Managerial Ability, Equity-based Compensation, and Audit Committee Effectiveness
APPENDIX Definitions of Variables
Variables Pred.
Sign Definitions
Dependent Variable
FRAUD_RISK An indicator variable that equals one if a firm’s F-score in year t is above 1.85 and zero otherwise. The F-score is computed using Model 3 in Table 7 of Dechow et al. (2011).
Control Variables
SIZE ? The natural log of the firm’s total assets at the end of year t.
LEVERAGE + Long-term debt divided by total assets at the end of year t.
Ln(OC) +
The natural log of the firm’s operating cycle, which is measured by sales turnover plus days in inventory following Givoly et al. (2010):
[Average receivable / (sales / 360) + Average inventory / (cost of goods sold / 360)], averaged over at least three of the last five years (t–4, t).
Sales_Volt +
Sales volatility, which is measured by the standard deviation of [sales / average total assets] over at least three of the last five years (t–4, t).
CF_Volt +
Cash flow volatility, which is measured by the standard deviation of cash from operations over at least three of the last five years (t–4, t).
LOSS + An indicator variable that equals 1 if a firm’s earnings before extraordinary items in year t-1 is negative, and 0 otherwise.
RESTR An indicator variable that equals 1 if a firm is involved in a debt restructuring in year t-1, and 0 otherwise.
CPA_EXP
Auditor industry specialization in year t, measured by the ratio of the sum of the square root of the total assets of the clients of an auditor in a specific industry to the total sum of the square root of the total assets of all clients of the auditor.
FOREIGN +
An indicator variable that equals 1 if a firm has a non-zero foreign currency translation in year t, and 0 otherwise.
SEGMENT +
Number of a firm’s business segments inside and outside the U.S. in year t.
MB + A firm’s market-to-book ratio in year t.
Sales_Grow + The industry-adjusted sales growth in year t.
ACSIZE Number of members in the firm’s audit committee in year t.
ACC_EXP
Percentage of audit committee members who are accounting experts with work experience as CPAs, CFOs, vice presidents of finance, financial controllers, or any other major accounting positions.
EXEC_EBC ?
Ratio of CEO’s and CFO’s equity-based compensation (stocks plus options) to their total compensation in year t.
MV + Firm’s market value of equity at the end of year t.
ROA + Net income divided by total assets at the end of year t.
PRIOR_REST + An indicator variable that equals one if the firm announced a restatement in the past 5 years (t-5, t-1), and zero otherwise.
Debt_Issue + An indicator variable that equals one if the firm issued debts in the past 5 years (t-5, t-1), and zero otherwise.
Equity_Issue + An indicator variable that equals one if the firm issued shares in the past 5 years (t-5, t-1), and zero otherwise.
CEO_Tenure The number of years an executive has served as the firm’s CEO as of the end of t-1.
CEO_Chair An indicator variable that equals one if the CEO is also the chair of the board at the end of t-1, and 0 otherwise.
CEO_Own Percentage of firm’s shares owned by the CEO at the end of t-1.
CEO_Bonus
Ratio of CEO’s bonus earned at the end of t-1 divided by the CEO’s cash compensation at the end of t-1.
Test Variables
EQUITY% + Ratio of equity-based compensation (stocks plus options) to total compensation paid to the audit committee members in year t.
CLAWBACK An indicator variable that equals one if a firm voluntarily adopts its clawback provisions in year t and zero otherwise.
MGR_Ability An indicator variable that equals one if a firm’s managerial ability score (MAS) in years t is above the sic2digit industry-year mean.
CLAWBACKEQUITY% Interaction term of CLAWBACK and EQUITY%.
MGR_AbilityEQUITY% Interaction term of MGR_Ability and EQUITY%.
