Managerial Ability, Equity-based Compensation, and Audit Committee Effectiveness
5. SUMMARY AND CONCLUSIONS
Regulators and the press have expressed great concerns about whether equity-based compensation weakens audit committees’ oversight effectiveness. However, extant literature provides limited and mixed results on this issue. In this study, we use firms’ risk of incurring material accounting misstatements as the proxy for audit committees’ oversight failures to examine whether firms paying more equity-based compensation to their audit committee members are more likely to be associated with higher fraud risk. We test this research question using a sample of 4,155 S&P 1500 firms during 2006~2010. The empirical results show that larger portions of stocks and options paid to the audit committees are associated with higher fraud risk. Since SOX and the SEC only require directors to be fully independent before they become audit committee members, our findings call into the need to put restrictions on the compensation practice so that audit committee members can maintain independence in fact rather than in appearance to successfully fulfill their oversight duties over time.
We then include a clawback indicator, a managerial ability indicator, and their interactions with the equity-based compensation to examine whether clawbacks and managerial ability may reduce the association between equity-based compensation and audit committees’ oversight failures. Using the same sample, we show
that firms paying larger portions of equity-based compensation have lower fraud risk when they adopt clawbacks and/or employ more capable managers. Notably, we find some evidence that the positive effect of adopting clawbacks appears to be larger than that of hiring capable managers.
Overall, our study contributes to the audit committee and clawback literature in three important aspects.
First, it provides a starting point for developing a theory about the association between equity-based compensation and audit committees’ oversight effectiveness. Second, it underscores the necessity of banning or restricting firms’ compensation practices so that audit committee members can really maintain their independence. Finally, Chan et al. (2012a) and Dehaan et al. (2012) report a negative association between clawbacks and restatement likelihood. Our study goes a step further to show that the adoption of clawbacks can reduce restatements possibly because clawbacks motivate audit committees to remain independent and, therefore enhancing their oversight effectiveness.
Some features of our study point to several directions for future research. First, given the insignificance of the interaction between equity-based compensation and managerial ability, future research may examine the reasons under richer settings. Second, we focus on equity-based compensation as one major source that could jeopardize audit committee independence. Future research may examine other factors (e.g., tenure of membership, penalties for oversight failures) that could also affect other aspects of audit committees. Finally, our empirical results support the SEC’s mandatory implementation of the clawbacks because clawbacks effectively mitigates the adverse effect of equity-based compensation on audit committees’ independence, leading to lower fraud risk.
REFERENCES
Abbott, L. J., S. Parker, and G. F. Peters. 2004. Audit committee characteristics and restatements. Auditing: A Journal of Practice & Theory 23 (1): 69–87.
Aboody, D., M. E. Barth, and R. Kasznik. 2004. Firms Voluntary Recognition of Stock-Based Compensation Expense. Journal of Accounting Research 42: 123-150.
Adams, R.B., H. Almeida and D. Ferreira. 2005. Powerful CEOs and their impact on corporate performance.
Review of Financial Studies (Vol. 18, No. 4): 1403-1432.
Adams, R. B. and D. Ferreria. 2008. Do directors perform for pay? Journal of Accounting and Economics 46 (1):
154–71.
Addy, N., X. Chu, and T. Yoder. 2011. Recovering bonuses after restated financials: adopting clawback provisions. Working paper, Mississippi State University and Louisiana Tech University.
Agrawal, A. and S. Chadha. 2005. Corporate governance and accounting scandals. Journal of Law and Economics 48 (2): 371-406.
Ahmed, K. and J. Goodwin. 2007. An empirical investigation of earnings restatements by Australian firms.
Accounting and Finance 47 (1): 1–22.
Armstrong, C. S., A. D. Jagolinzer, and D. F. Larcker. 2010. Chief executive officer equity incentives and accounting irregularities. Journal of Accounting Research 48 (2): 225-271.
Ashbaugh-Skaife, H., D. Collins, W. Kinney, and R. LaFond. 2007. The discovery and reporting of internal control deficiencies prior to SOX-mandated audits. Journal of Accounting and Economics 44 (1/2):
166–92.
Archambeault, F.T. Dezoort, and D. Hermanson. 2008. Audit Committee Incentive Compensation and Accounting Restatements. Contemporary Accounting Research 25 (4): 965–92.
Barrier, M. 2002. The compensation balance. Internal Auditor 59 (3): 42–7.
Barton, J. 2005. Who Cares about Auditor Reputation? Contemporary Accounting Research 22, 549-86.
