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The impact of the financial crisis on

CFO bonus plans

Name: Kim Koolhof Student number: 10871942

Date of final version: 22 June 2015 Word count: 8617

MSc Accountancy & Control, variant Control Amsterdam Business School

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S

TATEMENT OF ORIGINALITY

This document is written by student Kim Koolhof who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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Abstract

Despite widespread recognition that firms have to trade-off CFOs’ decision-making duties against their fiduciary duties in the design of CFO bonus plans, no research has been done on how management deals with this trade-off in times of financial crisis. Under influence of the financial crisis, the role of the CFO changed with an increased emphasis on decision-making duties. Given the limited span of attention and effort of managers, this may be at the expense of CFOs’ fiduciary duties. The objective of this paper is to examine how companies through CFOs compensations state their priority between internal control quality (fiduciary duties) and the evolved CFOs responsibilities (decision-making duties). From a sample of 4016 firm-year observations from 1128 firms, I find that the dependence on internal control quality in CFO bonus plans does not change in the shift from the pre-crisis period into the crisis period. Additionally, the results indicate that the increased emphasis on the productive decisions of CFOs does not go at the expense of their fiduciary duties. Some evidence suggest that CFOs are less strongly incentivized on the basis of accounting measures during the crisis while other results show no effect of the crisis. In summary, my results indicate that the financial crisis does not change the weight on performance measures in CFO bonus plans. The increased role of the CFO under influence of the financial crisis is not reflected in CFO bonus plans.

Keywords: Executive bonus plans, chief-financial officer, financial crisis, performance measures

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Table of content

1.Introduction ... 5

1.1 Background ... 5

1.2 Research question ... 6

1.3 Motivation and contribution ... 7

1.4 Structure ... 8

2. Literature review and hypothesis ... 8

2.1 CFO responsibilities and compensation ... 8

2.2 Sarbanes-Oxley act (SOX) and CFO compensation ... 9

2.3 Development in CFO responsibilities and compensation ... 11

3. Method ... 14

3.1 Sample design ... 14

3.2 Empirical model ... 14

3.2.1 Empirical test of hypothesis 1 ... 14

3.2.2 Empirical test of hypothesis 2 ... 15

3.3 Control variables ... 16

4. Results ... 17

4.1.Descriptive statistics ... 17

4.2.Results of hypothesis tests ... 19

4.2.1 Productive decisions in CFO BONUS plans ... 19

4.2.2 Fiduciary duties in CFO BONUS plans ... 21

5. Conclusion and discussion ... 24

References ... 26

Appendix: Variable definitions ... 30

             

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Introduction

       

1.1 Background

   

 

After a couple of high profile corporate scandals, The Sarbanes-Oxley Act (SOX) was introduced in 2002. The main goal of the act was to improve the quality of financial reporting and to increase investor confidence. One of the significant provisions is section 404, which requires management to annually disclose its assessment of firm’s internal control structure and procedures for financial reporting. Section 404 also requires auditors to report on management’s assessment of internal control structures. The auditor’s report must include the disclosure of any material control weaknesses. Ineffective internal controls increases the risk of misstatements, which results in less reliable financial statements with consequences such as a higher cost of capital, higher audit fees, lower bond ratings and auditor resignations (Hoitash, Hoitash and Johnstone, 2012).

Chief Financial Officers (CFOs) play a key role in corporate reporting and also have an important effect on quality of internal controls. In more general terms, CFOs have decision-making duties (so called productive decisions) but also have fiduciary duties geared towards the integrity of financial reporting. In 2009, Indjejikian and Matejka show that firms that want to emphasize the fiduciary duties of CFOs (e.g. when the cost of misreporting is high for those firms) provide less bonus incentives tied to accounting measures. The authors conclude that firms mitigate misreporting practices in part by deemphasizing CFO incentive compensation. Likewise for a sample of firms in 2005, Hoitash et al. (2012) found that in the post-SOX period, CFO compensation is negatively associated with internal control material weaknesses disclosures (ICMWD). This implies that directors use ICMWD when evaluating CFO performance. These studies show that in the post-SOX period CFO compensation is likely to depend more on their fiduciary duties. SOX has made firms much more concerned about the integrity of their financial reports, because of the increased costs of non-compliance for firms (e.g. higher cost of capital).

Under influence of the financial crisis, the role of CFOs changed with an increased emphasis on the productive decisions of CFOs. To respond to a changing landscape, CFOs responsibilities have shifted towards more focus on cost control and cash management and CFOs are taking greater responsibilities for long-term corporate planning and policy (Giles, 2014). This may even be at the expense of their fiduciary duties, for example, a decreased emphasis on strengthening and safeguarding the quality of internal controls. Firms may

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encourage these productive decisions by emphasizing accounting measures in CFO bonus plans. However, companies may also try to balance the productive and fiduciary duties of CFOs by emphasizing accounting measures in CFO bonus plans while not decreasing the emphasis on the quality of internal control measures in CFO bonus plan. Ultimately, firms face a trade-off between CFOs decision-making duties versus their fiduciary duties given the limited effort and attention span of managers when deciding how to design a of bonus plan of their CFOs. On the one hand, greater bonus incentives tied to accounting measures benefit CFOs productive responsibilities, but on the other hand this goes at the expense of incentivizing their fiduciary duties because lower bonus incentives benefit CFOs fiduciary duties

Taking together, we have seen that CFOs have fiduciary duties geared towards integrity of financial reporting but also have productive decisions making duties on for example financial planning, budgeting and corporate taxes. When designing a bonus plan for CFOs, firms face a trade-off between these two duties. We have seen that SOX has emphasized the fiduciary duties of CFOs by providing less bonus incentives tied to accounting measures. Besides this focus on fiduciary duties, we have also seen that under influence of the financial crisis, the role of CFOs has changed by emphasizing productive decisions of CFOs. Given these recent developments, the question arise how companies through CFO compensation state their priority between internal control quality (fiduciary duties) and the evolved CFOs responsibilities (productive decisions). This seems complicated because firms have to trade-off CFOs fiduciary duties against their decision-making duties in the design of CFO bonus plans. The research will investigate how to balance the productive and fiduciary duties in CFOs bonus plans as response to the economic crisis.

