Authors: Steven Balsam (Temple University), Afshad J. Irani (Washington and Lee University), and Jennifer Yin (University of Texas at San Antonio)
Publisher: Accounting Horizons, forthcoming
Date Published: September 2012
When chief financial officers manage earnings and expectations so that their firm’s results meet or slightly beat analysts’ targets, they receive about 40 percent more in bonus pay than they do when their company falls short of the mark, this paper finds, showing that the pay-for-performance trend that has come to dominate CEO compensation packages now extends to CFOs. The findings highlight the need for CFOs to encourage analysts to keep their earnings projections at achievable levels.
Previous research has established that CEO compensation is increasingly tied to how shareholders evaluate overall firm performance, measured through various metrics such as earnings, stock returns, and market share. Likewise, lower-level managers are often compensated according to their division’s performance and contribution to firm-wide success.
But the CFO’s role is a mixed bag. Although they have some firm-wide responsibilities, such as preparing financial statements, CFOs aren’t responsible for setting the company’s strategy and don’t generate operating profits themselves. Instead, they manage earnings and expectations by investing excess cash effectively and by maintaining external relations with investment banks and lenders to ensure access to less-expensive capital, among other things.
The role of the CFO has received some legislative attention in the United States in recent years. The Sarbanes-Oxley Act of 2002, for example, made CFOs explicitly responsible for the veracity of financial statements, and the Securities and Exchange Commission’s proxy statement revisions in 2006 stipulated that CFOs’ pay must be disclosed along with that of other top-earning executives. Little research, however, has examined the way CFOs are compensated.
This paper looks not only at the structure of CFO pay packages, but also at how compensation relates to job complexity, and whether CFOs are rewarded for effectively managing profits and earnings expectations. To conduct their study, the researchers obtained analyst forecast data from the Thomson Reuters I/B/E/S database, financial information from Compustat, stock returns from the Center for Research in Security Prices, and details on CFO pay from ExecuComp, which tracks executive compensation at S&P 1000 firms.
The researchers eliminated CFOs whose tenure had been less than two years and also ruled out abnormally low or high pay packages. In all, the researchers analyzed the compensation of 2,107 CFOs at 1,477 firms whose average assets approached US$3 billion, from 1993 to 2006.
Over the 14-year period, total annual compensation for CFOs averaged $1,261,290, including $266,104 in salary and $182,436 in bonuses as well as stock option grants and other forms of deferred payment, the researchers calculated. But these numbers increased sharply over time, they note, consistent with the emerging importance of CFOs. For example, average total compensation, after controlling for inflation, increased from $761,632 in 1993 to $1,462,484 in 2006.
As an example of how a CFO’s credibility in financial markets and analyst circles can be vital to a firm’s performance, the researchers cite a longtime CFO of the CBS Corporation, who had recently orchestrated a large bond issue that assuaged investor concerns about $1.2 billion in debt that was coming due. “The issuance of debt and/or sale of equity require the CFO to file registration statements and deal with underwriters, lawyers, auditors and investors,” the authors write, illustrating the range of contacts necessary to effectively manage earnings and expectations.
CFO compensation — both salary and bonus — increased with the size of the firm and the intricacy of its investing and financing activities. But, in what the authors call their most interesting finding, CFOs got much higher bonuses in years when they met or barely beat analyst expectations. The bonuses of these CFOs were 42 percent higher, on average, than what they received when their firm fell short of earnings goals.
The data showed that more than half of the firms that met or barely beat their targets either persuaded analysts to lower their forecasts or employed effective investment strategies to avoid missing their earnings goals. “In other words,” the authors write, “CFOs are being rewarded for their job-specific performance.”
To earn large compensation packages, it pays for CFOs to aim low — meeting or just beating earnings expectations by effectively investing profits and revising analysts’ expectations to a realistic level.