As the Demand for Audit Committees has Increased, So Too has Their PayPublished: October 10, 2007 in Knowledge@Emory
In July Xue Wang, assistant professor of accounting at Emory University’s Goizueta Business School, took to the stage to present her latest research at the 17th annual Southeast Summer Accounting Research Conference, which was held this year at Emory. Initially designed as a presentation setting for junior faculty members from four schools in the Atlanta area, including Georgia State, the University of Georgia, Georgia Tech and Emory, the conference has expanded to include accounting faculty and doctoral students from Duke University, the University of Virginia, the University of Florida and the University of North Carolina at Chapel Hill. Says Wang: “It’s an important forum to get feedback.”
Wang and her co-authors, Ellen Engel and Rachel M. Hayes, have used the suggestions of their academic colleagues to revise and further develop their working paper, “Audit Committee Compensation and Demand for Monitoring of the Financial Reporting Process.” Their research examines the relation between compensation paid to the members of the audit committees of public firms—who are basically in charge of overseeing, both internally as well as externally, a firm’s financial reporting process—and the demand for monitoring of the financial reporting process.
Regulatory changes, like the Sarbanes-Oxley Act of 2002, which is designed to protect investors by improving the accuracy and reliability of corporate disclosures, covering issues such as establishing a public company accounting oversight board, corporate responsibility, auditor independence and enhanced financial disclosure, have placed new pressures on corporate financial reporting. “Many feel that historically there has been a lack of variation in the compensation of board members. All board members received the same pay to avoid a hierarchy,” explains Wang, whose research interests are in the areas of executive compensation, corporate governance and securities regulation. “But with the most recent regulatory changes in accounting, including Sarbanes-Oxley (SOX), the audit committee has started taking a more active role in the financial reporting process. Accordingly, many audit committee members, particularly committee chairs, are granted a pay premium above and beyond other board members. We wanted to understand why this premium exists and probe some of the determinants of the premium.”
In order to do so, Wang and her co-authors collected detailed compensation data for outside directors from proxy statements between 2000 and 2004. Their analyses focus on audit committee compensation across two main time periods: the pre-SOX period including 2000 and 2001, and the post-SOX period from 2002 through the end of 2004. They collect data on the various forms of board member pay, including annual cash retainer and equity retainer, the number of stock option grants, the number of stock grants and the meeting fees paid to directors serving as chair of the audit committee, members of the audit committee, chair of the compensation committee and members of the compensation committee. The research also looks at the difference in compensation between audit committees and compensation committees—which oversee executive compensation—because audit committees are more likely to be affected by the demand for monitoring of the financial reporting process. Compensation committees are used as a control group.
The authors find that total compensation, total cash retainer compensation in particular, is positively correlated with proxies for the demand for monitoring of the financial reporting process. “We find that in the pre-SOX period there is not much difference between the audit committee and the other committees in terms of compensation,” notes Wang. “But after 2002 we see audit committee members have started to receive higher compensation than other committees. We attribute part of the increase to regulation that raises the responsibilities and the monitoring requirements of the audit committee.” For instance, the numbers of times the audit committees have meetings during the year in the post-SOX period is double that of the pre-SOX period.
The researchers are further intrigued by the variation they find between companies. Some companies give their audit committees a higher increase and others a lower increase. “We wanted to see where the variation comes from. So we use a construct that we call the “Demand for Monitoring of the Financial Reporting Process.” “The basic premise is that if the demand for monitoring of the financial reporting process is higher, then compensation will be higher,” says Wang. “We define the demand for monitoring of the financial reporting process as factors that influence the overall transparency and riskiness of the financial reporting process, including the complexity of the business and the firm’s organizational structure, the strength of internal control systems, financial reporting quality and litigation risk. Our finding is that the premium pay to the audit committees is related to this ‘Demand for Monitoring’ construct.”
Wang views their study as a first step toward understanding the compensation arrangements for audit committees. Based on comments from the Southeast Summer Accounting Research Conference, she and her coauthors are reworking the paper to better explain what factors are leading to the audit committee pay premiums. “SOX has many requirements for audit committees, like the requirement to disclose whether one of the members is a financial expert,” explains Wang, who has a separate paper focusing on firms’ reactions to the SOX regulations forthcoming in The Journal of Accounting and Economics. “If you have this kind of pressure to disclose, then there is pressure to hire a financial expert on the audit committee. Committee members are also bearing more risk because they are doing more jobs and all the members have to be independent from firm management. We find it interesting to probe the driving forces behind these pay premiums—is it the demand for credentials or is it compensation for risk-bearing?”
In future research, the authors suggest delving even further to explore how compensation incentives interact with reputation incentives to impact the effectiveness of the audit committees in monitoring financial reporting.