Beasley, M. S. 1996. An empirical analysis of the relation between the board of director composition and financial fraud. The Accounting Review 71 (2): 443–65.
Beasley, M.S., J.V. Carcello, R. Hermanson, and T. Neal. 2009. The audit committee oversight process.
Contemporary Accounting Research 26 (1): 65–122.
Beasley, M.S., J.V. Carcello, R. Hermanson, and T. Neal. 2013. An analysis of alleged auditor deficiencies in SEC fraud investigations: 1998-2010. Center for Audit Quality.
Bebchuk, L. and J. Fried. 2004. Pay without performance: the unfulfilled promise of executive compensation.
Cambridge, MA: Harvard University Press.
Beck, P., T. Frecka, and I. Solomon. 1988. An empirical analysis of the relationship between MAS involvement and auditor tenure: Implications for auditor independence. Journal of Accounting Literature 7: 65–84.
Bedard, J.C., S.M. Chtourou, and L. Courtean. 2004. The effect of audit committee expertise, independence, and activity on aggressive earnings management. Auditing: A Journal of Practice & Theory 23 (2): 13–35.
Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. 1999. Report and recommendations of the Blue Ribbon Committee on improving the effectiveness of corporate audit committees. New York, NY: NTSE and NASD.
Bowen, R.M, C.C. Andrew and S. Rajgopal. 2010. Whistle-blowing: Target firm characteristics and economic consequences. The Accounting Review 85 (4): 1239–1271.
Brick, I. E., O. Palmon and J. K. Wald. 2006. CEO Compensation, director compensation, and firm performance:
Evidence of cronyism. Journal of Corporate Finance 12 (3): 403-423.
Bronson, S., J. Carcello, C. Hollingsworth, and T. Neal. 2009. Are fully independent audit committees really necessary? Journal of Accounting and Public Policy 28 (4): 265–80.
Brown, A.B., P.Y. Davis-Friday, and L. Guler. 2011. Economic determinants of the voluntary adoption of clawback provisions in executive compensation contracts. Working paper. City University of New York-Baruch College.
Brown, A.B., P.Y. Davis-Friday, and L. Guler. 2013. M&A Activity and the Voluntary Adoption of Clawback Provisions in Executive Compensation Contracts. Working paper. City University of New York-Baruch College.
Bushman, R., Q. Chen, E. Engel and A. Smith. 2004. Financial accounting information, organizational complexity and corporate governance systems. Journal of Accounting and Economics 37 (2): 167-202.
Carcello, J. V., and T. L. Neal. 2000. Audit committee composition and auditor reporting. The Accounting Review 75 (4): 453-467.
Carcello, J. V., and T. L. Neal. 2003. Audit committee characteristics and auditor dismissals following ‘‘new’’
going-concern reports. The Accounting Review 78 (1): 95–117.
Carcello, J. V., T.L. Neal, Z-V Palmrose, and S. Scholz. 2011. CEO involvement in selecting board members, audit committee effectiveness, and restatements. Contemporary Accounting Research 28: 396-430.
Carpenter, J. 2000. Does Option Compensation Increase Managerial Risk Appetite? Journal of Finance 55 (5):2311–31.
Chan, L.H., K.C. Chen, T.Y. Chen, and Y. Yu. 2012a. The effects of firm-initiated clawback provisions on earnings quality and auditor's behavior. Journal of Accounting and Economics 54 (2-3): 180-196.
Chan, L., K.C. Chen, T.Y. Chen, and Y.X. Yu. 2012b. Substitution between real and accrual-based earnings management after voluntary adoption of compensation clawback provisions. Working Paper, Hong Kong University of Science and Technology. 2012 Journal of Accounting and Economics Conference.
Chan, L.H., K.C.W. Chen, and T.Y. Chen. 2013. The effects of firm-initiated clawback provisions on bank loan contracting. Journal of Financial Economics 110 (3): 659-679.
Chen, K. and J. Zhou. 2007. Audit committee, board characteristics, and auditor switch decisions by Andersen's clients. Contemporary Accounting Research 24 (7): 1085–117.
Cheng, Q. and T.D. Warfield. 2005. Equity incentives and earnings management. The Accounting Review 80 (2):
441-476.
Cohen, D.A., A. Dey, and T. Lys. 2008. Real and accrual-based earnings management in the pre- and post-Sarbanes-Oxley periods. The Accounting Review 83 (May): 757-788.