1.2 Research question

                                                                                                                                     

The purpose of this paper is to provide empirical evidence on the following question: ‘‘what is the influence of the financial crisis on CFO bonus plans?’’

More specific the two research questions that arise are:

‘‘Is the dependability of CFO bonus plan toward accounting measures more pronounced in times of financial crisis?’’

‘‘Is the dependability of CFO bonus plan toward internal control quality less pronounced in times of financial crisis?’’

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1.3 Motivation and contribution

 

 

    By examining the development of CFO invectives under influence of the financial crisis, this study contributes in several ways to existing literature. The purpose of this paper is to help fill the void in the literature, by examining the impact of the financial crisis on CFO bonus plans, by extending the work of Hoitash et al. (2012) and Indjejikian and Matejka (2009). For fiscal year 2005, Hoitash et al. (2012) report on the relationship between ICMWD and CFO compensation. 2005 was a period characterized by focus on internal control and financial reporting, however, no research has been done yet for more recent years on the relationship between ICMWD and CFO compensation since the introduction of the SOX. Indjejikian and Matejka (2009) provided a framework that characterizes CFO bonuses as a trade-off between CFOs’ decision-making responsibilities and their fiduciary duties over financial reporting. This framework is based on research until 2007. Theoretical insight and empirical evidence on how to develop a CFO bonus plan in times of high pressure due to economic crises seem to be missing, despite literature that suggests that CFOs are increasingly focused on their productive decisions in times of economic crisis. There is widespread recognition that firms have to trade-off CFOs’ decision-making duties against their fiduciary duties, but no research has been done yet on how management deals with this trade-off in times of economic crisis. Therefore, the purpose of this paper is to fill this gap in the literature. Second, by examining the development of CFO incentives, this study also contributes to existing literature on executive compensation. A lot of prior research has focused on examining the relationship between executive compensation and firm performance. However, the majority of these studies are based on CEO compensation, due to the assumption that CEOs are the primary decision makers of firms (Balsam et al., 2012). We have seen that in recent years, CFOs has become increasingly important to firms. Greiger and North (2006) shows that CFOs has a substantial amount of control over a firm’s reported financial results and research shows that CFOs are an important determinant of accounting practices (Ge, Matsumoto and Zhang, 2011). This study contributes to the literature on CFO compensation by examining the relationship between CFO bonus plans and the financial crisis. Third, this study offers a more integrated approach by providing a comprehensive view at CFO incentives. It looks at both CFOs productive and fiduciary duties. Prior literature (e.g. Indjejikian and Matejka, 2009) has adopted a one-dimensional approach by solely looking at one dimension of the trade-off. Those studies have only looked at how productive or fiduciary

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duties are incentivized. This study contributes by looking at the impact of the financial crisis on both how the productive and fiduciary duties are incentivized.

1.4 Structure

 

    The remainder of this paper will be structured as follows. Section two discusses the prior literature and hypothesis development. The research methodology is discussed in section three. Section 4 provides an overview of the empirical results and section five will present the conclusion and research limitations.

2. Literature review and hypothesis

 

2.1 CFO responsibilities and compensation

Executive compensation has long been examined. According to the agency theory, incentive compensation is generally thought to be a useful tool to align executive’s interests with those of shareholders or to motivate the executives to perform (Murphy, 1999). Moreover, the agency theory suggests that boards and compensation committees should use low-cost, observable performance metrics that can be attributed to CFOs in their performance evaluation (Holmstrom, 1979). CFOs have both managerial duties and fiduciary duties (Indjejikian and Matejka, 2009). They have a fiduciary responsibility to produce financial statements that fairly represent the firm’s financial condition (Indjejikian and Matejka, 2009). Relative to other executives, CFOs effort in this regard is likely to be the most important determinant of financial reporting quality (Mian, 2001). In addition to fulfilling this fiduciary responsibility, CFOs also have significant decision-making responsibilities, because they often serve as members of firm’s executive team (Siegel and Sorensen, 1999). These managerial duties include contributing to operational decisions, which effects firm financial performance (Mergenthaler, Rajgopal and Srinivasan, 2011). More specific, to fulfill their productive decisions they make decisions on financial planning and budgeting, corporate taxes, debt vs. equity financing, treasury, dividend and share repurchase policies, mergers and acquisitions (Brav, Graham, Harvey, and Michaely 2005; Gore, Matsunage, and Yeung 2011). Assuming that the principal’s task is to motivate the CFO to perform their productive tasks as well as motivate the CFO to perform his fiduciary duties, firms face a trade-off between the importance of CFOs’ decision-making duties and the importance of their fiduciary duties (Indjejikian and Matejka, 2009). Where does this trade-off come from? Since incentives for

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financial performance may be necessary to motivate CFOs to perform their decision-making responsibilities, this effectively means that CFOs are rewarded based on performance measures they themselves generate. Therefore, incentive weight on financial performance in CFO bonus plans is positively associated with proxies that capture the importance of CFOs decisions making responsibilities but negative associated with fiduciary responsibilities (Goldman and Slezak, 2005). Without the possibility of misrepresentation, so when manipulation can be perfectly prevented via monitoring, incentive contracts only needs to emphasize managerial effort. However, absent the ability to perfectly prevent manipulation via monitoring, the compensation contract will be susceptible to manipulation, resulting in an equilibrium contract that balances the net benefit of effort with the cost of manipulation (Goldman and Slezak, 2005).

