Audit committee cash compensation and propensity of firms to beat earnings by a large margin: Conditional effects of CEO power and agency risks

• Date: 01 November 2017
• Published date: 01 November 2017
• DOI: http://doi.org/10.1111/ijau.12098

ORIGINAL ARTICLE

Audit committee cash compensation and propensity of firms to

beat earnings by a large margin: Conditional effects of CEO

power and agency risks

Maria F. Rickling

1

|Divesh S. Sharma

2

1

M.E. Rinker, Sr. Institute of Tax and

Accountancy, School of Business

Administration, Stetson University, Florida,

USA

2

School of Accountancy, Coles College of

Business, Kennesaw State University, Georgia,

USA

Correspondence

Divesh S. Sharma, School of Accountancy,

Coles College of Business, Kennesaw State

University, 1000 Chastain Rd, MD 0402,

Kennesaw, GA 30144, USA.

Email: dsharma2@kennesaw.edu

This study examines the association between cash‐based compensation of directors on the audit

committee and the propensity with which firms beat forecasted earnings by a large margin. We

also examine how this association is affected by CEO power and three agency risk factors present

in the firm, namely size, leverage, and performance. We find that greater cash in the compensa-

tion structure is negatively associated with the likelihood of actual earnings beating forecasted

earnings by a large margin. In addition, we find that this negative association is modestly weaker

in firms managed by a powerful CEO and stronger in firms that are exposed to more agency risks.

Findings generally suggest compensation plans comprised predominantly of cash may promote

objective financial reporting oversight performed by the audit committee and more specifically

when CEOs are less powerful and need for monitoring is heightened. Our results have implica-

tions for investors, directors, regulators, governance activists, and future researchers.

KEYWORDS

Agency, analystforecast, audit committee,cash, CEO power, compensation,corporate governance,

earnings management, managerial hegemony

1|INTRODUCTION

There is widespread agreement amongst regulators, legislators, boards

of directors, auditors, and academics that the audit committee is the

primary internal governance mechanism responsible for overseeing

the quality of financial reports prepared by management (e.g., Beasley,

Carcello, Hermanson, & Neal, 2009; Carcello, Hermanson, & Ye, 2011;

DeFond & Francis, 2005; Security and Exchange Commission [SEC],

1999, 2003; US House of Representatives [SOX], 2002). The failure

of audit committees amongst the Enron‐type string of scandals led

the US Congress to pass the Sarbanes‐Oxley Act (SOX), which man-

dated audit committees to be comprised entirely of independent direc-

tors as well as the disclosure of the presence of a financial expert.

While there is a large volume of research investigating these reforms,

to advance knowledge about why some audit committees are more

effective than others, several researchers have called for examination

of the incentives facing the directors on the audit committee. Follow-

ing their reviews of the corporate governance literature, Carcello,

Hermanson et al. (2011) and Sharma and Sharma (2011) recommend

future research examine how the compensation of independent audit

committee members is related to the quality of financial reports.

Responding to this call is imperative because the contemporary litera-

ture offers relatively limited insight on how economic incentives affect

the audit committee's effectiveness in monitoring the quality of finan-

cial reporting in the post‐SOX period.

Owing to the paucity of studies examining audit committee com-

pensation and financial reporting outcomes, very little is known about

how cash compensation paid to audit committee directors is related to

directors' monitoring behavior. We examine the association between

cash compensation in the structure of audit committee compensation

and the propensity with which firms beat forecasted earnings by a

large margin. We also examine how this association is affected by

the power of the chief executive officer (CEO) and three agency risk

factors that could affect the firm's information environment, namely

firm size, leverage, and performance.

Underpinned by agency theory, the structure of audit committee

compensation can either be aligned with protecting shareholders'

interests or it could diverge and align with management's interests,

thus presenting agency issues. Some compensation experts argue less

cash and thus higher equity in the compensation structure could moti-

vate independent directors to focus on short‐term performance to the

detriment of the quality of the financial reporting process, while others

Received: 1 October 2015 Revised: 5 June 2017 Accepted: 8 June 2017

DOI: 10.1111/ijau.12098

304 © 2017 John Wiley & Sons Ltd Int J Audit. 2017;21:304–323.wileyonlinelibrary.com/journal/ijau

believe more cash and thus less equity will better motivate indepen-

dent directors to effectively monitor management including the quality

of financial reporting (Barrier, 2002). The investigation of General Elec-

tric by the Securities and Exchange Commission (SEC) supports the

former view when it was discovered that executives adopted improper

accounting procedures in order to exceed earnings expectations (SEC,

2009) that substantially increased the equity wealth effects of both

executives and directors. Similarly, other SEC investigations that

revealed fraudulent financial reporting designed to exceed earnings

expectations include American International Group (AIG), Diebold,

and Xerox (Goldfarb, 2010; Leone, 2010; SEC, 2009; Taub, 2008;

Walsh & Healy, 2009). While these highly visible anecdotes support

the argument that less cash, and thus more equity, in the compensa-

tion structure may have unintended consequences in relation to

exceeding earnings forecasts, research evidence on the implications

of cash compensation for independent directors on the audit commit-

tee is limited. We take the perspective that because the wealth effects

of cash compensation paid to audit committee directors are not con-

tingent on achieving current or future performance, we expect greater

cash in the audit committee's compensation structure to be negatively

associated with the propensity with which firms beat forecasted earn-

ings by a large margin.

