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Firms disciplined CEOs for financial misstatements well before Enron or Sarbanes-Oxley, study suggests

December 1, 2006

For more information, contact: Benjamin Haimowitz,

With the blue-ribbon Committee on Capital Markets Regulation having just urged less-stringent federal regulation of corporate financial reporting and with more groups and experts due to weigh in early next year, a study in a prestigious management journal asks a timely question:

How diligent have companies themselves been in policing their own financial reporting?

The answer suggested by the study in the current issue of the Academy of Management Journal:: more diligent than critics of corporate America tend to think.

Probing the response of companies to their own financial misstatements, the research finds that misstating companies were more than twice as likely to subsequently change chief executives or chief financial officers than were companies in which no misstatement occurred. In addition, they subsequently had about two thirds more turnover in their boards of directors and audit committees.

In the words of the study, "The executives and directors in charge at the time of the announcement are indeed held accountable and incur some degree of personal loss; settling up does occur."

"A fair amount of self-disciplining seems to have taken place," comments one of the report's authors, Dan Dalton of Indiana University, who carried out the research with Marne L. Arthaud-Day of Kansas State University, Indiana colleague Catherine M. Dalton, and S. Trevis Certo of Texas A&M University. Adds Dalton: "And this was well before the harrowing lessons of Enron or WorldCom or Arthur Andersen, not to mention the passage of Sarbanes-Oxley.

In the words of the study, its time frame "ensured that any turnover noted was not in response to the collapse of Enron (December 2001) or the subsequent passage of the Sarbanes-Oxley Act (2002)."

The report's findings derive from an analysis of executive and director turnover in 116 companies that filed material financial restatements in 1998 and 1999 because of accounting irregularities. "These are not routine financial restatements resulting from changes in accounting procedures or bookkeeping errors," the study notes. "Rather, these restatements are identified by the General Accounting Office (GAO) as resulting from 'aggressive' accounting practices, misuse of facts, oversight or misinterpretation of accounting rules, and fraud."

Each of the restating firms was paired with a company that was about the same size and from the same industry but which did not report a financial misstatement in the three-year period 1997-99 and therefore did not have to restate its finances during that span. The researchers then compared turnovers of CEOs and CFOs in each restating company and its matched pair in the 24 months following the focal company's restatement announcement. They also monitored post-announcement turnover in boards and audit committees in two annual proxy filings.

In their analyses, the researchers controlled for a variety of factors that can affect turnover in top management, such as whether the CEO served as chairman of the board or how companies fared in the post-restatement period in terms of such key financial measures as sales growth, return on assets, and stock price.

Of the 116 restating companies, 54 had CEO turnovers in the 24 months following the restatement announcement, compared to only 27 among the 116 matched pairs, and 55 had CFO turnovers, compared to 31 among the matched pairs. All else being equal, the CEO of a restating company was more than 2.3 times more likely to leave the company than the CEO of its matched pair, while a CFO of a restating company was more than twice as likely to depart than was the CFO of its matched pair. The fact that the sharpest difference in turnovers occurred in the 12 months following restatement suggested to the researchers "a close temporal relationship between the two events."

The discovery that financial misstatements evidently led to disciplining of top executives and directors adds a new dimension, the study's authors believe, to the understanding of managerial accountability. While there is no shortage of studies documenting the removal of corporate leaders because of companies' financial losses or low stock prices, this is among the first reports in which top-management turnover apparently resulted from  "organizational outcomes independent of firm performance." As the authors put it, "We found that restatement events predicted additional, unique variance in executive and director turnover even when we controlled for...accounting and market-based measures [of firm performance]."

To account for the self-disciplining they encountered, the authors invoke the idea of "legitimacy," a concept with deep roots in management literature. Whereas "poor performance may result from leader's honest mistakes or external environmental factors," they write, "restatements tend to involve intentional actions taken by firm leaders [and] therefore constitute a more direct breach of stakeholder trust...a potent threat to organizational legitimacy. Job loss is neither confined to the CEO as a 'sacrificial goat' nor narrowly targeted at the CFO and the audit committee...Instead, the threat to organizational legitimacy posed by a restatement event appears to be so great that any party directly associated with the corporate governance process is affected."

This evidence for corporate self-discipline notwithstanding, Prof. Dalton expresses doubt that much loosening of regulatory policy is now in the cards. "After Enron and WorldCom, Congress simply had to take action, and, whatever the flaws of Sarbanes-Oxley, it erects the three strong pillars indispensable to sound financial reporting -- independence, disclosure, and transparency. Still, as people weigh in on regulation issues in the coming months, they should appreciate that there was a growing recognition in the corporate world of the late 1990s (perhaps reflecting the increasing influence of institutional investors) that misstating and restating finances was not a legitimate corporate strategy. And it was companies' readiness to accept a new financial-regulatory regime to enforce this recognition that in large measure accounts for the fact that a mere five years later responsible people can be discussing easing the rules."

The study, entitled "A Changing of the Guard: Executive and Director Turnover Following Corporate Financial Restatements," is in the December 2006/January 2007 issue of the Academy of Management Journal. This peer-reviewed publication, now in its 49th year, is published every other month by the academy, which, with more than 16,000 members in 92 countries, is the largest organization in the world devoted to management research and teaching. The academy's other publications are the Academy of Management Review, Academy of Management Perspectives, and Academy of Management Learning and Education.

Media Coverage:
The Wall Street Journal. CEO Turnover Is High At Firms Restating Results. (Saturday, December 23, 2006). Many companies react swiftly to financial scandals. (Friday, December 22, 2006).

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