2.2 Sarbanes-Oxley act (SOX) and CFO compensation

After a couple of high profile corporate scandals including Enron and WorldCom, the Sarbanes-Oxley Act (SOX) was introduced in 2002. SOX places a great deal of emphasis on the effectiveness of internal control over financial reporting, which aims at providing reasonable assurance regarding the safeguarding of assets and that financial information is reliable (Public Company Accounting Oversight Board (PCAOB), 2007). SOX changes the public assertion, audit, and audit reporting landscape in two steps. First, section 302 of SOX (August 29, 2002) requires that officers certify the financial statements, including the effectiveness of the internal control over financial reporting and any material changes in internal control (Skaife, Collins, Kinney and Lafond, 2008). On June 5, 2003, the US Securities and Exchange Commission (SEC) adopted rules to implement Section 404 under SOX. Companies with fiscal year ending on/or after November 15, 2004 must comply SOX 404. Section 404 requires firms to prepare a report, which include a management assessment of effectiveness of internal control over financial reporting. A separate report is required from the firm’s external auditor providing an attestation opinion on management’s assessment of internal control effectiveness (Myllymäki, 2014). Auditors are required to indicate in their reports any material weaknesses found in the company’s internal control. An unqualified SOX section 404 opinion indicates that internal controls are ineffective.

A material weakness is defined as ‘‘a significant deficiency, or combination of significant deficiencies that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected’’

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(Public Company Oversight Board, 2004). Moreover, material weaknesses can exist when the design or operation of internal controls does not allow for the prevention or detection of a misstatement on a timely basis, which can result in a material misstatement in the financial statements (Chan, Farrel and Lee, 2008). In the empirical work to follow, internal control deficiencies disclosures made under SOX section 302 and section 404 are used as indicators of poor-quality accounting information.

SOX has prompted many studies into consequences of internal control material weaknesses. In 2008, Chan, Farell and Lee discovered the relationship between firms reporting ICMWs under section 404 of the Sarbanes-Oxley act and earnings management. They found that section 404 has the potential benefits of reducing the opportunity of intentional and unintentional accounting errors and improving the quality of reporting. Academics and practitioners have recognized and documented the importance of good internal control to the survival of organizations. Moreover, a study on the relationship between material weaknesses (MW) and cost of equity find evidence that material weaknesses negatively impact a firms cost of equity (Gorden and Wilford, 2012).

Before SOX, information about internal control quality was not readily available. Due the prohibitive cost of gathering performance information, boards typically settle for imperfect measures of performance such as market returns or earnings (Devers, Canella, Reilly and Yoder, 2007). These financial measures are imperfect because stock prices are highly sensitive and often depend on other factors beyond the CFOs control (Hoitash et al., 2012). Given the difficulties associated with these financial performance measures, nonfinancial performance measures can be a useful complement in evaluating CFOs performance (Hoitash et al., 2012; Feltham and Xie, 1994). Because of SOX, information about internal control quality is readily available as firms are required to gather internal control data regardless of their potential usefulness in CFO performance measurement (Hoitash et al., 2012). Therefore the reliance on financial performance measures in CFO bonus plans has been complemented by a reliance on non-financial performance measures. Moreover, SOX has made firms much more concerned about the integrity of their financial reports because of increased cost of non-compliance for firms. Prior research shows that incentives can discipline CFOs for their failure to maintain effective internal controls as well as to motive them to improve internal control problems. In line with the agency theory, Hoitash et al. (2012) found a negative relation between ICMWD and CFO compensation. Using a model they empirically examined the effect of CFOs fiduciary duties while controlling for CFOs managerial duties on compensation outcomes. The study provides new

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insight concerning the effect of SOX as it relates to changes in monitoring, reporting and certification of internal controls. More importantly, the results suggest that CFOs are held accountable not only for their managerial duties as reflected in firm financial performance, but also for their fiduciary duties associated with accurate financial reporting and high-quality internal controls.

2.3 Development in CFO responsibilities and compensation

 

   

Since the global financial crisis the role of the CFOs changed with an increased emphasis on the productive decisions of CFOs. This because their jobs have expanded to include crisis management (Giles, 2014).

