When Congress enacted stiff executive compensation clawbacks as part of the Dodd-Frank Act, the assumption was that the adoption of these kinds of measures would reduce the number of corporate restatements and increase investor confidence in financial reports. However, a new study focused on companies that have adopted clawback measures suggests that these gains may prove more illusory than assumed. As discussed in a January 20, 2015 Accounting Today article entitled “Clawbacks Can Lead to Accounting Gimmicks” (here), study by three academics from Hong Kong shows that while the clawback provisions may discourage one type of accounting manipulation, they may encourage another.
Section 954 of the Dodd-Frank Act requires the SEC to adopt rules requiring the national securities exchanges to prohibit the listing of the securities of any company that does not develop and implement provisions specifying that if the company restates its financial statements, the company will recover from any current or former officer of the company any incentive based compensation the officer received during the three-year period prior to the restatement. The SEC still has not issued the implementing regulations but many companies have voluntarily adopted clawback provisions.
The authors of the study referenced in the article analyzed financial reports from companies in the Russell 3000, comparing data from companies that adopted clawback provisions over the five year period preceding the passage of the Dodd-Frank Act with an equal number of non-adopters closely matched with them in other respects.
The authors found that the clawback provisions reduces the incidence of one kind of earnings manipulation – that is, “accruals management” – only to increase the incidence of another type of earning manipulation that if anything is more adverse to investors – “real-transactions management.” The first type, accruals management, refers to the manipulation of the various balance sheet items that require some element of estimation, such as bad debt reserves or estimates of inventory valuation. Real transactions management involves altering actual expenditures to achieve a temporary earnings boost, such as by cutting research and development or by slashing prices or easting credit terms to boost sales.
Crawback provisions deter earnings manipulation through accruals management because high accruals tent to attract the attention of regulators and auditors, increasing the likelihood of a restatement that would trigger the clawback. Managing transactions, while obviously sub-optimal from a business perspective, are unlikely to attract the attention of auditors and regulators. Manipulating the transactions may produce a short run earnings and stock price upswing, but will likely be followed by downturns in subsequent years.
The authors found that the patterns of increased transaction manipulation was particularly pronounced among two types of companies – that is, companies with high-growth opportunities (and therefore likelier to experience a sharper stock price decline if they were to miss forecasts) and those with a high degree of transient institutional ownership (that is, the kinds of investors that focus on short-term earnings targets).
The authors of the study concluded that “mandating clawbacks, as Dodd Frank does, is at best of dubious value and may actually be counterproductive in its encouragement of management practices.” The authors added that “since the clawback 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 come to pass when the law is fully enforced.”
Break in the Action: The D&O Diary will be on travel for the next few days so there will be an interruptoin in the normal publication schedule. Regular puiblication will resume later next week.