Chief Financial Officers on Their Company s Board of Directors: An Examination of Financial Reporting Quality and Entrenchment

Transcription

1 Chief Financial Officers on Their Company s Board of Directors: An Examination of Financial Reporting Quality and Entrenchment Jean C. Bedard Timothy B. Harbert Professor of Accountancy Department of Accountancy Bentley University 175 Forest Street Waltham, MA jbedard@bentley.edu Office: and Professorial Visiting Fellow University of New South Wales Rani Hoitash Department of Accountancy Bentley University 175 Forest Street Waltham, MA rhoitash@bentley.edu Office: Udi Hoitash College of Business Administration Northeastern University 404 Hayden Hall 360 Huntington Avenue Boston, MA uhoitash@neu.edu Office: July 2011 The authors thank participants of the Boston Accounting Research Colloquium, accounting research workshops at Bentley University, the 17 th Multinational Finance Society Conference, Laval University and the University of New South Wales for their helpful comments on this paper. We especially acknowledge the helpful comments of Jean Bédard, Ganesh Krishnamoorthy, and Arnie Wright. Electronic copy available at:

2 Chief Financial Officers on Their Company s Board of Directors: An Examination of Financial Reporting Quality and Entrenchment ABSTRACT This paper investigates why Chief Financial Officers (CFOs) serve on their company s board, and the association of this corporate governance choice with financial reporting quality. The percentage of CFOs serving on their own boards is not large, likely due to independence guidelines based on the agency perspective that company officers on boards could promote their own best interest at the expense of shareholders. However, prior research also offers another perspective: that when executives are an integral part of the board during strategic discussions (i.e., not just invited in for matters relating to finance), a two-way information advantage could be attained through better communication. Controlling for determinants of CFO board membership, we find that companies whose CFO has a seat on the board are less likely to have material weaknesses in internal control and financial restatements, and have higher earnings quality. While these results support the importance of the CFO s direct involvement in board discussions rather than the agency perspective, other results show that there are costs as well as benefits. Specifically, CFOs with a board seat have higher compensation and lower likelihood of termination, signaling greater entrenchment. Keywords: Chief financial officer; inside directors; board of directors; corporate governance Data Availability: Data are publicly available from sources identified in the paper. 1 Electronic copy available at:

3 Chief Financial Officers on Their Company s Board of Directors: An Examination of Financial Reporting Quality and Entrenchment 1. Introduction The literature on corporate governing boards studies two central issues: factors determining board composition, and the quality of board performance (Adams et al. 2009). This paper investigates these basic issues in the context of including a company s Chief Financial Officer (CFO) on its board of directors. In focusing on CFO board membership, we build on research recognizing that the role and importance of CFOs has grown relative to other corporate officers (Wang 2007; Krantz 2008; Li et al. 2010). 1 However, very few studies of corporate governance differentiate CFOs as board insiders from other corporate officers. Treating top management as a group implicitly assumes similarity within the group (e.g., Finkelstein 1992), but CFOs are differentiated from other officers on the basis of their specialized role and knowledge in the financial reporting function. Thus, it is important to examine variation in the CFO s place in the corporate structure, and how that variation relates to the quality of the financial reporting function (the CFO s area of authority). The literature on corporate governance recognizes that a seat on the board provides officers with power and influence (Finkelstein 1992). Influence is greater with a board seat due to both the ability to vote and (more subtly) the communications channel to other board members afforded by opportunity for more frequent in-depth interaction. Recognizing this potential, considerable prior research investigates the presence of corporate insiders on boards of directors. Most of these studies adopt a monitoring perspective based on agency theory, focusing on possible negative consequences to firms from reduced board independence that could result from insiders aligning against the best interest of the shareholders. According to this perspective, adding insiders to the board reduces its 1 In fact, some studies show that the CFO s influence on financial performance can be stronger than that of the CEO (Chava and Purnanandam 2007; Jiang et al. 2010). One factor likely driving this increased prominence in the U.S. is that the CFO is the only officer other than the CEO who certifies financial reports under Section 302 of the Sarbanes-Oxley Act of Further, the CFO is the only officer other than the CEO whose compensation is required to be reported in SEC filings even if not among the five highest paid officers. 1

