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Executive-pay clawbacks mandated by Dodd-Frank may not be the boon to investors they were intended to be, new study says
Clawback adoption reduces one kind of accounting ploy only to increase another
With the 114th Congress intent on trimming, or even cleaving, Dodd-Frank, some new research raises questions about one popular section of the act that happens not to be a principal target of lobbyists..
A study in the current issue of The Accounting Review, a scholarly journal from the American Accounting Association, finds that a heralded provision of the controversial 2010 law is likely to have an unwelcome unintended consequence -- namely, section 954, Dodd-Frank's so-called "clawback" mandate, which requires all firms listed on national securities exchanges to recover from executives any incentive compensation that was paid to them on the basis of erroneous company financial statements.
With regulators still wrestling with how exactly this will be enforced, clawbacks are not yet mandatory, but many companies have voluntarily enabled or required themselves to implement them. And, although previous research has found that such provisions reduce the number of corporate financial restatements and increase investor confidence in financial reports, the new research suggests that the gains implied by those findings may be more illusory than initially thought.
The new paper finds that, yes, adoptions of clawback provisions do reduce the incidence of one kind of earnings manipulation -- "accruals management" -- only to increase the incidence of another that is equally, if not more, adverse to investors -- that is, "real-transactions management." Accruals are non-cash accounting items that are particularly subject to manipulation because they typically entail some element of guesswork -- for example, predictions of future write-offs for bad debts or estimates of inventory valuations. Real-transactions management, in contrast, involves altering actual expenditures to achieve a temporary earnings boost, such as by cutting research and development (R&D) or by slashing prices or easing credit terms to accelerate sales.
As the study explains, clawback provisions "deter managers from using accruals management because high accounting accruals tend to attract more scrutiny from the SEC and auditors," which increases the likelihood of clawback-triggering financial restatements. But "real-transactions management, such as cutting back on R&D or on selling, general, and administrative (SG&A) expenses, is considered less risky." Even though it "represents a deviation from optimal business practices...it is unlikely to be deemed improper by auditors and regulators."
The result? A policy of "clawback adoption leads to less accruals management but greater real-transactions management." The latter tactic, the study goes on to show, produces a temporary blip in stock and operating performance followed by downturns in subsequent years, a finding "consistent with the notion that real activities management boosts short-term profits but sacrifices long-term firm value."
Comments a co-author of the paper, Kevin C. W. Chen, of the Hong Kong University of Science and Technology, "Mandating clawbacks, as Dodd-Frank does, is, at best, of dubious value and may actually be counterproductive in its encouragement of management practices, like reduced R&D, that can compromise the long-term competitiveness of a firm. Since the clawback policy 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 be come to pass when the law is fully enforced."
Collaborating with Prof. Chen on the research were Tai-Yuan Chen, a colleague at the University of Science and Technology; Lillian H. Chan of the University of Hong Kong; and Yangxin Yu of the City University of Hong Kong.
The study's findings derive from an analysis of financial reporting by companies included in the Russell 3000 index, which consists of the 3,000 largest U.S. firms. The researchers compared data of 236 companies that adopted clawback provisions over the five years preceding passage of Dodd-Frank (2005 through 2009) with an equal number of non-adopters closely matched with them in other respects. The principal focus was on how the adopters modified their use of accruals management and real-transactions management from the years preceding clawback adoption to those following it and how that compared with the analogous data from non-adopters. Real-transactions management was discerned through three measures -- 1) amount of discretionary expenses (those for R&D, advertising, and SG&A); 2) volume of overproduction of goods (to reduce costs per unit); and 3) cash flow from operations (reflecting price discounts and credit leniency).
The professors found that earnings-inflating accruals actually declined from pre-adoption to post-adoption of clawback provisions, while no significant effect was seen in non-adopters. Meanwhile, the amount of discretionary expenses and cash flow from operations both declined among adopters (the changes in both cases highly significant statistically), signaling a flurry of real-transactions management to boost earnings. No changes that clear were seen among non-adopters.
These patterns among adopters were largely limited, the study further reveals, to two subgroups of companies -- those with high-growth opportunities (that is, above the median in market-to-book ratio) and those with high levels of transient institutional ownership. Firms in the former group, the study explains, experience a sharper decline in stock price than value firms if they miss consensus forecasts and also rely to a greater extent on stock options and restricted stock in fashioning executive pay. As for the latter group, they must contend with investors whose portfolios have high turnover, investors who, in the words of the study, "tend to place significant focus on short-term earnings targets, which incentivizes managers to cut R&D investments to avoid negative earnings surprises."
The authors believe their findings to be of value not only to regulators but to investors as well. As Prof. Kevin Chen explains, "Investors should be on the lookout for a switch from accrual-based manipulation to real- transactions management following clawback adoption, particularly among firms under high pressure to achieve short-term earnings targets based on analyst forecasts. Since companies commonly provide three years of financial data in annual reports, investors can easily determine whether there has recently been a decrease in R&D or SG&A expenses and whether managers provide credible justification for any that occur."
Entitled "Substitution between Real and Accruals-Based Earnings Management after Voluntary Adoption of Compensation Clawback Provisions," the study is in the January/February issue of The Accounting Review, published every other month by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA and its specialty sections include Auditing: A Journal of Practice and Theory, Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Journal of Information Systems, and The Journal of the American Taxation Association.