CFO tenure, CFO board membership and accounting conservatism

Abstract

We examine the influence of chief financial officer (CFO) tenure and CFO board membership on accounting conservatism among Australian listed companies. The study uses market-based (i.e., timeliness of earnings to news) and accounting-based (i.e., accrual-based loss recognition) measures of conservative accounting. The results show that while longer CFO tenure and CFO board membership increases accounting conservativism, this is not the case when CFOs become entrenched through long board-membership tenure. This entrenchment appears to lead to the use of aggressive accounting practices. Overall, the results indicate that CFO tenure and CFO board membership improve financial-reporting quality by increasing accounting conservatism in organizations, providing evidence of the importance of recognizing these two governance characteristics in policymaking and in regulation.

Introduction

During the past decade, chief financial officers (CFOs) have received increasing attention from investors in the capital market because of their growing responsibilities in monitoring the production of accounting information and financial statements. Since the enactment of the Sarbanes–Oxley Act (SOX) in the United States (US) in 2002, the Securities and Exchange Commission (SEC) requires CFOs and chief executive officers (CEOs) to certify the accuracy and completeness of their company’s annual and quarterly financial reports.¹ By shifting greater fiduciary responsibility to CFOs and CEOs to produce more accurate and reliable financial reports, SOX is ensuring that adequate internal controls for public disclosure have been established and maintained, thereby providing greater confidence to investors and the market. Similar CFO and CEO fiduciary responsibilities also are practiced in Australia, as these responsibilities are a requirement enforced by the Australian Security and Investments Commission (ASIC) under Australia’s Corporations Act 2001.

The extant literature (e.g., Mian, 2001, Geiger and North, 2006, Dill, 2013) acknowledges that CFOs make an important contribution to top-level strategic decision making in organizations through their knowledge and input into competitive and financial-market strategies, operating policies, and investment decisions. Compared with other executives in the organization, CFOs have substantial control over the firm’s financial-reporting practices via their expertise and capacity to determine when and what financial numbers require reporting, and whether annual performance targets are being met (Mian, 2001, Geiger and North, 2006). CFOs also can influence the board of directors’ decisions in relation to stricter application of accounting standards to recognize bad news as losses rather than recognizing good news as gains, ensuring that conservative accounting practices are being followed. Given CFOs’ strategic decision-making position in organizations, it is important to understand their role in the financial-reporting process. Accordingly, we examine whether CFO tenure and membership on the board of directors have any effects on the company’s use of conservative accounting practices among Australian listed companies.

Conservative accounting practices can reduce potential earnings manipulation by managers, who might opportunistically increase earnings by choosing aggressive accounting practices that do not require a higher degree of verification for the recognition of good news in financial statements. Given that investors’ decision making relies on reported financial information, accounting conservatism demands timely information about bad news precisely because investors, debtholders, and creditors, as residual claimants, are more sensitive to a decline than an increase in firm value (Basu, 1997). Hence, research (e.g., Ball, 2001, Watts, 2003) suggests that accounting conservatism disciplines managerial investment decisions, thereby making it useful for mitigating agency problems.

Organizational behavior theory via the expertise hypothesis postulates two competing arguments on the consequences of the CFO’s tenure in organizations. One argument proposes that CFOs with longer tenure and who have unique knowledge about the firm have stronger incentives not to overstate earnings and/or net assets and not to withhold information on expected losses, thereby ensuring a higher degree of verification standards for gain recognition. Longer tenure also has a reputational effect on the CFO’s position. Milbourn (2003) argues longer CFO tenure within the firm assists CFOs to establish their reputation in the market, given that longer tenure is an indicator that the CFO has survived previous dismissal decisions by the board. Further, after establishing their reputation, CFOs can become more concerned with reputation protection (Diamond, 1989), and any detection of aggressive accounting practices that do not require strict verification standards for the recognition of good news in financial statements could adversely affect the CFO’s reputation. Thus, concern with preserving their reputation motivates the CFO to avoid such aggressive accounting practices. However, the opposing argument suggests that CFOs with longer tenure could become entrenched in their position (Morck et al., 1988) and thus more powerful in the organization, enabling them to choose more aggressive accounting practices that do not necessarily require strict verification of standards for the recognition of good news in financial statements.

CFOs are top-level executives in the organization who can be invited to sit on the company’s board of directors. A CFO’s board membership can give them the power to vote on important organizational matters, offer them opportunities to communicate directly and frequently interact with other board members, and provide them with greater responsibility over firm performance (Mobbs, 2011). CFOs who are board members and adopt conservative accounting practices can ensure accountability by explaining to management the implications of enforcing such accounting practices in the firm, particularly the effect of conservative accounting on share-price movements, on corporate management’s reputation, on risk, and on internal controls. In contrast, prior research also suggests that board membership provides executive officers with greater powers, which can have a detrimental effect on accruals quality and thus more aggressive accounting practices (Beasley, 1996, Dechow et al., 1996). However, social network theory and the theory of friendly boards suggest (Adams and Ferreira, 2007) that the quality and effectiveness of board decisions improves when company executives cooperate with external board members (Westphal, 1999).

Accordingly, we contend that CFO board membership will influence the firm’s conservative accounting practices. Further, consistent with agency theory, we argue that CFOs who hold board memberships, coupled with longer tenure on the board, might become entrenched in their positions. Entrenched CFOs are likely to be motivated to exploit accounting information to enhance their private interests by linking managerial compensation to reported earnings (Basu, 1997), thereby creating incentives to withhold information that would adversely affect their compensation. Therefore, CFOs with longer board-membership tenure are likely to be more powerful, thereby providing them with the ability and incentive to influence the timely reporting of good and bad news.

