Do Clawback Penalties Spur Misreporting?

Which is the better way to spur achievement – by rewarding employees for attaining goals or by penalizing them for failing to do so? While the question has remained a perennial matter of debate, a new scholarly paper observes that “given the financial scandals and crises in recent years, bonus contracts have come under a great deal of criticism, and penalty clauses have become increasingly prevalent.” A prominent element in this trend, the study notes, is the clawback mandate of the Dodd-Frank act of 2010, which requires public companies to take back incentive-based compensation awarded to executives on the basis of erroneous financial reporting.

Now some novel experimental research, largely motivated by the increase in clawbacks, raises doubts about this trend. While allowing that penalties may provide an effective spur to effort or achievement, the study in the current issue of an American Accounting Association journal The Accounting Review finds that they also tend to foster misreporting that exaggerates or falsifies those desired ends. In this sense, the study recalls earlier research in the journal which questioned whether clawback policies have reduced financial misreporting or simply increased managers’ resistance to clawback-triggering restatements that correct misreporting.

In the words of the new study, by Jennifer E. Nichol of Northeastern University, “While penalty contracts may sometimes encourage greater effort than bonus contracts as prior literature has shown, penalty contracts can also lead to greater dishonesty when effort is not successful.” She adds that “prior studies did not investigate possible alternative means of avoiding a penalty or acquiring a bonus outside of increased effort. In reality, there are often options available to employees beyond increasing effort, options that may include undesirable behaviors such as misreporting.”

And individuals subject to penalties, the study finds, are considerably more likely to avail themselves of that undesirable option than those who fail to earn a bonus. In the behavioral experiment comparing the two groups, in which participants take a test and report their results, twice as many of the penalty group than of the bonus group lied about their scores. And their lies elevated their scores by significantly larger amounts.

Yet, as Prof. Nichol writes, “this research does not find that penalty framing causes people to substitute effort with misreporting but suggests they will invest at least as much effort as they would under a bonus contract before resorting to dishonesty. This highlights the importance of setting targets that can be achieved through the greater exertion of effort when using penalty framing.”

And, expanding on this, she writes that, “when companies use bonuses, their controls should focus on increasing effort. When companies use penalties, their controls should focus on reducing dishonesty.”

What accounts for the greater misreporting by the penalty group compared to the bonus group, given that the award for reaching a goal was as great as the penalty for falling short? In a word, a feeling of entitlement. As the professor explains, “A penalty frame has a fundamentally different conceptual base (initial ownership of incentive funds) from a bonus frame…[D]ue to the sense of ownership conveyed by a penalty…employees are likely to believe they are more justified in lying to protect what they perceive themselves to own than in lying to obtain something they do not believe they own.”

The study’s findings are based an experiment involving 99 undergraduate business students, about evenly divided by gender, who participated in 30-minute sessions in a computer laboratory divided for privacy. After a brief practice task, students were asked to answer 30 difficult multiple-choice questions involving critical reasoning, sentence completion, and sentence correction. They were told that, if the scores they reported were 25 or above, they would earn $15, and otherwise they would receive $10, but there was a critical difference in how the $5 difference was framed – for half the participants as a bonus added to a $10 salary and for the remaining half as a penalty to be deducted from a $15 salary. Upon completion, participants would learn their actual score, but their compensation would be based not on this but on what they reported. Reported scores, they were assured, would remain confidential with no questions asked and no penalty for lying even if, in the words of the experiment instructions, “you will have to live with the knowledge that you chose to lie.”

Because of the difficulty of the test and the limited time allowed for its completion, it came is no surprise that only one participant scored high enough in actuality to earn $15. Of the remaining 98 participants, 27 boosted their scores, 18 of whom were in the penalty condition and only 9 in the bonus condition, a statistically significant difference. As for the amount that scores were raised, here too the penalty group significantly exceeded the other, the former boosting their scores on average by about 27% of the maximum possible, the latter by just 12%.

The two groups worked about the same amount of time on the test, and their average actual scores were about same, meaning the penalty group did not resort to lying as a substitute for effort but as a complement. Reinforcing this conclusion was the finding that time spent on the test was about the same for all participants, whether in the penalty or bonus condition, and whether assured before taking the test or only afterward that they could misreport without consequence. And no significant difference in misreporting emerged between genders.

In probing for an explanation of the difference between the groups, Prof. Nichol asked participants whether they deserved or were entitled to the full $15 payoff, with answers on a six-point scale from 1/strongly disagree to 6/strongly agree. Combining answers to the two questions yielded an average of about 2.9 for the bonus group and about 3.4 for the penalty group, a statistically significant difference. Further analysis indeed showed that contract framing (penalty vs. bonus) drove misreporting through the feeling of entitlement the framing engendered.

While the study does not deal specifically with clawbacks, Prof. Nichol acknowledges that the phenomenal increase in their prevalence in this century was an important factor in motivating the research. ‘”Granted, clawbacks have a considerable deterrent effect,” she says, “but is it greater than the incentive they give top executives to cover up misstatements that may have been beyond their control? The jury is probably still out on this.”

In any event, the professor adds, some companies have adopted an option that would seem in alignment with the findings of this study – the use of an escrow account as a kind of compromise between bonus and penalty, a device rewarding excellence like the former while offering less rationale to lie than the latter.

The study, entitled “The Effects of Contract Framing on Misconduct and Entitlement,” is in the May/June issue of The Accounting Review, a peer-reviewed journal published six times yearly by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA and its specialty sections include Auditing: A Journal of Practice and Theory, Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Journal of Information Systems, Journal of Financial Reporting, The Journal of the American Taxation Association, and Journal of Forensic Accounting Research.

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