Cohen, D.A. and P. Zarowin. 2010. Accrual-based and real earnings management activities around seasoned equity offerings. Journal of Accounting and Economics 50 (1): 2 - 19.
Committee of Sponsoring Organizations of the Treadway Commission (COSO). 1992. Internal control integrated framework. COSO, New York, NY.
Committee of Sponsoring Organizations of the Treadway Commission (COSO). 2004. Enterprise Risk Management - Integrated Framework. September. American Institute of Certified Public Accountants.
New York, NY.
Core, J., R. Holthausen and D. Larcker. 1999. Corporate governance, chief executive officer compensation, and firm performance. Journal of Financial Economics 51 (3): 371-406.
Cullinan, C.P., H. Du, and W. Jiang. 2010. Is compensating audit committee members with stock options associated with the likelihood of internal control weaknesses? International Journal of Auditing 14:
256-273.
Dalton, D.R., C.M. Daily, T. Certo, and R. Roengpitya. 2003. Meta-analyses of financial performance and equity: Fusion or confusion? Academy of Management Journal 46 (1): 13-26.
DeAngelo, L.E. 1981. Auditor independence, low balling and disclosure regulation. Journal of Accounting and Economics 3 (2): 113~127.
Dechow, P., and I. Dichev. 2002. The quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review 77 (4): 35–59.
DeChow, P.M., W. Ge, C.R. Larson, and R.G. Sloan. 2011. Predicting material accounting misstatements.
Contemporary Accounting Research 28 (1): 17-82.
DeFond, M. and J. Jiambalvo. 1994. Incidence and circumstances of accounting errors. The Accounting Review 66 (3): 643–55.
DeFond, M. L., R. N. Hann, and X. Hu. 2005. Does the market value financial expertise on audit committees of boards of directors? Journal of Accounting Research 43 (2): 153–93.
DeHaan, E., Hodge, F., and Shevlin, T. 2013. Does Voluntary Adoption of a Clawback Provision Improve Financial Reporting Quality? Contemporary Accounting Research (Forthcoming).
Demerjian, P.R., B. Lev, M.F. Lewis, and S.E. McVay. 2013. Managerial ability and earnings quality. The Accounting Review 88 (2): 463-498.
Desai, H., Hogan, C., Wilkins, M., 2006. The reputational penalty for aggressive accounting: Earnings restatement and management turnover. The Accounting Review 81, 83-112.
DeZoort, F. T., D. R. Hermanson, D. Archambeault, and S. Reed. 2002. Audit committee effectiveness: A synthesis of the empirical audit committee literature. Journal of Accounting Literature 21: 38–75.
Dichev, I. and D.J. Skinner. 2002. Large–sample evidence on the debt covenant hypothesis. Journal of Accounting Research 40(4):1091-1123.
Dhaliwal, D. V. Naiker, and F. Navissi. 2010. The association between accruals quality and the characteristics of accounting experts and mix of expertise on audit committees. Contemporary Accounting Research 27(3):
787-827.
Doyle, J., W. Ge, and S. McVay. 2007a. Determinants of weaknesses in internal control over financial reporting.
The Accounting Review 44 (1/2): 193–223.
Dunn, K.A. and Mayhew, B.W. (2004) Audit Industry Specialisation and Client Disclosure Quality, Review of Accounting Studies, 9, 35-58.
Eldenburg, L.G., K.A. Gunny, K.W. Hee, and N. Soderstrom. 2011. Earnings management using real activities:
Evidence from nonprofit hospitals. The Accounting Review 86 (5): 1605-1630.
Engel, E., R. Hayes, and X. Wang. 2010. Audit committee compensation and the demand for monitoring of the financial reporting process. Journal of Accounting & Economics 49 (1/2): 136–54.
Ezzamel, M. and R. Watson. 1997. Wearing Two Hats: The Conflicting Control and Management Roles of Non-Executive Directors. in K. Keasey, S. Thompson and M. Wright (eds.), Corporate Governance:
Economic, Management and Financial Issues. Oxford: Oxford University Press.
Fama, E. and K. French. 1995. Size and book-to-market factors in earnings and returns. Journal of Finance 50:
131–155.
Fama, E. F. and Jensen, M. C. 1983, Separation of ownership and control, Journal of Law and Economics 26 (2):
301–25.
Francis, J., R. LaFond, P. Olsson, and K. Schipper. 2004. Cost of capital and earnings attributes. The Accounting Review 79 (3): 967-1010.
Francis, J. 2005. The market pricing of accruals quality. Journal of Accounting and Economics 39 (June):
295-327.
