Human Capital

Do Clawbacks Cause as Many Problems as They Prevent?

While penalties for erroneous financial reporting may spur achievement, they also may lead executives to cover up their mistakes, study suggests.
David McCannMay 28, 2019

Which is the better way to spur achievement: by rewarding employees for attaining goals, or by penalizing them for failing to do so?

While the question has remained a perennial matter of debate, a new scholarly paper observes that “given the financial scandals and crises in recent years, bonus contracts have come under a great deal of criticism, and penalty clauses have become increasingly prevalent.”

How Startup CFO Grew Food Company 50% YoY

How Startup CFO Grew Food Company 50% YoY

This case study of JonnyPops’ success highlights the unusual financial and operational strategies that enabled rapid expansion into a crowded and highly competitive frozen treat market. 

A prominent element in this trend, the study notes, is the clawback mandate of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The provision requires public companies to take back incentive-based compensation awarded to executives on the basis of erroneous financial reporting.

Now, some novel experimental research, largely motivated by the increase in clawbacks, raises doubts about this trend. While allowing that penalties may provide an effective spur to effort or achievement, the study, in the May/June 2019 issue of the American Accounting Association journal The Accounting Review, finds that they also tend to foster misreporting that exaggerates or falsifies those desired ends.

“While penalty contracts may sometimes encourage greater effort than bonus contracts, as prior literature has shown, penalty contracts can also lead to greater dishonesty when [an] effort is not successful,” wrote the study’s author, Jennifer Nichol of Northeastern University.

She added that “prior studies did not investigate possible alternative means of avoiding a penalty or acquiring a bonus outside of increased effort. In reality, there are often options available to employees beyond increasing effort, options that may include undesirable behaviors such as misreporting.”

People who are subject to penalties, the study found, are considerably more likely to choose such undesirable options than are those who fail to earn a bonus.

In a behavioral experiment comparing the two groups, in which participants took a test and reported their results, twice as many individuals in the penalty group lied about their scores. And their lies elevated their scores by significantly larger amounts.

Yet, as Professor Nichol wrote, “this research does not find that penalty framing causes people to substitute effort with misreporting, but suggests they will invest at least as much effort as they would under a bonus contract before resorting to dishonesty. This highlights the importance of setting targets that can be achieved through the greater exertion of effort when using penalty framing.”

Expanding on that point, she wrote that “when companies use bonuses, their controls should focus on increasing effort. When companies use penalties, their controls should focus on reducing dishonesty.”

What accounts for the greater misreporting by the penalty group compared with the bonus group, given that the award for reaching a goal was as great as the penalty for falling short? In a word, it’s a feeling of entitlement.

In the same way investors are known to fear investment losses more than they value investment gains, the prospect of losing already-received incentive payouts is more motivating than the opportunity to gain a bonus.

The study’s findings are based an experiment involving 99 undergraduate business students. They were given 30 minutes to answer 30 difficult multiple-choice questions and told that if they reported scores above a certain level, they would earn $15; otherwise, they would receive $10.

For half of the participants, the $5 difference was framed as a bonus added to a $10 salary, while for the other half it was a penalty to be deducted from a $15 salary.

Upon completion participants would learn their actual score, but their compensation would be based not on that but on what they reported. Reported scores, they were assured, would remain confidential, with no questions asked and no penalty for lying even if, in the words of the experiment instructions, “you will have to live with the knowledge that you chose to lie.”

Given the test’s difficulty and the limited time allowed for its completion, only one participant scored high enough to actually earn $15. Of the remaining 98 participants, 27 boosted their scores; 18 of them were in the penalty condition and only 9 in the bonus condition.

As for the amount that scores were raised, here too the penalty group significantly exceeded the other, the former boosting their scores on average by about 27% of the maximum possible, the latter by just 12%.

Participants also were asked whether they deserved or were entitled to the full $15 payoff, with answers on a 6-point scale from 1 (strongly disagree) to 6 (strongly agree). The average results were about 2.9 for the bonus group and about 3.4 for the penalty group.

While the study does not deal specifically with clawbacks, Nichol notes that the large increase in their prevalence in recent years was an important factor in motivating the research.

“Granted, clawbacks have a considerable deterrent effect,” she says. “But is it greater than the incentive they give top executives to cover up [financial reporting errors] that may have been beyond their control? The jury is probably still out on this.”

In any event, the professor adds, some companies have adopted an option that would seem in alignment with the study’s findings: the use of an escrow account as a kind of compromise between bonus and penalty, rewarding excellence like the former while offering less rationale to lie than the latter.