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School of Accounting Seminar Series Semester 2, 2013
Audit committee members’ incentives and qualitative materiality judgments
Karla Johnstone
University of Wisconsin
Date: Friday 11th October 2013
Time: 3.00pm – 4.30pm
Venue: ASB 216
Australian School of Business School of Accounting
AUDIT COMMITTEE MEMBERS’ INCENTIVES AND QUALITATIVE MATERIALITY JUDGMENTS
Marsha B. Keune University of South Carolina
Assistant Professor University of South Carolina
1705 College Street Columbia, SC 29208
Karla M. Johnstone University of Wisconsin – Madison
Associate Professor University of Wisconsin – Madison
975 University Avenue Madison, WI 53706
August 2013
We acknowledge the following funding sources that supported this project: PwC InQuiries Research Grant, Wisconsin Alumni Research Foundation, the Deloitte Foundation, and the University of Wisconsin School of Business Andersen Center for Financial Reporting. We especially appreciate the helpful comments of Scott Bronson, Mike Ettredge, Dana Hermanson, Steve Kachelmeier, Bill Kinney, and Jay Thibodeau, and workshop participants at the Universities of Wisconsin and Texas. We acknowledge the helpful data collection assistance from Charles Boster, Kimberly Brant, Joel Fish, and Meng Li.
AUDIT COMMITTEE MEMBERS’ INCENTIVES AND QUALITATIVE MATERIALITY JUDGMENTS
SUMMARY: This study investigates the role of audit committee members’ economic incentives and external board service in judgments of detected misstatements. The results reveal a positive (negative) association between the relative level of audit committee member short-term (long-term) stock options and the likelihood that managers are allowed to waive qualitatively material misstatements, which illustrates the potential agency conflicts that can arise when compensating audit committee members with short-term stock options. Further, the results reveal a negative association between the number of boards on which the audit committee member serves and the likelihood that managers are allowed to waive qualitatively material misstatements, consistent with the notion that audit committee members consider their professional reputations when making judgments. We obtain these results while controlling for CEO stock option compensation, audit committee member diligence and financial expertise, corporate governance, and company characteristics such as financial condition, risk, and size. Keywords: Audit Committees, Book-or-Waive Decisions, Error Correction, Materiality. Data Availability: Data used in the study are available from public sources.
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AUDIT COMMITTEE MEMBERS’ INCENTIVES AND QUALITATIVE MATERIALITY JUDGMENTS
INTRODUCTION
When auditors detect non-trivial misstatements, Statement on Auditing Standards (SAS)
No. 114 requires auditors to inform managers. Further, SAS No. 89 requires auditors to inform
the audit committee about adjustments arising from the audit that could, either individually or in
the aggregate, have a significant effect on the financial reporting process. SAS No. 89 also
requires auditors to inform audit committee members about uncorrected misstatements that
managers have judged immaterial. Both of these requirements enable audit committee member
oversight of misstatement resolution (Libby and Kinney 2000; Johnstone, Sutton, and Warfield
2001; Cohen, Krishnamoorthy, and Wright 2002, 2010; Ng and Tan 2003; Keune and Johnstone
2012). Together, these parties must engage in a misstatement resolution process to determine
whether the misstatements will be corrected in the audited financial statements. This process is
important because “matters underlying adjustments proposed by the auditor but not recorded by
the entity could potentially cause future financial statements to be materially misstated, even
though … the adjustments are not material to the current financial statements.” (SAS No. 89,
paragraph .09).
Highlighting the importance of individual audit committee member incentives in
executing their oversight role of the misstatement resolution process, current public company
policy requires audit committee members to be independent of company managers (SEC 2003).
However, audit committee members have economic and reputational incentives that are not
addressed by current independence policies, and these incentives could affect audit committee
member oversight of the misstatement resolution process. The purpose of this study is to
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investigate the role of audit committee members’ economic incentives and external board service
in qualitative materiality judgments of detected financial statement misstatements.
Information concerning the existence and disposition of detected misstatements has not
previously been publicly observable (Kinney and Libby 2002; Nelson et al. 2002), or has been
limited to specific industries or financial issues (e.g., lease accounting as in Acito et al. 2009).
Using data made possible by regulation contained in Staff Accounting Bulletin No. 108 (SAB
No. 108), we are able to analyze misstatements that were previously judged immaterial and
remained uncorrected in the financial statements, but that have been judged to be material when
applying the guidance of SAB No. 108 (SEC 2006).1 SAB No. 108 was issued by the SEC in
September 2006 and requires the use of a “dual approach” when quantifying misstatements.
