Association between audit committees’ equity-based compensation and fraud risk

independence, it seems reasonable to infer that high economic bond also harms audit committee independence.

Based on this economic bond notion, we predict that equity-based compensation increases the economic dependence of audit committees on the managers because audit committee members’ wealth is tied closely with firms’ reported performance. Economic bond thus creates vested interests to the audit committee members in such a way that they may sacrifice their oversight objectivity. We measure equity-based compensation by using the ratio of equity payments (i.e., stocks and options) to total compensation paid to an audit committee (denoted by EQUITY%).² We predict the coefficient of EQUITY% to be positive.

3.1.3 Voluntary adoption of clawbacks

Consistent with prior studies (e.g., Chan et al. 2012a; Chan et al. 2013; Dehaan et al. 2012), we define variable CLAWBACK to be an indicator variable that equals one if a firm voluntarily adopts its clawbacks in year t and zero otherwise. We predict the coefficients of CLAWBACK and CLAWBACKEQUITY% to be negative.

3.1.4 Managerial ability

Demerjian et al. (2013) measure their managerial ability variable using the decile ranks of the managerial ability scores (denoted by MAS) developed in Demerjian et al. (2012) by year and industry with an aim to make the MAS more comparable across time and industries. This measurement may not be applicable to our study because we want to examine whether, at the firm level, more capable managers have less incentive to manage earnings and, therefore, can possibly mitigate the negative effect of equity-based compensation on firm’s audit committee. To capture the salient features that capable managers shall increase their managerial ability over time and this continuing improvement in managerial ability enhances firm’s earnings quality in year t, we define MGR_Ability to be an indicator variable that equals one if a firm’s MAS in years t is above the SIC 2-digit industry-year mean. We predict the coefficients of MGR_Ability and MGR_AbilityEQUITY% to be negative.

3.2 Empirical Models:

3.2.1 Association between audit committees’ equity-based compensation and fraud risk        

2The value of stocks will be determined by multiplying the number of shares awarded by the closing price. Following Brick et al. (2006) and Core et al. (1999), we compute the value of options using the 25 percent of their exercise price or the closing market price on the annual meeting date if exercise price is not available. We exclude meeting fees because they are often viewed as an opportunity cost of attending a meeting and, thus, are not similar to annual compensation (Adams and Ferreirs 2008). 

The first objective of our study is to examine whether equity-based compensation harms audit committees’

oversight effectiveness, leading to higher risk of material misstatements due to fraud. We use the following model (1) to investigate this research question (for brevity purpose, we ignore firm and year subscripts):

,

where the definitions of all variables are summarized in the Appendix. We control SIC 2-digit industry and year fixed effects for unobserved firm-level heterogeneity (Bowen et al. 2010; Linck et al. 2009). We also include the following control variables that may affect the incidence of fraud. Note that, since our tests rely on panel data, standard errors may be correlated within years and across time by firms. Thus, in estimating this model and all subsequent models we use the two-way clustering to adjust standard errors by firm and year (Petersen 2009).

Firm-specific characteristics

We control for SIZE because recent studies report that, from 1998~2010, smaller firms are more likely to make fraudulent financial reporting (e.g., Beasley et al. 2013). However, large firms are also subjected to higher control risk due to their large number of transactions across multiple accounting cycles (Doyle et al. 2007a).

Therefore, we predict no sign on the coefficient of SIZE. Controlling for firm size can capture firm-specific risk (Fama and French 1995) and potentially mitigate the problem of correlated omitted variables (Myers et al., 2005;

Ahmed and Goodwin 2007).

We use LEVERAGE to capture firms’ financing activities and predict its coefficient to be positive because managers tend to use discretionary accruals to avoid the violation of debt convents (DeFond and Jiambalvo 1994;

Dichev and Skinner 2002). We also consider three variables to proxy for firms’ business environment: Ln(OC), Sales_Volt, CF_Volt. Because longer operating cycle and larger sales and cash flow volatilities imply higher operating uncertainty (Dechow and Dichev 2002; Hribar and Nichols 2007), we predict the coefficients of these three variables to be positive.

