Clawbacks Can Lead to Accounting Gimmicks
The clawbacks on executive compensation mandated by the Dodd-Frank Act may discourage one type of accounting manipulation only to encourage another, according to a new study.
Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act contained a provision requiring all publicly listed companies to recover from executives any incentive compensation that was paid to them on the basis of erroneous financial statements. The Securities and Exchange Commission has still not determined exactly how the clawback provision will be enforced and it is not yet mandatory. But many companies have voluntarily enabled or required themselves to implement them.
While previous research has found that such provisions reduce the number of corporate financial restatements and increase investor confidence in financial reports, the new research suggests that the gains implied by those findings may be more illusory than initially thought.
The study appears in the January/February issue of The Accounting Review, a scholarly journal from the American Accounting Association, and was written by Kevin C. W. Chen and Tai-Yuan Chen of the Hong Kong University of Science and Technology, Lillian H. Chan of the University of Hong Kong, and Yangxin Yu of the City University of Hong Kong.
The new paper found that the clawback provision reduces the incidence of one kind of earnings manipulation—"accruals management"—only to increase the incidence of another that is equally, if not more, adverse to investors—that is, "real-transactions management." Accruals are particularly subject to manipulation because they often entail some element of guesswork, such as predictions of future write-offs for bad debts or estimates of inventory valuations. Real-transactions management, in contrast, involves altering actual expenditures to achieve a temporary earnings boost, such as by cutting research and development or by slashing prices or easing credit terms to accelerate sales.
Clawback provisions "deter managers from using accruals management because high accounting accruals tend to attract more scrutiny from the SEC and auditors," according to the study, increasing the likelihood of clawback-triggering financial restatements. But "real-transactions management, such as cutting back on R&D or on selling, general, and administrative (SG&A) expenses, is considered less risky." Even though it "represents a deviation from optimal business practices...it is unlikely to be deemed improper by auditors and regulators."
As a result, the study found, a policy of "clawback adoption leads to less accruals management but greater real-transactions management." The real-transactions management tactic, the study indicated, produces a temporary blip in stock and operating performance followed by downturns in subsequent years, a finding "consistent with the notion that real activities management boosts short-term profits but sacrifices long-term firm value."
"Mandating clawbacks, as Dodd-Frank does, is, at best, of dubious value and may actually be counterproductive in its encouragement of management practices, like reduced R&D, that can compromise the long-term competitiveness of a firm,” Chen said in a statement. “Since the clawback policy mandated by section 954 is more rigorous than what many firms have adopted on their own, it is reasonable to anticipate that the negative effects we saw in our study will be come to pass when the law is fully enforced."
Chen and the other researchers analyzed financial reporting by companies included in the Russell 3000 index, which consists of the 3,000 largest U.S. firms. The researchers compared data of 236 companies that adopted clawback provisions over the five years preceding passage of Dodd-Frank (2005 through 2009) with an equal number of non-adopters closely matched with them in other respects.
The principal focus was on how the adopters modified their use of accruals management and real-transactions management from the years preceding clawback adoption to those following it and how that compared with the analogous data from non-adopters. Real-transactions management was discerned through three measures: 1) amount of discretionary expenses (those for R&D, advertising and SG&A); 2) volume of overproduction of goods to reduce costs per unit; and 3) cash flow from operations reflecting price discounts and credit leniency.
The professors found that earnings-inflating accruals actually declined from pre-adoption to post-adoption of clawback provisions, while no significant effect was seen in non-adopters. Meanwhile, the amount of discretionary expenses and cash flow from operations both declined among adopters (the changes in both cases highly significant statistically), signaling a flurry of real-transactions management to boost earnings. No changes that clear were seen among non-adopters.
These patterns among adopters were largely limited, the study found, to two subgroups of companies— those with high-growth opportunities (that is, above the median in market-to-book ratio) and those with high levels of transient institutional ownership. Companies in the first group, the study explained, experience a sharper decline in stock price than value firms if they miss consensus forecasts and also rely to a greater extent on stock options and restricted stock in fashioning executive pay.
As for the second group, they must contend with investors whose portfolios have high turnover, investors who, in the words of the study, "tend to place significant focus on short-term earnings targets, which incentivizes managers to cut R&D investments to avoid negative earnings surprises."
The researchers believe their findings to be of value not only to regulators but to investors as well.
"Investors should be on the lookout for a switch from accrual-based manipulation to real- transactions management following clawback adoption, particularly among firms under high pressure to achieve short-term earnings targets based on analyst forecasts,” said Chen. “Since companies commonly provide three years of financial data in annual reports, investors can easily determine whether there has recently been a decrease in R&D or SG&A expenses and whether managers provide credible justification for any that occur."