Well, the previous idea was that earnings management was primarily driven by the CEO and therefore regulators around the world asked for the remuneration details of the CEO. But recently the SEC has started asking about the remuneration of the CFO as well, which in hindsight, makes perfect sense. After all, the CFO is the person who is actually managing the entire financial process which culminates in the production and propagation of the financial and earnings figures and announcement. A recent paper sheds some more light on this rather interesting and topical issue.
The authors cover the S&P 1500 firms for which CEO and CFO compensation data is available over the 1993 to 2006 period giving a total of 17542 firm years. They judge both cash pay and total pay, the latter including everything else such as option grants, incentive plans, etc. On an average, the CFO earns 1/3 of the CEO with an average equity incentive ratio of 11% for CFO’s compared to 24% for CEOs. Please bear in mind that 2002 saw the introduction of SOXA and the authors do include the impact of this on accounting treatments such as accruals management.
Prior to the introduction of SOXA, there is a positive association between the compensation of both CEO’s and CFO’s with accruals management. In other words, more the incentive, more are the accruals within the financial statements and the influence of the CFO is higher on the accruals management element compared to the CEO. The introduction of SOXA meant that active accruals management was dramatically reduced and there is no longer any relationship between the incentives to CFO and CEO and accrual management.
How about beating analyst forecasts? As you would know, analyst forecasts are extremely important in forming the market sentiments which drive how the market reacts post the earnings announcements. Similar to the above finding, the authors find that pre SOXA, CEO and CFO incentives are positively associated with the likelihood of reporting positive earnings surprises. They also find that greater the incentive, greater was the chance of an earnings surprise. In the post SOXA period, the equity incentives of the CEO is no longer positively associated with the likelihood of beating analyst forecasts. But surprisingly, the CFO is still highly influential in the likelihood of beating analyst forecasts.
The authors also carry out some additional tests and find:
We also find some weak evidence that earnings management incentives are strongest when the manager has compensation that is more sensitive to stock prices and the firm’s stock returns are more sensitive to accounting earnings.
In other words, the role played by the CFO is almost independent of the CEO at least in terms of accrual management, earnings management and general financial statements to the wider world. If I was a shareholder, I would peer at the CFO much more closely and if there is an element of equity incentive compensation to the CFO, then peer even more closely with a beady eye. I can see analyst models start to incorporate this as a factor. On the flip side, I am sure the CFO’s will be reading this and demanding more cash based compensation compared to stock based compensation. Not sure what the answer is, but it puts further pressure on the remuneration committee, the audit committee, the external auditors and regulators to make sure that the firms are presenting a true and fair picture of the accounts.
John(Xuefeng) Jiang,Kathy R.Petroni and Isabel Yanyan Wang, CFOs and CEOs:Who has the most influence on earnings management?, Journal of Financial Economics, doi:10.1016/j.jfineco.2010.02.007