How important is accounting knowledge for CFOs and other top corporate executives?
When the financial director of a major bank declared around the turn of the century that “the day of the finance director as bean counter is well and truly over,” he was reflecting much contemporary thinking. But, perhaps as a result of this century’s notorious corporate accounting scandals and severe global economic downturn, public opinion appears to have shifted.
“Academics, practitioners, and regulators frequently focus on the upside of accounting competence providing higher-order ability to generate financial reports free of material misstatements,” according to a new scholarly study.
In line with this trend, the Public Company Accounting Oversight Board, established by the United States Congress in 2002 in response to major accounting scandals, identifies a lack of managerial accounting competence as a major risk factor for financial misreporting.
In a 180-degree turn, a new scholarly paper published in the November issue of the American Accounting Association journal The Accounting Review investigates a previously unexplored question: whether the presence or absence of accounting expertise among top company executives can jeopardise financial reporting.
According to the study, “Do Auditors Recognize the Potential Dark Side of Executives’ Accounting Competence?” The discovery has significant implications for regulators, corporate directors, and, most importantly, external auditors who are responsible for certifying the accuracy of client companies’ financial statements.
Accounting professors Anne Albrecht of Texas Christian University, Elaine Mauldin of the University of Missouri, and Nathan Newton of Florida State University discovered that executives’ backgrounds as partners or managers in audit firms can significantly increase the present likelihood of financial misstatements in a study of over 3,000 public companies.
They write that prior experience “provides extensive knowledge of audit procedures and negotiation tactics.” As a result, when the external auditor finds misstatements, executives may use their higher-order ability to conceal them or avoid current-period adjustments.” After all, it is only later that the misreporting is revealed.
In short, accounting competence in the C-suite is a “two-edged sword” that can either enhance or undermine financial reporting, according to the professors.
“We do not expect that accounting competence alone leads to misstatements,” they go on to say, “because accounting competence may provide the ability to produce reliable financial reports, and we have no reason to expect more or less integrity from executives with accounting competence than from those without.” Accounting competence, on the other hand, interacts with other fraud-risk elements to increase the risk of material misstatement.”
What are the other fraud-risk factors? The professors concentrate on executive pay because “auditing standards specifically include them in risk assessment, and prior research suggests compensation-based incentives induce misstatement.”
Indeed, the study discovers that accounting expertise among top corporate executives significantly increases the extent to which executive compensation excesses induce financial misreporting.
When auditing backgrounds were not present in top management, companies with executive pay well above the median (at the 75th percentile) were only about 4% more likely to misstate than firms with lower pay (at the 25th percentile).
When audit-firm experience was present in executive suites, however, the high-pay firms were about 30% more likely to misstate than their low-pay counterparts. This is referred to as the “downside to a management characteristic considered beneficial in auditing standards” by the professors.
An apparent lack of awareness of this disadvantage among external auditors contributes significantly to the problem. Although auditors typically charge companies higher fees in response to excesses in executive pay, the increase is much smaller when the executive suite includes an auditing background.
“This result is consistent with auditors’ overconfidence in executives’ accounting competence and discounting the fee premium associated with excess compensation,” according to the study report.
To put it another way, “executives’ accounting competence raises the risk of material misstatement when combined with compensation-based incentives to underreport.” However, we find that audit fees do not reflect this increased risk, implying that auditors focus on the benefits of accounting competence.”
Over a 10-year period, the study used data from 3,252 public companies. An average of about 12% of the firms (as listed in proxy statements or annual reports) had prior audit experience as a partner or manager at a public accounting firm in any given year.
Approximately 61% of the executives with this background were CFOs, and approximately 9% were CEOs. Approximately 10% of company financial reports contained errors that were later corrected by restatements.
The professors calculated expected compensation based on a variety of factors, including company size, complexity, and financial performance, as well as executive tenures and management-ability scores.
The amount by which this estimate differed from the actual total pay was referred to as “excess compensation.” The results, which ranged from negative to positive (below and above expected levels), served as the foundation for ranking companies based on pay.
Past auditing experience among top executives did not increase the likelihood of financial misreporting significantly on its own. However, the likelihood increased significantly when that expertise was combined with excessive executive compensation, to the point where high-pay firms became significantly more likely to misstate than low-pay counterparts.
According to the study, “in the presence of compensation-based incentives, a dark side of accounting competence emerges.”