Historically, materiality of detected misstatements was evaluated using either a balance sheet or
an income statement approach.2 The dual approach requires applying both the balance sheet and
income statement methods to financial statement misstatements. As companies initially adopted
SAB No. 108, those companies with misstatements now judged material under the dual approach
were required to correct previously detected and waived misstatements. The disclosures about
these corrections provide the data that we use to conduct our analyses.
1 The misstatement judgments of audit committees and managers are constrained by the materiality considerations outlined in Staff Accounting Bulletin No. 99 (SAB No. 99) when determining if the misstatements affect the judgments and decisions of a reasonable person using the financial statements (FASB 1980). Quantitative materiality refers to the size of misstatements in relation to the overall financial statements. Qualitative materiality refers to considerations that may affect the decisions of financial statement users regardless of their quantitative materiality. SAB No. 99 identifies factors that should be considered in determining whether a quantitatively small misstatement may be qualitatively material (e.g., misstatements that mask a change in earnings, misstatements that hide a failure to meet analysts' expectations, and misstatements that increase managers’ compensation). 2 The income statement method focuses on the materiality of current year misstatements and the reversing effect of prior year misstatements on the income statement, which may allow misstatements to accumulate on the balance sheet. The balance sheet method focuses on ensuring that the yearend balance sheet is correct. Historically, the use of either method for quantifying misstatements was acceptable according to generally accepted auditing and accounting standards, and audit firms’ client portfolios varied in their used of the two methods (Keune and Johnstone 2009). See Nelson et al. (2005) for examples of the application of these methods.
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We develop a model explaining how audit committee economic incentives (the relative
level of audit committee member short-term and long-term stock option compensation) and
external board service are associated with the likelihood that managers are allowed to waive
misstatements that, if corrected, would have caused the company to miss its analyst forecast (i.e.,
qualitatively material misstatements). These misstatements were detected in past periods and
were waived based on judgments that they were immaterial; these misstatements would never
have been revealed publicly if not for the issuance of SAB No. 108. We control for CEO stock
option compensation, audit committee member diligence and financial expertise, corporate
governance, and various company characteristics such as auditor incentives and company
financial condition, risk, and size that prior literature has revealed are important in this context
(Keune and Johnstone 2009, 2012).
This study makes several contributions to existing literature. First, we inform the mixed
literature on the association between audit committee member economic incentives and financial
reporting outcomes (e.g., Archambeault, DeZoort, and Hermanson 2008; Magilke, Mayhew, and
Pike 2009; Bierstaker, Cohen, DeZoort, and Hermanson 2012). In experimental settings, Magilke
et al. (2009) find that students assuming the role of audit committee members that are
compensated with short-term (long-term) stock-based compensation prefer aggressive
(conservative) financial reporting, and Bierstaker et al. (2012) find that audit committee
members are more likely to support the external auditor when the audit committee member is
compensated with long-term stock options. In contrast, Archambeault et al. (2008) use empirical
data and find audit committee compensation incentives in the form of both short-term and long-
term stock option grants are positively associated with the likelihood of accounting restatements,
with the result regarding long-term stock option grants being inconsistent with expectations and
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economic theory. Our unique data on previously waived misstatements enables us to perform a
precise test of the association between short-term and long-term stock option compensation on
audit committee member judgments because we identify instances where audit committee
members allowed managers to waive misstatements that, if corrected, would have caused the
company to miss its analyst forecast. We contend that the threat of missing the analyst forecast
benchmark provides an ideal setting for testing predictions consistent with economic theory
regarding audit committee member compensation in the form of short-term and long-term stock
options and audit committee member financial reporting judgments.
We expect that relatively higher levels of audit committee member compensation in the
form of short-term (long-term) stock options will be associated with a shorter-term (longer-term)
focus on shareholder value rather than a longer-term (shorter-term) focus on maximizing current-
period stock prices. We conduct our tests using detected misstatements that existed in the
financial statements during the period 2003 to 2006. Consistent with our expectations, we find a
positive (negative) association between the relative level of audit committee member short-term
(long-term) stock options and the likelihood that managers are allowed to waive misstatements
that, if corrected, would have caused the company to miss its analyst forecast. We also find a
marginally positive association between the relative level of CEO short-term stock options and
the likelihood that managers are allowed to waive qualitatively material misstatements. In
supplemental analyses we find no association between the relative level of audit committee
member short-term (long-term) stock options and the likelihood that managers are allowed to
waive misstatements that are material due to their size (i.e., quantitative materiality) rather than
their ability to enable the company to meet the analyst forecast benchmark. In combination, these
results suggest that the structure of audit committee member compensation affects their financial
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reporting judgments related to qualitatively material misstatements that, if not for the issuance of
SAB No. 108, would have never been revealed to the public. In contrast, audit committee
members’ compensation does not affect their financial reporting judgments relating to less
subtle, quantitatively material misstatements that represent a “bright line” related to income.