Many observers consider the 2007-08-credit crisis the world’s deepest since the Great Depression of the last century. The origins of the crisis were initially attributed to governance failures in the financial sector. The collapse of the US real-estate market and the subsequent failure to offload subprime risks ultimately resulted in a credit crisis (Gregoriou, 2009). Governments, firms and consumers worldwide were negatively effected by worsening liquidity and decreasing confidence in international financial markets and banks were reluctant the lend money (Williams and Martinez, 2012). This situation demanded for constant attention and frequent changes in priorities and strategies, which required changes in the highest level of corporate hierarchy. Many firms were faced with severe threats that called for immediate action to ensure firm survival. Actions like massive cost-cutting, cash generation, shorting reporting cycles and tight budget control seemed necessary to cope with a decline in orders and revenues to ensure an appropriate and well-coordinated response to changed environmental conditions (Asel, Posch, Speckbacker, 2010). To ensure this, company’s exploit the strategic vision and leadership skills of the CFO to help create and execute business plans to survive. Therefore, CFOs jobs has transformed into that of a strategic advisor who is focused on the future (Giles, 2014). More evidence for this transformation towards an increased emphasis on productive decisions under influence of the financial crisis is found in several studies. For instance, of 164 CFOs questioned in a McKinsey survey last year, 87.8% reported that their CEOs expected them to play an active part in shaping their companies strategies. According the article, this change in responsibilities is not about the demands brought upon the position by SOX of 2002, that is yesterday’s challenge. Rather this call is a fundamental demand that the CFO play a major role in changing the business together with the CEO. Likewise, during 2010 and 2011, EY

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conducted two surveys of top finance executives across Europe, the Middle East, India and Africa (EMEIA) whit the purpose to get a better inside on the increasingly complex role of today’s CFOs. Overall they found that alongside their traditional mandate to provide financial insights and analysis, CFOs describe a greater involvement in supporting and even developing strategy, guiding key business initiatives (EY, 2012). More specific, the interviewees agreed that CFOs today must maintain a strong relationship with the CEO, because they have an important role to play in supporting strategy and helping to develop it. They also agreed that the CFOs nowadays contributes to operational decision-making, CFOs manage or materially support information technology, investor relations, and real estate and some are involved in commercial activities. Besides these new roles, they found that fundamental skills in finance are still paramount. Given the substantial impact that the credit crisis has had on the behavior of investors and banks, the question how to finance investments or refinance to decrease the cost of capital has become increasingly important for CFOs in recent years.

Overall, previous research suggests that while the more traditional roles and functions of the CFO still remain important, the CFOs role is fast changing. CFOs are increasingly involving themselves in all areas of company management including strategy selection, operation and finance. These developments are certainly reflective of increased firm pressure due to economic crisis. Based on this literature review, I propose that CFO bonus plans are more tied to accounting measures in times of economic crisis. The first hypothesis is;

Hypothesis 1: During the financial crisis, CFO bonus plans depend relatively more on accounting measures than before the financial crisis

Asel et al. (2010) found that firms acknowledge the need to adjust their management control system to the new challenges arising form the occurrence of economic crisis. According the article, firms should shorten reporting cycles because they seek for more up-to-date information. In this way, firms that are put under severe pressure by an economic crisis would be able to focus on financials to support and monitor cash management as well on cost-cutting activities. There is also evidence that recessions induce economic stress that leads to a higher incidence of fraud. This due to reduced internal controls caused by cost-cutting effort (AFCE, 2009). In other words, there is some evidence that an increased emphasis on the productive decisions of CFOs goes at the expense of their fiduciary duties. While CFOs still have to comply with all the reporting standards they also have to take greater responsibilities for long term corporate planning and policy. According the agency theory, incentive

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compensation is a useful tool to motivate executive’s to perform their tasks. Unfortunately, when designing a compensation plan for CFOs, firms face some difficulties because companies face a trade-off between CFOs fiduciary duties and their decisions-making duties in the design of CFO bonus plans. Given the pressure on CFOs due to the economic crisis, finding the right balance between these duties seems to become even more difficult. The increased emphasis on the productive decisions of CFOs may translate into a greater weight assigned to accounting measures in CFO bonus plans. Given the limited span of attention and effort of managers, this may be at the expense of CFOs’ fiduciary duties. Firms may try to balance this by also increasing the weight on fiduciary measures (however, possible at a lesser extent). Furthermore, the importance of financing decisions especially in a credit crisis may also imply that the quality of financial reporting is key. This may also lead to an increased emphasis of fiduciary measures in CFO bonus plans. However, notwithstanding the tension described before, most literature especially emphasized the importance of productive duties of CFOs during the financial crisis. So, the second hypothesis is formulated as follows;

Hypothesis 2: During the financial crisis, CFO bonus plans depend relatively less on internal control measures than before the crisis

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3. Method

3.1 Sample design

First, I obtained data on CFO compensation from ExecuComp for the sample period 2005-2010. The coverage of ExecuComp database roughly corresponds with the S&P 1500. This yields an initial sample of 6250 observations. Similar to other compensation literature, I eliminate firms in the finance industry (SIC codes between 6000 and 6999) and utilities (SIC codes between 4400 and 4999). These industries are heavily regulated and such firms may face additional provisions and limitation (e.g. limits on compensation), which may influence the findings (Chan et al. 2008). Furthermore, I dropped all missing data on CFO bonuses. I then obtained firm characteristics and performance data from COMPUSTAT. After dropping incomplete observations and merging Compustat data with ExecuComp data, the sample size is reduced to 4275 observations. Data on internal control quality is gathered from Audit Analytics. Missing data on these variables lead to the exclusion of 257 observations. My final sample is composed of 4016 firm-year observations derived from 1128 unique firms.

