Accounting expertise coupled with high levels of executive compensation can increase the risk of misstatement in financial reporting, according to a new academic study.
Where chief executives, including finance officers, have experience as partners or managers at audit firms and where they have incentives to misreport, the likelihood of misstatement in financial statements is elevated, according to research by three accounting professors across 10 years of reports by more than 3,000 public companies. The authors conclude executives with experience at audit firms can use that experience to hide misstatements or avoid adjustments when auditors find misstatements.
The finding is somewhat contradictory to the movement touched off by the Sarbanes-Oxley Act to require more accounting expertise in the C-suite and among audit committees. The authors of the study, which will appear soon in the academic journal of the American Accounting Association, acknowledge practice and research have established that an extensive knowledge of accounting and financial reporting are necessary elements of reliable financial reporting.
With that assumption in mind, the three academics developed and performed the study to explore whether there could be a “dark side” to such expertise—that “such knowledge and experience increase the likelihood of material misstatement when executives have an incentive to misreport.” They looked specifically at whether executive compensation levels could produce such an incentive.
The study finds when auditing backgrounds did not exist in top management, companies where executive pay was well above the median, or at the 75th percentile, were only about 4 percent more likely to have a misstatement in financial statements compared with companies where pay was relatively low, or at the 25th percentile. However, when audit backgrounds could be found on the resumes of those in the executive suite, the higher-paying companies were 30 percent more likely to end up with misstatements compared to lower-paying companies.
The research points out that auditing experience by itself among top executives was not associated with any difference in the likelihood of misstatements. The likelihood increased, the report says, when the expertise is associated with higher levels of executive compensation.
Auditing standards require auditors to consider executive competence when assessing the risk of misstatement. However, the language focuses auditors on the risk of misstatement associated with a lack of competence, the authors point out.
No one is telling auditors to consider the possibility that the executive team at a client company might be trying to outsmart them. “We provide evidence of the potential downside to a management characteristic considered beneficial in auditing standards,” the report says.