Electronic copy available at: https:ssrn.comabstract=2978195
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1. Introduction
In an attempt to deter management fraud, the SEC passed the Sarbanes-Oxley Act of 2002, Section 302, “Corporate Responsibility for Financial Reports”, that requires the Chief
Executive Officer CEO and the Chief Financial Officer CFO to certify the appropriateness of the financial statements and holds the top executives personally responsible for
misrepresenting the operations and financial conditions of the company. Since financial reporting primarily falls within the scope of the CFO responsibilities, the certifications
required by the Sarbanes-Oxley Act of 2002 force CEOs to take a more active role in the financial reporting process and assume responsibility for preparing financial statements
Chang et al. 2006; Geiger Taylor 2003. This study investigates the effects of increasing the CEO’s and the CFO’s accountability on earnings quality in a financial market setting. In
particular, we assume that the CEO may be held accountable for the CFO’s misreporting and consider the benefits and downsides of increasing the CEO’s responsibility for the reporting
bias introduced by the CFO. CFOs are formally in charge of the financial reporting process. It is therefore not surprising
that they exercise influence on the earnings report and should be held responsible for corporate misreporting e.g., Geiger North 2006; Jiang et al. 2010; Dichev et al. 2013. Interestingly,
abundant literature on earnings management investigates the link between financial misreporting and CEOs’ incentives to misrepresent earnings e.g., Burns Kedia 2006.
Given CEOs’ distinctive position in corporate control and their extensive decision rights, they can arguably prevent misreporting or foster earnings management by imposing pressure on
CFOs even if CFOs are personally responsible for the reliability of financials reports e.g., Feng et al. 2011; Dikolli et al. 2016.
After a series of corporate scandals such as Enron, WorldCom and Adelphia, US regulators followed the latter argument in their implementation of the Sarbanes-Oxley Act in 2002.
Particularly Section 302 of the Sarbanes-Oxley Act emphasizes the joint responsibility of the CFO and the CEO for the accuracy of the financial statements and should ensure that CEOs
can no longer claim ignorance about accounting and disclosure details as did the CEOs of Enron and Worldcom Chang et al. 2006; Geiger Taylor 2003. In line with this regulation,
in the recent case Perrenod versus United States, the CEO of Parallax Design and Construction, George Perrenod, was held responsible for accounting and payroll tax fraud
committed by the company’s CFO at the time, Stanley Thompson Wood 2013. In an empirical study, Chang et al. 2006 analyze the SEC Order that preceded the introduction of
3 Section 302 and find preliminary evidence that the certification requirement positively
influences the market value of complying firms.
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However, opponents of the certification requirement argue that the regulation imposed an unreasonable liability on CEOs. In a
provocative article in Capital Magazine, Don Luskin, the Chief Investment Officer at Trend Macrolytics, claims that the CEO “could still be found guilty of a felony even though he acted
in utter innocence and good faith ” Luskin 2004.
This anecdotal and empirical evidence raises the question how the responsibility for financial reporting bias should be allocated between the CFO and the CEO. Yet, contemporaneous
theory is silent on the effect of making the CEO accountable for the CFO’s reporting bias. We investigate the effects of the CFO’s and the CEO’s responsibility for financial reporting bias
in a hierarchical reporting setting where the firm’s CFO prepares an earnings report and the CEO then provides the report to the market. The CFO and the CEO may sequentially engage
in biasing the report. The uncertainty about the incentives and the actual biasing costs of the executives prevents the market from perfectly inferring the reporting bias.
In this setting, it seems likely that increasing the responsibility of the CFO and the CEO for the CFO’s reporting bias would reduce earnings management and increase the quality of
reporting earnings. In fact, we find that increasing the CFO’s responsibility for biasing the financial report deters him from engaging in earnings management activities and positively
influences earnings quality. However, contrary to the expectation, we show that increasing the CEO’s responsibility for the CFO’s biasing does not necessarily imply a higher quality of
reported earnings. Rather, making the CEO accountable for the CFO’s reporting bias has two opposing effects. On the one hand, if the CEO is held accountable for the CFO’s misstatement
of earnings, the CEO has an incentive to challenge the CFO’s report and partially reverse the introduced bias. On the other hand, the CEO’s cost of adjusting the report is unknown which
introduces additional noise to the reported earnings, thereby reducing earnings quality. Whether the overall effect of the CEO’s responsibility on earnings quality is positive or
negative depends on the CFO’s and CEO’s incentives to bias earnings and on the market’s uncertainty about the executives’ incentives and the costs of biasing. In particular, the earnings
quality is likely to increase in the CEO’s responsibility for the CFO’s reporting bias if the CFO’s cost of biasing and his responsibility for the reporting bias are low, if the market’s
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The SEC issued the Certification Order on June 27, 2002, requiring the CFOs and the CEOs of 947 large companies to certify the most recent financial statements. The Sarbanes-Oxley Act of 2002, Section 302
extended the one-time SEC Order to all 15,000 publicly traded firms and to a periodic requirement.
