Playing Follow-the-leader Misstating Financial Statements: Impact on CEO Compensation and Cost of Capital

Abstract

Effective internal control over financial reporting (ICFR) should either prevent or enable correction of any material misstatement in a firm’s financial statements. Independent auditors, guided by professional standards, prepare an ICFR audit report, which provides a gauge by which the public can evaluate the reliability of a firm’s financial information. A firm manager may be tempted to misstate financial statements if he/she perceives a substantial reward for doing so. This study examines whether managers and firms are rewarded for misstating their financial statements in situations where there are incentives to do so, specifically, when an industry-leading peer is fraudulently inflating its reported earnings. The authors test to see if managers experience an increase in compensation as a result of misstatement. The authors also test to see if their firms benefit from misstating via changes to their cost of capital. Results suggest that neither managers nor their firms benefit from managing earnings by misstating financial statements. These findings are important, because a manager who ex ante understands that misstating will not lead to benefits personally or his/her firm is less likely to misstate in the first place.

Citation

Wood, J. and Smith, L.M. (2021), "Playing Follow-the-leader Misstating Financial Statements: Impact on CEO Compensation and Cost of Capital", Baker, C.R. (Ed.) Research on Professional Responsibility and Ethics in Accounting (Research on Professional Responsibility and Ethics in Accounting, Vol. 24), Emerald Publishing Limited, Leeds, pp. 119-146. https://doi.org/10.1108/S1574-07652023006