Clawbacks make CEOs more accountable for firm's financial reporting

October 20, 2011

In recent years, corporate boards of directors have increasingly sought to dissuade accounting errors and fraud by tying executive compensation to behavior. The vividly named “clawback” provision requires top executives to pay back excess incentive pay in the event of an accounting restatement.

But do clawbacks actually improve the quality of financial reporting?

They do, according to a new study by Ed deHaan, Frank Hodge and Terry Shevlin of the University of Washington Foster School of Business. Their analysis of nearly 300 firms concludes that clawbacks improve the accuracy of financial statements and increase investor trust. They also result in CEOs receiving greater overall compensation.

“Our findings indicate that clawbacks are effective governance mechanisms that have a material impact on the quality and use of firms’ financial statements,” says Shevlin, chair of the Department of Accounting at the Foster School.

History of clawbacks

The clawback provision is a relatively new governance tool, but its popularity is growing rapidly. Clawbacks became increasingly prevalent following the financial reporting scandals of the early 2000s and the resulting Sarbanes-Oxley Act of 2002 which imposed greater personal accountability on top management of public companies.

By 2010, 82 percent of the Fortune 100 had voluntarily implemented clawback clauses in their executive compensation contracts (up from 18 percent in 2006).

Clawbacks are simple in design. They allow corporate boards to recoup incentive pay from senior executives in the event of a trigger event, most commonly an accounting misstatement. Cook the books, give back your bonus.

Incentives—bonus and equity—represent a large portion of executive compensation at public firms. Since incentives are often directly linked to the firm’s financial performance, they can lead executives to make choices that result in accounting restatements.

“Clawbacks are intended to reduce the risk of restatement by making managers repay ill-gotten performance-based compensation, thereby reducing the expected benefit to executives from misreported financial statements,” says Hodge, an associate professor of accounting at the Foster School.

The recently passed Dodd-Frank Wall Street Reform and Consumer Protection Act now requires all publicly traded firms to adopt a clawback provision for top management that is triggered by a restatement, regardless of fault.

Until now, there has been little evidence to indicate whether the clawback provision is just “cheap talk” or a measure with real claws.

Curbing misstatements

To find out, deHaan, Hodge and Shevlin analyzed 299 firms that voluntarily adopted clawback provisions between 2007 and 2009—comparing them to a control group of firms that did not employ clawbacks.

At question was whether this voluntary form of governance was successful at improving actual and perceived financial reporting quality—the extent to which accounting statements contain intentional or unintentional errors.

Indeed, the researchers found evidence of an increase in accounting accuracy after firms adopt clawback provisions, suggesting that they reduce the risk of an accounting restatement.  And investors perceive accounting reports to be more informative and reliable following clawback adoption.

At the same time, CEO compensation increases as a result of clawbacks. “CEOs appear to negotiate a higher base salary to defray the risk of potentially having to pay back bonuses,” explains deHaan, a doctoral student at the Foster School.

Finally, the authors found that clawback provisions requiring compensation repayment for both fraud and unintentional accounting errors are only marginally more effective than provisions that require repayment for fraud alone.

Inside governance

Accounting errors—intentional or not—are bad for business. Among the overwhelming body of evidence, a 2004 study co-authored by Foster School accounting professor Zoe-Vonna Palmrose demonstrates that announcing a misstatement sends a firm’s stock price plummeting. A 2006 study by Foster finance professor Jonathan Karpoff finds that getting caught cooking the books results in significant costs to firm value—both in fines and injury to the firm’s reputation.

“Given that restatements are significant economic events with well-documented negative consequences, and that there appears to be a link between restatements and executive compensation,” adds deHaan, “firms face a strong incentive to structure an executive’s compensation contract to reduce the risk of both intentional and unintentional accounting errors.”

As a voluntary measure, the clawback provision appears to accomplish this. Now that clawbacks have been mandated for public firms, the authors hope that better understanding the consequences of clawback adoption will allow the Securities and Exchange Commission to provide more informed guidance to firms tasked with managing such provisions. They also hope that their findings will be informative to Canadian and other international regulators that are considering implementing their own clawback requirements.

Finally, the authors believe that a wider swath of organizations that pay performance-based compensation and desire to curtail image-damaging behavior might do well to adopt a clawback provision to directly tie pay to good behavior.

“Does Voluntary Adoption of a Clawback Provision Improve Financial Reporting Quality?” is the work of Ed deHaan, a 4th year doctoral student, Frank Hodge, associate professor of accounting, and Terry Shevlin, professor of business administration, all at the University of Washington Foster School of Business.

Contact Terry Shevlin at shevlin@uw.edu for a copy of the complete academic paper.