The Effects of Firm-Initiated Clawback Provisions on Earnings Quality and Auditor Behavior

Abstract

While firm-initiated compensation recovery (or clawback) provisions are gaining popularity and the recently enacted Dodd-Frank Act seeks to make the clawback of erroneously awarded compensation mandatory for all listed companies, little is known about their effectiveness. We find that the incidence of accounting restatements declines after firms initiate such provisions. In addition, we show that investors and auditors view such provisions as associated with increased accounting quality and lower audit risk. Specifically, we find that firms' earnings response coefficients increase after the adoption of clawback provisions. Further, for firms that adopt clawbacks, auditors are less likely to report material internal control weaknesses, charge lower audit fees, and issue audit reports with a shorter lag. IntroductionCompensation recovery provisions (commonly known as ''clawbacks''), which allow firms to recoup compensation from corporate executives involved in accounting improprieties, were first introduced by Section 304 of the Sarbanes-Oxley Act (hereafter, SOX 304) in 2002. SOX 304 authorizes the Securities and Exchange Commission (SEC) to enforce the recovery of bonuses paid to CEOs and CFOs of public companies when the company restates its financial statements due to material noncompliance with any financial reporting requirement as a result of misconduct. However, due to the ambiguities in SOX 304 and the SEC's limited resources, SOX 304 has been successfully enforced in only a few cases (Salehi and Marino, 2008;Fried and Shilon, 2011;Morgenson, 2011). To facilitate the enforcement of clawbacks, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act also includes a section (Section 954) on the recovery of erroneously awarded compensation (hereafter, DFA 954). DFA 954 improves upon SOX 304 in two important respects. First, it designates a firm's board of directors, rather than the SEC, as the enforcer of clawbacks. Second, it does not require misconduct as a prerequisite for clawbacks.Since DFA 954 will not be implemented until the first half of 2012, it is not yet possible to empirically determine the extent to which mandatory clawbacks enforced by the board enhance financial reporting integrity. 1 The usefulness of the mandatory clawbacks, however, can be inferred from the clawbacks that are adopted voluntarily. Voluntary clawbacks have become increasingly popular among listed companies in recent years. According to a survey reported by Corporate Library, 194 companies in the S&P 500 index (about 39%) had adopted clawback provisions as of early 2010. Similar to DFA 954, voluntary clawbacks designate a firm's board as the enforcer of the clawbacks. However, unlike DFA 954, voluntary clawbacks usually require misconduct as a prerequisite for enforcement (Fried and Shilon, 2011). Voluntary clawbacks are therefore stronger than SOX 304 but weaker than DFA 954. If firm-initiated clawbacks are found to improve financial reporting quality, DFA 954 is also likely to be beneficial. In this study, we exam...

Does Board Independence Affect Audit Fees? Evidence from Recent Regulatory Reforms

“…Duchin et al 2010;Chan et al 2012). Note, however, that for clean inferences treatment should be assigned randomly over firms, which is not the case in our setting.…”

An International Perspective on Audit Report Lag: A Synthesis of the Literature and Opportunities for Future Research

“…Chan et al (2012) examined companies that have initiated compensation recovery provisions ('clawbacks') under Section 304 of the Sarbanes-Oxley Act of 2002 (SOX). They suggested that companies who initiate clawbacks are perceived to have higher accounting quality and lower audit risk, as indicated by shorter ARL for these companies.…”

Mandatory clawback provisions, information disclosure, and the regulation of securities markets

“…

a b s t r a c t Chan et al (2012) find that voluntary adoption of compensation clawback provisions is followed by fewer financial restatements and fewer auditor reports of material internal control weaknesses, higher earnings response coefficients, and reduced auditing fees and lags. They conclude that voluntary adoption of clawback provisions leads to increased financial integrity.

…”