Second, we extend the literature on materiality judgments in conjunction with the
disposition of detected misstatements (Wright and Wright 1997; Keune and Johnstone 2009,
2012). Wright and Wright (1997) analyze archival data from audit engagements and reveal that
material misstatements are sometimes waived and remain uncorrected in reported financial
statements. Keune and Johnstone (2009) provides contemporary descriptive insight on
materiality judgments by detailing information about companies that disclosed detected
misstatements via the requirements in SAB No. 108, including company size, industry
distribution, and the nature, direction, and magnitude of individual misstatements. Keune and
Johnstone (2012) extend that analysis by presenting results showing that managers are more
likely to waive qualitatively material misstatements as analyst following increases. However,
auditors are less likely to allow managers to waive qualitatively material misstatements as audit
fees increase, which is consistent with auditors expending effort to protect their reputations and
reduce their risk exposure by being unwilling to acquiesce to managers’ demands in such
settings. This current study extends that literature by considering the oversight role of audit
committee members, along with their economic incentives and external board service, in the
context of the qualitative materiality of waived misstatements.
Third, we extend prior research on the quality of director behavior in relation to external
board service. The “busyness hypothesis” suggests that directors serving on multiple boards may
be overcommitted in terms of their time and attention and that serving on multiple boards can
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threaten board member objectivity, independence, and willingness to investigate whistleblowing
allegations, all of which lead to weak governance oversight of managers (e.g., Core et al. 1999;
Shivdasani and Yermack 1999; Ferris et al. 2003; Fich and Shivdasani 2006; Hunton and Rose
2008, 2011). In contrast, the “reputation hypothesis” emphasizes the importance of strong
governance oversight in the market for directorships as directors develop reputations as high
quality monitors of managers (e.g., Fama 1980; Fama and Jensen 1983; Mace 1986; Lee et al.
2004; Srinivasan 2005). We extend this research by showing that there exists a negative
association between the number of boards on which the audit committee member serves and the
likelihood that managers are allowed to waive misstatements that, if corrected, would have
caused the company to miss its analyst forecast, which is consistent with the reputation
hypothesis.
We proceed as follows. In Section II, we articulate the resolution process for detected
misstatements and detail the academic theory underlying our hypotheses. We describe our
method and research design in Section III and our results in Section IV. Section V contains a
discussion of conclusions and limitations.
BACKGROUND AND HYPOTHESES The Role of Audit Committee Members in the Resolution of Detected Misstatements
Figure 1 depicts a conceptual model that describes the resolution process that occurs
upon misstatement detection. In Phase One, the auditor detects a non-trivial misstatement, and
SAS No. 114 (paragraph .40) requires the auditor to inform managers. In addition, SAS No. 89
(paragraph .09) requires the auditor to inform the audit committee about adjustments arising
from the audit that could, either individually or in the aggregate, have a significant effect on the
entity's financial reporting process and (paragraph .10) requires that the auditor inform the audit
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committee about uncorrected misstatements that were determined by managers to be immaterial,
and therefore that would be allowed to remain uncorrected in the audited financial statements.3
We expect that this communication will highlight to the audit committee members their fiduciary
responsibilities to users of the financial statements. Phase Two ensures that audit committee
members oversee the negotiation between the auditor and managers as these parties work
together to decide whether the misstatement is material. Importantly, during our sample period,
audit committee members would have been aware of the requirements of SAB No. 99, which
articulates the importance of considerations of both quantitative and qualitative materiality. One
aspect of qualitative materiality is SAB No. 99’s specific mention of the importance of
qualitative materiality considerations when correcting a misstatement would result in a failure to
meet analysts’ consensus expectations. In Phase Three, they evaluate the materiality of the
misstatement. In Phase Four, they work to make the final misstatement correction decision
(Johnstone et al. 2001; Cohen et al. 2002, 2010; Ng and Tan 2003).
Insert Figure 1 Here
Audit Committee Member Economic Incentives
Prior experimental research shows that audit committee members often support auditors’
conservative preferences in disagreements between auditors and managers (e.g., Knapp 1987;
DeZoort et al. 2003a, 2003b, 2008). However, audit committee members may face conflicts
when governing and overseeing the companies on whose boards they serve. While audit
committees are charged with acting in the best interests of shareholders, audit committee
member economic incentives may, under some circumstances, encourage a short-term self-
3 AU-C 450.07 provides updated guidance with respect to communicating with management about misstatements, and AU-C 260.13 provides updated guidance with respect to communication with those charged with governance about misstatements; the spirit of the guidance in the clarified standards is consistent with the original standards.