3.2 Empirical model

 

3.2.1 Empirical test of hypothesis 1

 

    In this section the model used to empirically test the first hypothesis is described. I examine whether firms changed the relationship between the level of CFO bonus and the level of accounting performance in response to the financial crisis. In particular, the dependence on accounting measures in CFO bonus plans from 2005 to 2007 is compared to the dependence of accounting measure in CFO bonus plans from 2008 to 2010. The regression equation is formulated as follows:

CFO_BONUS = β0 + β1Accounting measure + β2Accounting measure*Crisis + β3Crisis + CONTROLS + ε

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CFO_BONUS = Defined as formula-based bonuses supplemented by discretionary bonuses 1

ROA = ROA is used as accounting measure, which is calculated as the ratio of accounting earnings before interest and taxes divided by total assets

CRISIS = Crisis is a dummy variable for the crisis equal to one for the fiscal years 2008, 2009 and 2010 and equals to zero for the pre-crisis years

The coefficient β1 give the relationship between ROA and CFO bonus before the economic crisis. The sum of the coefficients (β1 + β2) give the relationship between ROA and the CFO bonus in the crisis period. So the coefficient β2 represents the difference in the relation between ROA and CFO bonus between the pre-crisis and crisis period. On the basis of my hypothesis, I expect that β2>0.

3.2.2 Empirical test of hypothesis 2

 

In addition to the first model, my second regression model examines whether firms changed the relationship between CFO bonus and ICMW disclosure in response to the financial crisis. In particular, the dependence on internal control measures in CFO bonus plans from 2005 to 2007 is compared to the dependence on internal control measures in CFO bonus plans from 2008 to 2010. The regression equation is formulated as follows:

Δ CFO_BONUS  =     β0 + β1ICMWD+ β2ICMWD* Crisis + β3Crisis + CONTROLS + ε  

Where,

Δ CFO_BONUS = The change in CFO bonus firm year t-1 to year t2

                                                                                                                         

1  Beginning in 2006, ExecuComp altered the definition of some compensation variables. In particular, the

bonus payment for many firms is reported under formula-bases bonuses (noneq_incent) or discretionary bonuses (bonus). The difference between the two is that non-equity incentive plan compensation is paid under a written plan while

discretionary bonuses are not explicitly linked to performance measures and subject to the discretion of the board of director. Previous literature concludes that the closest match of cash pay across 2005 and 2006 is to use bonus for 2005 and to use the

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ICMWD = An indicator variable equal to one if the firm had a material weakness in its section 404 report or in at least one if its section 302 reports, zero otherwise in year t.

The coefficient β1 give the relationship between ICMWD and the change in CFO bonuses before the economic crisis. The sum of the coefficients (β1 + β2) give the relationship between ICMWD and the change in CFO bonus in the crisis period. So the coefficient β2 represents the difference in the relation between ICMWD and CFO bonus between the pre-crisis and the pre-crisis. On the basis of my hypothesis, I expect β2<0.

3.3 Control variables

In this subparagraph, the control variables are explained. Control variables have the aim to improve the robustness of the findings by controlling for alternative explanations. Firm size plays a significant role in explaining CFO bonuses since total compensation is positively related to firm size. Larger firms are more complex and need higher talented CFOs, which requires higher CFO bonuses (Bebchuk and Grinstein, 2005). Therefore the natural log of total assets is used to control for firm size (SIZE). Geiger and North (2006) found a positive relation between firm growth en compensation policies because growth options increase monitoring difficulty. A measure for firm growth (GROWTH) is the book-to-market ratio of equity, which indicates the available growth opportunities for the firm. The financial condition of a firm also may influence the provision of bonuses (Indjejikian and Matejka, 2009). Therefore, leverage (LEVERAGE), which is calculated by dividing total liabilities by the book value of total assets, is included as a control variable. I will also control for accounting performance (ROA) and auditor type. I control for auditor type using an indicator variable for firms audited by big 4 auditors (BIG4). BIG4 is a dummy variable which equals 1 when the firm is audited by a big 4 firm, which includes Deloitte, E&Y, KPMG and PWC, otherwise it equals 0. Finally, I will control for industry effects at the two-digit SIC level.

                                                                                                                                                                                                                                                                                                                                                                                           

2  The focus is on changes in CFO bonuses associated with ICMWD. Therefore, I suggest corresponding with Hoitash et al. (2010) that in year t, when the ICMW is disclosed, firms’ initial response could be reflected in a decline in CFO

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4. Results

 

4.1.Descriptive statistics

 

 

    Table 1 provides the sample composition over industries. The classification of the firm-year observations by industry is made based on two-digit SIC codes. The sample is concentrated in manufacturing and, to a lesser extent, in the service industry.

Table 1

Descriptive statistics per industry

N % of total

Agriculture, forestry, fishing & hunting (SIC: 00-09)

12 0,3%

Mining & construction (SIC: 10-19) 339 8,44% Manufacturing (SIC: 20-39) 2165 53,92% Transportation (SIC: 40-49) 84 2,09%

Wholesale & retail trade

(SIC: 50-59) 534 13,30%

Services (SIC: 70-89)

862 21,46%

International affairs & Non-operating establishments

(SIC: 90-99)

20 0,50%

4016 100%

Table 2 reports descriptive statistics on variables used in both empirical models for the full sample. It shows that on average firms in the sample provide a bonus to their CFOs of $315K. The sample report a mean ROA of 3,2 percent and face growth opportunities as indicated by an average market-to-book ratio of 2.61. The sample consist for 60% out of companies from crisis periods and 89% of the sample consist of companies that are being audited by big 4 audit firms. 5% of the sample has disclosed an ICMW and the average sample finances about 17 percent of the assets through debt.

