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?

In our forthcoming Journal of Accounting Research paper, CFO Fiduciary Responsibilities and Annual Bonus Incentives, we examine how firms evaluate and compensate their CFOs. In addition to participating in decision making much like other senior executives, CFOs also have fiduciary responsibilities for reporting firms’ financial results and safeguarding the integrity of financial reporting. Although other top executives have fiduciary responsibilities for financial reporting as well, CFOs typically have more of an expertise and capacity to determine what numbers get reported. Responsibility for financial reporting raises the question of whether it is appropriate to reward CFOs bonuses contingent on financial performance that is effectively self-reported.

To provide a framework to understand why CFO compensation is tied specifically to financial performance, our paper presents an agency model with two executives, a CEO focused on production and a CFO entrusted with dual responsibilities. Our model generates two insights that have implications for changes in CFO compensation practices in the post Sarbanes-Oxley (SOX) environment. First, we find that if CFOs personally bear greater misreporting costs, then firms offer their CFOs steeper incentives tied to financial performance. The intuition is straightforward; if CFOs are more conscientious in discharging their fiduciary duties, then firms are more comfortable offering steeper incentives since rewards for reported performance are less susceptible to unwarranted overpayments. Second, we find that as misreporting becomes more costly, firms are less willing to tolerate misreporting. Hence, firms offer their CFOs weaker incentives tied to financial performance to expressly motivate them to focus more on their fiduciary duties.

We rely on a proprietary survey of CFO performance evaluation and compensation practices of public and private firms to conduct our empirical tests. Since public firms were affected by SOX much more than private firms, the public versus private distinction allows for an identification strategy of the SOX-effect on CFO compensation that has not been feasible in prior literature. Our survey was sent to approximately 30,000 members of the American Institute of Certified Public Accountants who are CFOs, CEOs, or other executives informed about CFO and CEO compensation. We received 1,353 responses from both public and private entities.

Our data indicates that annual bonuses are by far the most common incentive component of CFO compensation plans and that, on average, about 50 percent of the CFO bonus is based on accounting-based financial performance. In addition, the extent to which CEO and CFO incentives are tied to financial performance are highly correlated. More importantly, we find that from 2003 to 2007 public entities (relative to private entities) lowered the percentage of CFO bonuses contingent on financial performance. Specifically, we compare the bonus weight on financial performance measures that is expected in 2007 with the actual bonus weight in 2003 (indicative of incentives in the pre-SOX environment) and find marked differences for public versus private entities. For example, predicted values from one of our regressions suggest that public companies (with median sample characteristics) lowered the percentage of their CFO’s bonus that depends on financial performance by about six percent while comparable private companies with similar characteristics increased the percentage by about three percent. We interpret this result as evidence that firms mitigate earnings management or other misreporting practices in part by deemphasizing CFO incentive compensation.

The full paper is available for download here.