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interest rather than encourage actions that benefit the long-term interests of shareholders (Barrier
2002; Archer 2003; Dalton et al. 2003; Hillman and Dalziel 2003).
Agency theory provides insight into situations in which a conflict may arise due to the
separation between principals (shareholders) and agents (audit committee members or managers)
(Jensen and Meckling 1976; Fama 1980; Fama and Jensen 1983). The essential conflict in this
setting is that while the principal engages the agent to take actions on the principal’s behalf, the
agent's interests sometimes are not well-aligned with the principal's interests. One important
mechanism that can be used to alleviate this conflict is a contract between the parties that aligns
the interests of principals and agents (Lambert 2001). For example, audit committee member
compensation contracts that include stock options with a long-term focus may better align audit
committee member interests with shareholders’ interests than those such as stock options with a
short-term focus.
Exploring this issue in the context of outright financial reporting failure as proxied by
restatements, Archambeault et al. (2008) predict that audit committees’ short-term (long-term)
stock option grants will be positively (negatively) associated with the likelihood of accounting
restatements. Their results reveal that, in fact, both forms of option compensation are positively
associated with restatements, with the result regarding long-term stock options being inconsistent
with expectations and economic theory. Further, Cullinan et al. (2008) find that the negative
association between director independence and revenue misstatements is reduced when directors
are compensated with stock options. Extending these empirical results in an experimental
economics setting using student participants, Magilke et al. (2009) find that students assuming
the role of audit committee members that are compensated with current stock-based
compensation prefer aggressive financial reporting, whereas those compensated with long-term
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stock-based compensation prefer conservative reporting. In a related context, Bierstaker et al.
(2012) provide experimental evidence that audit committee members are more likely to support
the external auditor in a situation involving a financial reporting disagreement when the audit
committee is compensated with long-term stock options, and that this association is explained by
audit committee members’ sense of fairness to shareholders. Taken together, this emerging line
of research suggests that audit committee compensation contracts that encourage a short-term
focus are more likely to be associated with weaker audit committee member oversight of the
financial statements compared to compensation contracts that encourage a long-term focus.
In our setting, we are interested in economic incentives associated with the likelihood that
audit committee members will allow managers to waive detected misstatements that, if corrected,
would have caused the company to miss its consensus analyst forecast. Thus, rather than
focusing on outright financial reporting failure as in Archambeault et al. (2008), we study an
important subjective judgment that, if not for the issuance of SAB No. 108, would have never
been revealed to the public. Based on prior research, we anticipate that audit committee member
short-term (long-term) stock option compensation in the misstated company creates a short-term
(long-term) focus on shareholder value. This suggests that audit committee members with greater
short-term (long-term) stock options compensation will be more (less) likely to acquiesce to
managers’ preferences to waive correction of misstatements that enable the company to avoid
missing analyst forecasts. Stated formally:
H1: There is a positive association between the relative level of audit committee member short-term stock option compensation and the likelihood that managers are allowed to waive misstatements that, if corrected, would have caused the company to miss its analyst forecast (i.e., qualitatively material misstatements).
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H2: There is a negative association between the relative level of audit committee member long-term stock option compensation and the likelihood that managers are allowed to waive misstatements that, if corrected, would have caused the company to miss its analyst forecast (i.e., qualitatively material misstatements).
Audit Committee Member External Board Service: Busyness versus Reputation
There exist two competing theories in the literature explaining the quality of director
behavior in relation to the number of boards on which they serve: the “busyness hypothesis” and
the “reputation hypothesis.” The busyness hypothesis suggests that directors serving on multiple
boards may be overcommitted in terms of their time and attention. As a result, these directors
exhibit weaker monitoring of managers and thus contribute to weaker corporate governance
compared to that provided by directors serving on fewer boards (e.g., Core et al. 1999;
Shivdasani and Yermack 1999; Ferris et al. 2003; Fich and Shivdasani 2006). In addition, recent
experimental research provides evidence that serving on multiple boards can threaten board
member objectivity, independence, and willingness to investigate whistleblowing allegations
(Hunton and Rose 2008, 2011). Importantly, Hunton and Rose (2008) show that directors serving
on multiple boards for companies in the same industry are less likely to agree with the external
auditors’ adjustment or restatement recommendations compared to non-busy directors. If these
results were to hold in the context that we study, we would observe a positive association
between the number of boards on which the audit committee member serves and the likelihood
that the member will allow managers to waive qualitatively material misstatements.
