Why do CFOs work so hard to meet quarterly earnings benchmarks, even those based on a consensus of outside analysts? The answer is self-interest, according to a new study by three university professors.
CFOs and CEOs at companies that miss quarterly earnings benchmarks suffer reduced bonuses, smaller equity grants, and a greater chance of forced dismissal, say the professors, who analyzed data on S&P 1,500 companies from 1993 to 2004. The career penalties increased after the passage of the Sarbanes-Oxley Act, and they were worse for companies that publicly disclose quarterly earnings guidance.
"Our evidence suggests that boards [of directors] appear to react directly to managers' ability to meet earnings targets," say report coauthors Shiva Rajgopal, of the University of Washington Business School; Rick Mergenthaler, at the University of Iowa; and Suraj Srinivasan, at the University of Chicago Graduate School of Business.
When companies failed to meet two quarterly analyst-consensus forecasts within a year, boards cut CFO bonus pay by an average of $23,787 (based on a mean CFO salary of $297,340 during the study period). When the companies failed to meet all four forecasts in a year, CFO bonus pay dropped by $47,574. That's on top of deep cuts in equity grants, which boards slashed by up to 48 percent, and progressively higher odds of getting fired.
The results could mean that boards are implicitly motivating finance executives to make the numbers at all costs, even if it means committing fraud or forgoing needed investments. But at least one CFO says the harsh penalties are justified. "An important part of the CFO's role [is] to bring insight and realism to the forecasting process," says Ed Goldfinger, CFO of Zipcar. "It is equally likely that these dismissals and lower bonuses [would] result from [CFOs'] failure to properly understand their businesses and manage expectations."
One small consolation for CFOs: the study found that pay penalties were even steeper for CEOs. They lost an average $81,873 in bonus pay for two misses, and $163,745 for four, based on a mean annual salary of $584,810.