4 effectiveness and thus is potentially detrimental to corporate performance. Prior research often supports this view; for example, Dechow et al. (1996) find that companies with less independent boards are more likely to have SEC enforcement actions against them, and Klein (2002) finds such companies have lower earnings quality. In contrast, some prior research notes that insiders can contribute to board effectiveness (e.g., Fama and Jensen 1983; Klein 1998; Coles et al. 2008). In particular, studies such as Westphal (1999) and Adams and Ferreira (2007) suggests that when insiders become part of the board, they join its social group, forging stronger social ties with board members and aligning some of their own personal objectives with the board. This interaction can increase trust between insiders and other board members that results in mutual advice and collaboration, wherein insiders are more inclined to seek counsel from the board and provide information and advice in return. Because successful decisions by the board require transparency in information communicated by company insiders, their inclusion as members should, under this view, improve company outcomes. The agency and social interaction perspectives thus present opposing predictions for the consequences of including insiders (officers) on the board. However, effects for CFOs may be different from other officers due to the CFO s specialized knowledge and key role in the current economic and regulatory environment. If CFOs contribute to insider power on the board, we should observe lower financial reporting quality among companies making this choice. Specifically, CFOs with a seat on the board could use their increased power to infuse more bias into the financial reporting process, and to maintain poor internal controls that will fail to prevent this bias. On the other hand, if a board seat enables the specialized knowledge of the CFO to be brought to the attention of other board members through the improved communication channel, companies with the CFO on the board should perform better, especially when the performance measures specifically relate to CFO functions (e.g., financial reporting and internal control quality). Collaboration with the board could lead to better alignment with 2

5 objectives of shareholders (e.g., Adams and Ferreira 2007), and thus higher quality financial reporting and internal control systems. Regardless of whether direct access by the CFO to board deliberations through a seat on the board improves outcomes, this practice could come at a cost to investors if the power and enhanced social ties associated with a board seat could lead to greater entrenchment. The literature on CEO power shows that more powerful CEOs are more likely to receive higher compensation and resist dismissals, with greater power of CEOs variously measured as: (1) serving as chair of the board (Goyal and Park 2002); (2) being a company founder (Leone and Liu 2010); (3) having greater stock ownership (Denis et al. 1997); or (4) greater compensation centrality (Bebchuk et al. 2011). While entrenchment has not yet been studied for CFOs as board members, we expect that CFOs with a seat on their own board will have relatively higher compensation and lower likelihood of turnover. We investigate these issues in a sample of 7,034 firm-year observations from 2004 to To control for endogeneity, we use a series of two-stage models. The first stage of each model addresses factors associated with companies choice to include the CFO on the board. 2 The second stage tests the associations of CFO board membership with financial reporting quality, CFO compensation and turnover, respectively. 3 We first investigate the influence of CFO board membership on the quality of the financial reporting process. Our results show that companies with CFOs on the board have more effective internal control over financial reporting 4, higher accruals quality, and lower likelihood of restatements. These results imply that the activities of CFOs serving on the board are more aligned 2 We employ two instrumental variables in the first-stage model, expecting that appointment of the CFO to the board will be more likely if the CFO has longer tenure, and if the CFO serves on other corporate boards. Our rationale for choosing these instruments is discussed in the methods section. 3 As a baseline, we investigate the association between CFO board membership with accounting returns and operating cash flows, and find that both are higher among companies whose CFOs serve on the board. 4 We measure internal control over financial reporting using public disclosure of material weaknesses under US securities regulations resulting from the Sarbanes-Oxley Act of 2002 (SOX). SOX Section 404 requires registrants to document and test internal control over financial reporting, and the company s independent auditor to independently test those controls and opine on internal control effectiveness. Under Section 302, companies must design and maintain appropriate controls over the financial reporting and disclosure functions. Management must assert the effectiveness of those controls on a quarterly basis, and report on any detected material weaknesses. 3

6 with shareholder interest. Further, it suggests that these CFOs are also more likely to share information with other board members about the status of the financial reporting function, and secure sufficient resources to invest in the establishment, documentation and testing of internal controls. These results are obtained while controlling for factors that might influence CFO expertise (longer tenure and service on other boards) in the two-stage models. In supplemental analysis, we also test whether results are sensitive to controlling for CFO experience as CPAs, auditors, or company controllers. Results show some support for the expertise explanation, in that financial reporting quality is generally better when CFOs possess these types of experience. However, the positive association of financial reporting quality with CFO serving on the company s own board remains significant even after controlling for accounting expertise. We also examine whether our findings hold for other named executives, finding that a board seat for chief operating officers (COOs) is not associated with any of the financial reporting outcomes we examine, but are associated with firm accounting performance. While the above results imply value to CFOs serving on their own boards, we also expect and find evidence of CFO entrenchment in those companies. Specifically, CFOs serving on boards are more highly compensated than those in other companies, after controlling for economic factors often found to influence executive compensation. Further, we find evidence that as with powerful CEOs, CFOs serving on boards are less likely to face turnover following poor corporate performance. These results suggest that social relationships formed while serving on the board enable these CFOs to gain more resources from the company and avoid penalty in times of difficulty. This study contributes to the accounting literature on corporate governance in several ways. First, we distinguish the CFO from other board insiders based on that officer s specific role within the corporate hierarchy. Second, we demonstrate that the presence of CFOs on the board is associated with benefits that are specific to their realm of responsibilities. Third, we are the first to examine the entrenchment that emanates from board membership for specific a named executive other than the 4

