It's common sense that a corporation would want its C-Suite to have some knowledge of accounting practices, and one could assume that a lack of understanding of corporate accounting may heighten the risk for misstatements on financial reports. A new report suggested a surprising correlation between executives' accounting expertise and the risk of those misstatements, and researchers said the findings could be key to auditors, financial regulators and corporate directors.
CPA Practice Advisor found new research last week from the American Accounting Association's The Accounting Review that explores the connection between C-Suite members both with and without accounting expertise, and the presence of financial misstatements. The conclusions represent a shift in perception regarding the importance for CFOs and other C-level executives to have accounting expertise, following a string of high-profile accounting scandals over the years.
In their "Do Auditors Recognize the Potential Dark Side of Executives’ Accounting Competence?" report, accounting professors Anne Albrecht of Texas Christian University, Elaine Mauldin of the University of Missouri and Nathan J. Newton of Florida State University examined data from 3,252 public companies over a 10-year period. In addition to assessing how many members of the C-Suite have accounting experience, the researchers looked at other data points, including executive pay, complexity of company finances, financial performance and more.
The report concluded that while C-level executives' accounting expertise may not correlate with more frequent financial misreports by itself, the correlation occurs when executives are found to have "excess executive compensation" — that is, when they are paid significantly more than estimates would have guessed. The researchers examined executive pay as a risk factor because auditing standards include executive compensation in their risk assessment and prior research.
"A dark side of accounting competence [emerges] in the presence of compensation-based initiatives," the report's authors said, adding that executives with accounting expertise have "extensive knowledge of audit procedures and negotiation tactics. As a result, executives could use their higher-order ability to hide misstatements or to avoid current-period adjustments when the external auditor finds misstatements."
It's not that C-level executives with higher pay lack integrity, the report noted. Instead, the findings suggested that this "accounting competence interacts with other fraud risk elements to increase the risk of material misstatement."
What's more, the research found that auditors' fees tend to reflect the upside of C-Suite accounting competence, rather than the risks found in the report.
"The results suggest auditors over trust executives with accounting competence," the report said, "regardless of evidence of an aggressive reporting attitude."
Below, PYMNTS breaks down some of the key data points from the research.
Ten percent of company financial reports analyzed contained a misstatement that was ultimately corrected by following restatements.
Twelve percent of companies analyzed had at least one C-level executive with prior audit experience, either as a partner or manager of a public accounting firm. Sixty-one percent of these executives were the CFOs of their companies, while 9 percent were CEOs.
Thirty percent: the rate at which high-pay executives with accounting expertise are more likely to misstate. When looking only at high-pay executives, these professionals are only 4 percent more likely to misstate than firms with relatively low-pay executives. Yet, when high pay and accounting expertise are combined, the likelihood increases significantly.
Sixteen years ago, the U.S. Congress created the Public Company Accounting Oversight Board (PCAOB) to curb a recent rise in accounting scandals. The PCAOB lists a lack of managerial accounting competence as a key factor that raises the risk of financial misreporting. However, the American Accounting Association suggested regulators and auditors must examine the issue through a new lens, as accounting expertise may actually pose as another risk factor for misstatement, too.