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Risk, Incentives, and the Desirability of Prudent Managers

Friedman, Henry L., Risk, Incentives, and the Desirability of Prudent Managers (February 1, 2014). Available at SSRN: http://ssrn.com/abstract=2399690

“I analyze a model in which the CFO oversees a reporting system that provides information useful for monitoring, decision-making, and contracting. The CFO’s actions influence the precision and bias of the performance metric, as well as the productivity of the CEO. In this setting, I find that the CEO’s compensation incentives and the quality of the reporting system can be substitutes or complements. When they are substitutes, the CEO’s incentive compensation is positively related to performance metric risk, and firm value can be increasing or decreasing in the CFO’s risk aversion. In a simple difference-in-difference test comparing CEOs and CFOs around the introduction of SOX, I find evidence that firms’ preferences for CFO risk aversion are affected by biasing costs, consistent with the model’s predictions.”

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