Our study is among the first to analyze the relationship between

audit committee compensation structure, particularly cash‐based pay,

and financial reporting quality in the post‐SOX period. This is an impor-

tant contribution because SOX requires all audit committees of listed

companies to comply with independence, size, and expertise require-

ments implemented by the SEC. As such, variations in these attributes

of the audit committee have declined but the effectiveness of the audit

committee is not uniform (Sharma & Iselin, 2012).

Some argue that the willingness of audit committee members to

act and challenge management requires further research. Hence, our

study makes a second contribution to the limited literature by analyz-

ing the association between audit committee compensation and finan-

cial reporting through the lens of an alternate theoretical perspective

of corporate governance. Extant accounting and auditing literature

draws predominantly from agency theory when studying governance

issues (Cohen, Krishnamoorthy, & Wright, 2008), but operating under

this single theoretical assumption is ‘overly restrictive’and ‘disregards

the contextual richness within which governance structures are devel-

oped’(Cohen et al., 2008, p. 194). An alternative, managerial hege-

mony theory, contends that the board of directors may be personally

known by management and are therefore under management's control

and exist only to fulfill regulatory requirements (Cohen et al., 2008;

Kosnik, 1987). In this context, there is emerging evidence that power-

ful CEOs can inhibit the effectiveness of monitoring provided by the

audit committee (Carcello, Neal, Palmrose, & Scholz, 2011; Lisic, Neal,

Zhang, & Zhang, 2016). However, prior audit committee compensation

studies have not considered this influencing factor, which could

explain the mixed evidence in the literature. We extend the audit com-

mittee compensation and corporate governance literatures by investi-

gating how CEO power moderates the association between cash

compensation paid to audit committee directors and propensity of

firms to exceed earnings by a large margin. In congruence with the

managerial hegemony perspective, we believe powerful CEOs may

attenuate the association between audit committee cash compensa-

tion and the propensity with which firms beat forecasted earnings by

a large margin.

Prior audit committee compensation studies have not examined

other agency risk factors. We make a third contribution to the litera-

ture by filling this gap. Prior literature (e.g., Dey, 2008; Yermack,

2004) reports that agency risks are greater in smaller, more leveraged

and poor performing firms. For instance, smaller firms typically have

weaker governance systems, have less market and analyst following,

and attract less scrutiny from regulators. Firms with greater leverage

and poor performance have incentives to report higher earnings. Given

these governance issues, the audit committee's role in monitoring

financial reporting may be heightened when agency risks are greater.

In contrast, the audit committee's role may be lessened in larger firms

because of complementary external monitoring and scrutiny by the

SEC, analysts, large stakeholders like pension plans, and the media.

Thus, we expect cash compensation paid to audit committee directors

to be associated more strongly with the propensity with which firms

beat forecasted earnings by a large margin when agency risks are

greater.

Our empirical evidence suggests a significant association between

greater cash in the structure of audit committee compensation and the

propensity with which firms exceed forecasted earnings by a large

margin. Specifically, we find that greater cash in the compensation

structure of the audit committee is negatively associated with the like-

lihood of actual earnings exceeding forecasted earnings by a large mar-

gin. Moreover, the magnitude of the negative association increases as

firms exceed earnings by a large margin.

When we analyze CEO power as an influencing factor, we observe

that powerful CEOs (high CEO power) attenuate the negative associa-

tion between greater cash in the compensation structure of the audit

committee and the likelihood of actual earnings exceeding forecasted

earnings by a large margin. In contrast, when CEO power is low, we

continue to find a negative and significant association between greater

cash in the compensation structure of the audit committee and the

likelihood of actual earnings exceeding forecasted earnings by a large

margin. These results lend support to the managerial hegemony theory

of corporate governance.

In our tests relating to the three agency risk factors, we observe

that the negative association between greater cash in the compensa-

tion structure of the audit committee and the likelihood of actual earn-

ings exceeding forecasted earnings by a large margin holds only in

firms that are smaller, have higher leverage, and perform poorly.

In the context of our study, findings suggest that audit committee

compensation plans comprised predominantly of cash may be more

effective at maintaining the objectivity in financial reporting oversight

tasks performed by the audit committee because cash‐based pay is not

linked to firm performance‐related director wealth effects. In other

words, greater cash in audit committee compensation structure may

not motivate directors to focus on short‐term firm performance to

the detriment of reporting quality in order to reap firm performance‐

driven economic wealth benefits. Our findings further suggest that

some powerful CEOs could undermine the cash compensation effects

because of their influence on audit committee directors. The third

inference we draw from our findings is that audit committee cash

RICKLING AND SHARMA 305