A new study predicts the Securities and Exchange Commission’s final regulations on clawbacks of incentive based compensation for corporate executives could backfire and only encourage companies to avoid the kinds of financial restatements that might trigger a clawback.
The study, which appears in the current issue of The Accounting Review, a journal of the American Accounting Association, suggests that companies may find themselves pressed to move away from incentive compensation not only to accommodate their top executives but for the sake of the integrity of their accounting.
The paper, by Jonathan S. Pyzoha of Miami University in Ohio, found that incentive pay strongly boosts the tendency of top company financial officers to oppose restatement of prior company reports that overstated earnings. In the words of the study, which involved 112 CFOs and other top financial managers, "executive decision-making is negatively influenced during the restatement process when executive compensation structure is more heavily incentive-based....Firms may want to structure compensation with higher base salaries as a percentage of total compensation to deter negative behaviors in response to clawbacks.”
The researchers found that executive resistance occurs when the auditor proposing a restatement has limited knowledge of the client company's industry. In such cases executives with high incentive pay (in this study, compensation contingent on the company beating analysts' consensus earnings forecast) prove about 40 percent less likely than those with lower incentive pay to agree with the auditor’s restatement proposal. This is critical, the study explains, because a top financial officer's view strongly influences the shape of restatements or, indeed, whether there is a restatement at all.
The research raises doubts about the reason for the reduction in restatements observed among companies that voluntarily adopt clawback policies. Is this reduction due to improved reporting, or to executives’ resistance to restatements that will trigger clawbacks of the performance-based pay on which they heavily rely?
The study's findings, in the professor's words, "suggest that executives' influence over restatement decisions may need to be limited in a clawback environment...For example, it may be beneficial to enact legislation that requires the audit committee's financial expert to assume a formal role during the restatement process, such as being required to sign off on restatement decisions.”