Because of the separation of ownership and control of public companies, the quarterly earnings that firms report are immensely important to outside investors. They are the most relevant barometer of not only a company’s recent past performance, but also of its prospects for success in the future. The importance of “high quality” earnings – those that most accurately reflect the economic fundamentals of a company – has been demonstrated by researchers showing that they increase capital allocation efficiency (Biddle and Hilary 2006; Biddle et al. 2009), lead to a lower cost of capital for the firm (Aboody et al. 2005; Francis et al. 2005), and increase stock liquidity (Diamond and Verrecchia, 1991).
Responsibility for the substantial work required to generate informative earnings figures falls on the chief financial officer (CFO). But should we expect CFOs to always put in the effort necessary to best understand their companies’ economic performance and prospects? Agency theory suggests not. According to seminal theoretical work in financial economics, it is also the separation of ownership and control that may leave delegated managers of companies (their CEOs, CFOs, etc.) under-incentivized to exert maximum effort in the performance of their obligations. In our new paper titled “Chipping Away at Financial Reporting Quality,” we provide empirical evidence of public company CFOs shirking their duties when their compensation is not strongly tied to the performance of their firms.
Our empirical strategy is built on the assumptions that the amount of effort a CFO exerts will be inversely related to the amount of leisure they consume, and that we can measure their leisure consumption by tracking the amount of golf they play. Using the United States Golf Association’s online records for establishing players’ handicaps, we are able to identify the golfing records for 385 CFOs from 2008 to 2012. The average CFO in this sample records 20 rounds of golf per year, which, assuming an average round takes five hours, translates to 2.5 work weeks. There is also considerable variation in the time CFOs allocate to golf. Thirteen percent of CFOs in the sample do not record any rounds in a year and ten percent record 46 or more per year. Consistent with the predictions of agency theory, we find that the amount of golf CFOs play is a function of their economic incentives to create value in their jobs. Using the sensitivity of CFOs’ stock and option holdings to their firms’ performance as a measure of incentives, we find that that they play 23 percent less golf when their incentives are one standard deviation higher.
We then test how CFO effort impacts job performance. Our analysis focuses on how CFO effort is associated with the relationship between the discretionary component of company’s reported earnings (those that are not derived mechanically from cash flows during the quarter) and the cash flows that are realized in the future. We find significant evidence that greater leisure consumption by the CFO is associated with lower actual financial reporting quality. For example, a one standard deviation decrease in golf played annually is associated with a 13 percent increase in the informativeness of earnings for future cash flow realizations. (We provide further support by evaluating the link between CFO leisure and a number of other proxies for financial reporting quality found in the accounting literature.)
We also find that CFO effort is related to the usefulness of firms’ conference calls. Managers provide less information and use a more uncertain tone during their calls when the CFO consumed more leisure. A final analysis considers whether these conditions impact investors’ ability to understand firm values. We find both that equity analysts have more difficulty projecting a company’s expected earnings when the CFO consumes more leisure, and that the stock price adjustments to new earnings information are muted. Overall, these results suggest that CFOs consume more leisure when they are under-incentivized, and that as a result they are less effective in their roles as managers of the financial reporting process.
We believe these results should be important to all parties concerned with the quality of financial reporting. This includes the investors who rely on such information to make investment decisions, regulators charged with ensuring the integrity of our financial markets, directors and Chief Executive Officers to whom CFOs report, and those other company officers whose own compensation is tied to their firms’ stock value. Further, we think this analysis is particularly important – perhaps alarming? – given that the evidence comes from S&P 1500 firms in the period 2008 – 2012. This suggests that these concerns are quite relevant today even though agency issues have been considered and studied in different contexts for many years now.
These results complement Biggerstaff, Cicero, and Puckett (2015), which provides evidence that CEOs who play excessive amounts of golf lead underperforming firms. Maybe now wouldn’t be a bad time for directors to check both their CEO’s and CFO’s hands for callouses and a golf glove tan-line.
Aboody, D., J. Hughes, and J. Liu. 2005. Earnings Quality, Insider Trading, and Cost of Capital. Journal of Accounting Research 43 (5):651-673.
Biddle, G.C., and G. Hilary. 2006. Accounting quality and firm-level capital investment. The Accounting Review 81 (5):963-982.
Biddle, G.C., G. Hilary, and R. S. Verdi. 2009. How does financial reporting quality relate to investment efficiency? Journal of Accounting and Economics 48 (2):112-131.
Biggerstaff, L.E., Cicero, D.C., and W.A. Puckett. 2015. FORE! An Analysis of CEO Shirking. Management Science, accepted.
Diamond, D.W., and R.E. Verrecchia. 1991. Disclosure, liquidity, an the cost of capital. Journa of Finance 46 (4): 1325 – 1359.
Francis, J., R. LaFond, P. Olsson, and K. Schipper. 2005. The market pricing of accruals quality. Journal of Accounting and Economics 39 (2):295-327.
The preceding post comes to us from Lee E. Biggerstaff, Assistant Professor of Finance at Farmer School of Business at Miami University, David C. Cicero, Assistant Professor of Finance at Culverhouse College of Commerce at The University of Alabama, Brad Goldie, Assistant Professor of Finance at Farmer School of Business at Miami University, and Lauren C. Reid, Assistant Professor of Business Administration and Accounting at the Joseph M. Katz Graduate School of Business at the University of Pittsburgh. The post is based on their article, which is entitled “Chipping Away at Financial Reporting Quality” and available here.