Table 2 Descriptive statistics

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Stats N Mean sd p10 p25 p50 p75 p90 Crisis 4016 0.60 0.49 0.00 0.00 1.00 1.00 1.00 CFO Bonus 4016 315.17 435.17 0.00 74.78 200.00 400.00 710,00 Δ CFO bonus 2871 47.910 35.57 -183 -44.835 20.00 130.00 319.70 ROA 4016 0.03 0.67 -0.06 0.01 0.05 0.09 0.14 ICMWD 4016 0.05 0.22 0.00 0.00 0.00 0.00 0.00 GROWTH 4016 2.61 2.71 0.79 1.34 2.09 3.29 5.18 LEVERAGE 4016 0.18 0.21 0.00 0.00 0.14 0.27 0.41 SIZE 4016 7.09 1.58 5.22 6.02 6.97 8.10 9.12 Big4 4016 0.89 0.32 0.00 1.00 1.00 1.00 1.00

Table 3 presents pre-crisis and crisis comparisons of the variables, i.e. the year 2005 to 2007 compared with the year 2008 to 2010. There are 1599 observations for the pre-crisis period and 2417 observations for the crisis period. As might be expected, the accounting performance is significantly lower in the crisis years. However, the CFO bonus is not significantly different as indicated by the test for significant differences in means and medians. Firms disclosed on average fewer ICMWs in the crisis years compared to the pre-crisis years. This suggests that during the pre-crisis years, internal control quality has improved.

Table 3

Descriptive statistics – Pre-crisis and crisis period

Pre-crisis Crisis Test for sign.

difference

Variable Mean Median Mean Median Mean Median

CFO Bonus 304.824 190.000 322.041 200.5000 Δ CFO bonus 32.846 21.907 53,788 18.099 ICMWD 0.088 0.000 0.034 0,000 *** *** ROA 0.074 0.060 0.005 0.487 *** *** GROWTH 2.859 2.434 2.450 1.871 *** LEVERAGE 0.172 0.132 0.178 0.139 SIZE 7.953 6.890 7.129 7.044 * BIG4 0.891 1.000 0.884 1.000

Note: *,**,*** denote p<0.1, p<0.05, p <0.001 respectively

Table 4 reports Pearson correlation coefficients. A significant positive correlation is present between CFO bonus and ROA, consistent with the intuition that CFOs are incentivized for their productive tasks by means of accounting performance measures. Furthermore, the correlation table reveals a negative correlation between ICMWD and CFO bonus, which suggest that ICMWDs are associated with reductions in the CFO bonus. The

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table also shows that CFO bonus is significantly positive correlated with size, leverage, and big4. This indicates, for example, that CFO bonuses are higher if firms are larger and that CFOs are more strongly incentivized for their productive tasks in highly leverages companies. Finally, a negative significant correlation is present between ICWMD and big4, which suggest that ICWMD is lower if firms are audited by a big four accounting firm. This is in line with prior literature, which state that clients of Big 4 auditors are less likely to report weaknesses (Rice and Weber, 2011)

Table 4

Pearson Correlation Matrix

Correlations expressed in bold are significant at a level 5% significance level

4.2.Results of hypothesis tests

   

 

4.2.1 Productive decisions in CFO Bonus plans

Table 5 presents the regression summary statistics for the first empirical model (1). The first hypothesis tests whether CFO bonus plans depend relatively more on accounting measures during the financial crisis than before the financial crisis. More specific, it is expected that during the financial crisis firms assigned greater weight to accounting measures in CFO bonus plans compared to the period before the financial crisis. The first column presents the main effect of accounting performance on CFO bonus. The coefficient on accounting measure is not significant, which suggests that there is insufficient evidence to show that CFOs are incentivized on the basis of accounting performance over the entire sample period. The second column presents the results for the first empirical model (1). The coefficient on accounting measures is positive and significant, which suggest that CFOs are

1 2 3 4 5 6 7 8 1. CFOBonus 1.00 2.ΔCFObonus 0.50 1.00 3.ROA 0.04 0.04 1.00 4.ICMWD -0.04 -0.01 0.03 1.00 5.GROWTH -0.00 0.02 -0.00 0.02 1.00 6.SIZE 0.48 0.08 0.06 0.10 -0.00 1.00 7.LEV. 0.07 -0.00 -0.02 0.03 -0.01 0.24 1.00 8.BIG4 0.16 0.04 0.01 -0.04 -0.02 -0.35 -0.14 1.00

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incentivized on the basis of their accounting performance before the crisis. However, the coefficient of interest on the interaction between accounting measure and crisis is negative and significant. This shows that CFOs are less strongly incentivized on the basis of accounting measures during the crisis years. It can be concluded that hypothesis 2 is rejected due to the fact that there is a decrease instead of an increase.

I repeated the analyses, but this time I estimated the empirical model by means of robust regressions. Robust regressions produce more accurate results, because estimation biases due to influential statistics, compromised out of outliers and high leverage data points are limited. A robust regression weights observations differently based on how behaved they are (UCLA: Statistical consulting Group 2013). My main inferences are affected. The coefficient from the main effect of accounting performance on CFO bonus in column three is positive and significant, which suggest that CFOs are incentivized on the basis of accounting performance over the entire sample period. Additionally, the coefficient on accounting measure of the robustness regression for the first empirical model (column 4) is positive and significant, suggesting that CFOs are incentivized on the basis of their accounting performance before the crisis. These results state that board and compensation committees use accounting performances as financial measure of CFO performance. The results from the coefficient of interest on the interaction between accounting measure and crisis are consistent with the OLS regression because the coefficient remains negative and significant. Therefore, I reject H1.

