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American Accounting Association

AMERICAN ACCOUNTING ASSOCIATION
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Advice to CFOs of firms where the CEO is a founder: In the event of accounting irregularities, watch your back!

Some eyebrows were raised a few years ago when a special committee at Apple Computer Inc. absolved Steve Jobs of wrongdoing in the backdating of stock options and instead placed responsibility for the accounting irregularities on a former Apple CFO and another departed employee. Considering that backdating resulted in the removal and punishment of CEOs at dozens of other firms, the outcome at Apple seemed to some observers a reflection of Mr. Jobs' unique standing at the company and in the corporate world.

Now new research suggests that the outcome at Apple was anything but unique. Whatever the actual role of Mr. Jobs in options backdating (if any), CEOs who are company founders, like Mr. Jobs, survive accounting irregularities unscathed  much more often than not. In varied cases of financial misstatements analyzed in the current issue of the American Accounting Association's Accounting Review, over 70% of founder CEOs kept their jobs.

In contrast, only about half of non-founder CEOs survived announcements of accounting irregularities, with the other half departing during the six months before or after the announcements.

The difference is even more striking when other factors affecting CEO turnover are taken into account, in which case, the study finds, "the impact of an irregularity on the probability of CEO turnover is roughly twice as high when the CEO is not the founder."

"Although intuition would suggest that turnover would be lower for CEOs of founder-managed firms, the magnitude of the impact is quite striking," conclude the report's authors, Andrew J. Leone of the University of Miami School of Business Administration and Michelle Liu of Penn State University's Smeal College of Business .

But the good fortune of founder CEOs means bad news for chief financial officers, the research also reveals. In instances where founder CEOs survived, their CFOs remained in place merely about 18 percent of the time. In cases where non-founder CEOs survived, in contrast, about 46 percent of CFOs remained as well. Almost one fourth, in fact, kept their jobs even when a non-founder CEO was removed.

By way of explanation, the authors note that "it is typically necessary for the firm to fire someone in the wake of an accounting irregularity. Given the relatively high costs of firing founder CEOs, coupled with the high costs of not firing anyone...boards will attempt to shield the found CEO from blame -- and designate the CFO as the 'scapegoat' -- when accounting irregularities occur."

But isn't an equally good explanation, if not a better one, simply that CFOs are the officers most deserving of blame for accounting irregularities, particularly when CEOs lack accounting expertise? Anticipating that possibility, the professors analyzed the relationship of the accounting expertise of CEOs to turnovers of CEOs and found it to be insignificant, leading them to conclude that "boards' decisions to retain the founder CEO are not due to the lack of accounting expertise."

The researchers also found that the amount of stock owned by the CEO was not a significant factor in chief execs' continued tenure in firms with irregularities. Instead, their survival "is consistent with the board of directors recognizing that replacing the founder CEO with the next best manager will reduce firm value."

The firms analyzed in the study are drawn from databases of corporate restatements compiled by the Government Accountability Office spanning the 10 years 1997-2006. Restatements were classified as irregularities, as distinct from accounting errors, if firms used variants of the words "irregularity" or "fraud" in describing misstatements or if companies announced an independent internal investigation or if the SEC or US Department of Justice conducted an investigation. Of 666 firms that met these conditions, the professors focused on those that had irregularities within eight years of their initial public offering, thereby increasing the likelihood that CEOs would be founders. The final sample consisted of 96 firms with irregularities, 24 of which had founders as CEOs and 72 of which did not.  The authors then selected a control sample by matching each of the 96 restatement firms to a non-misstating firm based on industry and IPO date.

Among the 24 founder CEOs in companies with irregularities, 14 remained while CFOs left; seven departed, all but one with CFOs; and three survived along with CFOs. Among the 72 non-founder CEOs in firms with irregularities, 37 remained, 17 with their CFOs, and 35 departed, 27 with CFOs. As expected, turnover rates were substantially less for executives of control firms, where there was no significant difference in turnover rates between founder CEOs and non-founder CEOs.

The authors therefore urge regulators to attend to "the nature and level of independence involved in [companies'] investigatory process around accounting irregularities. The vast majority of the firms in our sample announced an internal investigation into the alleged accounting irregularities. Nonetheless, evidence suggests that these board-initiated investigations may lack objectivity when the CEO in question is also the founder of the firm."

As for CFOs in firms headed by founders, their plight is suggested by the case of one officer cited in the study who wrote to his company's directors expressing concern about the pressure to which he was subjected to manipulate the firm's earnings. In the words of company records, "The Audit Committee of our Board of Trustees initiated an investigation promptly following receipt of a letter [from the CFO] alleging among other things, a 'tone at the top' problem within management, and raising concerns regarding various accounting methodologies that were being considered by management in connection with certain transactions."

How was the CFO's initiative rewarded? "Although [the] audit committee concluded that no wrongdoing had occurred," Leone and Liu note, "the firm decided to restate its earnings and fire its CFO on the same day."

The study, entitled "Accounting Irregularities and Executive Turnover in Founder-Managed Firms," is in the January/February issue of The Accounting Review, published six times a year by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA or its specialty sections include Accounting Horizons, Issues in Accounting Education, AUDITING: A Journal of Practice and Theory, Behavioral Research in Accounting, The Journal of the American Taxation Association, and The Journal of Management Accounting Research.

 

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