CFOs and CEOs may have circumvented Sarbox's mandated independence requirements by getting cronies to serve on boards, leading to increased earnings management, according to a paper to appear in an upcoming issue of Accounting Horizons. The law's independent-director requirement, intended to ensure better corporate governance, defines independence based largely on the individual's financial or familial ties to the firm or the CFO/CEO.
But individuals are likely to form social ties -- from prior employment, education, or memberships in social, cultural, or charity organizations --- and thus it is understandable that these informal friendship ties with individual directors could be used by the CFO or CEO to "capture" the board, or otherwise undermine corporate governance and board oversight.
Gopal V. Krishnan and Ke Yang of Lehigh University, K. K. Raman of the University of North Texas, and Wei Yu of the University of Tennessee looked at 2000-2007 data for 1,300 companies, and found that CFOs and CEOs "picked more socially connected directors" post-Sarbox. Although the proportion of "formally independent" directors increased during the period, "CFOs/CEOs picked more socially connected directors in the post-SOX time period as a way out of the mandated independence requirements," the paper states. "Our results also suggest a positive relation between CFO/CEO-board social ties and earnings management."
Their research formed its sample from the intersection of the BoardEx, Compustat and IBES databases. The social ties data came from BoardEx which contains biographical data on the directors and top five earners in publicly traded US firms, including current and previous employment, education, affiliation to not-for-profit and religious organizations, club memberships and current board memberships. "
An example of a social tie that is formed as a result of past employment is when the CFO/CEO and a director previously worked for the same firm at the same time," the authors write. "Similarly, an education-driven social tie is formed when the CFO/CEO and a director graduated from the same university."
Firms with more social ties between the CFO/CEO and the board are more likely to manage earnings to avoid failing to meet (or beat) the analyst earnings forecast, avoid reporting a loss, avoid reporting an earnings decline, and report accruals (earnings) of lower quality," they find.
These "findings are useful in better informing regulators and investors faced with questions about the possible consequences of CFO/CEO-board social ties for information quality," they argue. "For regulators a consideration of these social ties could be relevant in ongoing reform of corporate governance and financial reporting."
Sign up for CIO Asia eNewsletters.