Does Equity Compensation Compromise Audit Committee Independence? Evidence from Earnings Management1

• Published in: Journal of managerial issues Vol. 24; no. 3; p. 293
• Main Authors: Lynch, Luann J, Williams, Susan Perry
• Format: Journal Article
• Language: English
• Published: Pittsburg Pittsburg State University, Department of Economics 01.10.2012
• Subjects: Audit committees; Auditors; Bias; Boards of directors; Compensation; Compromises; Earnings management; Employees; Equity; Financial reporting; Restricted stock; Restrictions; Stock options; Stockholders; Studies; United States > US
• ISSN: 1045-3695

This study examines whether the use of equity to compensate audit committee members is related to earnings management by the firm on whose board those members serve. The study is motivated by the enhanced role of the audit committee through recent regulatory initiatives, the focus on audit committee independence, and suggestions by some governance organizations for additional equity compensation and ownership targets for board members. Results suggest that the use of stock options in audit committee members' pay packages is associated with higher earnings management and the use of stock in those pay packages is associated with lower earnings management in firms on whose board those members serve. The findings regarding options are driven by vested options, consistent with audit committee members being sensitive to the potential short term price effects of earnings management. The findings regarding stock are driven by restricted stock grants, consistent with that form of compensation motivating a longer term view in alignment with shareholder interests. The results have important implications for allowing audit committee members to hold a financial interest in the firm on whose audit committee they serve, suggest that alternative forms of equity compensation may result in differing degrees of audit committee effectiveness, and suggest that board compensation committees should exercise caution in determining audit committee members' pay packages. [PUBLICATION ABSTRACT]