As an untabulated robustness analysis, the results are repeated, but now I included an additional control variable: D_LOSS equal to one if ROA<0, zero otherwise. That is, the negative coefficient on the interaction between accounting measure and crisis may be caused by substandard performance during the crisis years. However, still the coefficient on the interaction between accounting performance and crisis is not positive and significant. That is, the coefficient is now not significantly different from zero. So, I still reject my hypothesis. Overall, the majority of the results seem to indicate that CFOs are incentivized on the basis of their accounting performance before the crisis years. Some evidence suggests that CFOs are less strongly incentives on the basis of accounting measures during the crisis while other results show no effect of the crisis. In either case, I reject my first hypothesis. There can be different reasons, which cause the unexpected relation between CFO bonus and accounting measure. A possible explanation for these mixed results is that companies may struggle with the ways to provide incentives to their CFO in crisis times. The topic of executive compensation has been highly debatable and the financial crisis of 2008 further prompted public and media to question executive compensation practices (Vemala, Nguyen, Nguyen

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and Kommasani, 2013). With regard to the control variables, the results indicate that CFO bonus is significantly positive correlated with size and significantly negative correlated with leverage. Overall, the model performance F-value (24.95) is highly significant (p<0.001).

Table 5

Regressions results equitation (1)

Note: *,**,*** denote p<0.1, p<0.05, p <0.001 respectively

Dependent variable: CFO bonus OLS regressions Robust regression

Main effect Model 1 Main effect Model 1

Variables Pred. β0: Intercept -627.08*** (<0.01) -748.67*** (<0.01) -325.18*** (0.01) -290.43*** (<0.01) β1: Accounting measure + 3.90 (0.66) 33.70*** (<0.01) 19.28*** (<0.01) 163.74*** (<0.01) β2: Accounting measure*Crisis + -- -102.55*** (<0.01) -- -163.74*** (<0.01) β3: Crisis + -- 6.77 (0.58) -- 18.14*** (<0.01) β4 : GROWTH -0.11 (0.62) -0.11 (0.62) 0.12 (0.27) 0.08 (0.42) β5: LEVERAGE -88.15*** (<0.01) -95.94*** (<0.01) -60.20*** (<0.01) -57.20*** (<0.01) β6: SIZE 140.70*** (<0.01) 145.84*** (<0.01) 90.11*** (<0.01) 88.38*** (<0.01) β7: Big4 -22.45 (0.27) -22.56 (0.27) 1.25 (0.90) 2.22 (0.82) β8: D_LOSS -- -- -- --

Industry controls Yes Yes Yes Yes

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4.2.2 Fiduciary duties in CFO BONUS plans

  The second hypothesis argues that firms changed the relationship between CFO bonus and ICMW disclosure in response to the financial crisis. Expected is that CFO bonus plans depend relatively less on internal control measures during the financial crisis compared to before the financial crisis. I used 2871 observations, because the sample is limited to changes from 2006 onwards3. Table 6 presents the regression statistics for this model. The left column presents the results for changes in CFO bonus in relation to ICWMD for the entire sample. The coefficient on ICMWD is not significant, which suggest that the CFO bonus is not affected by ICWMD. The second column presents the effect of the economic crisis on the relationship between ICMWD and CFO bonus (equitation 2). The coefficient on ICMWD*CRISIS that accounts for difference in the relation between ICMWD and CFO bonus between the pre-crisis and the crisis is not significant. Following from the results of the regression model, the dependence on internal control measures in CFO bonus plans does not change in the shift from the pre-crisis period into the crisis period. Therefore, hypothesis 2 is rejected, as the relationship between ICWMD and CFO bonuses does not decrease during crisis periods.

Again, I repeated the analysis by performing robust regressions. The robustness check corroborates the OLS results, since the coefficient of interest on the interaction between ICWMD and crisis is again not significant (column 4). Some of my main inferences are affected. That is, I find that ICWMD leads to a reduction in the CFO bonus for my whole sample period. From these results we can conclude that some evidence suggests that reporting quality with respect to internal controls is used by boards and compensation committees as a nonfinancial measure of CFO performance. The crisis seems to have no effect on this relationship. With regard to the control variables, the results indicate that the change CFO bonus is significantly positive correlated with the change in size and the change in ROA and significantly negative correlated with the change in leverage. Overall, the model performance F-value (1.74) is highly significant (p<0.001).