We use LOSS and RESTR to capture firms’ financial performance. We predict the coefficient of LOSS to be positive because operating losses are indicative of severe negative shocks in firm’s performance. Also, financial

distress firms are more likely to have internal control weaknesses due to their lack of sufficient resources to invest on internal controls (Ashbaugh et al. 2007), resulting in a higher possibility of committing fraudulent financial reporting. In contrast, if firms are under debt restructuring, they have less incentive to manage earnings because there is an increased monitoring from outsiders such as regulators, auditors, creditors, and the financial institutions. Therefore, we predict the coefficient of RESTR to be negative.

We consider CPA_EXP because auditor industry specialization represents an important dimension of audit quality that will help the auditor detect potential frauds. A specialist’s knowledge of the industry is developed through extensive auditing experience, specialized staff training, and expensive investments in information technology. Relative to non-specialist auditors, this industry knowledge enables specialist auditors to provide higher quality audit service to the clients (Dunn and Mayhew 2004; Gul et al. 2010). We thus predict the coefficient of CPA_EXP to be negative.

Prior studies indicate that firms with greater complexity are more likely to incur internal control weaknesses (Ashbaugh et al. 2007). In addition, firms with growth opportunity have stronger incentive to avoid negative earnings surprises (Frankel et al. 2002; Matsumoto 2002) or to have more discretion in terms of accounting choices (Smith and Watts 1992). We adopt FOREIGN, SEGMENTS, MB, and Sales_Grow to control for these firm-specific characteristics and predict the coefficients of these four variables to be positive.

Audit committee characteristics

We consider ACSIZE because larger audit committees are perceived to have increased power (Chen and Zhou 2007; Kalbers and Fogarty 1993) and are more likely to challenge top management and internal control personnel in fulfilling their monitoring responsibilities (Goh 2009; Krishnan 2005). In addition, prior research shows that it is the accounting expertise (denoted by ACC_EXP), rather than the broadly-defined financial expertise, that improves audit committees' oversight effectiveness (e.g., Bédard et al. 2004; Goh 2009; Krishnan 2005; Krishnan and Visvanathan 2008).³ Since specialized accounting skills contribute to audit committees’

effectiveness (Agrawal and Chadha 2005; DeFond et al. 2005; McDaniel et al. 2002), accounting expertise is        

3See DeFond et al. (2005) and Dhaliwal et al. (2010) for the controversy of the SEC’s proposed (which include individuals with experience in accounting or auditing only) and final (which include accounting expertise and any experience in supervising employees with financial responsibilities and overseeing the performance of the companies) definitions of financial expertise under SOX.

more likely to be associated with less fraudulent financial reporting. Therefore, we predict the coefficients on ACSIZE and ACC_EXP to be negative.

Board’s overall compensation policy

Because audit committee members are part of the board members, their compensation packages are highly related to the board’s overall compensation policy. Therefore, it is necessary to include a variable to control for board’s compensation. Since ExecuComp only provides compensation data for CEOs and CFOs, we adopt EXEC_EBC to proxy for boards’ compensation policy.⁴ There are two counter-balancing forces that may affect the association between EXEC_EBC and fraud risk. On one hand, CEOs and CFOs awarded with high equity-based compensation may prefer higher earnings quality with an aim to lower cost of capital and raise stock prices (Francis et al. 2004, 2005). On the other hand, entrenched CEOs and CFOs awarded with equity-based compensation are likely to boost current earnings to drive stock price up so that they can exercise options or sell stocks (Cheng and Warfield 2005). Therefore, we make no prediction for EXEC_EBC.

3.2.2 How do clawbacks and managerial ability affect the association between audit committees’ equity-based