TABLE 1 Descriptive Statistics
Panel A: Distribution by Years and Industries
Years
Industries
2006 2007 2008 2009 2010 Total
Agriculture, Forestry, and Fishing 1 (0.02%)
Mining and Construction 48 (1.16%)
Manufacturing—nondurables 152 (3.66%)
Manufacturing—durables 257 (6.19%)
Transportation and Utilities 47 (1.13%)
Wholesalers and Retailers 122 (2.94%)
Business Services 84 (2.02%)
Consumer Services 34 (0.82%)
Panel B: Distribution of Compensation Components
Average Amount of Annual Compensation ($) Compensation Ratio
Year Cash Stock Option Total Cash Stock Option
2006 229,827.7 179,602.6 150,978.3 560,453.7 41.02% 32.05% 26.94%
2007 246,918.9 219,176.3 161,961.4 628,056.7 39.31% 34.90% 25.79%
2008 266,448.6 252,411.3 148,617.5 667,477.5 39.92% 37.82% 22.27%
2009 269,848.2 273,382.1 105,083.2 648,313.5 41.62% 42.17% 16.21%
2010 273,790.9 293,905.3 99,358.3 667,054.4 41.04% 44.06% 14.90%
Total /Average 1,286,879.3 1,218,477.6 665,998.7 3,171,355.7 40.58% 38.42% 21.00%
Panel C: Statistical Properties of the Sample (N = 4,155)
Variables Mean Median Std. Dev. 25th 75th Max. Min.
FRAUD_RISK 0.0229 0.0000 0.1495 0.0000 0.0000 1.0000 0.0000
CLAWBACK 0.2241 0.0000 0.4170 0.0000 0.0000 1.0000 0.0000
MGR_Ability 0.5875 1.0000 0.4923 0.0000 0.0000 1.0000 0.0000
SIZE 7.5373 7.4066 1.4921 6.4665 8.4619 11.6469 4.5439
LEVERAGE 0.1633 0.1442 0.1559 0.0038 0.2583 0.6747 0.0000
Ln(OC) 4.5526 4.6639 0.6663 4.1894 4.9750 5.9756 2.4425
Sales_Volt 0.1381 0.1022 0.1187 0.0617 0.1728 0.7009 0.0133
CF_Volt 0.0437 0.0341 0.0339 0.0217 0.0541 0.2134 0.0057
LOSS 0.1552 0.0000 0.3622 0.0000 0.0000 1.0000 0.0000
RESTR 0.4395 0.0000 0.4964 0.0000 1.0000 1.0000 0.0000
CPA_EXP 0.0326 0.0296 0.0257 0.0100 0.0491 0.1727 0.0010
FOREIGN 0.3819 0.0000 0.4859 0.0000 1.0000 1.0000 0.0000
SEGMENT 2.6996 2.0000 2.0374 1.0000 4.0000 13.0000 1.0000
MB 1.8884 1.5929 0.9993 1.2332 2.2134 7.1889 0.6521
Sales_Grow 0.0109 -0.0024 0.1679 -0.0707 0.0736 1.1858 -0.4900
ACSIZE 3.6693 4.0000 1.3212 3.0000 4.0000 9.0000 1.0000
ACC_EXP 0.2070 0.2000 0.2301 0.0000 0.3333 1.0000 0.0000
EXEC_EBC 0.6951 0.7724 0.2283 0.6052 0.8584 0.9729 0.0044
EQUITY 0.5314 0.5443 0.2019 0.4289 0.6616 0.9419 0.0000
MV 7.6192 7.4608 1.5572 6.5408 8.5482 13.1308 2.5995 ROA 0.0533 0.0607 0.0961 0.0262 0.0992 0.2853 -0.6508
PRIOR_REST 0.2662 0.0000 0.4420 0.0000 1.0000 1.0000 0.0000
Debt_Issue 0.7362 1.0000 0.4407 0.0000 1.0000 1.0000 0.0000
Equity_Issue 0.2633 0.0000 0.4405 0.0000 1.0000 1.0000 0.0000
CEO_Tenure 8.0544 1.8611 11.3223 0.0000 12.7611 59.8556 0.0000
CEO_Chair 0.5478 1.0000 0.4978 0.0000 1.0000 1.0000 0.0000
CEO_Own 1.7558 0.0000 4.3624 0.0000 1.6800 32.4000 0.0000
CEO_Bonus 0.1553 0.0000 0.2417 0.0000 0.3103 0.8824 0.0000
Panel D: Mean and Median Tests between Firms with and without Voluntary Adopting of Clawbacks
