Risk & Compliance

Fears Over Downside to Clawbacks Are Unwarranted: Study

Contradicting prior research, a new report finds that increased performance-based compensation for CFOs actually steers them away from earnings man...
David McCannJune 7, 2018
Fears Over Downside to Clawbacks Are Unwarranted: Study

Even as the SEC continues to maintain that the clawbacks provision of the Dodd-Frank Act remains on the commission’s to-do list, failure to finalize the rule eight years after the law’s passage inevitably raises doubts about its ultimate fate.

Yet the great majority of firms in the S&P 1500 have on their own adopted rules that enable them to claw back compensation that executives received on the basis of misstated financial reporting.

And in doing so, new research suggests, companies have largely overridden a warning about a potential hazard of such measures — at least when it comes to CFOs.

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The warning is that CFOs whose pay is substantially geared to company performance, as it commonly is, will be impelled by the prospect of clawbacks to resist restating reports that overstated earnings. And indeed, prior studies have reported that clawbacks do have that effect and are tied to earnings management.

But a study in the current issue of The Accounting Review, a peer-reviewed publication of the American Accounting Association, draws a different conclusion. It suggests that companies with clawback rules generally seek to protect accounting integrity. And they do so while maintaining, and even enhancing, the advantages of performance-based CFO pay.

The study, by Peter Kroos and Frank Verbeeten of the University of Amsterdam and Mario Schabus of the University of Melbourne, finds clawback adoption to be associated not with weakened ties between pay and company performance but “with greater CFO bonus incentives tied to accounting measures.”

On the surface that seems counterintuitive, given the presumptive risk a firm incurs when linking company performance to the pay of a corporate officer who oversees the measurement and reporting of that performance.

But the study finds that, on average, the sensitivity of CFO bonus pay to a company’s return on assets, a key measure of performance, nearly doubles following clawback adoption. Such sensitivity is found to be less pronounced for other top executives.

These developments, the study concludes, have occurred because companies are not only boosting bonuses based on accounting integrity, they’re also increasing bonus pay for strategic output that improves performance.

In short, CFOs have less incentive to manage earnings through accounting then they did previously because (1) they’re getting paid for accounting integrity, and (2) they prefer not to jeopardize the bonus money extended for the more creative aspects of their job.

“Prior to clawback adoption,” the professors write, “firms have been under-incentivizing CFOs’ decision-making duties to emphasize the role CFOs have as watchdogs for financial reporting integrity. The implementation of clawbacks could enable firms to incentivize CFOs’ decision-making duties more appropriately … without increasing their propensity to misreport.”

As would be expected, the effect of clawbacks on performance-based CFO pay is not the same in all circumstances.

“The sensitivity of CFO bonuses to return on assets varies systematically with the extent to which the firm’s accounting system is susceptible to misreporting,” the report says.

“Specifically, the increase in CFO bonuses tied to accounting measures after adoption of clawbacks is less pronounced in subsamples with internal control material-weakness disclosures, higher abnormal accruals [often a sign of accounting manipulation], higher CEO power, and lower audit committee power.”

The study’s findings draw on a large database that provides information on clawback adoption by companies in the Russell 3000, which consists of the 3,000 largest U.S. public firms.

In an analysis spanning the seven-year period 2007 through 2013, the professors compared CFO compensation of companies that had clawback rules during this period with that of firms that did not. They controlled for such fundamentals as company size, profitability, and indebtedness, and such governance factors as board size, CFO tenure, and whether the CEO served as board chairman.

In sum, the professors write, clawback adoption leads to a 98% increase in accounting-based pay-for-performance sensitivity.