7 CEO. Overall, these results could have important implications for boards and their structure. Absent best practice, independent board members should assess the tradeoffs of the benefits associated with the appointment of the CFO to the board along with the potential drawbacks. The remainder of this paper proceeds as follows. Section II discusses relevant literature, leading to our research expectations. Section III describes compilation of the sample, variable measurement, and empirical models. Results of main tests and additional analysis are presented in section IV, and Section V presents conclusions and limitations. 2. Prior Research and Development of Expectations In this section we review several lines of literature that provide background for our analyses. First, we briefly review the agency perspective on the potentially detrimental aspects of corporate executives as insiders on the board, and also discuss research supporting the alternative view that in some circumstances, insiders contribute an information advantage to board deliberations that could improve corporate outcomes. Second, we review research on the role and importance of CFOs in particular, as distinct from other corporate officers. Third, we discuss the literature on financial reporting quality and the potential influence of CFO board membership on reporting outcomes. Then, recognizing that the influence gained from an executive s position on the board could lead to entrenchment, thus enabling greater capture of resources from the company, we provide an overview of the literatures on executive compensation and turnover with respect to this possibility. Corporate Insiders on the Board and Company Outcomes: Two Perspectives In complex organizations such as the modern corporation, the specialized knowledge needed for effective management is diffused throughout the organization. Fama and Jensen (1983) argue that better decisions can be achieved through delegation of decision-making authority to individuals with specialized knowledge. However, they note that control of the agency problem in such organizations is achieved by ratification and monitoring of those decisions by residual claimants, or by extension, their 5

8 representatives. This perspective implies that greater separation of managers from board decisionmaking will benefit investors. Most prior research on corporate officers as insiders on their own company boards adopts the agency perspective, often focusing on the overall percentage of board members who are insiders. Much of this literature finds that the separation of independent board members from the influence of insiders is desirable. For instance, studies conclude that lack of independence associated with greater presence of insiders is detrimental to financial reporting quality as measured by fraud (Beasley 1996), SEC enforcement actions (DeChow et al. 1996), and discretionary accruals (Klein 2002). Others find that lack of independence is associated with less effective compensation policies (Ryan and Wiggins 2004). Although monitoring of executives is one of its primary responsibilities, the board is also responsible for guiding management by furnishing advice and consultation on strategic and other important matters (e.g. Westphal 1999). Conventional wisdom suggests that one key factor to effective board advising is the set of information they consider. Yet board members often do not have direct access to detailed company data, and consequently, the information they possess is inferior (e.g. Ravina and Sapienza 2010). Therefore, external board members depend on company management for information. The nature of the information they receive is likely to dictate the scope for board deliberations. As a result, the quality of board decisions depends on cooperation from company executives. Social network theory posits that social relationships between executives and board members are the basis for mutual giving of advice. A social tie increases in strength with the frequency of the contact, emotional depth and mutual confiding, and the reciprocity based on favors and obligations (Granovetter 1973). This implies that executives who sit on corporate boards likely forge better ties with board members due to their frequent meetings as collogues. In addition, such executives might establish a reciprocal relationship with board members that could originate from past actions as well as an understanding and commitment on future voting. 6

9 Another important factor that contributes to collaboration is trust, which is required when individuals provide information that exposes vulnerable positions (Mayer et al. 1995). In order to share information on sensitive issues, executives need to believe that the board is looking to collaborate on finding resolution rather than take punitive actions. Executives with extensive personal contact with board members through interactions within and outside of meetings are more likely to engage in mutual trust relationships, increasing the likelihood that they will seek and give advice. Consistent with these perspectives, Westphal (1999) develops a framework on advice-seeking CEOs, showing how social factors in the form of trust and perceived social obligations between the CEO and the board can contribute to board involvement and effectiveness in firm management. Testing this framework, Westphal finds that monitoring activity is not decreased by social ties between board and management, and such ties enhance the provision of advice from outside directors on strategic issues. Supporting this notion, prior research shows that the information provided by board insiders is more important in companies with high R&D, where firm-specific information is more needed (Coles et al. 2008). Another theoretical model predicting positive returns to greater involvement of executives on boards is that of Adams and Ferreria (2007). In their model, the CEO sees tradeoffs in sharing information with the board because while sharing information can contribute to the quality of the advice given by the board, it can also assist the board in monitoring the CEO. Thus, greater monitoring intensity of boards (i.e., less friendly to management) could cause managers to suppress information sharing and reduce interactions with the board, leading to a subsequent decline in shareholder value. Collectively, social network theory and the literature on collaboration and friendly boards suggest that better information sharing motivated by social relationships and reciprocity can lead to better board decisions and firm performance. Consistent with this perspective, several studies find performance improvements associated with greater involvement of insiders on boards. For instance, Klein (1998) finds that insiders on the finance and investment committees are associated with higher stock market 7

