Adoption of Clawbacks Tied to Earnings Manipulation

Voluntary adoption of clawback policies is correlated with an increase in "real transactions management," a way to artificially boost earnings.
Matthew HellerJanuary 21, 2015
Adoption of Clawbacks Tied to Earnings Manipulation

The benefits of the Dodd-Frank Act provision allowing “clawbacks” of incentive compensation paid to corporate executives may come with an unintended consequence that is adverse to investors, according to a new study.

The U.S. Securities and Exchange Commission has yet to implement the clawback mandate but many companies have voluntarily enabled or required themselves to implement clawback policies as a way of increasing investor confidence in financial reports. Dodd-Frank requires all publicly-listed firms listed to recover from executives any incentive compensation that was paid to them on the basis of erroneous financial statements.

In the study of corporate adopters of clawback provisions, published in the American Accounting Association‘s journal, Accounting Review, researchers from the Hong Kong University of Science and Technology found that adoptions reduce the incidence of one kind of earnings manipulation known as “accruals management.” However, clawback policies increase the incidence of another kind of earnings manipulation that is “equally, if not more, adverse to investors” — that is, “real-transactions management.”

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Real-transactions management involves altering actual expenditures to achieve a temporary earnings boost, such as by cutting research and development or by slashing prices or easing credit terms to accelerate sales.

As a result, the study says, the total amount of earnings management does not decrease subsequent to clawback adoption and although real transactions management temporarily boosts clawback adopters’ short-term profitability and stock performance, this trend reverses after three years.

“Mandating clawbacks, as Dodd-Frank does, is, at best, of dubious value and may actually be counterproductive in its encouragement of management practices, like reduced R&D, that can compromise the long-term competitiveness of a firm,” study co-author Kevin C.W. Chen said in a news release.

“Since the clawback policy mandated by [Dodd-Frank] is more rigorous than what many firms have adopted on their own, it is reasonable to anticipate that the negative effects we saw in our study will be come to pass when the law is fully enforced,” he added.

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