Clawback provisions allow firms to recover compensation from corporate executives involved in accounting improprieties. But are they a deterrent? Do they improve financial reporting? These are important questions at a time when executive compensation is under the microscope.

Lilian H. Chan, Kevin C.W. Chen, Tai-Yuan Chen and Yanxin Yu have been investigating and found some encouraging results: clawback provisions are indeed associated with fewer accounting restatements, a perception of better accounting quality, and lower audit risk.

They focused on voluntary clawback provisions introduced by boards of 343 companies by early 2010. Although there are mandatory provisions under the 2002 Sarbannes-Oxley Act, these are ambiguous and difficult to enforce. The Dodd-Frank Wall Street Reform and Consumer Protection Act will tighten such provisions but they did not come into effect until this year so it is too soon to say how effective they are.

"Executives have incentives to manipulate accounting earnings for personal benefit (for example, to enhance their bonus or increase the value of their option holdings)," the authors say.

"Without clawback provisions, when financial misstatements occur, the greatest penalty the board can impose on managers is to replace them. With the provisions, they can impose additional monetary penalties and disciplined managers can also suffer substantial reputation loss in the labor market."

The authors consider whether the voluntary provisions adopted by their sample group were merely a signal to investors of a firm's financial integrity - in which case they would be adopted mainly by firms with better financial reporting quality - or actually led to improvements by firms. They found firms were less likely to experience financial misstatement after adoption than before, suggesting that on this measure, "clawback initiation does not simply serve as a signal but leads to real improvements in reporting integrity."

Companies with clawback provisions also experienced a higher earnings response coefficient after adoption than before (the ERC measures investors' perception of earnings quality). Furthermore, auditors were less likely to report material internal control weaknesses after firms adopted clawback provisions, suggesting that improvements had been made.

Adoption also had a positive effect on firms' auditing fees. Prior to adoption they paid higher fees, but after adoption they saw an average 6.5 per cent decrease in fees, relative to the control group in the study. The adopting firms also experienced shorter audit lags between the end of their fiscal year and the release of their audit report, suggesting less auditing effort was needed due to lower auditing risk.

The findings still leave some room for interpretation on the true impact of clawback provisions, though.

"While our finding of a reduction in misstatements for clawback adopters is consistent with real improvements in reporting integrity," the authors say, "the results on perceived earning quality and audit risk can be due to either real improvements in reporting integrity or the reactions of investors and auditors to the signal associated with clawback adoption. Firms with high accounting quality might use voluntary clawbacks to signal their superior quality and in response auditors and investors might react to the signal in their assessment of the quality of the accounting system."

Nonetheless, the results imply that the provisions of the Dodd-Frank Act may be useful in reducing accounting improprieties because its requirements are generally more stringent than the voluntary provisions adopted by firms in their study.