10 returns. Similarly, Adams et al. (2005) find that the lack of insiders on the board other than the CEO is associated with increased volatility of company performance, suggesting that the presence of other executives on the board reduces CEO power. In sum, while agency theory predicts that monitoring of executives is best done by an independent board, and thus insider membership should be minimized, an alternative perspective predicts that the advising function of the board is best performed when interaction with management is facilitated through greater insider membership. While most studies adopt the agency perspective, results are mixed. In this following section, we discuss why it is important to separately examine CFOs on corporate boards, given their specialized knowledge and skills relative to other executives. Chief Financial Officers as Distinct from Other Executives A number of prior studies treat corporate executives as a group of insiders. If board insiders are frequently aligned with the position of the CEO (a plausible scenario), then this perspective makes sense. However, executives in particular positions differ in knowledge of their specific domain and also may differ in relative influence. If so, specific qualifications and/or roles could result in differential impact on company outcomes. Certainly this is true of CEOs, and given their dominant position in the corporate hierarchy, prior research often considers them separately. The literature on CEOs examines their agency conflicts and their impact on corporate performance, sometimes differentiating within the CEO group on dimensions including their relative power in the form of chairing the board (Goyal and Park 2002), stock ownership (Denis et al. 1997), being the sole insider on the board (Adams et al. 2005) and compensation centrality (Bebchuk et al. 2011). 5 However, prior literature does not separately consider CFOs as board members. 5 Other research differentiates board insiders not on the basis of office held, but on characteristics such as additional directorships. Masulis and Mobbs (2011) find that executives with additional directorships are more independent and consequently are less dependent on the CEO. 8

11 Our study of CFOs is motivated by certain features of the current business environment. First, the relative importance of the CFO role has increased in recent years. Regulations originating from the Sarbanes-Oxley Act of 2002 require that both the CFO and CEO certify the financial reports of public companies. This increased responsibility elevates the power and importance of CFOs beyond that of other executives. Second, increasing complexity of the business environment requires the CEO to rely more heavily on other top executives. In that regard, CFOs bring their unique experience as it relates to complex business transactions and financial reporting. Further, a recent report from Ernst & Young (2010) indicates that 35 percent of CFOs surveyed are heavily involved in the strategy development, in addition to maintaining the usual CFO roles. Consistent with these trends, research shows COO compensation is declining relative to CFOs (Wang 2007) and that some Fortune 500 companies are eliminating the COO position (Krantz 2008). These factors motivate further investigation of the role of CFOs in board deliberations. CFOs as Board Members and Financial Reporting Performance A key function of the office of the CFO is corporate financial reporting. This function has gained in importance following SOX, given that the CFO is now required to certify the financial statements as well as accept greater responsibility over company internal controls. Our interest lies in whether CFOs who sit on their own corporate board will be more or less likely to promote quality in the financial reporting process. The agency perspective is consistent with the view that CFOs who sit on corporate boards might exploit their connections and take advantage of their greater power to maintain weak controls over financial reporting. This would allow greater latitude in choices of accounting methods, recognition of income effects of transactions, etc., thus enabling executives to gather more resources for themselves at the expense of investors. In contrast, the theory of friendly boards contends that an information advantage accrues from greater board/ management collaboration (Adams and Ferreria 2007). Hence, if a CFO on the board shares more relevant information with board 9

12 members, the capacity of the board to advise the CFO will be greater. Under this perspective, CFOs who sit on the board experience better collaboration with board members, and consequently develop better plans and obtain more resources to address any identified problems in controls. This approach is consistent with research by Cohen et al. (2007), who investigate external auditors views of corporate governance quality. They find that auditors tend to assess lower risk in companies in which the board and management communicate well on key issues. In sum, we expect that in companies whose own CFO serves on the board, financial reporting quality will differ. The sign of this association could be positive (based on greater information advantage) or negative (based on greater agency costs). Prior research on financial reporting quality examines varying measures of financial reporting outcomes. We focus on three commonly used metrics: (1) the effectiveness of internal controls in the financial reporting system; (2) the quality of earnings emanating from that system (measured as abnormal accruals or accrual noise ); and (3) the restatements of past financial reports. All of these measures relate to the function and responsibilities of CFOs and in the following sections we present the findings of past research and the link to CFOs. First, we consider the CFO s role in maintaining effective controls over financial reporting. The premise behind the provisions of SOX related to internal controls (Sections 302 and 404) is that maintaining effective internal controls over financial reporting is in the best interest of investors. Past research shows that CFO knowledge (Li et al. 2010) as well as board strength and financial expertise contribute to internal control quality (Krishnan 2005, Zhang et al. 2007, Hoitash et al. 2009). However, CFO board membership (which could give rise to greater agency conflict or to better collaboration with board members) has not been addressed. Recent studies measuring the extent of insider participation on boards (Zhang et al and Krishnan 2005) do not find that board independence is associated with internal control quality, motivating separate examination of specific executives such as the CFO. Research also shows personal consequences for CFOs that fail to maintain effective 10

