The Allocation of Responsibility between CEO and CFO for Financial Misreporting: Implications for Earnings Quality

Even though financial reporting primarily falls within the scope of the CFO responsibilities, there is considerable evidence for the CEO’s influence on corporate misreporting. Regulatory initiatives such as the Sarbanes-Oxley Act of 2002 have therefore increased the CEO’s responsibility in the preparation of financial statements and made CEOs partially accountable for misreporting by their subordinates. We analyze the allocation of responsibility between the CEO and the CFO in a theoretical model and highlight their implications for earnings quality. While increasing the CFO’s responsibility generally improves earnings quality, assigning higher responsibility to the CEO may have detrimental effects. Our results show that higher CEO responsibility is particularly beneficial if the CEO has superior information about the CFO’s (financial and non-financial) reporting objectives. Furthermore, the responsibilities of the CEO and the CFO are substitutive regulatory instruments: Regulators should only increase CEO responsibility if CFOs cannot be held responsible for their own misreporting decisions.