A firm sometimes has to issue a “financial restatement” when its managers discover errors in the income statement it had previously issued. As you might guess, the errors are likely to have caused the firm’s profit to appear higher than it was. According to an article on barrons.com, the federal government’s Securities and Exchange Commission (SEC) has been considering “requiring public companies to claw back improperly awarded incentive compensation in the event of certain financial restatements.”

a. Why might a firm’s management have reasons to issue an income statement that overstates a firm’s profit?

b. What does the SEC mean by requiring a company to “claw back” compensation? Shouldn’t a firm’s board of directors want to claw back improperly awarded compensation without being required to do so? Briefly explain.