Equity-Based Compensation and the Effectiveness of Audit Committees

• In Event: Auditing 2

Abstract

Despite the increasing use of equity to compensate audit committee members, there is a paucity of archival research on the effect of equity-based compensation on audit committees’ effectiveness in the post-SOX era. Equity-based incentives could offer incentives to audit committee members that promote better monitoring or help in recruiting talented directors with accounting expertise. However, recent experimental evidence suggests that audit committee members prefer biased reporting when compensated with equity-based compensation. We examine the effect of equity-based compensation on the effectiveness of audit committees in enhancing earnings quality. For a sample of S&P 1500 firms, we find that equity-based compensation has a negative effect on earnings quality. We also find that equity-based compensation attenuates the effect of audit committee’s accounting expertise on earnings quality. Further, this negative effect is more problematic for firms with low external monitoring and firms with high fraud risk. Our results have important implications for boards of directors, regulators, investors, and others.

Authors

• Gopal V. Krishnan, American University

• Hung-Chao Yu, National Chengchi University