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With reporting season in full swing, many ASX-listed companies are releasing their financial results to the market.
These results are used to cast judgement on the performance of the company, led by the chief executive officer (CEO). Amid all the information released by the company, there is one figure all eyes will fixate on – earnings.
The earnings figure will have wide-ranging impacts on company employees, investors, and everyday Australians who have their superannuation invested in the stock market.
Despite its importance, the financial reporting process that goes on behind the scenes to decide the earnings figure is hidden to those outside the boardroom.
The hidden process in financial reporting
Financial reporting is a complex process that involves millions, if not billions, of company transactions summarised into one earnings figure. While the concept of earnings is straightforward, the choices made in calculating them are anything but simple.
At face value, earnings are the difference between what a company receives from customers for delivering a good or service and what it costs the company to deliver that good or service.
However, behind the figure are many choices the company makes about which accounting policies to use. This includes deciding how long an asset will last or how many customers will not pay their debts to the company.
These decisions can result in major changes to the earnings figure.
Boardroom power play
Typically, investors benefit from higher stock values when their companies report higher than expected earnings.
Often, the other big winner is the CEO. CEOs regularly receive large bonuses when earnings exceed performance targets set by the company. This is designed to motivate CEOs to improve company performance.
However, academic research reveals some CEOs will engage in disturbing action to meet performance targets.
Instead of driving genuine performance improvements, the pressure faced by CEOs to meet targets often results in them pushing for accounting policies that inflate earnings.
There are safeguards to maintain checks and balances on the CEO. The board of directors is responsible for overseeing CEO decision-making to protect investor interests.
But some CEOs have power over the board of directors, and have the ability to push back on restrictions on their decision making.
CEO power isn’t just about charisma or leadership style. It’s about the ability to influence key decisions, particularly in financial reporting.
When a CEO wields excessive power — due to long tenure, significant ownership, or close personal ties to the board — they can inflate earnings to present a more favourable picture of the company’s performance than reality warrants.
The audit committee: a critical safeguard
A key safeguard against this is the audit committee – a group within the board of directors. Members of the audit committee monitor the financial reporting process used in generating earnings to protect the interests of investors.
However, our research examining more than 2,500 US companies across 12 years uncovers a troubling trend about how CEOs reduce the effectiveness of the audit committee.
Powerful CEOs appear to influence the decision of who serves on the audit committee. These CEOs often favour committees which provide weaker monitoring – resulting from less knowledge of accounting or a lack of authority to question the CEO.
CEOs also prefer audit committee members to be people with whom they share close personal ties. This may include members who attended the same university or have membership at the same golf club.
The consequences of a powerful CEO having a “weaker” audit committee? Earnings are more likely to be inflated to meet performance targets.
Measures to avoid conflicting interests
In Australia, there are some protections against this corporate manoeuvring.
The ASX Corporate Governance Principles recommend separating the roles of CEO and board chair, having boards where most directors are independent of the company, and ensuring audit committees have the relevant qualifications and experience.
However, our research suggests these measures are not enough to protect investors’ interests. While recommendations promote safeguards to limit direct conflicts of interest, they fall short of dealing with the root cause – CEOs wielding excessive power over their colleagues.
This issue is exemplified in the case of Qantas where the board of directors failed to challenge the decisions made by former CEO Alan Joyce.
Importantly, Alan Joyce exerted power over the board of directors, controlling key decisions and often disregarding the input of the board of directors.
What’s needed
In companies there is a power struggle to influence key accounting decisions about earnings.
Although there are safeguards, our research points towards CEO power being a threat to the effectiveness of those safeguards protecting the integrity of the earnings figure and other accounting information.
Investors and individuals involved with companies should take the earnings figure with a grain of salt.
This should especially be the case when the company has a CEO who holds outsized influence. Such awareness is crucial in helping to protect the interests of investors and all Australians dependent on the stock market for their financial wellbeing.
Nelson Ma, Associate Professor, corporate governance, innovation, University of Technology Sydney; Anna Bedford, Associate professor, corporate governance, mergers and acquisitions, University of Technology Sydney; Matthew Grosse, Senior lecturer, accounting, University of Technology Sydney, and Samir Ghannam, Senior lecturer, accounting, University of Technology Sydney
This article is republished from The Conversation under a Creative Commons license. Read the original article.