In contrast, the reputation hypothesis suggests that the market for directorships serves as
a source of incentives for board members to develop reputations as high quality monitors of
managers (e.g., Fama 1980; Fama and Jensen 1983). Directorships are valuable in terms of
prestige, visibility, and professional contacts (Mace 1986). By serving on multiple boards,
directors develop knowledge about manager styles or strategies used by other companies
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(Carpenter and Westphal 2001), and their presence is associated with improved financial
performance of the companies on whose boards they serve (e.g., Keys and Li 2005; Linn and
Park 2005). Board members, including audit committee members, operate in an employment
market in which they are rewarded (punished) for effective (ineffective) monitoring of managers,
and individual directors value their reputational capital (e.g., Srinivasan 2005). Board members’
reputational capital suffers when a company experiences financial problems, so they have strong
incentives for high quality monitoring (Lee et al. 2004). If audit committee members act in
accordance with the reputation hypothesis, we would expect to observe a negative association
between the number of boards on which the audit committee member serves and the likelihood
that the member will allow managers to waive qualitatively material misstatements.
The body of literature related to the reputation and busyness hypotheses has not reached a
unanimous conclusion about the validity of one of these hypotheses over the other, and it seems
clear that both have some validity depending on the individual circumstances (Jiraporn et al.
2009). In fact, while Hunton and Rose (2008) report results consistent with the busyness
hypothesis as described previously, they also show that the effect of busyness is most
pronounced when auditors recommend a restatement, which is the setting in which audit
committee reputation would be harmed the most. Thus, audit committee members appear to be
motivated to make decisions that will avoid damaging their reputations.
Given the differing expectations suggested by the busyness versus the reputation
hypothesis, we make the following non-directional prediction:
H3: There is an association between the number of boards on which the audit committee member serves and the likelihood that managers are allowed to waive misstatements that, if corrected, would have caused the company to miss its analyst forecast (i.e., qualitatively material misstatements).
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METHOD AND RESEARCH DESIGN
Sample Description
Our analyses examine misstatements that existed in the financial statements from January
1, 2003 to September 30, 2006. We identified misstatement data in 10-Qs filed from November
15, 2006 to February 28, 2007 and 10-Ks filed from November 15, 2006 to February 15, 2008.4
We collected the misstatements in our sample by reading SAB No. 108 disclosures and
identifying companies that corrected misstatements in accordance with SAB No. 108.
Misstatements are included in our sample when companies provide the individual misstatement
amounts related to specific years in our sample period. Using these disclosure data, each
misstatement in our sample represents the income statement effect of an error that is present in
the financial statements during a specific year.
We perform our analyses at two levels. First, we perform disaggregated analyses at the
individual audit committee member level to match our analyses with our hypotheses. Our
hypotheses predict the association between individual audit committee member economic
incentives and external board service and the likelihood that managers are allowed to waive
qualitatively material misstatements. Performing analyses at the audit committee member level
also allows us to control for individual audit committee characteristics (e.g., financial expertise
or tenure). However, this approach to our analyses may overweight audit committees with a large
number of members. Therefore, we also perform aggregated analyses at the audit committee
level using the mean values of individual audit committee member measures.
4 See Keune and Johnstone (2009) Exhibit 1 for a SAB No. 108 disclosure example. We restrict our analyses to the period after the Sarbanes-Oxley Act of 2002 (SOX) because SOX implementation could have changed the roles of audit committees and managers in misstatement materiality decisions. Our sample does not include misstatements for which companies disclosed a cumulative amount and did not provide information that allows us to identify specific amounts and years related to the misstatement. We do not include misstatements that management disclosed as identified in the same period as SAB No. 108 implementation. The company would not have been aware of these misstatements in past periods. Therefore, these misstatements are not appropriate for testing our hypotheses.
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Table 1, Panel A reports our sample selection, and Panel B displays sample frequencies
by industry. Disaggregated (aggregated) level analyses use individual misstatement amounts for
each audit committee member (audit committee) year. We initially identified 2,852 (810)
observations with SAB No. 108 misstatement data and audit committee member data for the
disaggregated (aggregated) audit committee sample. We remove 545 (167) observations in our
disaggregated (aggregated) sample for companies with missing data in Corporate Library, Audit
Analytics, Compustat, ExecuComp, or proxy statements. Then, we remove 943 (267)
observations for missing IBES data and companies that reported missing consensus forecast
(because our analyses focus on companies that reported meeting or beating consensus forecast),
and we arrive at a final disaggregated (aggregated) sample of 1,364 (376) observations.
