To deter financial misstatements, many companies have recently adopted compensation recovery policies—commonly known as “clawbacks”—that authorize the board to recoup compensation paid to executives based on misstated financial reports. Clawbacks have been shown to reduce financial misstatements and increase investors' confidence on earnings information. We show that the benefits come with an unintended consequence of certain firms substituting for accruals management with real transactions management (e.g., reduce research and development [R&D] expenditures), especially firms with strong incentives to achieve short-term earnings targets, such as firms with high growth or high transient institutional ownership. As such, the total amount of earnings management does not decrease subsequent to clawback adoption. We further show that although real transactions management temporarily boosts those clawback adopters' short-term profitability and stock performance, this trend reverses after three years. In summary, clawbacks may have unexpected effects for a subset of firms whose managers are under greater pressure to meet earnings goals. Data Availability: All data used in the study are publicly available from the sources cited in the text.

While firm-initiated compensation recovery (or clawback) provisions are gaining popularity and the recently enacted Dodd-Frank Act seeks to make the clawback of erroneously awarded compensation mandatory for all listed companies, little is known about their effectiveness. We find that the incidence of accounting restatements declines after firms initiate such provisions. In addition, we show that investors and auditors view such provisions as associated with increased accounting quality and lower audit risk. Specifically, we find that firms' earnings response coefficients increase after the adoption of clawback provisions. Further, for firms that adopt clawbacks, auditors are less likely to report material internal control weaknesses, charge lower audit fees, and issue audit reports with a shorter lag. IntroductionCompensation recovery provisions (commonly known as ''clawbacks''), which allow firms to recoup compensation from corporate executives involved in accounting improprieties, were first introduced by Section 304 of the Sarbanes-Oxley Act (hereafter, SOX 304) in 2002. SOX 304 authorizes the Securities and Exchange Commission (SEC) to enforce the recovery of bonuses paid to CEOs and CFOs of public companies when the company restates its financial statements due to material noncompliance with any financial reporting requirement as a result of misconduct. However, due to the ambiguities in SOX 304 and the SEC's limited resources, SOX 304 has been successfully enforced in only a few cases (Salehi and Marino, 2008;Fried and Shilon, 2011;Morgenson, 2011). To facilitate the enforcement of clawbacks, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act also includes a section (Section 954) on the recovery of erroneously awarded compensation (hereafter, DFA 954). DFA 954 improves upon SOX 304 in two important respects. First, it designates a firm's board of directors, rather than the SEC, as the enforcer of clawbacks. Second, it does not require misconduct as a prerequisite for clawbacks.Since DFA 954 will not be implemented until the first half of 2012, it is not yet possible to empirically determine the extent to which mandatory clawbacks enforced by the board enhance financial reporting integrity. 1 The usefulness of the mandatory clawbacks, however, can be inferred from the clawbacks that are adopted voluntarily. Voluntary clawbacks have become increasingly popular among listed companies in recent years. According to a survey reported by Corporate Library, 194 companies in the S&P 500 index (about 39%) had adopted clawback provisions as of early 2010. Similar to DFA 954, voluntary clawbacks designate a firm's board as the enforcer of the clawbacks. However, unlike DFA 954, voluntary clawbacks usually require misconduct as a prerequisite for enforcement (Fried and Shilon, 2011). Voluntary clawbacks are therefore stronger than SOX 304 but weaker than DFA 954. If firm-initiated clawbacks are found to improve financial reporting quality, DFA 954 is also likely to be beneficial. In this study, we exam...

In this paper, we examine the effect of shareholder rights on reducing the cost of equity and the impact of agency problems from free cash flow (FCF) on this effect. We find that firms with strong shareholder rights have a significantly lower implied cost of equity after controlling for risk factors, price momentum, analysts' forecast biases, and industry and year effects than do firms with weak shareholder rights. Further analysis shows that the effect of shareholder rights on reducing the cost of equity is significantly stronger for firms with more severe agency problems from FCFs.