13 controls, finding that CFO turnover is greater following material weakness disclosure (Li et al. 2010) and their compensation is lower (Hoitash et al. 2009). Collectively, these studies suggest strong incentive for CFOs to maintain effective internal controls. Other research that has emerged since implementation of the SOX internal control provisions supports their importance to the financial markets. For example, companies publicly disclosing weaknesses in internal control have lower earnings quality (Ashbaugh-Skaife et al. 2008; Doyle et al. 2007b) and higher cost of capital (Ashbaugh-Skaife et al. 2009). Disclosure of such weaknesses yields a negative market reaction (Hammersley et al. 2008) and higher audit fees (Raghunandan and Rama. 2006; Hoitash et al. 2008). Further, Feng et al. (2009) show that management earning guidance is more accurate when internal controls are effective. Second, studies on board independence and financial reporting quality also examine the output of the financial reporting system; i.e., the quality of earnings, primarily based on the unexpected portion of accruals. Agency theory predicts that in the absence of effective oversight, management will have the ability to take advantage of the flexibility in accruals to manipulate earnings. Indeed, prior studies demonstrate the importance of CFOs and other governance players to financial reporting quality. For instance, Geiger and North (2006) find that discretionary accruals are lower for new CFOs, while Jiang et al. (2010) find that CFO incentives are more linked to some earnings management techniques than are CEO incentives. Additional evidence consistent with the agency perspective is observed by Klein (2002) and Xie et al. (2003) who find that weaker boards and audit committees are linked to more earnings management. Thus, recent findings generally confirm the existence of an agency conflict with respect to accruals and indicate that CFOs do influence their quality. 6 6 However, not all evidence is consistent, as Larcker et al. (2007) find that some measures of weaker boards (i.e., those that are larger, have older directors, and more anti-takeover practices) are associated with less accrual management. 11

14 Third, a number of studies examine restatements as a proxy for financial reporting quality, finding CFO characteristics linked to both the likelihood of restatements and to consequences that follow. For instance, with respect to skill set, Aier et al. (2005) finds that CFO expertise is negatively associated with restatement likelihood. Also, Collins et al. (2009) find that company executives, including the CFO, experience bonus penalties and increased turnover likelihood before and during restatement years. Arthaud-Day et al. (2006) find that CFOs turnover likelihood is twice as high in firms that file restatements. Other studies finds that audit committee expertise is negatively related to restatement likelihood (Agrawal and Chadha 2005; Abbott et al. 2004). In terms of personal consequences to board members, past research find that restatements are associated with significant labor market penalties for individuals that serve on the board (Arthaud-Day et al. 2006; Srinivasan 2005). Yet, past research on restatements does not link CFOs to the board and how CFO board membership specifically alters restatement likelihood. In sum, we expect an association between CFO board membership and the three financial reporting metrics mentioned above. But given contradictory theory and mixed prior results of prior research, we test the nondirectional expectation that the presence of the company s CFO on its board will be associated with financial reporting quality. CFOs on Company Boards and Entrenchment We next investigate whether CFOs with a seat on their board gather more personal resources from the company. This prediction is supported by prior literature on entrenchment, which finds that executives with greater power are more likely to be highly compensated and to resist turnover following weak corporate performance. Below, we review the literatures on executive compensation and turnover relevant to testing our expectations. Executive Compensation 12

15 Corporate boards are responsible for setting compensation plans that help align managerial incentives with shareholders wealth. Since executive compensation is the product of negotiation between management and the board, executive power over individual board members and influence on the negotiation process can hamper its effectiveness. Prior research on executive compensation shows that better functioning boards more closely link compensation to economic determinants and management performance (Yermack 1996; Core et al. 1999; Bebchuk et al. 2002). Other research concentrates on the social links between the board and executives. Several studies link social networks to compensation. Hallock (1997) finds that CEOs with interlocking directorships with their board members receive higher pay, and Larcker et al. (2006) find higher levels of total compensation when there is a stronger link between the CEO and members of the compensation committee. Fich and White (2003) find higher CEO compensation in sympathetic boards, wherein one or more pairs of board members serve together on a different company s board. Together, these studies suggest that the social ties afforded to CFOs by board membership will be associated with higher compensation. While these studies all examine CEOs (who commonly serve on their own board), our interest is in CFOs, relatively few of whom are granted this privilege. Agency theory predicts that greater executive power yields greater resource extraction, thus CFOs with a board seat could influence the board to grant them higher excess compensation, for two reasons. First, in the same way that external social ties influence board decisions with respect to the CEO, CFOs can forge social ties internally with their own board members. Boards with stronger ties to the CFO might choose not to curb CFO compensation, which could lead to excessive pay. Second, a CFO on the board also votes on many important issues along with other board members including ratifying director pay and the nomination and reappointment of directors. This creates interdependency, analogous to the interdependency created by the CEO chairing the board. While the strength of interdependency between CFO and other board members is likely not as strong as that of the CEO, we still expect that the social relationships of 13

