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CFO options rise when there's auditing expertise

Ed Zwirn | Dec. 1, 2011
Academic studies and practical experience long have shown that the more auditor expertise you have, the fewer the incidences of earnings management.

Academic studies and practical experience long have shown that the more auditor expertise you have, the fewer the incidences of earnings management. Proceeding from the premise that firms will grant more equity-based compensation if financial-statement manipulation is more likely to be detected, a yet-to-be-published paper by Sudarshan Jayaraman and Todd Mibourn of Washington University's Olin Business School in St. Louis finds that CFOs, in particular -- but also their CEO bosses -- do indeed bring home more of the equity bacon when their companies are subject to expert scrutiny.

"Our study is one of the first to examine the underlying economic determinants of CFO compensation and how these differ from those of other executives," write Jayaraman and Milbourn.

According to the study, the association between auditor expertise and equity compensation is attenuated by the presence of institutional investors. That's presumably because these shareholders, "on account of their large ownership stakes, have both the incentives as well as the means to gather costly private information about earnings and to use this information to monitor managers."

The results show that a one-standard-deviation increase in auditor expertise increases equity-based CFO compensation by 2.95% in firms with no institutional ownership, and by 1.02% in those with the median level of institutional ownership.

Similarly, a one-standard-deviation increase in auditor expertise increases CEO equity compensation by 2.6% in a company with no institutional ownership, but only by 0.89% in a firm with median institutional ownership.

But while CEOs and CFOs reap the benefit of having an auditor with expertise in their industry, the same does not hold true for other members of the C-suite. Not only is there no relation between auditor expertise and equity compensation among these other executives, the report says, but "institutional ownership plays no role in the association between equity-based compensation of other executives and auditor expertise."

This similarity between CEOs and CFOs, although not the others among top execs, indicates that "CFO incentives matter as much for financial reporting outcomes as do CEO incentives," the authors say. "These results provide additional assurance that the association between auditor expertise and managerial compensation stems from the effect of equity-based incentives on financial misreporting -- which are likely to be relevant only for CEOs and CFOs."

 

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