Chief Financial Officer Co-option and Chief Executive Officer Compensation

Abstract

We study whether relative power in the chief executive officer (CEO)–chief financial officer (CFO) relationship influences CEO compensation. To operationalize relative power of a CEO over a CFO, we define CFO co-option as the appointment of a CFO after a CEO assumes office. We find that CFO co-option is associated with a CEO pay premium of about 10%, which is concentrated more in the early years of the co-opted CFO’s tenure and in components of compensation that vary with the achievement of analyst-based earnings targets. Our evidence also indicates that a primary channel through which CEO power over a co-opted CFO yields the achievement of earnings targets is the use of earnings management to inflate earnings. Co-opted CFOs rely primarily on using discretionary accruals to manage earnings prior to the Sarbanes–Oxley regulatory intervention and switch to real-activities manipulation afterward. The evidence thus suggests that the form of earnings management depends on costs imposed on the CFO to inflate earnings. This paper was accepted by Suraj Srinivasan, accounting.

Can CFOs Resist Undue Pressure from CEOs toManage Earnings?

“…Prior research shows that CEOs of manipulating firms use their power and authority to exert pressure on CFOs regarding financial reporting practices. This helps CEOs achieve personal financial gains (Feng et al, 2011;Dikolli et al, 2020) and/or maintain their reputation for beating earnings expectations (Chu et al, 2019). 2,3 In this study, we argue that, while most CFOs are constantly subjected to CEO pressure, some CFOs are less susceptible to it, and hence less likely to engage in earnings management.…”

“…Wu (2019) focuses on CFO awards as a means for increasing CFO power over the CEO and finds that more CFO power is associated with less earnings management; Dikolli et al (2020) look at CEO tenure relative to the CFO and find that longer-tenured CEOs have the ability to pressure newly-appointed CFOs to inflate earnings in order to enhance their own compensation. These studies typically focus on a single or a small set of managerial attributes that can influence the balance of power between the CEO and the CFO.…”

“…they lead into higher CEO compensation) at the expense of the quality of financial reporting (see e.g. Feng et al, 2011;Dichev et al, 2013;Friedman, 2014;Chu et al, 2019;Dikolli et al, 2020).…”

CEO tenure: An integrative review and pathways for future research

“…Early conceptual and process works focused on the phases of CEO tenure (e.g., Gabarro, 1987; Hambrick & Fukutomi, 1991; Mintzberg, 1973; Vancil, 1987). Building on these works, scholars in both fields have examined a variety of topics in relation to CEO tenure, including CEO‐related factors, such as motivation and commitment (e.g., Hambrick et al, 1993; McClelland et al, 2010); compensation (e.g., Hill & Phan, 1991; Singh & Harianto, 1989; Taylor, 2013; Wowak et al, 2011); CEO–board relations (e.g., Graham et al, 2020; Hou et al, 2017); CEO–top management team (TMT) dynamics (e.g., Dikolli et al, 2021; Ocasio, 1994); and CEO decision‐making (e.g., Ali & Zhang, 2015; Marinovic & Varas, 2019). Scholars have also examined the relations between CEO tenure and various outcomes at individual and firm levels, such as innovation (e.g., Wu et al, 2005), strategic change (e.g., Boeker, 1997), and performance (e.g., Miller, 1991; Miller & Shamsie, 2001; Simsek, 2007).…”

“…reveal that as CEO tenure advances, a CEO gains growing influence on the organization and its resources, increasing the ability to create a unity of purpose with internal stakeholders like employees and better respond to the needs of external stakeholders like customers over time, which may affect firm performance. In exploring a more complex relationship that accounts for both the predisposition and the opportunity to exert social influence to serve one's own interests, O'Reilly et al (2014) find that longer tenures increase the ability of narcissistic CEOs to influence boards of directors and receive significantly larger compensation packages.Relatedly, a few studies have used CEO tenure as a proxy for CEO's closeness to specific roles or individuals in the upper echelons.For instance,Simsek (2007) finds that TMTs serve as important interfaces between the CEO and firm outcomes and that the analysis of their joint interaction offers a more complete and accurate understanding of how CEOs exert influence on firms' outcomes Dikolli et al (2021). argue that the power of the CEO relative to the power of the CFO significantly affects CFO compensation, especially when the CFO is appointed during the CEO's tenure.…”