4 uncertainty about the CFO’s incentives is high and if the uncertainty about the CEO’s actual
cost of biasing is low. Our analysis is related to two strands of literature. First, we build on studies that investigate
earnings management in a financial market setting. In a steady-state learning model where investors are perfectly informed about managerial reporting objectives, Stein 1989 shows
that reporting bias is rationally anticipated by investors. As a consequence, earnings management decreases the welfare, but does not affect the information content of earnings.
This result collapses if the market is uninformed about the manager’s reporting objectives. Fischer and Verrecchia 2000 and Dye and Sridhar 2004 introduce exogenous noise that
prevents the market from fully recovering the reporting bias. Fischer and Verrecchia 2000 assume that investors have incomplete information about the financial and non-financial
incentives of the management. Dye and Sridhar 2004 consider uncertainty about the manager’s private biasing costs.
Both models have been extensively used in the earnings management literature. For instance, Sankar and Subramanyam 2001 as well as Ewert and Wagenhofer 2005 extend the analysis
to a two-period reporting framework with accrual reversals. Heinle and Verrecchia 2016 analyze firm’s decision whether to disclose and to bias information in the presence of other
firms who may also release potentially biased reports. There are few studies which consider financial reporting as multi-stage process. Dye and
Sridhar 2004 study the interaction between the firm’s accountant and the manager. The role of the accountant is limited to aggregating subjective information elicited from the firm’s
manager and objective information. Caskey et al. 2010 consider a two-stage reporting game similar to ours. The manager of a firm provides a potentially biased preliminary report to the
firm’s audit committee. The audit committee is able to correct the report based on its own private information about fundamentals.
We add to this strand of literature in the following ways. First, we explicitly address the allocation of responsibility in the firm’s financial reporting process and focus on its effects on
earnings quality.
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Second, we study a two-stage reporting game where the CEO has superior
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Ewert and Wagenhofer 2005 analyze an alternative way to increase the responsibility of top executives by tightening the accounting standards. They do not differentiate between financial reporting bias introduced by
the CFO or CEO and focus on the trade-off between accounting and real earnings management.
5 information about the financial or non-financial incentives of the CFO compared to the
financial market. Second, our analysis is related to the literature on the interaction of CFO and CEO in financial
reporting decisions. Indjejikian and Matĕjka 2009 analyze the simultaneous incentive
contract choice for the CEO and the CFO of a firm. Both parties provide productive effort, but the CFO can additionally overstate earnings and improve reporting quality by reducing the
measurement error. Friedman 2014 and Friedman 2016 analyze the interaction of the CEO’s and CFO’s decisions in an optimal contracting setting. The CEO provides productive
effort while the CFO can improve reporting quality and at the same time can bias the financial report. Friedman 2014 assumes that a powerful CEO can force the CFO to choose a bias
level in his best interest. High CEO power implies lower reporting quality and higher bias levels if the CFO is primarily accountable for corporate misreporting. The assignment of
responsibility should reduce the powerful CEO’s willingness to apply pressure to account for these detrimental effects. Friedman 2016 does not consider the case that the CEO is
accountable for reporting bias, but discusses the incremental effect of effort interactions between CEO and CFO. Improved reporting quality reduces the CEO’s productive effort
costs. In this sense, improving reporting quality serves multiple purposes monitoring, decision-making, and contracting.
Within this strand of literature, our analysis is most closely related to Friedman 2014. We also discuss the role of CEOs in influencing the firms’ earnings management and study the
implications of CFO and CEO responsibility. In contrast to Friedman 2014, we do not consider an optimal contract choice, but assume exogenous incentives tied to the firm’s stock
price and focus on the effect of the CFO and CEO responsibility on the financial market. Our analysis accounts for the sequential structure of the reporting interaction and different sources
of asymmetric information between CFO and CEO as well as between the firm and the financial market.
We contribute to the literature in the following ways. First, we account for the hierarchical structure of the financial reporting process and study earnings management in a setting where
the CFO and the CEO can sequentially bias the earnings report. Second, we analyze the allocation of responsibility for financial misreporting between the CFO and the CEO and find
that higher CEO responsibility for the CFO’s misreporting does not necessary imply higher earnings quality. This result is contrary to the expectation and has consequences for regulators,
who should consider the potentially adverse effects of making the CEO accountable for
6 reporting bias by his subordinates on earnings quality. If CFO’s can hardly be held accountable
for misreporting earnings, increasing the responsibility of the CEO becomes more beneficial, i.e., the CFO’s and CEO’s responsibility for the CFO’s bias in financial reports are substitutes
with regard to earnings quality. Finally, we address the role of compensation disclosure and transparency with regard to managerial incentives. We show that higher responsibility of the
CEO is beneficial if there is high uncertainty about the CFO’s incentives in the market. Such uncertainty potentially arises from limited transparency with regard to his financial incentives
and career opportunities. The remainder of the paper is organized as follows. Section 2 describes the model and the
assumptions underlying the analysis. Section 3 considers the optimal biasing strategies of the CFO and the CEO and Section 4 characterizes the rational expectations equilibrium. Section
5 presents comparative static results for earnings quality, and Section 6 concludes.
2. The Model
