Do Clawback Policies Accomplish Their Desired Purpose?

They may, but new research surprisingly suggests that clawbacks may also prompt managers to drive down their companies' effective tax rates.
David McCannDecember 16, 2019

Will the SEC ever finalize section 954, the clawbacks rule, of the Dodd-Frank Act?

It’s been nearly a decade since the much-heralded bill was signed into law and almost five years since the SEC proposed rules to implement section 954. The key provision requires all companies listed on national securities exchanges to adopt “clawbacks” — policies to recover incentive compensation awarded to executives on the basis of erroneous company financial statements.

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Five years later, however, the rules have yet to be finalized, and their future remains in doubt.

Should they be finalized? Research on the value of clawbacks has yielded mixed findings.

As noted in a paper to be published in the January issue of The Accounting Review, a peer-reviewed publication of the American Accounting Association, some studies have concluded that companies that voluntarily adopted clawbacks improved their financial reporting.

Other research, however, has found that adoption pushes managers to juggle company operations in ways that may compromise long-term shareholder value.

The new paper could add to doubts about clawbacks. At a time of ballooning federal debt and claims that corporations don’t pay their fair share of taxes, the study concludes that clawback adoption has had the unanticipated effect of prompting managers to drive down their companies’ effective tax rates (ETRs).

The research, by Thomas Omer and Thomas Kubick of the University of Nebraska – Lincoln and Zac Wiebe of the University of Arkansas, compared 233 companies that voluntarily adopted clawbacks with similar firms that were non-adopters.

The professors found that from soon after adoption, companies were significantly more likely than non-adopters to (1) report a new subsidiary in a tax-haven country; (2) increase payments for auditor-provided tax services; and (3) increase board interlocks with companies that had low effective tax rates.

Why the urgent push for tax savings among adopters?

“Capital market pressures to meet earnings expectations do not subside following clawback adoption,” the professors wrote. They explained that executives feeling pressure to meet earnings goals or forecasts have often resorted to manipulating accruals, or non-cash accounting items that commonly involve some element of estimation or guesswork.

But “the potential costs of these [accrual-based] strategies are higher in a clawback environment because aggressive accruals can attract regulatory scrutiny and lead to forfeited compensation,” according to the paper. “Reducing income-tax expense is an attractive alternative.”

Thus does ETR reduction become a substitute for aggressive accruals manipulation, as clawback adoption makes the latter strategy more personally risky for managers.

The professors estimated that the 233 clawback adopters in their study lowered their ETRs enough in their clawback-adoption year to save an average of about $18 million. That amounted to about 1.6% of their average pre-tax net income.

The study, based on information from six databases, involved matching each of the 233 firms that adopted clawbacks in the course of an eight-year period with a non-adopter in the same industry that was similar in 21 additional respects.

The clawback adopters and the control companies averaged almost the same effective tax rates in the year before adoption — but that quickly changed. The ETRs of adopters dropped by an average of about 1.6 percentage points (or about 5%) in the adoption year, while those of the non-adopters were virtually unchanged.

Further, the professors found the lower ETRs were sustained in at least two post-adoption years.

They also found that companies that adopted a robust clawback policy (where recovery of compensation was contingent on material misreporting, whether intentional or not) were more likely to lower their ETRs than firms where clawbacks were contingent on outright misconduct in reporting.

Given that the study employed data from before the Tax Cut and Jobs Act became effective in December 2017, which sharply reduced corporate tax rates, has the effect of clawback adoption on ETR reduction changed from what the professors found it to be?

“On the one hand,” said Omer, “corporate leaders are under no less pressure than before to meet earnings targets and forecasts. On the other hand, if lowering an ETR from 21% to 19% is more difficult and more expensive to achieve than lowering it from 32% to 30%, a tax-based strategy might be a less desirable option to meet earnings goals than it was before tax reform.”