Performance-based pay, of course, is an important instrument for aligning the interests of managers with the interests of shareholders. But an abundance of recent evidence suggests that these high-powered incentives also provide managers with incentives to cook the books.
And while previous literature on the relationship between incentive pay and earnings manipulation has focused largely on CEOs, a yet-to-be-published paper by Harvard Business School's Felix Oberholzer-Gee and Julie Wulf takes this focus to the level of CFOs and division managers as well. And it finds that high chief financial officer pay levels may deserve special scrutiny by companies.
"Companies report significantly higher discretionary accruals, excess sales and have a higher incidence of future lawsuits when CFOs are paid larger bonuses," write Oberholzer-Gee and Wulf. "The magnitudes of these effects are much larger for CFOs in comparison to both CEOs and division managers."
Higher bonuses lead CFOs to increase accruals upward and to shift revenues toward the fourth quarter, they find, with a one-standard deviation in CFO bonuses increasing excess Q4 sales by 71.5% of their mean value. The comparable figure for CEO bonuses is 45.9% and that for division managers is an "insignificant" 37%.
A similar calculation of the CFO stock option effect finds that excess sales rise by 66.6% of their mean value, while the comparable CEO effect is 45.8%.
Companies whose CFOs receive a large number of options were also found to report higher discretionary accruals and experience a greater likelihood of future lawsuits.
Also supported by their research, the authors add, are changes "in the SEC requirements regarding disclosure of CFO compensation" motivated "by concerns about increases in equity incentives and the effect this might have on the quality of financial statements."
"While CEOs ultimately are responsible if inaccurate or misleading information is provided to the investment community, the incentive to misrepresent financial reporting is a problem that clearly stems from the 'bottom up' and is not limited to 'top down,'" the paper states.
"Our findings have important policy implications and suggest that compensation committees should review pay policies of other managerial positions in addition to CEOs," argue Oberholzer-Gee and Wulf. "Importantly, if the committees wanted to weaken incentive pay to get more truthful reporting, diluting the CFO's bonus and stock options would be a good place to start."
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