Why do CFOs manipulate earnings? Often because of CEO orders

Much research into the underlying causes of accounting scandals has focused on the role of the CEO or the executive team, rather than the CFO. But given the nature of their job responsibilities, CFOs are in a unique position to facilitate and even carry out accounting schemes. For example, Scott Sullivan, former CFO of WorldCom, admitted to making the most of the illegal accounting decisions, while Stuart Lasher, former CFO of Silk Greenhouse, created and backdated papers to justify the deferral of expenses.

One rare report specifically examined why CFOs engaged in the manipulation of earnings. It found that there were two possible explanations. First of all was the fact that CFOs may “cook the books” for their own personal financial gain. Richard Scrushy, the former CEO of HealthSouth, blamed his former CFOs for an accounting scandal worth $2.5bn. In testimony, he said: “Every one of them has a motive, bonuses, stock options, an opportunity to make a lot of money, power and greed.”

Then there’s the CFO who becomes involved in accounting manipulations because of pressure from the CEOs In fact, research shows that CFOs often claim that they make improper accounting decisions under CEOs’ instruction. William Owens, the former HealthSouth CFO, stated that Scrushy had demanded management inflate financial figures to meet market expectations. 

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It is the latter option that has reared its ugly head once more in research, with Henry Friedman’s study – titled “Implications of power: When the CEO can pressure the CFO to bias reports” – citing that CEOs with significant “power” often “compromise the independence of a CFO who is responsible for reports upon which performance is assessed.

“There has been significant discussion about who is ultimately responsible for accounting manipulations. At the same time there has been a big push to increase punishment for executives that are anywhere near wrongdoing, which is usually the CFO. One party may be taking the actions, but it’s the other one that caused them to act.”

Friedman suggested the research would have implications for the interaction between the CEO and the CFO in terms of financial reporting quality that offers a “lens” into the motivations behind accounting manipulation.

For example, the research findings suggested boards could avoid accounting scandals by putting the proper incentives and safeguards in place when a CEO and CFO are hired, rather than attempting to force disincentives after the act.

In fact, Friedman argued that the increase in punishment against CFOs that manipulate accounting can often “backfire.”

“The research indicates that harsher punishments against CFOs could actually lead to lower financial reporting quality,” Friedman said. “Increasing the punishment or costs to the CFO just forces them to figure out new ways of getting around getting caught.”

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Image: Shutterstock

By Shané Schutte

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