How does the type of equity compensation of audit committee affect audit fees?

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Abstract

Based on agency theory, if equity compensation aligns audit committee members' interests with those of shareholders, the audit committee will provide effective oversight and demand more thorough audit coverage and scope. This will result in higher audit fees paid to the external auditor. This study specifically examines the associations between the types of equity compensation of audit committee members and audit fees. Our findings show differential impacts of equity compensation of audit committee in the forms of option grants and stock awards on audit fees. Specifically, equity compensation using stock awards is more effective than using option grants in aligning the interests of audit committee members with the interests of shareholders to provide better oversight of financial reporting.

Introduction

The audit committee and its members are consistently under scrutiny because, in many respects, they serve as guardians of the integrity of a firm's financial statements. Prior studies have examined audit committee effectiveness using measures such as committee independence, committee member expertise, committee size, and committee meeting frequency. For an audit committee to execute its fiduciary responsibility effectively, there has to be an incentive to do so. Undoubtedly, equity is playing a larger role in director compensation structures in recent years. However, mixed views exist as to whether equity compensation provides incentives that better align the interests of audit committee with shareholder's interests or impair the objectivity and effectiveness of the directors. Based on agency theory, if equity compensation aligns audit committee members' interests with those of shareholders, the audit committee will provide effective oversight and demand more thorough audit coverage and scope. This will result in higher audit fees paid to external auditor. This study investigates the effect of different types of equity compensation of audit committee on the level of audit fees, which is a measure of audit quality.

The last decade reveals a substantial shift in director compensation from cash-based to more equity-based compensation.1 According to a global governance survey of S&P 500 firms by Spencer Stuart, the average total compensation of non-employee directors increased by approximately 29% from 2005 to 2015, with an additional increase of 8% from 2015 to 2017.2 In addition, stock awards and option grants represent the largest share of total director compensation with an increase in stock awards (and a decrease in option grants) in the composition of director compensation in recent years.3 The breakdown of director compensation in 2017 shows that 56% was in the form of stock awards and 4% was in option grants (Spencer Stuart, 2018).

The Sarbanes-Oxley Act (SOX) included significant changes to improve the audit committee's effectiveness and independence, but currently there is no regulation in regards to an appropriate compensation structure for audit committees. Due to the trend of increasing director compensation, many companies have included shareholder-approved limits on annual compensation per director in recent years to provide protection against potential lawsuits. According to a survey of director compensation by FW Cook in 2017, 51% of companies had annual limits on non-employee director compensation, a significant increase in such limits from 32% in 2016 (Krauser & Giacone, 2017). In addition, 74% of the limits in 2017 were applied to equity compensation only.4 These shareholder-approved limits on annual director compensation point out a concern of shareholders regarding the impact of equity compensation on the monitoring role of directors. Further, fewer small-cap firms (38%) are found to have annual limits on director compensation compared to large-cap firms (64%), suggesting a need to raise the awareness and to address the impact of director compensation, especially in smaller firms.

Prior research has investigated whether the type of equity compensation might have the potential to influence the effectiveness of the audit committee using different measures for audit quality. However, findings of prior research are mixed. For instance, several studies examining the relationship between stock options grants and the effectiveness of the audit committee provide inconsistent evidence concerning the effects of short and long-term option grants on the likelihood of restatement, material misstatement, and judgement of the audit committee in an auditor-management disagreement (Archambeault, DeZoort, & Hermanson, 2008; Bierstaker, Cohen, DeZoort, & Hermanson, 2012; Keune & Johnstone, 2010). Examining the associations of financial reporting quality with the types of audit committee compensation, Campbell, Hansen, Simon, and Smith (2011) find that stock option compensation is associated with earnings management, while stock award compensation does not affect audit committee oversight. The only study that examines the relationship between audit committee compensation and audit fees is by Engel, Hayes, and Wang (2010). However, the main focus of the study by Engel et al. (2010) is on total compensation versus cash retainer. An empirical question remains as to how equity compensation in the forms of option grants and stock awards should be used to compensate audit committees for better audit quality.

This study tries to fill the gap. Using a sample of 467 firm observations in the S&P SmallCap 600 Index, this study provides consistent evidence that stock option compensation of audit committee is associated with lower audit quality. This is evident in the negative association between annual option grants of audit committee and audit fees. The study also provides evidence that equity compensation in the form of stock awards, however, is associated with higher audit quality, apparent in the positive association between stock awards and audit fees.

This study contributes to the existing literature in several ways. First, the study extends the emerging line of research by examining the effects of different types of equity compensation of audit committee on audit fees. Second, using a sample of S&P SmallCap 600 firms, this study aims to contribute further evidence to the discussion by focusing particularly on small firms, which lack alternative monitoring mechanisms creating additional impact of audit committee compensation structure on audit quality. Finally, the results of this study have practical implications for regulators and investors by providing additional insight into the impact of compensation structure of audit committee on audit quality. Specifically, these results contribute evidence consistent with the notion that placing restrictions on option grants may improve audit quality. Also, continuing the use of stock awards may in fact increase audit quality.

Section snippets

Audit committee compensation

Over the years, corporate governance practices have remained in the spotlight for investors, regulators and academics. Several studies have investigated multiple facets of audit committee compensation, both because it is unregulated and because it can potentially have an impact on the functioning of the audit committee. The culmination of the papers discussed below suggests that the types of compensation provided to audit committee members may influence their judgements and potentially the

Empirical model

The dependent variable (LNAF) in this study is measured as the natural logarithm of total audit and audit-related fees. We use information gathered from the Audit Analytics database for this measure. Consistent with prior research, and the audit fees model, audit fees are an indicator of both audit committee effectiveness and audit quality (Abbott et al., 2003a, Abbott et al., 2003b; Abbott et al., 2004; DeZoort, Hermanson, Archambeault, & Reed, 2002; Engel et al., 2010; Hayek, 2015; Naiker,

Summary statistics

Table 4 provides descriptive statistics for the sample. Total compensation is the sum of all components of audit committee compensation (cash and equity). The mean (median) of the sample is $581.05 ($529.12) thousand. The mean (median) of the cash component of total compensation is approximately $253.77 ($238.95) thousand. Total equity compensation for the sample averages $306.48 thousand.

The average equity component of total compensation is approximately 50.61%, consistent with the threshold

Sensitivity analysis

Additional analysis is employed using alternative measures of audit quality. In addition to using audit fees as a measure of audit quality, we use whether or not the firm has a restatement as the dependent variable in the regression model for sensitivity analysis. Results of sensitivity analysis are reported in Table 9, Table 10, Table 11. Table 9 presents the results for option grants, Table 10 presents results for stock awards, and Table 11 presents results for total equity compensation.

Conclusions

Prior studies on executive compensation find that stock options are associated with executives' opportunistic behavior such as earnings management and financial restatements (Carter, Lynch, & Tuna, 2007). Similar results are found on director equity compensation. For example, Persons (2012) finds a significantly positive association between director stock-option compensation and the fraud likelihood. On the other hand, there is no association between the fraud likelihood, and independent

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