Variablea
Means Medians Firms adopting
Clawbacks (n = 931)
Firms do not adopt Clawbacks
(n = 3,224)
t statisticsb
Firms adopting Clawbacks
(n = 931)
Firms do not adopt Clawbacks
(n = 3,224)
Wilcoxon z Statisticsb
FRAUD_RISK 0.0075 0.0273 -4.90*** 0.0000 0.0000 -3.56***
MGR_Ability 0.6390 0.5726 3.64*** 1.0000 1.0000 -3.63***
SIZE 8.4126 7.2845 19.53*** 8.3719 7.1972 18.78***
LEVERAGE 0.1850 0.1579 5.09*** 0.1673 0.1309 6.37***
Ln(OC) 4.5708 4.5474 0.97 4.6854 4.6555 0.42
Sales_Volt 0.1300 0.1405 -2.45** 0.0969 0.1038 -2.95***
CF_Volt 0.0386 0.0452 -5.61*** 0.0307 0.0353 -5.80***
LOSS 0.1375 0.1604 -1.76* 0.0000 0.0000 -1.70*
RESTR 0.5424 0.4097 7.23*** 1.0000 0.0000 7.18***
CPA_EXP 0.0324 0.0327 -0.29 0.0295 0.0298 -0.72
FOREIGN 0.4082 0.3744 1.87* 0.0000 0.0000 1.87*
SEGMENT 3.0967 2.5850 6.24*** 3.0000 1.0000 6.06***
MB 1.7417 1.9308 -6.11*** 1.5418 1.6196 -3.23**
Sales_Grow 0.0009 0.0138 -2.14** -0.0071 0.0000 -2.42***
ACSIZE 4.0934 3.5468 10.50*** 4.0000 3.0000 10.80***
ACC_EXP 0.1860 0.2131 -3.33*** 0.1667 0.2000 -3.04***
EXEC_EBC 0.7735 0.6725 14.22*** 0.8261 0.7505 13.41***
EQUITY% 0.5339 0.5307 0.47 0.5323 0.5484 -0.85
MV 8.3795 7.3997 16.00*** 8.2464 7.2583 15.80***
ROA 0.0497 0.0543 -1.28 0.0600 0.0608 -0.79
PRIOR_REST 0.3136 0.2525 3.59*** 0.0000 0.0000 3.72***
Debt_Issue 0.8260 0.7103 7.83*** 1.0000 1.0000 7.06***
Equity_Issue 0.1386 0.2993 -11.56*** 0.0000 0.0000 9.81***
CEO_Tenure 8.2911 7.9861 0.70 1.8083 1.9222 0.21
CEO_Chair 0.6198 0.5270 5.02*** 1.0000 1.0000 5.01***
CEO_Own 1.1589 1.9281 -5.89*** 0.0000 0.0000 -3.27***
CEO_Bonus 0.0678 0.1806 -15.95*** 0.0000 0.0000 -12.88***
aSee Appendix for the definitions of all variable.
bAsterisks ***, **, * indicate two-tailed significance at the 0.01, 0.05, 0.10 levels, respectively.
TABLE 2: Correlation Coefficientsa Panel A: Variables used in the first-stage of the Heckman Model
Variablesb CLAWBACK MV ROA PRIOR_REST Debt_Issue Equity_Issue CEO_Tenure CEO_Chair CEO_Own CEO_Bonus
CLAWBACK 0.245
(0.000) PRIOR_REST 0.058
(0.000) Debt_Issue 0.109
(0.000) Equity_Issue -0.152
(0.000) CEO_Tenure 0.011
(0.469) CEO_Chair 0.078
(0.000) CEO_Bonus -0.195
(0.000)
TABLE 2: Correlation Coefficientsa (cont’d) Panel B: Variables used in testing the variables of interest
Variablesb FRAUD_RISK CLAWBACK MGR_
Ability SIZE LEVERAGE Ln(OC) Sales_Volt CF_Volt LOSS RESTR CPA_EXP FOREIGN SEGMENT MB Sales_Grow ACSIZE ACC_EXP EXEC_EBC EQUITY%
FRAUD_RISK -0.055
(0.000)
CLAWBACK -0.055 (0.000)
MGR_Ability -0.065 (0.000)
LEVERAGE 0.024 (0.119)
Sales_Volt 0.136 (0.000)
Sales_Grow 0.222 (0.000)
EXEC_EBC -0.019 (0.228) aThe Pearson (Spearman) correlation coefficients are reported in the lower left (upper right) part of the Table. Two-tailed p values are reported in parentheses.
bSee Appendix for the definitions of all variables.
