Internal Control Material Weakness and CFO Compensation - Essay Example

? Finance and Accounting Article Table of Contents Table of Contents 2 Introduction 3 Summary of Article 3 Research Method 6 Primary Hypothesis 7 Support of Research towards Hypothesis 7 Contribution of Article 7 Further Research 8 Recommendation 8 Conclusion 8 Reference 9 Introduction Reactions of legislative towards the recent corporate scandals highlight the responsibility of managers for the accurateness of financial reporting. Compensation of chief financial officers (CFOs) depends on their accuracy in term of reported internal control quality as they play important role in the supervision of internal control compliance. This paper will focus on the relationship between the CFO compensation and the internal control material weakness disclosures. Conceptual model have been proposed to evaluate the performance of the CFO for making compensation decisions. Earlier it considers the quantitative financial performance measures and the managerial duties of the CFO but now it also considers fiduciary duties of the CFO in the post Sarbanes-Oxley Act (SOX) era towards the judgment of CFOs compensation. Conceptual model also takes into account two interactive factors and that are governance oversight and costs of firm of financial statement misreporting. Hypothesis tests, control variables, correlation matrix, robustness test and a look back analysis have been conducted to show the relationship between ICMW and the CFO compensation. Thus this paper focuses on the various threads of literature in judging the CFO compensation. Summary of Article Under the SOX Act of 2002, the CFOs and the CEOs i.e. the chief executive officer are required to maintain, establish and assess the effectiveness of internal control and also required to report o this assessment in both annual and quarterly financial statements. In the post SOX period CFOs have been more responsible for their actions as they play primary role in the oversight of internal control fulfillment. Conceptual model, literature review and the hypotheses: In order to understand the compensation process of the CFOs the proxy statements of the sample firms have been reviewed. CFO compensation includes both long term and short term incentive mechanisms. The short term incentive mechanism are proposed to reward attainment of firm annual objectives and long term mechanisms are designed to encourage sustainable growth of the firm and to align the management interest with those of shareholders. Different proxy statements state that along with the compensation committees, CEOs also plays an important role in deciding the CFO compensation. The discussion suggests that in the current year i.e. year t, with the disclosure of ICMW, CFO compensation has resulted a decline in comparison to previous year. Managerial duties of CFO involve adding towards operational decisions which influences the financial performance and fiduciary duties include maintaining top quality internal controls. Prior research has not observed the association between internal quality control and the CFO compensation because compensation of executives was earlier based on financial performance measures only but now it depends on nonfinancial performance measures also. It is expected that ICMW disclosure has resulted a decrease in CFO compensation. The conceptual model expresses two factors that influence the relationship between the CFO compensation and the ICMW disclosures. First is governance oversight and the second factor is costs of firm of financial statement misreporting. Agency theory stresses on the disagreement between shareholders and managers. The conflict is that though the shareholders employs the managers to take actions on their behalf but sometimes the manager’s interest are not aligned with those of the shareholders. There are certain difficulties associated with financial performance measures so, nonfinancial measures are considered more important in evaluating agent’s performance and also regarded as the key drivers of the firm value according to the prior research. Internal control disclosure of SOX provides low cost information that can be used by the boards to examine CFO performance. Thus, a negative relation is predicted between CFO compensation and ICMW disclosure. Recent research also focuses on the fact of negative relation between changes in CFO compensation and ICMW disclosure is more pronounced for CFOs operating in organization with CEOs and compensation committees who holds greater financial proficiency compared to those who holds less financial proficiency. It is also examined that firms with stronger governance oversight will lead to more negative relation between changes in CFO compensation and ICMW disclosure as compared to firms with weaker governance oversight which is a first hypothesis. The second hypothesis is that the negative relationship between changes in CFO compensation and ICMW disclosure is more for CFOs working in firms with higher costs of financial misreporting. Independent and control variables: The second hypothesis is judged by using three independent variables i.e. analyst coverage, credit rated and litigation variable. ICMW disclosure only captures the tendency to miss analyst forecast, so the observed relationship between the CFO compensation and the ICMW disclosures might be because of the missing analyst forecast and not