The role of ACs in enhancing financial reporting quality has received much attention in the past decade. Therefore, research evidence on factors that may affect the effectiveness of ACs is of interest to regulators, boards of directors, and investors. While regulators and the press have expressed concerns about whether equity incentives weaken AC oversight effectiveness, extant literature provides only limited and mixed results on this issue. In this study, we focus on AC equity incentives measured by equity portfolio delta and vega and examine whether these equity incentives enhance or impair AC determination of audit fees and auditor choice.
Using a sample of 1,707 firm observations during 2004 and 2013, we find evidence suggesting that equity incentives induce AC members to compromise their independence by paying lower audit fees. Second, using audit report lag as the proxy for audit effort, we also find a negative relationship between audit effort and AC equity incentives. These findings are robust to controlling for endogeneity, firm’s ex ante litigation risk, and relative power of CFOs and ACs.
Third, we document that ACs receiving larger equity incentives are less likely to hire national-level, city-level, and joint industry experts, even though management is still involved in
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national-level auditor selection. Fourth, firms whose ACs determine to pay a lower level of audit fees in the previous year exhibit lower earnings quality in the current year.
Our results have important implications for regulators, boards of directors, investors, and others. First, while the appointment of auditors and the determination of audit fees are generally viewed as solutions to enhance financial reporting quality, our results suggest that choosing an appropriate level of equity incentives and compensation for ACs are also important. Second, since SOX and the SEC only require directors to be fully independent before they become AC members, our findings highlight the need to place restrictions on compensation practices so that AC members can maintain independence in fact rather than in appearance and fulfill their duties in choosing auditors and agreeing to audit fees. Third, we focus on equity incentives as one major factor that could harm AC effectiveness. Future research could examine factors (e.g., tenure of membership, penalties for oversight failures) that may also affect other aspects of AC effectiveness.
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APPENDIX