Insert Table 1 Here
Model
We estimate a logit regression model that predicts the likelihood that managers are
allowed to waive misstatements that, if corrected, would have caused the company to miss its
annual analyst forecast rather than meeting or beating the forecast:
Qual_Mat = α+ β1PerACShort + β2PerACLong + β3ACDirectorship + β4PerCEOShort + β5PerCEOLong + β6ACTenure + β7ACExpert + β8ACMtgs + β9BoardNum + β10CEOCOB + β11Block + β12Merger + β13Age + β14ROA + β15Size + β16MTB
+ β17Lev + β18Seg + β19MisType + β20Industryi + ε.
(1)
Our dependent variable is based on a calculation using misstatements, reported EPS, and
analysts’ consensus forecasts. Our sample consists of misstatements that existed in the financial
statements during a given year. We compare the per share effect of a misstatement on the income
statement in year t to the relevant reported actual and forecast annual EPS. Qual_Mat equals one
if correcting the misstatement is qualitatively material because it would have caused a company
that reported meeting or beating the last analysts’ median consensus forecast before the earnings
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report to miss that consensus forecast, and equals zero otherwise.5 The Appendix illustrates
calculation of the dependent variable, and Table 2 provides variable definitions.
Insert Table 2 Here
Independent Variables
Hypothesis-Testing Variables
Our models contain three hypothesis-testing variables. Regarding audit committee
member economic incentives, we measure the relative level of short-term audit committee
member compensation, PerACShort, as the percentage of an audit committee member’s current
year compensation that is in the form of stock options vesting in one year or less.6 Hypothesis 1
predicts a positive relation between PerACShort and Qual_Mat. We measure the relative level of
long-term audit committee member compensation, PerACLong, as the percentage of the audit
committee member’s current year compensation that is in the form of stock options vesting in
more than one year. Hypothesis 2 predicts a negative relation between PerACLong and
Qual_Mat. Audit committee member directorships (ACDirectorship) is the natural log of the
number of board directorships plus one held by the audit committee member in the disaggregated
audit committee model and is the natural log of the mean of board directorships plus one held by
the audit committee in the aggregated audit committee model. Hypothesis 3 predicts a non-
directional relation between ACDirectorship and Qual_Mat.
5 SAB No. 99 recognizes other types of qualitatively material misstatements (e.g., changing a net loss to net income or changing net income trends). However, our data do not provide sufficient observations of other types of qualitatively material misstatements for us to perform analyses. Consequently, we focus our analyses on qualitatively material misstatements that enabled a company to meet or beat analyst consensus forecast. We believe this type of qualitatively material misstatement provides a strong test of our hypotheses related to audit committee member stock-based compensation. 6 Consistent with Archambeault et al. (2008), we use 25 percent of the option exercise price (or the annual meeting price if the exercise price is not disclosed) to value the stock options when stock option values are not disclosed by the companies.
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Control Variables
Our model includes control variables related to CEO compensation. We include measures
for the relative levels of CEO short-term (PerCEOShort) and long-term stock option
compensation (PerCEOLong) to control for any relation between audit committee member and
CEO compensation policies (e.g., Archambeault et al. 2008). Consistent with the economic
rationale described in the development of Hypothesis 1 and Hypothesis 2, we predict that
PerCEOShort will be positively associated with Qual_Mat, and we predict that PerCEOLong
will be negatively associated with Qual_Mat.
Our models also include control variables related to corporate governance. In the
disaggregated audit committee model, we include a measure for audit committee member tenure
(ACTenure) to control for any relation between audit committee member tenure and our other
audit committee member constructs of interest; the aggregated audit committee model includes a
measure of the mean tenure for all members within the audit committee. We make no directional
prediction for ACTenure because audit committee members with longer tenure may have more
management allegiance (Vafeas 2003; Byrd et al. 2010), while audit committee members with
shorter tenure may have less organization-specific experience, competence, and commitment to
shareholder interests (Bebchuk et al. 2002; Vafeas 2003). We control for the financial expertise
of the audit committee member. ACExpert equals one in the disaggregated audit committee
sample if the audit committee member is a financial expert and equals zero otherwise. In the
aggregated audit committee sample, we control for the percentage of audit committee members
who have financial expertise (ACExpert%). Consistent with Keune and Johnstone’s (2012)
findings regarding the overall percentage of audit members who are financial experts, we expect
audit committee financial experts will be more familiar with materiality concepts and therefore
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negatively associated with Qual_Mat.7 Audit committees that have more meetings may be more
diligent in their oversight of the financial statements and be less likely to allow the waiving of
material misstatements (Abbott et al. 2004; Bedard and Gendron 2010). Conversely, audit
committees may have more meetings in order to evaluate and resolve material misstatements.
