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A new study finds that falling short of analysts' profits forecasts hits CFOs directly where it hurts: in their wallets and their chances of getting fired.
Vincent Ryan, CFO.com | US
July 18, 2008
Why do CFOs work so hard to meet quarterly earnings benchmarks, even those based on a consensus of analysts instead of company-provided earnings guidance? The answer is self-interest, according to a new study by three university professors.
CFOs and CEOs at companies that miss quarterly earnings benchmarks suffer reduced bonuses, smaller equity grants, and a greater chance of forced dismissal, say the professors, who used data on S&P 1,500 companies from 1993 to 2004. While the extent of these penalties obviously is greater when the earnings target is missed by a wider margin, it is the mere fact of missing the target at all that triggers a punitive response.
"It's pretty shocking — it looks like just the act of missing has negative consequences," one of the study's authors, Shiva Rajgopal of the University of Washington Business School, told CFO.com. "We controlled for everything we could think of," including the magnitude of the earnings surprise and the company's share price and operating performance.
The career penalties got worse after passage of the Sarbanes-Oxley Act, and they're also worse for companies that publicly disclose quarterly earnings guidance.
"Our evidence suggests that boards [of directors] appear to react directly to managers' ability to meet earnings targets, and senior managers' preoccupation with meeting earnings benchmarks might be based at least partly on career concerns," says the report, whose other authors are Rick Mergenthaler (University of Iowa) and Suraj Srinivasan (University of Chicago Graduate School of Business).
One reason these results are disconcerting for public companies and their investors is that career penalties over missed targets could influence CFOs (and CEOs) to take unhealthy actions to meet the forecasts — even if those actions destroy long-run value or are fraudulent.
When companies failed to meet just two quarterly analyst consensus forecasts, the careers of senior executives suffered damage. In such cases, the CFO received a lower bonus equivalent to 8 percent of salary, a 24 percent relative to an equity grant with no misses, and had a 0.62 percent higher probability of being dismissed. (The chance that a CFO will be forcefully dismissed at all is 5 percent, so the dismissal penalty is significant, the authors say.) In dollar terms, the approximate decrease in CFO pay on missing two quarterly forecasts is $23,787 (based on a mean CFO salary during the study period of $297,340).
By failing to meet all four consensus quarterly earnings forecasts in a year, CFOs got hit even harder: a 16 percent lower bonus, a 48 percent lower equity grant, and a 1.53 percent higher probability of getting the ax. A small consolation for CFOs is that the penalties were even steeper for CEOs, except in the case of being dismissed. If a company missed an analyst forecast once during a year, the "forced turnover rate" was 4.6 percent for the CFO versus 2.7 percent for the CEO; if the firm reported four misses, the CFO turnover rate climbed to 8.2 percent versus 6.2 percent for the CEO.
Interestingly, for the CFO only, the company's prior history of meeting or beating analysts' projections did not appear to lessen the penalties of missing just one or two quarterly earnings forecasts.
When a company missed other earnings benchmarks, such as earnings falling below prior-year earnings, the career consequences were not as severe, at least in terms of compensation. CFOs' bonuses were cut, but equity compensation was not affected.
After passage of Sarbanes-Oxley in 2002, the study found, short-termism worsened. From that time through the end of the study period (year-end 2004), when a CFO missed a consensus analyst forecast, bonus and equity grant cuts were larger, and the chances of being dismissed greater. This despite the findings of other academic studies that the three-day stock-price reaction to meeting or beating analyst forecasts has lessened since Sarbox.
Across all years, CFOs who provided earnings guidance fared worse than their nondisclosing counterparts. If a CFO provided guidance and then missed analysts' expectations, he or she was subject to greater bonus cuts and was more likely to be fired.
Given the other trends in CFO careers, such as shortening average tenure, it is perhaps not a surprise that such emphasis is placed on quarterly earnings. "Senior executives don't have incentive to focus on the longer term," concluded Rajgopal.