Hypothesis Development

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equity-based compensation makes outside members become insiders, which contradicts the traditional definition of independence.¹⁵ In another study, Archambeault et al. (2008) uses restatements announced during 1999 and 2002 to show that both short-term and long-term options are associated with higher restatement likelihood.

In contrast, Cullinan et al. (2010) uses 456 post-SOX firms that have ICW during 2004 and 2005 to examine the association between the likelihood of ICW and option compensation for audit committees. They report a marginally significant association between stock compensation and the incidence of ICW, and conclude that firms with a stock option plan for their audit committees are significantly more likely to report an internal control weakness. Engel et al. (2010) shows that, firms facing a higher demand for monitoring of the financial reporting process pay higher total compensation and cash retainers to their audit committees.

My study differs from the above studies in three aspects. First, since the level of audit committee compensation increases substantially after SOX (Linck et al. 2009), the findings reported in Bédard et al. (2004) and Archambeault et al. (2008) may be different in the post-SOX period. Second, these two studies focus on the analysis of option compensation, and there is a lack of evidence of differential compensation components. It is not clear that, how cash and stock compensation affect audit committees’ oversight effectiveness. Finally, the implication from Cullinan et al.’s (2010) findings is limited because the reported ICW do not necessarily mean that the audit committees are not effective. It is possible that the audit committees effectively identify the weakness and thus initiate the auditor (and management) to report ICW. Rather than using ICW alone, I use outcome measures to capture the audit committees’ oversight effectiveness.

2.3 Hypothesis Development

Prior experimental research has shown that cash compensation does not create direct incentives for audit committees to prefer biased reporting. Magilke et al. (2009) finds that students serving as audit committee members are least biased when there is no stock-based audit committee

15Prior studies have defined audit committee independence using whether audit committee members are employees or affiliators of the firm (e.g., Klein 2002a; Abbott and Parker 2004; Lennox and Park 2007).

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compensation. This suggests that if the audit committees are paid in cash, financial reporting quality shall improve. In a recent empirical research, Engel et al. (2010) shows that firms having higher demand for monitoring financial reporting process pay more cash retainers to audit committees. The cash compensation for audit committee might be a tool to strengthen the effectiveness of monitoring financial reporting. Based on the above findings, I assume that increasing the amounts and portions of cash compensation may improve audit committee independence. I posit the following hypothesis:

H1a: The amounts and portions of the cash compensation are negatively associated with

audit committees’ oversight failure.

Before SOX, the exchanges’ listing requirements provide for the appointment of certain affiliated directors if the board determines it is in the best interests of the firm for these individuals to serve on its audit committee (Klein 2002b; NYSE Rule §303.01[B][3][b]; NASDAQ Rule 4310[c][26][B][ii]). Therefore, many audit committees did not have fully independent outside directors before SOX (Klein 1998, 2002b; Vicknair et al. 1993). The pre-SOX studies use the percentage of outsiders (who may or may not own firms’ shares) on the audit committees (e.g., Bédard et al. 2004; Klein 2002a; Abbott and Parker 2000) and whether audit committees do not include employees (e.g., Abbott et al. 2000; Lennox and Park 2007) to measure audit committee independence. Because the inside-affiliated directors probably hold firms’ shares before they became members, the issue of equity-based compensation is not important in the pre-SOX period.

However, Section 301 of SOX mandates that audit committees be composed entirely of independent directors, and thus, audit committee members’ stock ownership exists almost from the equity-based compensation. Therefore, an investigation of the association between equity-based compensation and audit committee independence becomes important.

