Material Weakness: A Pain in the Bonus

When a company's material-weakness disclosures rise, the CFO's bonus falls, according to a new study.

While the pay of chief executive officers may be based on bold metrics like their companies’ bottom lines, CFO compensation requires a more intricate calculus. For finance chiefs, the key factor these days is internal controls.

A new study by Udi Hoitash, Rani Hoitash and Karla Johnstone, accounting professors at Rutgers University, Bentley College, and the University of Wisconsin at Madison, argues that CFO compensation in a post-Sarbanes-Oxley world hinges strongly on material weaknesses of internal controls, accounting expertise, and a CFO’s relationship with the board.

Since Sarbox was enacted in 2002, companies have sought CFOs with more technical experience, particularly in accounting and auditing. Because of the more demanding set of skills needed to be a CFO, their pay has increased. According to the study, the average finance chief earns a base salary of $316,932 and an average bonus of $222,764. Charged with certifying accurate financials, CFOs who knowingly make mistakes can be fined millions of dollars and face prison. The greater responsibility comes with bigger rewards, but also more painful penalties for mistakes.

Observing 635 CFOs in 2005, the authors find that when a company’s material-weakness disclosures increase, finance chiefs feel a pain in their bonuses. The effect is made worse if the CFO has previous experience as an internal auditor. Although internal-audit experience is prized in the new regulatory world, it also comes with greater expectations.

“These results imply that boards and compensation committees hold higher expectations for CFOs with greater expertise and internal corporate reputation relative to other CFOs,” the study said.

Moreover, CFOs that work with particularly strong boards are most likely to be punished for financial-reporting errors. At the same time, finance chiefs who sit on their own companies’ boards—a sign of power within the company—tend to earn higher salaries. A place on another firm’s board also bodes well for a CFO’s salary, as it enhances his reputation.

Discuss

Your email address will not be published. Required fields are marked *