“It’s all well and good that you can identify the actor who is responsible for the specific manipulation and punish them after the fact,” says Henry Friedman, assistant professor of accounting at the UCLA/Andersen School of Management. “But the research shows it might be more useful to focus on the incentives around manipulation and very powerful CEOs as potential red flags.”
The history of accounting scandals is littered with powerful CEOs that pressured CFOs to manipulate earnings, including Enron, WorldCom and HealthSouth. Freindman’s study — titled “Implications of power: When the CEO can pressure the CFO to bias reports” cites former HealthSouth CEO’s infamous “fix it” demand to the CFO as a prime example of that pressure.
According to Friedman’s thesis, CEOs with significant “power” — including those with significant influence over the board, excess compensation tied to earnings and direct responsibility for financial reporting — often “compromise the independence of a CFO who is responsible for reports upon which performance is assessed.” Financial executives end up being pressured to manipulate accounting as a result of the pressure from CEOs, even though they often have little to gain from the scheme.
“There has been significant discussion about who is ultimately responsible for accounting manipulations,” says Friedman “At the same time there has been a big push to increase punishment for executives that are anywhere near wrongdoing, which is usually the CFO. One party may be taking the actions, but it’s the other one that caused them to act.”
Friedman argues that the research, which will be published in the Journal of Accounting and Economics, has implications for this interaction between the CEO and the CFO in terms of pay for performance, firm value measurement and financial reporting quality that offers a “lens” into the motivations behind accounting manipulation.
For example, the research findings suggest boards could avoid accounting scandals by putting the proper incentives and safeguards in place when a CEO and CFO are hired, rather than attempting to force disincentives after the act.
In fact, Friedman argues that the increase in punishment against CFOs that manipulate accounting can often “backfire.”
“The research indicates that harsher punishments against CFOs could actually lead to lower financial reporting quality,” Friedman explains. “Increasing the punishment or costs to the CFO just forces them to figure out new ways of getting around getting caught.”