Shareholders face a daunting information asymmetry problem when it comes to measuring the performance of the CEO. As head of the corporation, the CEO is in charge of the firm’s management information system. Accounting methods always leave room for managerial interpretation, and this flexibility can and has been used to understate expenses and inflate reported earnings. When CEO compensation is tied to various accounting performance targets, it is a bit like asking students to fill out their own final grade report. At a minimum, shareholders should not be surprised when accounting data places firm and managerial performance in a favorable light. Shareholders must take steps to guard against significant manipulation of accounting standards and/or accounting bias that results in a meaningful distortion of accounting performance.
A. What pitfalls are faced by independent auditors and boards of directors in their efforts to maintain the firm’s accounting statements as independent and unbiased indicators of firm and managerial performance?
B. What corporate governance mechanisms might be used to guard against the manipulation of the firm’s accounting statements?