The Advisors' Blog

– Broc Romanek, CompensationStandards.com

Here’s an excerpt from this article from Accounting Today:

The clawbacks on executive compensation mandated by the Dodd-Frank Act may discourage one type of accounting manipulation only to encourage another, according to a new study. Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act contained a provision requiring all publicly listed companies to recover from executives any incentive compensation that was paid to them on the basis of erroneous financial statements. The Securities and Exchange Commission has still not determined exactly how the clawback provision will be enforced and it is not yet mandatory. But many companies have voluntarily enabled or required themselves to implement them.

While 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 study appears in the January/February issue of The Accounting Review, a scholarly journal from the American Accounting Association, and was written by Kevin C. W. Chen and Tai-Yuan Chen of the Hong Kong 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 new paper found that the clawback provision reduces 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 particularly subject to manipulation because they often entail some element of guesswork, such as 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 or by slashing prices or easing credit terms to accelerate sales.

Clawback provisions “deter managers from using accruals management because high accounting accruals tend to attract more scrutiny from the SEC and auditors,” according to the study, increasing 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.”