All powerful incentives. If you want someone to do something, tie their pay to it and it will be done. But beware, incentives can also have unintended consequences. I always remember the story a compensation consultant told me many years ago about the volunteer fire department that offered incentives to firefighters who showed up when the alarm sounded. One firefighter was so motivated by this incentive that he turned to arson to boost his earnings. I don’t know if this scenario actually happened somewhere, but the story is still a good cautionary tale when it comes to designing incentives.
A new paper, "Earnings Management from the Bottom Up: An Analysis of Managerial Incentives Below the CEO," by Felix Oberholzer-Gee and Julie Wulf of Harvard University’s Graduate School of Business Administration, suggests that similarly dysfunctional incentives could exist for senior managers in many companies, including CFOs.
Although companies rightly focus on CEO pay and CEO actions that could manipulate earnings, this paper is unique because it does not look solely at the top-down actions of the CEO. It does include CEOs in its analysis but it also looks for bottom-up activity from division managers and CFOs that could impact company results and, by extension, incentive payouts for these managers. In addition, the authors analyze all elements of incentive pay, not just equity-based incentives, and focus on a several measures of earnings manipulation, such as end-of-year excess sales and class action litigation, as well as discretionary accounting accruals.
Although the authors recognize that performance-based pay is an important way to align management and shareholder interests, their research indicates that certain incentives could actually be motivating executives to manipulate reported earnings. The study yielded four broad conclusions:
- The authors found a link between pay below the level of CEO and measures of earnings manipulation. This link was found to be generally stronger for CFO pay than for CEO and division manager pay.
- The authors found that earnings manipulation takes place by changing discretionary current accruals and manipulating fourth-quarter sales.
- Stock options seem to encourage earnings manipulation as much as other forms of incentives. Companies that award their CFOs a large number of options report "higher discretionary current accruals, larger excess fourth-quarter sales and greater likelihood of future lawsuits," according to the study.
- These problems are no limited to equity incentives. Other types of incentives, particularly bonuses, can also create a strong incentive for executives to try to game the system and manipulate earnings to get a larger payout.
Although CEO compensation design will remain a key issue for companies, these findings suggest that companies also need to work together to find the right mix of incentives for CFO and other senior-level managers below the CEO level. The key is to find that elusive sweet spot for incentives that encourages the right behaviors and maximizes efforts that positively impact both company results and management incentive payouts.
You can find the abstract and a link to download the full paper here.