retained.  We view independent directors’ trading as suggestive of collusion because, like CEOs and other executive directors, they personally benefit by selling their equity at inflated prices during the period over which earnings are misreported.  To the extent that the misreporting sustains the firm’s overvaluation, the fact that directors engage in abnormal selling suggests they have access to negative information about the firm that they do not reveal to shareholders.  We posit that independent directors prefer not to attract attention to their own abnormal selling.  Thus, even though dismissing the CEO could enhance shareholder value by restoring credibility, directors whose trading actions align with those of CEOs have weaker incentives to replace the CEO.

…continue reading: Why Do CEOs Survive Corporate Storms?

In our paper, Analyzing Speech to Detect Financial Misreporting, forthcoming in the Journal of Accounting Research, we examine whether nonverbal vocal cues elicited from speech are useful in detecting intentional deception in financial reporting. Detecting deceptive financial reporting is an increasingly important concern for auditors, regulators, investors, and the various constituents that interact with corporations. High profile accounting scandals such as Enron, WorldCom, Tyco, and Satyam have cost market participants several billions of dollars and eroded confidence in published financial statements. These events call into question the ability to uncover financial misstatements by auditors who review and provide an opinion on the financial statements (PCAOB [2007], [2010]). Even sophisticated market participants such as institutional investors and analysts have been remarkably unsuccessful at detecting financial fraud (Dyck et al. [2010]).

…continue reading: Analyzing Speech to Detect Financial Misreporting

In the paper, Executive Overconfidence and the Slippery Slope to Financial Misreporting, forthcoming in the Journal of Accounting and Economics as published by Elsevier, our detailed analysis of a sample of 49 firms subject to SEC Accounting and Auditing Enforcement Releases (AAERs) suggests two distinct explanations for the misstatements. Just over one quarter of the cases represent many of the well-publicized examples of corporate fraud including Adelphia, Enron, Healthsouth, and Tyco. The nature of the misstatements, their timing, and an analysis of the executives suggest that the activities are consistent with a strong inference of intent on the part of the respondent and consistent with the legal standards necessary to establish fraud.

However, perhaps more surprising, we find that the actions by the executives in the remaining three quarters of the cases are not consistent with the pleading standards required to establish an intent to defraud. Rather, our analysis of the 49 AAER firms suggests that optimistic bias on the part of executives can explain these AAERs. We show that the misstatement amount in the initial period of alleged misreporting is relatively small, and possibly unintentional. Subsequent period earnings realizations are poor, however, and the misstatements escalate. Using a matched sample of non-AAER firms, we show that the misreporting firms did not simply get a bad draw on earnings. Nor does it appear that weaker monitoring relative to the matched sample explains why the misreporting manager’s optimistic bias affects the financial statements.

…continue reading: Executive Overconfidence and the Slippery Slope to Financial Misreporting

The SEC yesterday announced its first use of a non-prosecution agreement, one of the new investigative tools that the agency unveiled nearly a year ago. The SEC simultaneously filed an enforcement action against a former sales executive of Carter’s, Inc. See SEC v. Elles, Civ. Action No. 1:10-CV-4118 (N.D. Ga.). The Commission did not bring any enforcement action against the company.

At first blush, this appears to be the sort of case in which the SEC historically would likely have brought charges against a public company. According to the complaint, the executive granted and concealed substantial unauthorized discounts to the company’s largest customer. By misrepresenting the facts and creating false documents, the executive allegedly caused the company to delay recognizing these discounts until later periods, thereby inflating the company’s reported earnings in the earlier periods. When the company discovered the scheme, it conducted an internal investigation, self-reported the matter to the SEC and ultimately restated its financial statements covering a five-year period.

…continue reading: The SEC’s First Non-Prosecution Agreement

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.

…continue reading: Why Do CFOs Become Involved in Material Accounting Manipulations?

In the paper Do Investors See Through Mistakes in Reported Earnings?, forthcoming in the Journal of Financial and Quantitative Analysis, we test whether investors see through mistakes in reported earnings by examining market reaction to initially reported erroneous earnings and valuation of restating firms during the error period, before earnings are corrected. We also examine the long-run return performance of restating companies in three periods: (1) the period prior to the mistake (pre-error period); (2) the period after the mistake has been made but before the restatement (error period); (3) and the period after the restatement (post-restatement period). We focus on the error period, which we split into four quartiles.

…continue reading: Do Investors See Through Mistakes in Reported Earnings?