Given these competing possibilities, we make no directional prediction for the relation between
the number of audit committee meetings (ACMtgs) and Qual_Mat.
To control for the overall governance and external monitoring of the company, we
include measures for number of board members (BoardNum), companies with a CEO who is also
the chairman of the board of directors (CEOCOB), and block shareholders who are neither
managers nor directors (Block).8 Smaller boards are more effective monitors (Yermack 1996).
We expect smaller boards are less likely to allow the waiving of qualitatively material
misstatements, so we predict a positive relation between the number of board members and
Qual_Mat. We expect that when the CEO is also the chair of the board (CEOCOB = 1), other
board members cannot operate as effectively in performing their oversight roles (Jensen 1993;
Klein 2002). Indeed, Beasley (1996) and Farber (2005) find the joint role is positively associated
with material, fraudulent financial reporting. Therefore, we expect a positive association between
CEOCOB and Qual_Mat. Beasley (1996) and Farber (2005) also suggest that block shareholders
provide corporate oversight and are negatively associated with material, fraudulent financial
7 We define audit committee financial experts as members with accounting (i.e., Certified Public Accountants, Chartered Accountants, chief accounting officers, vice presidents of finance, controllers, treasurers, Big N or national audit firm employees or partners) and finance (i.e., business school faculty, bankers, investment bankers, Certified Financial Analysts, and venture capitalists) expertise. We use this definition because companies are conservative in their designation of audit committee financial experts (Carcello et al. 2006). Also, note that audit committee financial expertise as we have defined it here differs from audit committee organization-specific expertise that may be associated with audit committee member board tenure. 8 We do not control for the use of a Big N audit firm as 98 percent (98 percent) of our disaggregated (aggregated) audit committee sample observations uses a Big N audit firm. Thus, the measure has insufficient variance for inclusion in our model.
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reporting. Thus, we expect block shareholders (Block) will be negatively associated with
Qual_Mat.
Our models include control variables for various features of the sample companies and
misstatements. We control for the number of years the company has been publicly traded, Age
(Archambeault et al. 2008; Keune and Johnstone 2012). We expect that older companies are
more likely to have larger misstatements that can be qualitatively material, but younger
companies may be more aggressive in their financial reporting practices. Thus, we make no
directional prediction for the relation between Age and Qual_Mat. We control for the company’s
return on assets (ROA), size (Size), market to book ratio (MTB), leverage (Lev), and number of
operating segments (Seg), which represent risk, complexity, and propensity to grant stock-based
compensation. We do not make directional predictions for these variables. Further, audit
committee member economic incentives and external board service could vary systematically
with the demands and complexities of the company’s accounting policies and related
misstatements, and misstatements arising from more complex accounting polcies could be more
likely to be material. We control for the presence of misstatements arising from complex
accounting policies (e.g., derivatives, pensions, consolidations, etc.), MisType. Consistent with
Keune and Johnstone (2012), we expect a positive relation between MisType and Qual_Mat. We
also control for industry membership based on categories used in Ashbaugh et al. (2003).
18
Alternative Tests of Hypotheses
We develop several alternative specifications of Model 1 to examine the robustness of
our results. First, we include the relative level of audit committee member (PerACShares) and
CEO (PerCEOShares) restricted and unrestricted share compensation. This specification enables
us to control for share-based compensation in addition to long-term stock option compensation.
Next, we classify stock options for which vesting data are not stated as either short-term
or long-term stock option compensation measures. Some proxy statements do not provide
sufficient details for us to determine vesting periods of stock option compensation. In our
primary model, we do not make assumptions regarding the vesting periods of the stock option
compensation. Instead, we classify stock options without vesting period details as other forms of
compensation and include these amounts in total compensation (i.e., the denominator). This
measurement choice ensures that the stock options we classify as short term are, indeed, short
term in nature and the stock options we classify as long term are, indeed, long term in nature.
However, it is possible that our results are sensitive to this choice. Therefore, in robustness tests
we first classify stock options without vesting data as short-term stock options for measuring
audit committee member (PerACShortwNS) and CEO (PerCEOShortwNS) compensation. Then,
we classify stock options without vesting data as long-term stock options for measuring audit
committee member (ACShortNS) and CEO (CEOShortNS) compensation.
Finally, we include alternative measures of short-term and long-term CEO compensation.
In Model 1, we measure CEO short-term and long-term stock option compensation consistently
with our audit committee member compensation measures. However, CEOs generally receive
other incentive compensation in addition to stock options. To determine if our results are robust
to alternative measures of CEO compensation, we include cash bonuses in our definition of CEO
19
short-term compensation (PerCEOShortwbonus) to consider the short-term effects of incentive-
based cash compensation (consistent with Archambeault et al. 2008). Then, we include restricted
shares (PerCEOLongwrestrict) in our definition of CEO long-term compensation (consistent
with Archambeault et al. 2008).