due to weak internal controls. Control variables to name a few percentage change in total assets, percentage change in book to market value, change in annual stock return and percentage change in return on assets have been used to control for company size, to control for investment opportunities, to control for market performance and to control for accounting performance. The empirical results revealed that ICMW disclosure firms miss more quarterly analyst consensus forecasts in relation to those not disclosed ICMWs. According to correlation matrix, ICMW is inversely related with changes in bonus, total, and equity compensation. A “look-back” analysis test was conducted in which CFO compensation data for fiscal year 2005 was compared to 2003 to observe whether firms that revealed ICMWs in 2005 contributed lower compensation of CFO in 2003. The result shows no relation between ICMWs revealed in 2005 and the CFO compensation level in 2003. The “robustness test” conducted shows that even though the CEO is somewhat responsible for the usefulness of internal controls, compensation of CEO is not related with ICMW disclosures. Research Method The research method which is employed by the author is both the primary research and the secondary research. Both researches have been done to assess the relationship between the CFO compensation and the ICMW disclosures. Conceptual model is used in the primary research. Through primary research it is revealed that the negative relationship between changes in CFO compensation and ICMW disclosure is more pronounced for CFOs operating in organization with CEOs and compensation committees who holds greater financial proficiency compared to those who holds less financial proficiency. It is also observed that firms with stronger governance oversight will lead to more negative relation between changes in CFO compensation and ICMW disclosure as compared to firms with weaker governance oversight. Moreover, the negative relationship between changes in CFO compensation and ICMW disclosure is more for CFOs working in firms with higher costs of financial misreporting. Dependent, independent and control variables are used for secondary research. The empirical results through the use of these variables shows that ICMW disclosure firms miss more quarterly analyst consensus forecasts in relation to those not disclosed ICMWs. These variables do not show much difference between organizations with or without ICMWs. Primary Hypothesis The primary hypothesis of the paper is that the negative relationship between changes in CFO compensation and the ICMW disclosures is more coherent for CFOs operating in organizations with stronger governance oversight. Support of Research towards Hypothesis The research fully supports the hypothesis and it highlights the significance of the work of the compensation committee. It also proposes that boards should appoint financial experts in order to serve not only on the compensation committee but also on the audit committee, as it will develop the oversight of the CFO. Contribution of Article The article partially contributed towards the relationship between the changes in CFO compensation and the ICMW disclosures because there are certain limitations in the interpretation of the results. First of all, there are likely correlated mislaid variables that are not included in the models, and therefore depending on the results amounts to supposing that such variables are unable to give convincing another explanations for the results. Secondly, the dependence on publicly accessible disclosures regarding compensation committee expertise and CEO financial expertise probably measures the constructs of interest with error. Finally, the sample period taken was fiscal year 2005 which is illustrated by heightened managerial sensitivity to the importance of financial reporting and the internal control. The economic downturn has moved the focus of responsibilities of CFO towards cost control and cash management. Therefore, the results may be precise to the period under analysis. Further Research Further research could be done to examine whether there is further information pertinent to evaluating the CFO performance in times of economic downturn and whether these actions and their relative significance vary based on the economic and regulatory environment. Recommendation The summation highlights the main findings of the article by considering the primary and secondary research. So, the summation is sufficient to get the view of the relationship between changes in CFO compensation and the ICMW disclosures in various areas. Furthermore, if one wants to view more closely the empirical data then, can prefer the article. Conclusion The article focuses on the conceptual model that inspects the consequences of CFO fiduciary duties, while controlling for managerial duties for CFO, on compensation outcomes. Empirical tests reveal that changes in CFO bonus, total and equity compensation are negatively related with ICMW disclosures. Further it also focuses on the fact that there are certain limitations in the interpretation of the results. So, further research could be done to build upon this article’s findings (Hoitash, Hoitash and Johnstone, 2012, pp.768-798). Reference Hoitash, R. Hoitash, U. and Johnstone, K.M., (2012). Internal Control Material Weakness and CFO Compensation. Vol. 29. Madison: Contemporary Accounting Research. Read More