Farrell, J., Rabin, M., 1996. Cheap talk. The Journal of Economic Perspectives 10: 103-118.
Fich, E., Shivdasani, A., 2006. Are busy boards effective monitors? Journal of Finance 61 (2): 689–724.
Financial Reporting Council. 2003. Combined Code on Corporate Governance. London, U.K.: FRC. Available at http://www.frc.org.uk/documents/pdf/combinedcodefinal.pdf.
Frankel, R.M., M.F. Johnson, and K.K. Nelson. 2002. The relation between auditors’ fees for non-audit services and earnings management. The Accounting Review 77 (supplement): 71-114.
Goh, B. 2009. Audit committees, boards of directors, and remediation of material weaknesses in internal control.
Contemporary Accounting Research 26 (2): 549–79.
Gul, F.A., J.B. Kim and A.A. Qiu. 2010. Ownership concentration, foreign shareholding, audit quality, and stock price synchronicity: evidence from China. Journal of Financial Economics 95: 425-44.
Hanlon, M., S. Rajgopal, and T. Shevlin. 2003. Are executive stock options associated with future earnings.
Journal of Accounting and Economics 36 (1/3): 3-43.
Harwood, E. and L. Simmons. 2012. The tenth anniversary of SOX: Its impact and implications for future securities litigation and regulatory enforcement activity. Corporate Accountability Report 10 (28).
Bloomberg BNA.
Higgs, D. 2003. Review of the role and effectiveness of non-executive directors. London: Department of Trade and Industry.
Hillman, A.J. and T. Dalziel. 2003. Boards of directors and firm performance: Integrating agency and resource dependence perspectives. Academy of Management Journal 28 (3): 383-96.
Hoitash, U., R. Hoitashm and K.M. Johnstone. 2014. Internal control material weaknesses and CFO compensation. Contemporary Accounting Research (forthcoming).
Hribar, P., and C. Nichols. 2007. The use of unsigned earnings quality measures in tests of earnings management.
Journal of Accounting Research 45 (5): 017–1053.
Jensen, M.C. 1993. The modern industrial revolution, exit, and the failure of internal control systems. Journal of Finance 48, 831–880.
Kadan, O. and J.M. Swinkels. 2008. Stocks or options? Moral hazard, firm viability, and the design of compensation contracts. Review of Financial Studies 21 (1): 451-482.
Kalbers, L., and T. Fogarty. 1993. Audit committee effectiveness: An empirical investigation of the contribution of power. Auditing: A Journal of Practice & Theory 12 (1): 24–49.
Kim, J.B., I. Yeung, and J. Zhou. 2013. Material weakness in internal control and stock price crash risk:
Evidence from SOX Section 404 disclosure. Working paper. City University of Hong Kong.
Kinney, W.R., and Shepardson, M.L., 2011. Do control effectiveness disclosures require SOX 404(b) internal control audits? A natural experiment with small U.S. public companies. Journal of Accounting Research 49: 413-448.
Klein, A. 1998. Firm performance and board committee structure. Journal of Law and Economics 41:275-303.
Klein, A. 2002a. Audit committee, board of director characteristics, and earnings management. Journal of Accounting and Economics 33 (3): 375–400.
Klein, A. 2002b. Economic determinants of audit committee independence, The Accounting Review 77 (2):
435–52.
Krishnan, J. 2005. Audit committee quality and internal control: An empirical analysis. The Accounting Review 80 (2): 649–75.
Krishnan, G., and G. Visvanathan. 2008. Does the sox definition of an accounting expert matter? The association between audit committee directors' accounting expertise and accounting conservatism. Contemporary Accounting Research 25 (3): 827–58.
Lennox, C., and C. Park. 2007. Audit firm appointments, audit firm alumni, and audit committee independence.
Contemporary Accounting Research 24 (1): 235–58.
Leone, A.J., J.S. Wu and J.L. Zimmerman. 2006. Asymmetric sensitivity of CEO cash compensation to stock returns. Journal of Accounting and Economics 42 (1/2): 167-192.
Linck, J.S., Netter, J.M., Yang, T., 2009. The effects and unintended consequences of the Sarbanes-Oxley Act on the supply and demand for directors. Review of Financial Studies 22 (8): 3287–3328.
Magee, R.P. and M.C. Tseng. 1990. Audit pricing and independence. The Accounting Review 65 (2): 315-336.
Magilke, M., W. Mayhew, and J. Pike. 2009. Are Independent audit-committee members objective?
