Why Do Companies Cook the Books? Look to the Bean Counters.
Paying corporate accountants more removes incentives for financial misreporting.
Researchers have often overlooked lower-level employees who are directly involved in keeping the books.| iStock/AndreyPopov
Bad bookkeeping’s been in the news a lot lately. Sam Bankman-Fried’s FTX crypto empire came crashing down amid news that an $8 billion shortfall was being tracked in a sloppy Excel spreadsheet. The Brazilian retailer Americanas has been engulfed in crisis since it revealed a $3.8 billion accounting “irregularity:” Its cash reserves had suddenly vanished. The former CEO of the German payments firm Wirecard is on trial for allegedly reporting $2.1 billion in nonexistent revenues.
Why do companies fudge their figures, even at the risk of financial or legal disaster? One explanation is that bonuses and other financial rewards encourage senior executives to overstate performance and downplay losses: If good news buoys share prices substantially, they are in for a windfall.
Yet a piece of the financial misreporting puzzle is missing, and it’s not hidden in the corner office. In a new paper, Stanford Graduate School of Business professors Christopher Armstrong, John Kepler, and David Larcker, and Shawn Shi, PhD ’23, of the University of Washington’s Foster School of Business, argue that manipulated numbers aren’t the result of bosses alone — they also depend on the actions of rank-and-file employees and their financial incentives.
Recent research has largely overlooked the lower-level employees who are more directly involved in the financial reporting process, explains Armstrong, a professor of accounting. “If you want to understand black box accounting” — a method to obscure books without technically breaking the law — “you need to think more carefully about the internal monitors and their role in shaping corporate financial reporting. It’s hard to believe they would initiate misreporting, but it’s not as hard to believe they could turn a blind eye to it.”
The new paper is the first detailed look at how the financial incentives of rank-and-file accountants relate to how well their companies keep their books. After poring over compensation data and indicators of accounting quality from 384 publicly traded U.S. firms between 2000 and 2004, the researchers found evidence of a positive relationship between the total annual pay of lower-level accounting employees and the quality of their employers’ financial reports.
Counting on Bean Counters
Additionally, the researchers found that companies with lower-quality financial reports tended to pay their accountants more after the introduction of the Sarbanes-Oxley Act in 2002, which toughened reporting rules following a string of financial scandals. As firms spent more on compliance, those that handed out the largest pay increases saw the most improvement in the quality of their financial reports.
“The level of pay is an indicator of a firm’s commitment to investment in their human capital,” Armstrong says. This partly explains why the deep-pocketed “Big Four,” which arguably attract more competent and motivated employees, conduct the best audits. The incentives from a potential promotion — and the higher pay and prestige that come with it — can also encourage companies’ accountants to be more diligent, the paper finds.
Not all compensation is good for financial reporting, however. The paper illuminates a negative relationship between audit quality and contingent pay — cash bonuses tied to corporate earnings or equity compensation pegged to share price. “If you’re an internal accountant and you see aggressive revenue recognition, you’re more likely to take a more conservative stance if you’re not paid a bonus, even if the company misses earnings targets,” Armstrong explains.
This suggests that increasing fixed compensation rather than variable compensation may be a better way to prevent the books from being cooked. “The prospect of losing that additional bit of income over their career can outweigh any gains from turning a blind eye to misreporting or errors,” he adds, noting that “police officers are more likely to take bribes if they are underpaid.”
This raises the question of whether higher fixed pay for accountants might mitigate senior executives’ attempts to tweak the figures. The researchers found that the positive relationship between fixed pay and accounting quality is more pronounced when senior executives have stronger financial motives to misreport, as is the negative relationship between bonuses and reporting quality.
Conscientious junior accountants can save their bosses from themselves by accurately estimating the useful life of assets and allowances for accounts receivable and recognizing uncertain earnings in a way that faithfully depicts the economic reality of their company’s activities. However, Armstrong says, “Our evidence suggests that higher pay moderates the incidence of misreporting, but it doesn’t fully mitigate it.”
Firms should bear in mind who decides the compensation and incentives for their junior bean counters, he adds. “If senior executives are largely responsible for setting these pay plans, then that’s also an opportunity to design the incentives in a way that encourages complicity in any potential misreporting.” This risk, he says, calls for corporate boards — and especially their audit committees — to ensure that they have adequate oversight over pay.
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