Newswise — When a new chief executive officer (CEO) comes into a company, it’s natural for the CEO to want to clean house and bring in his or her own people. In fact, statistics show that 60 percent of the time, companies hire a new chief financial officer (CFO) soon after hiring a CEO. That can be potentially good for a firm; after all, you want to have top execs that work well together.
According to a new study by a team of researchers including Darden Professor Shane Dikolli, however, it can be good for the CEO as well — and sometimes at the expense of long-term company health. “We wanted to see if CEOs who are involved in the appointment of new CFOs also pressure them into managing earnings in a way that benefits the CEOs,” Dikolli says. By artificially managing earnings to hit performance targets, in other words, a CFO could help increase a CEO’s annual pay.
COMPENSATION RESEARCH: BEFORE AND AFTER
Previous research has shown a similar phenomenon with CEOs exerting influence over board members: When a critical mass of directors are appointed after the CEO, then corporate governance is weaker and executive pay higher. Dikolli’s paper, written with John Heater and William Mayew of Duke’s Fuqua School of Business and Mani Sethuraman of Cornell’s Johnson School of Management, is the first to show that CEOs may be extending their influence down the hierarchy as well. The paper will appear in a forthcoming issue of the journal Management Science.
In order to explore the phenomenon, Dikolli and his colleagues assembled a database of executive pay and hiring data. For CFOs hired after a CEO, they further divided the data into two groups: 1) CFOs that are in their first three years of tenure, and 2) CFOs with greater than three years at the firm. “The idea is that most of the pressure the CEO could exert would happen within the first three years, when a CFO is new and trying to establish a reputation within the firm,” Dikolli says. “During that time, new CFOs might change the way earnings are reported to influence investors the way a CEO wants them to.”
On the other hand, Dikolli and his colleagues speculated that CFOs who were at the firm before the CEO hire and remained in place afterward might be less likely to change their practices to benefit the new chief executive. “An incumbent CFO often has a very strong history with the company and is very driven by company norms and previous commitment to disclosure strategies, and so she or he would probably be less likely to be pressured into managing earnings in a way that would meet external expectations,” Dikolli says.
RESULTS AND ANALYSIS
The results they found are striking: When CFOs were hired after their CEOs assumed office, CEO pay was 10 percent higher overall. Of course, those results could also be explained by greater synergy between the CEO and CFO. “Maybe they just work well together and overall profits are higher,” Dikolli says. However, synergy effects should become more prevalent over time. In the data, however, “The effect starts to dwindle after year three,” Dikolli says. That provides strong evidence that CEOs are exerting pressure on their new CFOs when they first join the firm in ways that increase their own compensation.
Additional evidence also suggests synergistic effects are an unlikely explanation. First of all, the increase in executive pay was almost entirely due to variable pay, not fixed pay, which would also increase with company growth resulting from a cooperative management team. Even more importantly, they discovered that the firms were much more likely to just meet earnings targets, or beat them by only 1 cent per share — an indication that they were managing earnings to achieve a predetermined outcome.
Furthermore, the authors found indications that firms were changing their earnings management techniques over time. Before the passage of the Sarbanes-Oxley Act in 2002, firms were using accrual management (selectively reporting accruals as income) to meet targets. After regulations deterred such practices, however, firms switched to using real activities management — for example, changing discretionary expenditures by spending less on production or R&D to reduce expenses and increase profits.
Such practices aren’t necessarily immediately harmful, Dikolli says, but they can affect firm performance over time. “In the short term, it probably doesn’t filter through, but in the longer term, you might expect there to be lower performance versus what a firm could have earned had it spent more,” he says.
A DELICATE BALANCE
Earnings reporting can be a delicate balance, Dikolli continues. Even if a CEO is exerting pressure on a CFO to report higher earnings, the motivation might not necessarily be personal gain; making a company look better to investors can bolster its stability in the capital markets. Due to the potential effect on long-term company health, however, Dikolli recommends increased vigilance on the part of investors and board members in evaluating earnings numbers reported after the hiring of a new CEO and CFO team.
“I would have questions about any reductions in discretionary expenditures that caused a firm to just meet or beat targets after the appointment of a new CFO,” Dikolli says. “There should be a justifiable economic reason for it.”
Shane S. Dikolli co-authored “CFO Co-Option and CEO Compensation,” forthcoming in Management Science, with John C. Heater and William J. Mayew, both of the Duke University Fuqua School of Business, and Mani Sethuraman of the Cornell Univrsity Samuel Curtis Johnson Graduate School of Management.
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