16 CFOs with board members are stronger than those of other CFOs who do not sit on the board. Thus we expect higher excess compensation of CFOs on the board, relative to other CFOs. Executive Turnover Among the various disciplinary options of boards, executive dismissals are the ultimate and most extreme action. While dismissing top executives such as the CEO and CFO entails significant costs in loss of human capital and knowledge, boards will sometimes take this action following poor company performance, such as weak market-adjusted returns (Coughlan and Schmidt 1985; Warner et al. 1988), or financial irregularities such as restatements (Desai et al. 2006; Collins et al. 2009; Hennes et al. 2008). However, social network theory posits that closer relationships between board and executives foster protection from forced turnover. Since the board can be viewed as a production team, board members know that the dismissal of other board members can disrupt intra-team relationships, leading to loss of efficiency. Guedj and Barnea (2009) support this notion, showing lower turnover of CEOs in companies with more connected boards, and less sensitivity of CEO turnover to company performance. The relative power of company executives can also impact the sensitivity of turnover likelihood to firm performance, as shown in several studies on CEOs. Relative power in this literature is measured by in terms of higher managerial ownership (Denis et al. 1997), relative compensation in comparison to other top executives (Bebchuk et al. 2011), chairing the board (Goyal and Park 2002), and association with the founding family (Leone and Liu 2010). In sum, this literature finds that although weak performance increases turnover likelihood, more powerful CEOs are better able to resist turnover in such circumstances. As with the executive compensation literature, less is known about the turnover of non-ceo executives. Fee and Hadlock (2004) study non-ceo executives as a group and observe that the turnover of non-ceo executives increases following poor returns but the sensitivity of turnover of these executives is lower than that of the CEO. A few studies in this line of research concentrate 14

17 specifically on CFOs. Most relevant to the current investigation, Mian (2001) examines a large sample of CFOs and finds that their departure likelihood increases following poor market and accounting performance. Other research (e.g., Arthaud-Day et al. 2006; Agrawal and Cooper 2009; Collins et al. 2009; Menon and Williams 2008) find that CFO turnover likelihood is greater following negative events such as financial restatements or auditor resignation. Further, Li et al. (2010) finds that CFO turnover is greater after the disclosure of a material weakness in internal controls and Mergenthaler et al. (2011) find similar results for CFOs who misses analyst earning forecasts. The turnover of non-ceo executives could also increase if the CEO chooses to dismiss others for poor performance in order to shift away the blame and demonstrate responsiveness to poor performance. Such a reaction is generally supported by legitimacy theory, wherein stakeholders may influence firm decisions to preserve their interests (Suchman 1995) and the CEO might dismiss the CFO in an attempt to please stakeholders. For instance, Khanna and Poulsen (1995) show that executives may serve as the CEO scapegoats who are dismissed in order to maintain the CEO reputation. Additionally, Leone and Liu (2010) find that CFO turnover is higher following financial irregularities in firms wherein the CEO is the founder, and theorize that this partially occurs because the blame is often directed by the founder at the CFO. Collectively, the above studies argue that management turnover is linked to company performance. Yet, although the CEO literature establishes that several CEO characteristics associated with greater power help shield CEOs from turnover, there is no similar evidence with respect to the CFO. We expect that CFOs on boards, having greater access to board members and better social ties, are more likely to be able to influence board decisions relative to CFOs with less access to the board. Further, it is less likely that CFOs who sit on the board will serve as CEO scapegoats. This implies that CFOs who are on their own corporate boards will be protected from dismissal, and will be less likely to be dismissed following poor performance, relative to CFOs who do not sit on their firm s board. 15

18 In the following section, we outline methods for testing our research expectations concerning the association of CFO board membership with financial reporting quality, company performance, compensation and turnover. 3. METHOD Sample construction Our sample is based on companies included in the AuditAnalytics governance database for the period 2004 (the earliest year available) through This database provides information on directors and executives, including age, tenure, biographical information and compensation. To identify chief financial officers, we search for the phrase CFO in the standardized title of each executive, yielding 18,200 unique firm-year observations. We eliminate observations with missing CFO compensation, age or tenure, as well as firms with missing board characteristics such as the size or the number of meetings, yielding 11,936 observations. We gather accounting information from Compustat and stock return data from the Center for Research in Security Prices (CRSP) database. Eliminating observations with missing stock return values, accounting data or accrual quality information leaves 8,291 observations. Merging auditor-related and internal control effectiveness data from the AuditAnalytics database results in loss of another 176 observations, resulting in a sample size of 8,115 with complete data. Due to differences in regulatory environment, we eliminate financial and utilities companies, which leaves 7,094 observations. Finally, to avoid confounding effects we eliminate 60 CFOs who also hold the CEO position. Our final sample thus contains 7,034 firm-years. 7 Variables and Models To test our expectations regarding CFOs serving on their own company s board, we construct a binary variable that equals one for CFOs with this position, zero otherwise (CFO_ON_OWN_BOARD). 7 From this base, the sample size used in some models is lower due to additional data requirements. We report the final sample for each model in the respective tables of results. 16

