Spillover Effects of Internal Control Weakness Disclosures: The Role of Audit Committees and Board Connections

We find that firms are less likely to report an internal control material weakness (as mandated by the Sarbanes‐Oxley Act) in a given year if one of their audit committee members is concurrently on the board of a firm that disclosed a material weakness within the prior three years. We find a similar spillover effect for financial restatement disclosures. The spillover from material weakness disclosures is evident only if a shared director has more experience with the disclosing firm or can channel more information about the disclosed material weakness. Our findings suggest that prior director experiences outside the firm influence the work of audit committees inside the firm. One rationale is that a director’s prior experience with an adverse disclosure helps diffuse important insights and serves as a catalyst for improvements in a firm’s internal control and financial reporting practices. An alternative explanation, which we cannot dismiss, holds that a director’s prior experience helps a firm to underreport material weaknesses and financial restatements without any attendant improvements in the underlying practices.RÉSUMÉRetombées de la communication des déficiences du contrôle interne : rôle des liens entre comités d’audit et conseils d’administrationLes auteurs constatent que les sociétés sont moins susceptibles de faire état de déficiences importantes du contrôle interne (comme les y oblige la Loi Sarbanes‐Oxley) dans une année donnée si l’un des membres de leur comité d’audit est concurremment membre du conseil d’administration d’une société ayant fait état de déficiences importantes du contrôle interne au cours des trois années précédentes. Ils notent des retombées semblables dans le cas des informations relatives au retraitement des états financiers. Les retombées de la communication de déficiences importantes sont évidentes uniquement si un administrateur commun possède davantage d’expérience auprès de la société qui communique l’information ou s’il peut véhiculer davantage d’information au sujet de la déficience importante communiquée. Les constatations des auteurs permettent de croire que les expériences antérieures de l’administrateur à l’extérieur de la société influent sur le travail du comité d’audit au sein de la société. Une explication possible serait que l’expérience antérieure d’un administrateur en matière de communication d’information défavorable contribue à la diffusion d’indications importantes et sert de catalyseur à l’amélioration du contrôle interne et des pratiques d’information financière d’une société. Une autre explication que l’on ne peut écarter serait que l’expérience antérieure d’un administrateur facilite à la société la communication tronquée des déficiences importantes et des retraitements des états financiers, sans qu’il y ait d’amélioration des pratiques sous‐jacentes à l’avenant.Peer Reviewedhttps://deepblue.lib.umich.edu/bitstream/2027.42/149526/1/care12448.pdfhttps://deepblue.lib.umich.edu/bitstream/2027.42/149526/2/care12448_am.pd

Rational information leakage

Empirical evidence suggests that information leakage in capital markets is common. We present a trading model to study the incentives of an informed trader (e.g., a well-informed insider) to voluntarily leak information about an asset’s value to one or more independent traders. Our model shows that, although leaking information dissipates the insider’s information advantage about the asset’s value, it enhances his information advantage about the asset’s execution price relative to other informed traders. The profit impact of these two effects are countervailing. When there are a sufficient number of other informed traders, the profit impact from enhanced information dominates. Hence, the insider has incentives to leak some of his private information. We label this rational information leakage and discuss its implications for the regulation of insider trading. This paper was accepted by Mary Barth, accounting. </jats:p

CFO role and CFO compensation: an empirical analysis of their implications

Given concerns over CFO pay, especially incentives, and considering the tension between a CFO’s fiduciary responsibility and being a key member of the firm’s executive team, we examine the determinants and effects of CFO compensation amount, incentive intensity, and proximity to CEO compensation in a sample of European companies (FTE 500, 2005-2009). First, we focus on the CFO role as a determinant of CFO compensation. Like prior work, we proxy for CFO roles by using hand-collected public data on education and past professional experience, but we supplement these proxies with proprietary data to more directly capture the firm-specific nature of the CFO job in term of its similarity with that of the CEO. We thus argue how CFOs can have varied roles characterized by different levels of financial expertise and CEO-likeness, and document that it is this latter aspect that is associated with CFO compensation. Second, we study the effects of CFO compensation design on outcomes in the CFO’s realm related to financial reporting. We find that CFO financial expertise is positively associated with financial reporting quality, while a CFO’s pay long-term incentive intensity and a CFO’s incentive compensation proximity with the CEO are negatively associated with financial reporting quality. Overall, then, our results suggest that CFOs get rewarded for their CEO-likeness, and particularly for their being similar to the CEO in terms of tasks and decision making authority. But it is their financial expertise that is positively related to financial reporting quality. At the same time, using compensation that is more incentive intensive and more similar to that of the CEO appears to be potentially detrimental to the quality of financial reporting. These results are relevant for boards involved in selecting highly expert CFOs, and their compensation committees charged with defining subsequently effective incentive compensation plans for those CFOs

Renegotiation and Relative Performance Evaluation: Why an Informative Signal may be Useless

Although Holmström's informativeness criterion provides a theoretical foundation for the controllability principle and inter firm relative performance evaluation, empirical and field studies provide only weak evidence on such practices. This paper refines the traditional informativeness criterion by abandoning the conventional full-commitment assumption. With the possibility of renegotiation, a signal's usefulness in incentive contracting depends on its information quality, not simply on whether the signal is informative. This paper derives conditions for determining when a signal is useless and when it is useful. In particular, these conditions will be met when the signal's information quality is either sufficiently poor or sufficiently rich

Dynamic incentives and responsibility accounting

In dynamic principal–agent relationships, unless a principal can commit to a multiperiod contract, incentives are affected by a problem known as the ratchet effect. We present a two-period agency model to show that the use of more aggregate performance measures and greater consolidation of responsibility helps mitigate the ratchet effect. For example, an aggregate measure may be preferred to a set of disaggregate measures to avoid aggravating the ratchet effect. Similarly, it may be preferable to consolidate responsibility for two activities in the hands of one agent despite the potential loss of performance evaluation information implied by consolidation

Reply to: dynamic incentives and responsibility accounting: a comment

Christensen et al. (Dynamic incentives and responsibility accounting: a comment, J. Account. Econ. 35 (2003) 423) examine Indjejikian and Nanda (J. Account. Econ. 27 (1999) 177) and suggest that our characterization of the inefficiency arising from limited commitment as a “ratchet effect” phenomenon is misplaced. In this reply, we describe the ratchet effect as commonly understood in the literature, clarify the role of contractual commitments in our analysis, and then illustrate why both the substance and interpretation of our original results continue to be appropriate