TABLE 3
Regression of Fraud Risk on Audit Committee’s Equity Compensationa
Variablesb Predicted Signs Coefficientsc
(2 statistics)
Intercept ? -2.942***
(36.40)
SIZE ? -0.023
(0.32)
LEVERAGE + 0.711#
(2.58)
Ln(OC) + 0.303***
(15.45)
Sales_Volt + 2.539***
(19.50)
CF_Volt + -4.606**
(4.08)
LOSS + 0.047
(0.03)
RESTR -0.100
(0.72)
CPA_EXP -6.939***
(31.83)
FOREIGN + -0.012
(0.01)
SEGMENT + 0.019
(0.48)
MB + -0.207*
(3.24)
Sales_Grow + 2.533***
(30.89)
ACSIZE -0.029
(1.31)
ACC_EXP -0.056
(0.24)
EXEC_EBC ? -0.412**
(4.14)
EQUITY% + 0.568***
(14.85)
Fixed Effects Included
N 4,155
Pseudo R2 0.073
Likelihood Ratio 2 313.318***
aThe dependent variable is FRAUD_RISK.
bSee appendix for the definitions of the variables.
cIn estimating the 2 statistics, we use two-way clustering (year and industry) to adjust standard errors.
Outliers are trimmed at the top and bottom 1% of the distributions of continuous variables. Asterisks
*, **, and *** denote two-tailed significance levels at 10%, 5%, and 1%, respectively; pound key # denotes one-tailed significance at the 0.1 level.
40 TABLE 4
Regression of Fraud Risk on Audit Committee’s Equity Compensationand Clawbacksa Panel A: Heckman’s First-stage model:
Variablesb Predicted Signs Coefficientsc (tstatistics)
Intercept ? -3.101***
(-22.08)
MV + 0.330***
(18.10)
ROA + -0.105
(-1.15)
PRIOR_REST + 0.254***
(4.84)
Debt_Issue + 0.064
(1.07)
Equity_Issue + -0.321***
(-5.32)
CEO_Tenure -0.003#
(-1.42)
CEO_Chair 0.025
(0.51)
CEO_Own -0.016**
(-2.47)
CEO_Bonus -1.774***
(-14.89)
Fixed Effects Not Included
N 4,155
Pseudo R2 0.167
Likelihood Ratio 2 760.40***
aThe dependent variable is CLAWBACK.
bSee appendix for the definitions of the variables.
cIn estimating the t statistics, we use two-way clustering (year and firm) to adjust standard errors.
Outliers are trimmed at the top and bottom 1% of the distributions of continuous variables. Asterisks
*, **, and *** denote two-tailed significance levels at 10%, 5%, and 1%, respectively.
41
TABLE 4 (con’t)
Regression of Fraud Risk on Audit Committee’s Equity Compensationand Clawbacksa Panel B: Heckman’s Second-stage model:
Variablesb Predicted Signs Coefficientsc (2 statistics)
Intercept ? -4.583***
(12.34)
SIZE ? 0.071
(0.87)
LEVERAGE + 0.674#
(2.31)
Ln(OC) + 0.349***
(13.34)
Sales_Volt + 2.589***
(16.25)
CF_Volt + -4.666**
(4.34)
LOSS + 0.084
(0.08)
RESTR -0.060
(0.34)
CPA_EXP -7.093***
(51.86)
FOREIGN + -0.021
(0.01)
SEGMENT + 0.021
(0.76)
MB + -0.219*
(3.35)
Sales_Grow + 2.500***
(27.00)
ACSIZE -0.019
(0.55)
ACC_EXP -0.047
(0.18)
EXEC_EBC ? -0.336#
(1.82)
EQUITY% + 0.510***
(12.31)
CLAWBACK -0.234
(0.89)
EQUITY% CLAWBACK -0.528**
(4.14)
LAMDA ? 0.334#
(2.29)
Fixed Effects Included
N 4,155
Pseudo R2 0.075
42
Likelihood Ratio 2 464.73***
aThe dependent variable is FRAUD_RISK.
bSee appendix for the definitions of the variables.
cIn estimating the 2 statistics, we use two-way clustering (year and firm) to adjust standard errors.