19 In the following subsections, we introduce our models and discuss variables relevant to each. Variable definitions are provided in Table 1. Insert Table 1 about Here Financial Reporting Quality Internal Control Quality Our first expectation is that the company s own CFO on the board will be associated with differences in financial reporting quality. Model 1 tests this hypothesis through a logistic regression model whose dependent variable, representing the quality of the company s internal controls over financial reporting, takes two forms. The first indicates whether a MW under Section 302 or 404 is reported (MW). Under Section 302, management documents its internal controls over financial disclosures, discloses whether those controls are effective, and reports MW that have been identified. In contrast, Section 404 requires that management test controls over financial reporting, and that auditors independently test those controls and present an audit opinion regarding any MW detected. Because Section 302 reports are unaudited, there is widespread concern that they under-report the extent of internal control problems. Thus, our second dependent variable (MW404) measures MW reported under Section 404 only. Model 1 is as follows: MW/MW404 = α + β 1 CFO_ON_OWN_BOARD+ β 2 PAFE + β 3 PSFE + Β 4 ACSIZE + β 5 INDEPENDENCE + β 6 ASSETS + β 7 LOSS + β 8 SEGMENT + β 9 BIG4 + β 10 AUDITOR_CHANGE + β 11 LITIGATION+ β 12 SALES_GROWTH + β 13-16YEAR_DUMMIES + β INDUSTRY_DUMMIES + e (1) In addition to the test variable, CFO_ON_OWN_ BOARD, this model also includes control variables with directional expectations consistent with prior related work (Ashbaugh-Skaife et al. 2007; Doyle et al. 2007a; Hoitash et al. 2009). We control for audit committee financial expertise by including PAFE, the proportion of members with accounting financial expertise (e.g., CPA and CFO experience); and PSFE, the proportion of audit committee members with supervisory financial 17

20 expertise (e.g., CEO experience). We control for audit committee strength using the size of the audit committee (ACSIZE). We expect a negative association with respect to all audit committee variables. We also measure board independence using an indicator variable that equals one when the number of insiders is less than the sample median (INDEPENDENCE). Due to contrasting arguments cited in the literature review, we do not propose a direction for this variable. Model 1 also controls for company characteristics found by prior research to be associated with MW disclosure. We control for company size using the natural log of total assets (ASSETS), expecting larger companies to have lower likelihood of MW disclosure. We measure profitability with a binary variable indicating whether the company has incurred losses in the last two years (LOSS), expecting that losing companies have fewer resources to invest in internal controls. We expect that more complex companies will have difficulty controlling their operations, and measure complexity using the number of business and geographic segments (SEGMENT). We expect that larger audit firms have better clients with fewer control problems, measuring audit firm size through a binary variable indicating whether the auditor is a Big 4 firm (BIG4). We also include a binary variable indicating whether the company has changed its auditor (AUDITOR_CHANGE), expecting a positive sign (Hoitash et al. 2009). Because companies in litigation-prone industries are more likely to report MW (Ashbaugh- Skaife et al. 2007), we include a binary variable indicating membership in these industries (LITIGATION). 8 Finally, because rapidly growing companies may outstrip the capabilities of internal controls (Doyle et al. 2007a), we use an indicator variable equal to one if year over year industryadjusted sales growth falls into the top quintile; zero otherwise (SALES_ GROWTH). Accruals-Based Earnings Quality Model 2 tests whether companies whose CFOs serve on the board vary in earnings quality. The two dependent measures of Model 2 are commonly used proxies for the extent to which managers 8 The following SIC codes are associated with industries more prone to litigation: 2833 to 2836, 3570 to 3577, 3600 to 3674, 5200 to 5961, and 7370 (See Ashbaugh-Skaife et al. 2008). 18

21 use their afforded flexibility with accruals to manage earnings. The first measure (ABSDACCROA) is a variant of the modified Jones model (Dechow et al. 1995) as introduced by Kothari et al. (2005), which augments the modified Jones method by controlling for company performance with the lagged return on assets in the computation model. The second measure of earnings quality (AQ), based on Dechow and Dichev (2002), maps accruals with past, current and future cash flows. This measure is calculated as a standard deviation over a seven year horizon. Model 2 is as follows: ABSDACCROA/AQ = α + β 1 CFO_ON_OWN_BOARD + β 2 PAFE + β 3 PSFE +β 4 ACSIZE + β 5 INDEPENDENCE+ β 6 ASSETS + β 7 MW + β 8 MB+ β 9 LEVERAGE + β 10 PROPLOSS + β 11 STDSALES + β 12 STDOPCASH+β 13 INVREC + β 14 NO_INT+ β 15 FOREIGN+ β 16 FIRM_AGE + β 17 BIG4+ β 18 LITIGATION + β YEAR_DUMMIES + β INDUSTRY_DUMMIES + e (2) All independent variables common to Models 1 and 2 share similar directional expectations. 9 We also include MW, expecting that companies reporting a MW will have higher abnormal accruals (Ashbaugh-Skaife et al. 2008). To control for growth opportunities, we include the ratio of market value of equity to book value of equity (MB), with no directional expectation (Ashbaugh-Skaife et al. 2008). We expect positive associations of abnormal accruals with the ratio of debt to total assets (LEVERAGE), the number of years with reported net loss (PROPLOSS), and volatility as measured by the standard deviations of sales (STDSALES) and cash flows from operations (STDOPCASH), measured over all years with available data on Compustat. We also include (INV_REC), the ratio of inventory plus receivables to total assets, expecting a positive association; and (NO_INT), an indicator variable that equals one if there are no intangible assets, with an expected negative sign. To further control for company complexity we indicate whether the company has foreign operations (FOREIGN) expecting a positive association. We control for firm age (FIRM_AGE) and expect that more mature companies will have better accruals quality. 9 Specifically, we expect that larger companies with stronger audit committees, more financial expertise, better financial strength, reduced complexity and those that are audited by larger auditors and do not belong to a litigation prone industry will report lower abnormal accruals. We propose no directional expectation for board independence (Larcker et al. 2007). 19

