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    Internal Control Material Weaknesses and CFO Compensation.
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 14.0 Corporate Matters, 14.07 Executive Compensation 
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    Title:
    Internal Control Material Weaknesses and CFO Compensation.
    Practical Implications:

    The results emphasize the importance of the composition of the compensation committee. Specifically, results suggest that boards should consider appointing financial experts to serve not only on the audit committee but also on the compensation committee, as it would improve the oversight of the CFO. The results reveal that CFOs are held accountable not only for their managerial duties as reflected in firm financial performance, but also for their fiduciary duties associated with accurate financial reporting and high-quality internal controls.

    Citation:

    Hoitash, R., Hoitash, U., & Johnstone, K. M. 2012. Internal Control Material Weaknesses and CFO Compensation. Contemporary Accounting Research 29 (3): 768-803.

    Keywords:
    executive compensation, CFO compensation, material weakness, internal controls
    Purpose of the Study:

    The purpose of this paper is to help fill the void in the literature by examining the association between internal control material weakness (ICMW) disclosures and CFO compensation. Under the Sarbanes-Oxley Act of 2002 chief executive officers (CEOs) and chief financial officers (CFOs) are required to establish, maintain, and evaluate internal control effectiveness and to report on this evaluation in both quarterly and annual financial statements. CFOs play a leading role in the oversight of internal control compliance, and research shows that in the post-SOX period CFOs are being held more accountable for their actions. As a result, CFO compensation outcomes are likely to depend in part on reported internal control quality.

    In recent years there has been a trend toward including nonfinancial performance measures in compensation decisions, particularly given the fact that internal control information has become readily available with the implementation of SOX. Therefore, the tests will detect an association between internal control quality and CFO compensation outcomes only if boards and compensation committees incorporate this new nonfinancial performance measure into their compensation decisions.

    Design/Method/ Approach:

    The authors obtain compensation data from ExecuComp, firm characteristic data from COMPUSTAT, and internal control quality data from Audit Analytics. A final sample of 604 firms from the fiscal year 2005 was developed. The authors conduct ordinary least squares regressions in which they use as the dependent variable the change in various components of CFO compensation: total compensation, bonus, equity, and salary. 

    Findings:
    • The basic finding is that the change in CFO total compensation, bonus compensation, and equity compensation, but not base salary, are each negatively associated with ICMW disclosures.
    • These results are economically significant. ICMW disclosures are associated on average with a 14.9 percent decrease in CFO bonus (as a percentage of salary) compared to the prior year.
    • Although the CEO is also responsible for certifying internal control reports, robustness tests reveal no significant association between ICMW disclosures and changes in any of the CEO compensation measures.
    • Account specific ICMWs (as opposed to general, company-wide ICMWs) drive the effects on CFO compensation, which highlights the importance of CFO-specific job responsibilities in relation to compensation outcomes.
    • Results also reveal that CFOs at firms with stronger corporate governance experience larger bonus compensation decreases upon an ICMW disclosure compared to CFOs at ICMW-disclosing firms with weaker corporate governance.
    • CFOs in firms with greater cost of misreporting experience larger declines in bonus compensation and total compensation compared to CFOs in firms with lower costs of misreporting.
    Category:
    Corporate Matters, Internal Control, Standard Setting
    Sub-category:
    Executive Compensation, Impact of SOX, Reporting Material Weaknesses