When firms reward audit committees by equity-based compensation, an affiliation relation occurs between the audit committees and the firms because audit committee members’ wealth is

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tied closely with firms’ reported performance.¹⁶ Archambeault et al. (2008) shows that firms with option compensation for their audit committees are significantly more likely to have higher likelihood of restatements. However, they use the pre-SOX data, and their finding may be different in the post-SOX period because the pre- and post-SOX restatements tend to be caused by different types of misstatements (Hennes et al. 2008). Archambeault et al. (2008) focuses on options purely, and only use restatements as the measure of audit committees’ oversight effectiveness. Cullinan et al. (2010) uses ICW in 2004-2005 as the measure of audit committees’ oversight failures only and finds that firms with option compensation are more likely to report ICW. The concerns about their findings are that ICW may reflect effective audit committees and firms are still in their learning stage in 2004-2005. Thus, Cullinan et al.’s (2010) results may not be convincing. In light of the potential problem of audit committees compensated by firms’ stocks and options, I consider both stock and option compensation in this study and predict a positive association between equity-based compensation and audit committees’ oversight failure. These give rise to the following hypotheses:

H1b: The amounts and portions of the stock compensation are positively associated with

audit committees’ oversight failure.

H1c: The amounts and portions of the option compensation are positively associated with

audit committees’ oversight failure.

Recently, shareholders, legislators, and compensation reform advocates have endorsed clawback provisions as a tool to prevent executives and employees from retaining undeserved windfalls and to enhance pay-for-performance initiatives (Scott and Bradley 2010). While

16With respect to the qualification of the independence, the SOX states that an audit committee member cannot accept any fees from the company other than for serving as a director, and cannot be an affiliated person of the company or any of its subsidiaries. Under NYSE rules approved on August 1, 2002, audit committees must consist of a minimum of three members. To be independent, a director must not have any relationship with the company that interferes with the exercise of independent judgment, and must not have worked for the company within the past three years.

NASDAQ’s board of directors approved similar rules on July 24, 2002, and amended them on August 21, 2002, to reflect certain provisions of the Sarbanes-Oxley Act. AMEX’s board of directors also approved new corporate governance rules conforming to the Act in September 2002. Accordingly, companies should ensure that current and new audit committee members have no potential conflicts of interest that may interfere with their ability to act independently from management (Buchalter et al. 2003).

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clawback provisions can be employed for a variety of purposes, many clawbacks are drafted to be triggered under violations of firm policy or ethical misconduct. Desai et al. (2006) points out that, if managers understand that their fraudulent behavior will be penalized ex post through a loss in wealth, job, and/or reputation, they should have less incentive to engage in earnings manipulation ex ante. Similarly, Caskey et al. (2010) indicates that the misreporting penalty affects not only audit committees’ ex post reporting process, but also their ex ante information-collection process.

Therefore, clawback provisions may serve as an effective tool in strengthening audit committees’

oversight effectiveness.

Since clawback provisions impose restrictions against illusory gains for board compensation, it is reasonable to assume that clawbacks could improve board governance.¹⁷ Specifically, firms may be more interested in ensuring that incentive pay is based on appropriate time horizons because clawbacks can offer a backstop against payments of bonuses (including cash, stocks, and options) based on fleeting or illusory gains in performance metrics (Scott and Bradley 2010).¹⁸ Since the equity-based compensation may weaken audit committees’ independence while clawback provisions could improve audit committees’ oversight effectiveness, the issue of whether the positive effect of clawback provisions outweighs the negative effect of equity-based compensation becomes an empirical one. Currently, no studies have ever examined this issue. I thus posit the following hypothesis:

H2: Firms’ voluntary adoption of the clawback provisions will change the association between equity-based compensation and audit committees’ oversight failure, if exist.

17The litigation risk due to firms’ recoupment enforcement is expected to affect board governance. The growth of shareholder litigation against directors coupled with the media attention and reputational damage to the directors who are sued, and to some extent to all directors. Lipton (2008) indicates that, to compound pressures on boards, shareholder litigation and other public attacks on board members have been undermining the willingness of some of the most qualified individuals to serve as directors.

18Engel et al. (2010) indicate that cash compensation for audit committee is positively associated with firms’ demand for financial reporting monitoring. Chan et al. (2012a) suggest that clawbacks are effective governance mechanisms that improve financial reporting quality. Therefore, it is expected that firms using more cash compensation are less likely to have audit committees’ oversight failure when firms adopt clawback provisions.

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CHAPTER 3 RESEARCH DESIGN