Outliers are trimmed at the top and bottom 1% of the distributions of continuous variables. Asterisks
*, **, and *** denote two-tailed significance levels at 10%, 5%, and 1%, respectively; pound key # denotes one-tailed significance at the 0.1 level.
43 TABLE 5
Regression of Fraud Risk on Audit Committee’s Equity Compensationand Managerial Abilitya
Variablesb Predicted Signs Coefficientsc (2 statistics)
Intercept ? -2.856***
(38.31)
SIZE ? -0.022
(0.28)
LEVERAGE + 0.659#
(2.27)
Ln(OC) + 0.245*
(3.56)
Sales_Volt + 1.527***
(18.01)
CF_Volt + -2.844#
(2.51)
LOSS + -0.045
(0.03)
RESTR -0.111
(0.91)
CPA_EXP -6.816***
(23.37)
FOREIGN + -0.008
(0.00)
SEGMENT + 0.021
(0.76)
MB + -0.152#
(1.80)
Sales_Grow + 2.497***
(29.86)
ACSIZE -0.030
(1.20)
ACC_EXP -0.082
(0.51)
EXEC_EBC ? -0.438**
(3.99)
EQUITY% + 0.874***
(15.86)
MGR_Ability -0.014
(0.02)
EQUITY% MGR_Ability -0.578**
(4.85)
Fixed Effects Included
N 4,155
Pseudo R2 0.074
Likelihood Ratio 2 321.83***
aThe dependent variable is FRAUD_RISK.
bSee appendix for the definitions of the variables.
44
cIn estimating the 2 statistics, we use two-way clustering (year and firm) to adjust standard errors.
Outliers are trimmed at the top and bottom 1% of the distributions of continuous variables. Asterisks
*, **, and *** denote two-tailed significance levels at 10%, 5%, and 1%, respectively; pound key # denotes one-tailed significance at the 0.1 level.
45 TABLE 6
Regression of Fraud Risk on Audit Committee’s Equity Compensation, Clawbacks, and Managerial Abilitya
Variablesb Predicted Signs Coefficientsc (2 statistics)
Intercept ? -4.598***
(17.54)
SIZE ? 0.077#
(1.73)
LEVERAGE + 0.632
(1.64)
Ln(OC) + 0.321***
(8.79)
Sales_Volt + 2.671***
(35.54)
CF_Volt + -5.150**
(6.56)
LOSS + -0.017
(0.01)
RESTR -0.068
(0.25)
CPA_EXP -6.943**
(3.85)
FOREIGN + -0.016
(0.02)
SEGMENT + 0.017
(0.38)
MB + -0.163*
(3.45)
Sales_Grow + 2.462***
(70.12)
ACSIZE -0.020
(0.21)
ACC_EXP -0.071
(0.14)
EXEC_EBC ? -0.365
(1.63)
EQUITY% + 0.828***
(9.75)
CLAWBACK -0.184
(0.25)
MGR_Ability -0.021
(0.01)
EQUITY% CLAWBACK -0.644**
(4.26)
EQUITY% MGR_Ability -0.602**
(4.89)
LAMDA ? 0.356**
(5.10)
46
Fixed Effects Included
N 4,155
Pseudo R2 0.077
Likelihood Ratio 2 334.72***
aThe dependent variable is FRAUD_RISK. The first-stage model for controlling for clawbacks’
endogenity is the same as that reported in panel A of Table 4 and, therefore, is omitted in this table.
bSee appendix for the definitions of the variables.
cIn estimating the 2 statistics, we use two-way clustering (year and firm) to adjust standard errors.
Outliers are trimmed at the top and bottom 1% of the distributions of continuous variables. Asterisks
*, **, and *** denote two-tailed significance levels at 10%, 5%, and 1%, respectively; pound key # denotes one-tailed significance at the 0.1 level.