Few public-company CFOs these days serve on their own companies’ boards, in part thanks to Sarbanes-Oxley regulations that require boards to maintain a majority of independent directors and a general push from investors to have fewer insiders involved. However, companies that do elect their CFOs as board members may see important benefits in their financial reporting, a new study shows — though they will likely pay a premium for it.
“Very consistently, our results show it’s good to have the CFO on the board with respect to financial reporting quality,” says Bentley University professor Rani Hoitash, a co-author of the study, along with Bentley professor Jean Bedard and Northeastern University professor Udi Hoitash (Rani’s brother).
Only about 8% of publicly traded companies have their CFOs on their boards, according to the research, which looked at 7,034 publicly traded companies between 2004 and 2007. Those companies displayed few unique characteristics and were not associated with a particular size or industry. Some things they did have in common included fewer than average audit committee members with direct accounting experience; a lower likelihood of being audited by a Big 4 firm; and a lower proportion of independent directors overall. They were also somewhat less likely to report a net loss than others.
The study looked at three measures of financial reporting: likelihood of reporting a material weakness, likelihood of filing a restatement, and quality of accrual accounting.
The most notable finding was that having a CFO on the board was associated with a lower incidence of material weaknesses, during a period in which the number of reported weaknesses exploded, due to newly enacted Sarbanes-Oxley requirements. Of companies with their CFOs on the board, 12% reported problems with their internal controls, compared with 15.9% of those without their CFOs on the board — a 28% difference. Companies with their CFOs on their boards were also 15% less likely to restate their results, and more likely to have lower discretionary accruals, which is usually consistent with less earnings management.
The authors also tested the impact of having the company’s COO on the board, for comparison. However, the quality of the financial reporting at the 11% of companies that had their COOs on their boards was no different than the reporting quality at the other companies in the study, the analysis found. “If a company is trying to improve the quality of its financial reporting, the CFO is clearly the person to appoint to the board,” says Rani Hoitash.
Quality comes at a price, of course, and that was evident in a number of factors that the study authors consider evidence of CFO “entrenchment.” For one, director CFOs commanded significantly higher compensation levels, garnering an average of $218,715, or 34.5%, more in total compensation than their nondirector peers did ($89,290 of that difference was in cash). There was also a 35% lower turnover rate (8.2% vs. 12.7%) among CFOs who sat on their own companies’ boards, an advantage that sometimes persisted even following a decline in earnings.
“When you have more power, you’re going to directly benefit yourself,” observes Rani Hoitash. That may not be all bad, though. “It could well be that their entrenchment and increased power allows CFOs to concentrate on performing their own responsibilities in a more effective manner,” the authors posit in the paper.
Corporate governance experts say they’re intrigued by the study’s results, though not necessarily persuaded. “I don’t think that the authors’ findings merit reserving a seat at the board table for every CFO, but they should provide some food for thought for those investors who oppose the election of inside directors in a knee-jerk-fashion,” says Patrick McGurn, special counsel to proxy advisory firm Riskmetrics.
Adding the CFO to the board could be helpful in cases where he or she is expected to succeed the CEO, adds Peter Gleason, managing director and CFO for the National Association of Corporate Directors (NACD). Otherwise, he says, “there’s not much reason to have another insider on the board, because are you really going to counter any vote a CEO may have?”
As CFO of the NACD, Gleason notes that he already spends a lot of time with the organization’s directors and isn’t sure what having a formal board seat would add. “I can’t imagine there would be a tremendous difference in the financial data the board gets when the CFO is on the board compared to when the CFO reports to the board,” he says.