CFOs whose pay is strongly linked to their employers’ financial fortunes are likely to push back against auditors proposing accounting restatements if the companies have clawback policies, according to a new study published in The Accounting Review.
The research complicates the theory that restatements are declining merely because of the deterrent effect of the growth in the number of voluntary corporate clawback policies, according to Jonathan S. Pyzoha, the author of the study.
That number has been rising dramatically since the 2010 passage of the Dodd-Frank Act, which mandated that all public companies have such policies. According to a survey of the Fortune 100 cited by the study, the portion of companies with clawback policies rose from 18% in 2006 to 87% in 2012.
The percentage of public firms with clawback plans – policies aimed at recovering incentive compensation erroneously paid out to executives as a result of previously misstated financials – will surely rise when the Securities and Exchange Commission gives final approval to the rules it proposed on the issue in July.
The “ultimate goal of the clawback policy,” explains Pyzoha, an assistant professor of accounting at Miami University in Ohio, “is to deter future restatements for errors and for fraud.”
To be sure, prior research cited by the study has established that at companies that have voluntarily adopted clawbacks, “there are fewer restatements because upfront the CFOs and the financial statement makers are doing a more diligent job” of preventing the errors and fraud that can lead to misstatements, he says.
What’s new about his findings, which are based on an experiment involving 112 CFOs, controllers, and treasurers from publicly traded companies, is the effect clawbacks have on restatements after the misstatements have been discovered, Pyzoha contends.
“Yes, [CFOs] probably are being better about the quality of the financial statements upfront. But on the back end,” he adds, “what we may be seeing is that the executives are fighting restatements” in order to avoid clawbacks of their pay.
The CFO pushback intensifies when “lower quality” auditors – ones who lack general audit knowhow and specific knowledge of the client’s industry – propose restatements.
At such times, finance executives with high incentive compensation (pay contingent on the company’s beating analysts’ consensus earnings forecast) “prove about 40% less likely than [those with] lower incentive pay to agree with the auditor’s restatement proposal,” according to a press release issued by the American Accounting Association, which publishes The Accounting Review.
“This is critical,” according to the release, “because a top financial officer’s view strongly influences the shape of restatements or, indeed, whether there is a restatement at all.”
The purpose of the experiment was to “investigate executive decision-making after the external auditors have proposed a restatement that will lead to a clawback of previously earned incentive compensation,” according to the study.
The senior finance executives were asked to make decisions as the CFO of a hypothetical large, publicly traded medical machine manufacturer. In the case they studied, the auditor proposes a restatement of the manufacturer’s previous year’s financials as the result of an accounting error.
If the company restates, then its clawback policy requires the finance chief to pay back any incentive compensation that was earned in 2010 (the year in question) based on the misstatements.
The CFO earned the incentives in that year, when the company beat consensus analyst forecasts for earnings per share. Since the proposed restatement caused the 2010 financials to no longer beat EPS, the CFO would have to pay back all of the incentives under the clawback policy.
The experiment presupposed two different accounting methodologies that could be used to calculate impairment of the machines, according to Pyzoha. The hypothetical auditors determined that the company used the one that was overly aggressive and should have used a more conservative approach. On that basis, they proposed the restatement.
Part of the background information given to the participants in the experiment was that the hypothetical company had adopted a clawback policy in the current year. Under that policy, if there was a restatement at any time in the prior three years, the clawback would be triggered.
As a result, the company’s senior executives would have to pay back any incentives that they should not have earned. If the restatement went through, “they would lose all of their compensation that they would have earned in the previous year,” Pyzoha said.
“Ultimately, the study examined in that setting what CFOs may do when they’re facing that potential risk of a restatement from the auditor,” he added. “And the study essentially shows that they are more willing to fight in a negotiation with the auditor to potentially avoid restating the financial statements.” And thereby losing, potentially, a lot of money.