Experimental Evidence. The Accounting Review 84 (6):1959–81.
Matsumoto, D. A. 2002. Management’s incentives to avoid negative earnings surprise. The Accounting Review 77 (July): 483-514.
McDaniel, L., R.D. Martin, and L.A. Maines. 2002. Evaluating financial reporting quality: The effects of financial expertise vs. financial literacy. The Accounting Review 77 (1): 139-167.
McConnell, D.K., and G.Y. Banks. 2003. How Sarbanes-Oxley will change the audit process. Journal of Accountancy 196 (3): 49-55.
Menon, K. and D.D. Williams. 2004. Former audit partners and abnormal accruals. The Accounting Review 79 (4): 1095–118.
Menon, K. and D.D. Williams. 2008. Management turnover following auditor resignations. Contemporary Accounting Research 25 (2): 567–604.
Millstein, I.M. 2002. Oversight hearing on accounting and investor protection issues raised by Enron and other public companies. US Senate Committee on Banking, Housing, and Urban Affairs, Washington, DC, available at: http://banking.senate.gov/02_02hrg/022702/ millstn.htm.
Monks, R., and N. Minow. 2001. Corporate governance, 2nd ed. Oxford, UK: Blackwell Publishing.
Myers, J. N., L. A. Myers, and Z. V. Palmrose. 2005. The length of auditor-client relationships and financial statement restatements. Working paper. University of Texas A&M.
Naiker, V., and D. Sharma. 2009. Former audit partners on the audit committee and internal control deficiencies.
The Accounting Review 84 (2):559–87.
National Association of Corporate Directors (NASD). 2001. Director compensation: Purposes, principles, and best practices. Washington DC: NACD.
National Association of Corporate Directors (NASD). 2003. Director compensation survey 2002-2003.
Washington DC: NACD.
NYSE Listed Company Manual. Updated. New York, NY: New York Stock Exchange.
New York Times .2007. Holding the line (unsigned editorial), The New York Times, 2 January, p. A18.
Palmrose, Z. V., V. Richardson, and S. Scholz. 2004. Determinants of market reactions to restatement announcements. Journal of Accounting and Economics 37 (1): 1–31.
Petersen, M. 2009. Estimating standard errors in finance panel data sets: Comparing approaches. Review of Financial Studies 22 (1): 435-480.
Ross, S. 2004. Compensation, Incentives, and the Duality of Risk Aversion and Riskiness. Journal of Finance 59 (1):207–25.
Securities and Exchange Commission (SEC). 1974. Notice of amendments to require increased disclosure of relationships between registrants and their independent public accountants: Accounting Series Release No. 165. Washington D.C.
Securities and Exchange Commission (SEC). 2003. Disclosure required by Sections 406 and 407 of the Sarbanes-Oxley Act of 2002 [Release No. 33-8177; 34-47235]. Washington D.C.
Securities and Exchange Commission (SEC). 2004. Final Rule: Temporary Postponement of the Final Phase-in Period for Acceleration of Periodic Report Filing Dates [Release No. 33-8507]. Washington D.C.
Securities and Exchange Commission (SEC). 2006. Final Rule: Executive Compensation and Related Person Disclosures [Release No. 33-8732]. Washington D.C.
Sinnett, W.M. 2007. Skillsets changing again. Financial Executive 23 (5): 35-37.
Smith, C.W. and R.L. Watts. 1992. The investment opportunity set and corporate financing, dividend, and compensation policies. Journal of Financial Economics 32: 263-292.
Srinivasan, S. 2005. Consequences of financial reporting failure for outside directors: Evidence from accounting restatements and audit committee members. Journal of Accounting Research 43 (2): 291–334.
Taub, S.2005. Board pay surges by double digits. CEO.com, October 3. http://www.cfo.com.
The Wall Street Journal. 2006. Study cites role outside directors had with options. The Wall Street Journal, 18 December, B3.
Vafeas, N. 2003. Length of board tenure and outside director independence. Journal of Business Finance &
Accounting 30: 1043-1064.
Williamson, R. 1984. Living the Sky: The Cosmos of the American Indian, Boston: Houghton Mifflin.
Winikoff, E. 2006. Director Compensation: NASDAQ 100 vs. NYSE 100. Frederic W. Cook & Co., Inc.
Xie, B. W.N. Davidson III. and P.J. DaDalt. 2003. Earnings management and corporate governance: The role of the board and the audit committee. Journal of Corporate Finance 9: 295-316.
APPENDIX