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Transparency in financial restatements becomes less likely as more pay of top execs is linked to stock price, study finds

During the past two years companies making financial restatements have set a dubious record: more than three fourths have made what are sometimes referred to as "stealth" disclosures. This means they have chosen to disclose restatements in a way other than the most transparent one – the one that sends the clearest signal of prior accounting errors to investors – namely, filing Form 8-K with the SEC. 

Should this be a concern? In 2003, the year before the SEC's landmark strengthening of restatement-reporting requirements, one third of restating companies filed 8-Ks, and in 2005 two thirds did, both well above the recent levels. True, the commission's mandate that companies file this form is less than absolute, permitting firms to employ some less transparent means if the amounts involved are not material. But are companies using this loophole to avoid 8-Ks for other reasons than materiality?

New research suggests a significant number are doing just that. A paper in the September issue of the American Accounting Association journal Accounting Horizons, analyzes close to 1,200 corporate restatements and finds that the more top executives' pay is dependent on their companies' stock price, the greater the likelihood of stealth disclosures. It also suggests that firms' CFOs are likely to be more of a barrier to this practice than regulators, given that their compensation is generally less dependent than that of CEOs on stock performance.

Observing that "lower-transparency restatement disclosures are associated with less unfavorable market reactions than 8-K disclosures," the study's authors, Brian Hogan of the University of Pittsburgh and Gregory A. Jonas of Case Western Reserve University, write that, "by avoiding the high-transparency disclosure of restatements, executives can attempt to soften the effect of negative market reaction on company stock, provide more time to manage stock sales to their advantage, reduce the risk of being terminated, and minimize damage to their reputations."

Yet, the interests of CEOs and CFOs where restatements are concerned can diverge markedly, the study notes. As the professors explain, "prior literature shows that CFOs face more severe penalties than CEOs in the form of job loss and labor market penalties... With greater equity rewards at stake, CEOs may be more willing to take the risk of a low-transparency restatement disclosure. Conversely, CFOs, having relatively less equity-based pay and the risk of more severe penalties may be less willing."

In sum, "as the disparity in the equity-based pay proportions between these two executives increases, the likelihood of a high-transparency disclosure of a restatement increases. Conventional wisdom for executive pay has been to increase the equity component of pay to better align management interests with shareholder interests. However, to the extent greater equity-based pay supports low-transparency disclosures, pay-structure alignment between [these two] executives may not always be in the best interests of stakeholders."

Profs. Hogan and Jonas reached these conclusions through an analysis of 1,178 corporate financial restatements issued from August 2004 – when the SEC implemented an 8-K filing requirement (softened shortly thereafter) – through December 2013. Instances where Form 8-K was filed were defined as highly transparent. Low-transparency disclosures mostly entailed simply correcting items in misstated prior financial statements without taking special steps to signal the changes to investors. In addition, a smaller number of low-transparency cases consisted of formal amended filings, which can pertain to a multitude of company issues other than financial ones and may attract no more than a cursory look from investors. 

The professors analyzed the relationship of these different disclosures to the percentage of CEO and CFO pay that was composed of stocks or stock options. In doing so, they controlled for a large number of factors that affect disclosure choice, such as magnitude of misstatements, the number of periods misstated, the quarter in which a restatement was issued, and whether it was initiated by management or an external auditor.

The professors found that in companies which issued high-disclosure restatements a mean of 45% of CEO pay and 38% of CFO pay was stock-related, while in low-disclosure companies the comparable figures were 46% and 43%. In other words, the mean difference in the former group was more than twice as great as in the latter.

Further, in analysis that took controls into account, the percentage of executive pay that was stock-based proved to be significantly related to disclosure transparency, with higher percentages for both CEOs and CFOs translating to lesser transparency. The difference between CEO and CFO percentages was also significantly related to transparency, with greater difference translating into greater transparency.

In conclusion, the professors question the effectiveness of the current regulatory regime as it pertains to restatements. "By maintaining a presumption of innocence and appearance of forthright reporting," they write, "executives might reasonably expect to mitigate the likelihood and magnitude of SEC enforcement actions as well as position themselves more favorably to defend against lawsuits. However, our results suggest that executives with a higher proportion of equity-based pay are less likely to choose a high-transparency restatement disclosure. Thus, either the regulations and stakeholders do not mete out penalties of sufficient severity, or the penalties are assessed too infrequently, to be a deterrent to low-transparency restatement disclosures."

Asked if investors would be better off had the SEC stuck with its original inclination 12 or more years ago to require 8-K filings for restatements, the authors note that there was less ambiguity in the original regulation; currently a restatement may be disclosed in less obvious ways based on judgment of companies and their auditors. Absent any change in current regulation, they add, investors will do well to check firms’ proxy statements and look for daylight between the pay structures of the CEO and the CFO.

The new study, entitled "The Association between Executive Pay Structure and the Transparency of Restatement Disclosures,” is in the September issue of Accounting Horizons, published quarterly 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 The Accounting Review, Auditing: A Journal of Practice and Theory, 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. In addition, the AAA is inaugurating two new publications, the Journal of Financial Reporting and Journal of Forensic Accounting Research.