How important is it for CFOs or other top corporate executives to have accounting expertise?

Around the turn of the century, when the financial director of a major bank stated that “the day of the finance director as bean counter is well and truly over,” he was reflecting much contemporary thinking. But since then, perhaps driven by this century’s notorious corporate accounting scandals and severe worldwide economic recession, opinion appears to have shifted.

As a new scholarly study notes, “academics, practitioners, and regulators commonly focus on the upside of accounting competence providing higher-order ability to generate financial reports free of material misstatements.”

Reflecting this trend, the Public Company Accounting Oversight Board, which the U.S. Congress created in 2002 in response to the major accounting scandals, lists lack of managerial accounting competence as a prominent risk factor for financial misreporting.

Now, in a switch, the new scholarly paper, in the November issue of the American Accounting Association journal The Accounting Review, probes a previously unexplored question: whether the presence of accounting expertise among top company managers, as well as its absence, can compromise financial reporting.

The study — titled “Do Auditors Recognize the Potential Dark Side of Executives’ Accounting Competence?” — concludes that it can. The finding carries important implications for regulators, corporate directors, and, most crucially, external auditors charged with certifying the accuracy of client companies’ financial statements.

Focusing on the CFOs, CEOs, and other top executives of more than 3,000 public companies, accounting professors Anne Albrecht of Texas Christian University, Elaine Mauldin of the University of Missouri, and Nathan Newton of Florida State University find that executives’ backgrounds as partners or managers in audit firms can substantially increase the present likelihood of financial misstatements.

That prior experience, they write, “provides extensive knowledge of audit procedures and negotiation tactics. As a result, executives could use their higher-order ability to hide misstatements or to avoid current-period adjustments when the external auditor finds misstatements.” Restatements exposing the misreporting come, after all, only later.

In short, accounting competence in the C-suite is, the professors write, a “two-edged sword” that can either enhance or subvert financial reporting.

They further explain, “We do not expect that accounting competence alone leads to misstatements, because accounting competence may provide the ability to produce reliable financial reports, and we have no reason to expect more or less integrity from executives with accounting competence than from those without it. Instead … accounting competence interacts with other fraud-risk elements to increase the risk of material misstatement.”

What other fraud-risk elements? The professors focus on executive compensation, since “auditing standards specifically include them in risk assessment and prior research suggests compensation-based incentives induce misstatements.”

And, indeed, the study finds that accounting expertise among top corporate managers greatly increases the extent to which executive-pay excesses induce financial misreporting.

When auditing backgrounds were absent from top management, companies where executive pay was well above the median (at the 75th percentile) were only about 4% more likely to misstate than were firms where that pay was relatively low (at the 25th percentile).

But when audit-firm experience was present in executive suites, the high-pay firms were about 30% more likely than their low-pay counterparts to misstate. The professors term this the “downside to a management characteristic considered beneficial in auditing standards.”

Contributing considerably to the problem is an apparent lack of awareness of this downside among external auditors. Although auditors typically charge companies higher fees in response to excesses in executive pay, the boost is much less when there is auditing background in the executive suite.

“This result is consistent with auditors’ over-trusting executives with accounting competence and discounting the fee premium associated with excess compensation,” the study report notes.

Put slightly differently, “executives’ accounting competence increases the risk of material misstatement when combined with compensation-based incentives to misreport. However, we do not observe that audit fees reflect this increased risk, suggesting that auditors focus on the upside of accounting competence.”

The study drew on data from 3,252 public companies over a 10-year period. In any given year, an average of about 12% of the firms had one or more top executives (as listed in proxy statements or annual reports) who had prior audit experience as a partner or manager at a public accounting firm.

About 61% of the executives with this background were CFOs and about 9% were CEOs. About 10% of company financial reports contained misstatements that were corrected by subsequent restatements.

In measuring executive pay, the professors calculated expected compensation from many factors, including companies’ size, complexity, and financial performance, as well as the tenures and management-ability scores of executives.

How much this estimate differed from actual total pay was termed “excess compensation.” The results, ranging from negative to positive (below and above expected levels respectively), provided the basis for ranking companies on pay.

By itself, past auditing experience among top executives did not significantly increase the likelihood of financial misreporting. But the likelihood increased greatly when that expertise met up with excess executive compensation, so much so that high-pay firms became considerably more likely than their low-pay counterparts to misstate.

In the words of the study, “a dark side of accounting competence emerges in the presence of compensation-based incentives.”

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3 responses to “The Dark Side of Accounting Expertise”

  1. As a former CPA with Big 8 firm experience, and Controller/CFO experience with 3 different Public companies, I have long held that CFO’s really should not come from Public Accounting/Auditing. The Controller is the chief accounting officer of the company, and that position should be responsible for all things accounting and reporting. The CFO’s primary responsibility is to understand the operational side of the business well enough to provide the company with the financing it needs to operate and grow the business. Consequently, CFO’s should come from the Treasury and Finance industry. CPAs have no real training, knowledge or experience in the financial markets in order to fulfill that role. Trying to make a good Finance guy out of a CPA, almost never works well. Where I have seen the problem aside with non-public company, is they have a very weak Controller so they feel they have to hire someone into the CFO position, and their assumption is he/she will be a higher-level accountant or Chief Accounting Officer. Many Public company upper managers have the same mentality, and those companies typically have higher level Treasury and Financing activity and needs. Therefore, the CFO reports to the CEO and may even be on the BOD, with the Controller reporting to the CFO. What the company ends up with are two good CPA/accountants with no experience in the Financial Markets, and the CFO is very little help securing, planning, and managing the financing activities and needs of the company without a lot of outside help from consultants who do.
    Much of the problem, is the lack of accounting and financial experience and knowledge of CEOs and members of the BOD. They need to be educated with respect to the proper respective roles and skill sets both positions require and how to match those with the needs of the company. I submit that both the Controller and the CFO should report to the CEO or no further down the latter than COO or EVP. The Controller and CFO roles are very different and so should the skill sets and backgrounds. I also submit that a company will typically be better served if the Controller’s background and experience is from the Management Accounting side of the accounting spectrum instead of from Public Accounting side, even for a Public Company. The CFO’s background should be from Banking, Financial Services, or Investment Banking, depending on the type of financing needs of the company. A CFO is a user of the company’s financial reporting and statements, but with the above background they should not be responsible for them.
    In the above scenario, I would feel much better as a CEO and the outside auditor, that the financial statements would be more accurate, in compliance with GAAP, and be less likely to be misstated, since the Controller is completely accountable for them and independent of the CFO. That would not mean that the CFO would not be a significant contributor to the financial statements, but they should not solely be his responsibility, and he should not be in a position to exert undo pressure or influence on the Controller. After all, both have to sign the SEC and other Statements. If the Controller is too weak for this management structure, the position should be upgraded. If there is not enough financing work to merit hiring a CFO, then use outside consultants with help from the Controller, until the financing requirements increase.

    • really liked your comment, clearly stating the roles of the CFO and the FC. also indicating the fact why financial operations and financial reporting are 2 different but integrated objectives.

  2. In my brief career @ a Big Four firm, I once walked into an engagement where the Senior Manager assured the Senior Associate and Staff that “the great thing about [client] is that the CFO is a former [Big 4 Firm I worked at] Senior Manager. Even then I shook my head quietly thinking whatever happened to professional skepticism

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