22 Restatements Model 3 investigates the association of CFO on the board with financial reporting quality as measured by a restatement of prior financial reports. We use two variables to measure a financial reporting restatement. The first (RESTATEMENT) is an indicator variable equal to one for the first misstated year (Agrawal and Cooper 2009; Armstrong et al. 2010). The second is RESTATEMENT- PERIOD, an indicator variable equal to one for any year that was subsequently restated. 10 This analysis uses the same control variables as Model 1, with similar expected signs. 11 CFO Entrenchment CFO Compensation Based on prior literature and the arguments presented in Section 2 of this paper, our second expectation is that CFOs who serve on the board will be more entrenched. One observable outcome of entrenchment is higher compensation. Model 4 tests this association, with the dependent variable taking two forms: the natural log of total cash (TOTALCASH, the sum of base salary and cash bonus), and the natural log of total compensation as reported in the financial reports (TOTALCOMP). 12 TOTALCASH/ TOTALCOMP = α + β 1 CFO_ON_OWN_BOARD + β 2 CFOAGE + β 3 CFOFOUNDER + β 4 BOARDSIZE + β 5 INDEPENDENCE + β 6 ASSETS + β 7 MB + β 8 RETURN + β 9 LOSS + β 10 STDRET + β YEAR_DUMMIES + β INDUSTRY_DUMMIES + e (4) In addition to the test variable CFO_ON_OWN_BOARD, Model 4 includes a number of control variables standard to this line of research. Those not previously defined include the age of the CFO (CFOAGE) and whether the CFO is a member of the founding family of the company (CFOFOUNDER). To construct the latter measure, we searched all CFO biographies for the term 10 We use the misstated period as opposed to the restatement announcement year in order to be sure that the CFO was present at the time of the misstatement. However, using the restatement announcement year yields qualitatively similar results. 11 We eliminate the year 2007 from this analysis because the discovery and reporting of misstatements often lags several years. Therefore, misstatements in fiscal year 2007 are underrepresented. 12 The requirement to report total compensation exists from 2006, and thus our sample for the total compensation model is significantly reduced. 20

23 found yielding 293 unique CFO biographies. We then read all the relevant biographies and constructed a binary variable that equals one if the CFO or one of her family members is the founder of the company (CFOFOUNDER). We predict a positive sign for both variables because older CFOs have more experience and CFOs who are founders are more entrenched. We also control for BOARDSIZE, predicting that larger boards will grant the CFO higher compensation (Core et al. 1999, Yermack 1996), and for board INDEPENDENCE, but do not predict a sign. We predict higher compensation for CFOs employed by larger companies (ASSETS), and those with more investment opportunities, measured as market/book ratio (MB, calculated as the market value of equity divided by the book value of equity). We expect that CFO compensation will be higher in companies where stock returns are higher (RETURN) and will be lower in companies that incurred losses in any of the prior two years (LOSS). Finally, to control for risk, we include the standard deviation of stock returns (STDRET) measured over the preceding five years (Core et al. 1999). CFO Turnover Also consistent with the entrenchment literature, we expect that CFOs who serve on the board will have lower turnover likelihood. Model 5 is a probit regression whose dependent variable (CFOCHANGE) is a binary variable equal to one if a new CFO is identified the following year and the departed CFO age is below 60, to account for potential retirement (e.g., Bebchuk et al. 2011). 13 CFOCHANGE = α + β 1 CFO_ON_OWN_BOARD + β 2 CFOAGE + β 3 CFOFOUNDER (5) + β 4 CEOCHANGE+ β 5 BOARDSIZE + β 6 INDEPENDENCE + β 7 ASSETS + β 8 RETURN + β 9 ROA + β 10 MW + β YEAR_DUMMIES + β INDUSTRY_DUMMIES + e Since the literature on CFO turnover is sparse, we use the following control variables previously documented to affect CEO turnover. We control for CFOAGE and CFOFOUNDER, because older executives are naturally more likely to leave the company (Warner et al. 1988), and 13 Since we require the following year to produce the turnover indicator, our sample for this analysis does not include the year