The Effects of Executive Compensation and Auditor Industry Specialization on Financial Reporting Executives\' Decision-Making during a Potential Restatement That Will Lead to a "Clawback"

In accordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the Securities and Exchange Commission is required to propose and adopt clawback rules. After a financial statement restatement, a clawback is utilized to recover incentive compensation that was previously paid out to a manager based on the misstatement. My study investigates financial reporting executives' (FREs) decision-making after the external auditors have proposed a restatement that will lead to a clawback. I performed a web-based experiment that was electronically distributed to sixty FRE participants (i.e., CFOs, controllers, and treasurers) and manipulated executive compensation structure (i.e., a higher percentage of total compensation based on incentives or a lower percentage of total compensation based on incentives) and auditor industry specialization (i.e., industry-specialist or non-industry specialist) in a clawback environment.

I hypothesized that higher incentives or the presence of a non-specialist auditor would cause FREs to be less likely to agree with an auditor's proposed restatement, more likely to involve the external auditor's national office, and more likely to request termination of the external auditors. Further, I posited that the two factors would interact for each of the three dependent variables. As predicted, my results reveal that FREs are less likely to agree with the restatement due to loss aversion when a higher proportion of their pay is incentive-based; however, auditor specialization does act to mitigate the influence of loss aversion by increasing their likelihood to accept the restatement. Additionally, I find that FREs are highly likely to request the involvement of the national office and very unlikely to request termination of the auditors across all conditions.

In consideration of the upcoming clawback rules, this is a timely study that makes important contributions. First, I find an unintended negative consequence of clawback regulation, as my results indicate that clawbacks may exacerbate aggressive financial reporting decisions by FREs during a restatement negotiation. Further, I find that specialist auditors can act as effective monitors of FREs' behaviors in a clawback environment. Last, my results provide evidence for firms regarding the influence of executive compensation structures on FREs' decision-making in a clawback setting.