Most of the literature on CFOs’ role in relation to accounting practices is based on US data, with limited research in the context of the Australian market. In the early 2000s, CFOs were involved in a number of high-profile corporate failures in Australia that resulted in heightened and ongoing scrutiny from Australian regulators and investors.² Section 295A of the Australian Corporations Act 2001 requires CEOs and CFOs of listed entities to sign off on their company’s annual accounts, and to declare that the company’s financial reports present “a true and fair view in accordance with relevant accounting standards.” ASIC also requires the board of directors to ensure that CFOs have the sufficient qualifications, knowledge, competence, experience, and integrity to undertake their roles (ASIC, 2014).

There are several important differences between the institutional environments of the US and Australia. For example, compared with the US, Australia has lower litigation risk (Lim, 2011), higher ownership concentration (La Porta et al., 1998), relatively larger private benefits of control (Nenova, 2003), a relatively weaker monitoring system (Dignam and Galanis, 2004, Muniandy et al., 2016), and Australian firms are significantly smaller than US firms. In addition, unlike in the US, resource (i.e., mining and energy) companies mainly dominate the Australian capital market.³ Given that mining projects require significant upfront investment, coupled with long project lives and high uncertainty over the prospects of these projects, management decision making in Australia relies on the type of recognition and measurement standards used in the resources sector. For example, higher levels of uncertainty in the resources sector could influence the CFO to adopt accounting policies that would expedite the recognition of expenses/losses and defer revenues/gains. Australia’s accounting treatment in relation to certain items in its accounting standards such as AASB 138 is also different from that found in the US Generally Accepted Accounting Principles (GAAP).⁴ These environmental and institutional factors suggest that the CFO’s board experience, coupled with their tenure in the organization, could play an important role in whether they utilize aggressive or conservative accounting approaches.

To achieve our research aims, we examine all non-financial firms listed on the Australian Securities Exchange (ASX) during the period 2001–2014 to measure the effect of CFO tenure and CFO board membership on conservative accounting practices. We follow previous literature and use market-based, that is, Basu’s (1997) timeliness of earnings to news, and accounting-based, that is, Ball and Shivakumar’s (2005) accrual-based loss recognition, measures of accounting conservativism. Consistent with the reputation and expertise arguments, we find that the CFO’s overall tenure in the organization as CFO is significantly and positively associated with conservative accounting practices, suggesting that longer-serving CFOs are more likely to ensure a higher degree of verification standards for the recognition of bad news in financial statements. Similarly, our results show that CFO board membership is significantly and positively associated with a greater degree of accounting conservatism observed in the financial-reporting practices of Australian companies. However, we observe a significant negative effect on accounting conservatism for CFOs who have longer board-membership tenure,⁵ suggesting entrenched CFOs are less likely to practice accounting conservativism. Our results are robust to alternative measures of accounting conservatism, as well as to the inclusion of additional control parameters such as CEO tenure and self-selection bias. Overall, our results suggest that CFO tenure in the organization and board membership are important CFO characteristics that influence conservative accounting financial-reporting practices.

Our study contributes to the extant literature and to practice. First, it is one of the first investigations to provide robust evidence on the role of CFOs in conservative accounting practices. Second, it expands the limited Australian evidence on the role of CFOs in organizations, particularly by identifying which CFO corporate-governance characteristic is potentially affecting conservative accounting practices among listed companies in Australia. Third, it examines the unique effect on accounting conservatism of the CFO’s tenure in the organization, their corporate board membership, and their tenure as a member on the board of directors. Prior research has considered only CFO characteristics such as gender (Barua et al., 2010), equity incentives (Billings et al., 2014), new CFO appointments (Geiger and North, 2006), and financial expertise combined with educational background (Aier et al., 2005).

By differentiating between the CFO’s membership on the board of directors and their tenure as a member of the board of directors, we are able not only to uniquely examine the entrenchment effect, but also gauge which of these governance characteristics specifically affects the financial-reporting process. In doing so, our study provides useful insights into some of the contrasting perspectives presented in the extant literature (e.g., Geiger and North, 2006, Ali and Zhang, 2015) on the role of top management’s tenure and board membership in relation to financial-information disclosure. For example, while Geiger and North (2006) show a significant reduction in discretionary accruals in the period following the appointment of a new CFO, Ali and Zhang (2015) find greater earnings management in the early years (i.e., first three years) of CEO service compared to the later years of CEO service (i.e., one year prior to the CEO turnover year).

Our study contributes to these contrasting perspectives by discerning that while longer CFO tenure in the organization and CFO board membership improves financial reporting via the greater use of conservative accounting practices, this is not the case when CFO’s become entrenched on the company’s corporate board because this entrenchment appears to lead to the use of aggressive accounting practices. The findings of this study are relevant for policy makers because they enable identification of the specific roles that CFOs can play in enhancing the governance of organizations, as well as how their expertise and preservation of reputation can positively affect improvements in financial-reporting quality.

The remainder of the paper is organized as follows: Section 2 presents the literature review and hypothesis development; Section 3 outlines the research methodology and sample-selection procedures; Section 4 discusses the results of the empirical tests; Section 5 presents additional analyses; and Section 6 briefly summarizes the paper and offers conclusions.