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Internal Control Material Weaknesses and CFO Compensation

57 Pages Posted: 7 Oct 2007 Last revised: 5 Dec 2012

Rani Hoitash

Bentley University - Department of Accountancy

Udi Hoitash

Northeastern University - Accounting Group

Karla M. Johnstone

University of Wisconsin - Madison - Department of Accounting and Information Systems

Date Written: June 1, 2011

Abstract

Boards of directors and compensation committees predominantly use financial measures reflecting executive managerial duties as inputs to executive compensation decisions. Yet, despite the fact that Holmstrom (1979) suggests that any readily available performance measure should be considered in executive compensation decisions, there is little research on the link between executive compensation and non-financial performance measures. We develop and test a model of chief financial officer (CFO) compensation with specific emphasis on the link between the disclosure of internal control material weaknesses (ICMW), a non-financial performance measure reflecting CFO fiduciary duties, and CFO compensation. Since internal controls are under the direct responsibility of the CFO, the disclosure of an ICMW reflects poorly on his/her performance. As a baseline, we find that ICMW disclosures lead to decreases in CFO compensation (bonus, equity, and total). Of greater interest, we find that CFOs at firms with stronger governance experience larger compensation decreases upon ICMW disclosures compared to CFOs at firms with weaker governance. In addition, CFOs at firms with greater costs of financial statement misreporting experience larger compensation decreases upon ICMW disclosures compared to CFOs at firms with lower costs of misreporting. Taken together, these results contribute to the relatively sparse literature on CFOs by illustrating the importance of CFO fiduciary duties and the interaction of those duties, in terms of firm governance and misreporting costs, with changes in CFO compensation.

Keywords: CFO Compensation, Internal Controls, Corporate Governance, Sarbanes-Oxley Act of 2002

JEL Classification: J33, G34, G38, M49

Suggested Citation

Hoitash, Rani and Hoitash, Udi and Johnstone, Karla M., Internal Control Material Weaknesses and CFO Compensation (June 1, 2011). Contemporary Accounting Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1019359

Rani Hoitash

Bentley University - Department of Accountancy ( email )

175 Forest Street
Waltham, MA 02452-4705
United States

Udi Hoitash (Contact Author)

Northeastern University - Accounting Group ( email )

360 Huntington Ave.
Boston, MA 02115
United States
671-373-5839 (Phone)

Karla M. Johnstone

University of Wisconsin - Madison - Department of Accounting and Information Systems ( email )

School of Business
975 University Avenue
Madison, WI 53706
United States
608-234-1052 (Phone)
608-265-5031 (Fax)

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