As the financial industry awaits clawback regulations from the US Securities and Exchange Commission (SEC), a recently published study in The Accounting Review supports critics who say the measure will have unintended consequences, but it describes reasons why that aren’t so readily apparent.
The pending SEC rules would require public companies to recoup or claw back incentives for top executives if there are material errors in financial statements.
In Why do Restatements Decrease in a Clawback Environment? An Investigation Into Financial Reporting Executives’ Decision-Making During the Restatement Process, Jonathan Pyzoha, assistant professor of accountancy at Miami University, found that the regulations will push companies to avoid restatements that would trigger a clawback.
That may seem like a no-brainer, but it’s more complicated than that, according to the study.
In an experiment, Pyzoha gathered 112 CFOs, controllers, and treasurers from publicly traded companies to act as CFOs of a medical manufacturer who are considering a hypothetical error restatement submitted by auditors. In the scenario, an auditor has proposed a restatement of the previous year’s financial report that will bring earnings below forecasts and result in a clawback of incentive compensation given when the forecast was exceeded.
The scenario, Pyzoha writes, requires professional judgment because the error is based on an ambiguous accounting standard, ASC 360-10 Property, Plant and Equipment: Overall – previously Financial Accounting Standards Board Statement No. 144, Accounting for Impairment or Disposal of Long-Lived Assets. (Pyzoha limited the amount of authoritative guidance because it constrains accounting choice.)
For about half of the participants, incentive pay comprises 80 percent of their total $2.5 million compensation. Incentives comprise 40 percent for the rest of the study participants. Half of each group works with auditors experienced in medical manufacturing audits. The other half works with experienced auditors but whose exposure to the medical industry is limited.
Here are the study’s findings:
- When a “lower quality” auditor with less knowledge of a client’s industry is involved, executives are 40 percent more likely to resist restatements when financial incentives are a greater percentage of their total pay than executives whose incentives are lower. The study contends this is critical “because a top financial officer’s view strongly influences the shape of restatements or, indeed, whether there is a restatement at all.” (Note that compensation in this study is based on the company exceeding analysts’ consensus earnings forecast.)
- However, executives with the same percentage of incentives will more likely accept a restatement from a “higher quality” auditor.
- Executives avoid a restatement by finding more ways to disagree than agree with it. It’s a process that Pyzoha describes as “motivated reasoning,” which holds that people with incentives will reach the conclusion they want to reach by gathering information that makes it more likely to get what they want. Too wonkish? OK, put it this way: If you’re rewarded for a certain outcome or conclusion, you’ll find information that supports it.
Pyzoha writes that the study presents three potential changes:
- Regulations requiring a formal role for an audit committee’s financial expert during the restatement and limiting executives’ restatement decision-making when a clawback is involved.
- Auditors paying more attention to resistant executives when a clawback is possible.
- Companies paying higher base salaries as a proportion of compensation because the base pay isn’t subject to clawbacks and using incentives linked to nonfinancial performance goals.