Who Cooks the Books?

“The boss made me do it.”

That’s the main conclusion of a new study from the University of Washington Foster School of Business and the University of Pittsburgh on why chief financial officers (CFOs) become involved in accounting fraud.

Analyzing a comprehensive sample of material accounting manipulations disclosed between 1982 and 2005, the research team led by Foster’s Weili Ge and Terry Shevlin concluded that CFOs bear substantial legal costs for intentionally “cooking the books,” yet reap limited immediate financial benefits. At the same time, chief executive officers (CEOs) of manipulating firms hold far more power and incentives to do so than their counterparts in non-manipulating firms.

“Taken together, our findings are consistent with the explanation that CFOs are involved in material accounting manipulations because they succumb to pressure from CEOs, rather than because they seek immediate personal financial benefit from their equity incentives,” says Shevlin, a professor of accounting at the Foster School of Business.

Indirect evidence

The spate of corporate accounting scandals over the past decade has led to significant losses for investors, triggered a series of corporate governance reforms and prompted efforts to identify the underlying causes of these scandals. Where most research on the topic has focused on the equity incentives of the CEO or executive team as a whole, the new study investigates the incentives and role of the CFO who, after all, oversees financial reporting.

“People often underemphasize the role of CFOs,” says Ge, an assistant professor of accounting at the Foster School. “Usually regulators, practitioners and researchers treat the executive team as a whole.”

Since it would be impossible to determine the precise motivation for every case of fraud, the researchers pieced together indirect evidence lodged in the cases of 676 firms alleged by the Securities and Exchange Commission (SEC) to have manipulated financial statements between 1982 and 2005, as compared to non-manipulating firms during the same period.

What’s their motivation?

Shevlin, Ge and their co-authors found that CFOs were most often named as culpable in SEC enforcement releases, and faced penalties such as job termination, future employment restrictions, fines and criminal charges. At the same time, CFOs of fraudulent firms did not have equity incentives any different from CFOs of firms that did not cook the books.

In contrast, CEOs of fraudulent firms had higher equity incentives and more power than counterparts at firms that practiced compliant accounting.

The researchers also noted that, in the three years prior to their financial misstatements, manipulating firms experienced higher CFO turnover than non-manipulating firms, suggesting that some CFOs lose their jobs because they refuse to participate in accounting manipulations under CEO pressure.

One final bit of more direct evidence: the SEC enforcement releases indicate that CEOs were more likely than CFOs to have orchestrated the accounting manipulations as well as having benefited financially from the manipulations.

Introduce checks and balances

Ge says most experts believe that altering executive compensation is the most effective way to dissuade C-level officers from manipulating financials.

“While it is important to fix executive compensation in order to prevent future accounting fraud,” she says, “fixing equity incentives is not enough. We also have to fix corporate governance.”

Shevlin adds that boards of directors, acting in the best interests of shareholders, should consider insulating the CFO from his traditional boss: the CEO. “It’s difficult to do in practice,” he says, “But there are some companies who have the CFO report directly to the audit committee.”

Attention to the relative power of the CEO over the CFO and the function of financial reporting is key.

“When you allow a CEO to get too powerful,” Ge says, “there is a greater risk of manipulations and all forms of fraud.”

The paper, “Why Do CFOs Become Involved in Material Accounting Manipulations?” is forthcoming in the Journal of Accounting and Economics. It is the work of Weili Ge and Terry Shevlin of the University of Washington Foster School of Business, and Mei Feng and Shuqing Luo of the University of Pittsburgh Katz Graduate School of Business.

The paper won the 2008 Glen McLaughlin Prize, awarded annually to the best unpublished research paper in accounting ethics.