                                                                                                                         

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Table 6

Regressions results equitation (2)

Note: *,**,*** denote p<0.1, p<0.05, p <0.001 respectively

Dependent variable:  Δ CFO bonus

OLS regressions Robust regression Main effect Model 2 Main effect Model 2

Variables Pred. β0: Intercept 75.27 (0.47) 47.08 (0.65) 52.52 (0.22) -4.27 (0.92) β1: ICMWD - 3.48 (0.92) 30.74 (0.54) -26.68* (0.07) -10.13 (0.64) β2: ICMWD*CRISIS - -- -39.56 (0.57) -- -25.26 (0.39) β3: Crisis - -- 31.97** (0.02) -- 3.29 (0.62) β4 :  ΔGROWTH -0.09 (0.64) -0.08 (0.66) 0.02 (0.76) -0.02 (0.78) β5:  ΔLEVERAGE -305.6*** (<0.01) -302.31*** (<0.01) -121.33*** (<0.01) -67.12** (0.04) β6:  ΔSIZE 195.19*** (<0.01) 203.22*** (<0.01) 95.31*** (<0.01) 67.47*** (<0.01) β7: Big4 46.21** (0.03) 46.66** (0.03) 24.08*** (<0.01) 27.56*** (<0.01) β8:  Δ  ROA 9.7 (0.31) 9.01 (0.35) 200.40*** (<0.01) 211.28*** (<0.01)

Industry controls Yes Yes Yes Yes

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5. Conclusion

CFOs have fiduciary duties geared towards the integrity of financial reporting, but also have productive-decision making duties. When designing a compensation plan for CFOs, firms face a trade-off between these duties. Prior research shows that in the post-SOX period firms emphasized the fiduciary duties of CFOs by providing less bonus incentives tied to accounting measures. However, under influence of the financial crisis, the role of CFOs changed with an increased emphasis on the productive decisions of CFOs. Firms may encourage these productive decisions by emphasizing accounting measures in CFO bonus plans. However, given the limited span of attention and effort of managers, this may be at the expense of CFOs’ fiduciary duties.

Given these recent developments, this research will investigate how management deals with this trade-off in times of economic crisis. On the one hand, it is expected that firms assigned greater weight to accounting measures in CFO bonus plans in the crisis period compared to the pre-crisis period. On the other hand, it is expected that firms decreased the emphasis on internal control quality in CFO bonus plans in the crisis period compared to the pre-crisis period.

The findings are inconsistent with these predictions. I find that CFOs are incentivized on the basis of their accounting performance before the crisis. Some evidence suggest that CFOs are less strongly incentivized on the basis of accounting measures during the crisis while other results show no effect of the crisis. Therefore, there is insufficient evidence to conclude that the financial crisis influences the dependence on accounting measures in CFO bonus plans. Regarding CFOs fiduciary duties, some evidence suggests that ICMWD leads to a reduction in the CFO bonus. However, I find that the dependence on internal control quality in CFO bonus plans does not change in the shift from the pre-crisis period into the crisis period. Furthermore, the test for significant difference in means and medians shows that firms disclosed on average fewer ICWMs in the crisis years compared to the pre-crisis years. This suggests that the increased emphasis on the productive decisions of CFOs does not go at the expense of their fiduciary duties. Taken together, from this study it can be concluded that the increased role of the CFO under influence of the financial crisis is not reflected in CFO bonus plans. The results indicate that the financial crisis does not change the weight on performance measures in CFO bonus plans. In addition, the emphasis on strengthening and safeguarding the quality of internal controls has remained under influence of the pressure of the financial crisis.

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This study contributes in several ways. There is widespread recognition that firms have to trade-off CFOs’ decision-making duties against their fiduciary duties, but no research has been done on how management deals with this trade-off in times of economic crisis. Second, this study offers a more integrated approach by providing a comprehensive view at CFO compensation. Finally, it contributes to existing literature on executive compensation because most existing literature is focused on CEO compensation.

As for any study, my study is subject to limitations. First, CFO bonus and internal control data are obtained for large publicly listed American firms. Therefore, results are limited for small and mid-sized firms, non-American firms and privately held firms. Prior research examined determinants of weaknesses in internal control for firms disclosing material weaknesses from 2002 to 2005. They found that these firms tend to be smaller, younger and more complex (Doyle, Ge, McVay, 2006). Therefore, further research could be directed to investigate whether the findings could be replicated in different settings. Second, this study looks specific on the effect of the crisis on CFO bonus plans. The crisis may influence other elements within the compensation contract of CFOs like; base salary or equity compensation. Finally, the R-Squared of my regression models are relatively low. This implies that there is much room for future research to examine on more possible determinant(s) that influence(s) CFO bonus plans. So, there is enough space for future research to investigate the effect of the financial crisis on CFO compensation. This is interesting to study, especially since executive compensation has been heavily debated since the financial crisis.

         

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Appendix: Variable definitions

 

Variable name Description

Dependent variables:

CFO Bonus Formula-based bonuses supplemented by discretionary

bonuses

Δ CFO Bonus The change in CFO bonus firm year t-1 to year t

Independent variables:

CRISIS Am indicator variable for crisis equal to one for the fiscal

years 2008, 2009 and 2010 and equals to zero for the pre-crisis years

ROA Net Income divided by beginning of the year assets

ICMWD An indicator variable equal to one if the firm had material

weakness in its section 404 report or in at least one if its sections 302 zero otherwise in year t.

Control variables:

GROWTH Market value of equity divided by the book value of

equity

Δ GROWTH The percentage change of book-to-market from year t-1 to

year t

SIZE Natural logarithm of total assets

Δ SIZE The percentage change in the natural logarithm of total

assets from year t-1 to year t

LEVERAGE Long-term debt divided by the average total assets

Δ LEVERAGE The percentage change in leverage form year t-1 to year t

Δ ROA The percentage change in return on assets from year t-1 to

year t

Δ BIG4 An indicator variable equal to 1 one when the auditor is a

Big 4 firm, zero otherwise

D_LOSS An indicator variable for financial loss equal to one if

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