Clawback threat helps boost CFO performance and pay

Companies that have the ability to “claw back” compensation from managers if it was received on the basis of misstated financial reporting generally try to protect the integrity of their accounting while maintaining and improving the advantages of performance-based CFO pay, according to a new study.

The study, by Peter Kroos and Frank Verbeeten of the University of Amsterdam and Mario Schabus of the University of Melbourne, found that clawback adoption was associated with greater CFO bonus incentives tied to accounting measures. The paper appears in the May/June issue of The Accounting Review, published by the American Accounting Association.

The study noted that the Securities and Exchange Commission still hasn’t finalized a clawback rule in the Dodd-Frank Act of 2010, but the majority of companies in the S&P 500 have adopted their own rules allowing them to claw back compensation that managers received on the basis of misstated financial reporting. They have done so, despite fears that CFOs whose pay is mostly geared toward firm performance, as is typical, would resist restatements of corporate reports that overstated earnings, threatening the integrity of company accounting. However, the study found those fears to be misplaced, and that clawbacks provisions actually seem to help CFOs with their performance-based pay.

The severe penalties for misreporting that clawbacks impose on CFOs also allow for increased incentives for them to perform extra functions. “CFOs perform dual roles within corporations,” the researchers wrote. “On the one hand, as members of the executive management team they have significant decision-making responsibilities. They make decisions on, e.g., financial planning and budgeting, cost reduction initiatives, debt versus equity financing, mergers and acquisitions, dividend and share repurchase policies, and treasury. On the other hand, CFOs play a key role in financial reporting. They have the ultimate responsibility over the preparation of financial statements.”

In balancing these two roles, according to the study, “an increase in CFOs’ misreporting costs [stemming from the introduction of clawbacks] may allow firms to more fully incentivize CFOs’ decision-making duties without increasing their propensity to misreport…Prior to clawback adoption, firms have been under-incentivizing CFOs’ decision-making duties to emphasize the role CFOs have as watchdogs for financial reporting integrity. The implementation of clawbacks could enable firms to incentivize CFOs’ decision-making duties more appropriately by increasing their bonus incentives…without increasing their propensity to misreport.”

However, the impact of clawbacks on performance-based CFO pay varies across companies. The study found “the sensitivity of CFO bonuses to [company] return on assets varies systematically with the extent to which the firm’s accounting system is susceptible to misreporting. Specifically, the increase in CFO bonuses tied to accounting measures after adoption of clawbacks is less pronounced in subsamples with internal control material-weakness disclosures, higher abnormal accruals [often a sign of accounting manipulation], higher CEO power, and lower audit committee power.”

To conduct the study, the researchers used a database with information on clawback adoption by companies in the Russell 3000, analyzing data from 2007 through 2013. They compared CFO compensation of companies that had clawback rules with companies that lacked such provisions, while controlling for factors such as size, profitability, and indebtedness and governance factors including board size, CFO tenure, and whether the CEO served as board chairman.

“In sum, the findings suggest that clawback adoption is associated with greater CFO bonus incentives tied to accounting measures,” said the study. “Clawback adoption leads to a 98 percent increase in the accounting-based pay-for-performance sensitivity.”

The 17th century headquarters of the Dutch East India Company, now used by the University of Amsterdam
Typical canal side cityscape of Amsterdam, opposite from the 17th century HQ of the Dutch East India Company, now used by the University of Amsterdam

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