RESULTS
Descriptive Statistics
Table 3 provides descriptive statistics for audit committee compensation (Panel A) and
independent variables in the disaggregated audit committee sample (Panel B) and the aggregated
audit committee sample (Panel C).9 Recall that each observation in our disaggregated sample
represents an audit committee member, and each observation in our aggregated sample
represents an audit committee.
Panel A reveals that audit committee members that allowed managers to waive material
misstatements receive lower average levels (about $2 thousand) of long-term stock options
(ACLTOptions) than audit committee members that allowed managers to waive immaterial
misstatements (about $15 thousand) in both the disaggregated and aggregated audit committee
samples (t = 10.19, p < 0.01; t = 5.60, p < 0.01). Audit committee members that allowed
managers to waive material misstatements receive lower average levels (about $4 thousand) of
stock (ACStock) than audit committee members that allowed managers to waive immaterial
misstatements (about $10 thousand; t = 3.45, p < 0.01) in the disaggregated sample, while this
comparison is insignificant in the aggregated sample (t = 0.90, p = 0.37). In terms of total audit
committee member compensation, audit committee members that allowed managers to waive
material misstatements receive lower average levels (about $78 thousand) of total compensation
9 At less than 3.50, the VIFs from the hypothesis-testing model estimated using linear regression are all well below the 10.00 threshold recommended by Belsley et al. (1980). Thus, collinearity does not appear to be a concern in our hypothesis-testing analyses.
20
(ACTotal) than audit committee members that allowed managers to waive immaterial
misstatements (about $109 thousand; t = 4.30, p < 0.01) in the disaggregated sample, while this
comparison is insignificant in the aggregated sample (t = 0.92, p = 0.36). While the size of these
amounts may seem small in comparison to the overall wealth of some audit committee members,
it is important to note that prior research finds board members attend more board meetings when
the company pays even a relatively small incentive compensation, such as $1,000, for each
meeting (Adams and Ferreira 2008), indicating that even small amounts of financial
compensation are sufficient to alter board member behavior.
With regard to hypothesis-testing variables, Panel B shows that audit committee members
that allowed managers to waive material misstatements have higher relative short-term stock
option compensation (PerACShort: t = -3.18, p < 0.01; PerACShortwNS: t = -2.84, p = 0.01)
than audit committee members that allowed managers to waive immaterial misstatements in the
disaggregated sample, while Panel C shows that this comparison is insignificant in the
aggregated sample (PerACShort: t = -1.53, p = 0.13; PerACShortwNS: t = -1.38, p = 0.17). Panel
B and Panel C show that audit committee members that allowed managers to waive material
misstatements have lower relative long-term stock option compensation than audit committee
members that allowed managers to waive immaterial misstatements in the disaggregated
(PerACLong: t = 9.02, p < 0.01; PerACLongwNS: t = 6.68, p < 0.01) and aggregated samples
(PerACLong: t = 5.18, p < 0.01; PerACLongwNS: t = 3.64, p < 0.01). In terms of the number of
outside directorships that audit committee members hold, Panels B and C show that audit
committee members that allowed managers to waive material misstatements have fewer outside
directorships (ACDirectorship) than audit committee members that allowed managers to waive
21
immaterial misstatements in the disaggregated and aggregated samples (t = 3.84, p < 0.01; t =
2.00, p = 0.05).
Insert Table 3 Here
Tests of Hypotheses
Table 4 presents tests of hypotheses using the disaggregated and aggregated audit
committee samples.10 Hypothesis 1 predicts a positive association between the relative level of
audit committee member short-term stock option compensation (PerACShort) and the likelihood
that managers are allowed to waive qualitatively material misstatements. Results using both the
disaggregated and aggregated audit committee samples provide support for this hypothesis (z =
1.80, p = 0.04; z = 1.93, p = 0.03). The odds ratio on PerACShort (1.02) indicates that, holding
all else constant, the odds that managers are allowed to waive qualitatively material
misstatements increases by two percent with each one percentage point increase in the proportion
of total audit committee member compensation paid in short-term stock options.
Insert Table 4 Here
Hypothesis 2 predicts a negative association between the relative level of audit committee
member long-term stock option compensation (PerACLong) and the likelihood that managers are
allowed to waive qualitatively material misstatements. Results using both the disaggregated and
aggregated audit committee samples provide support for this hypothesis (z = -1.77, p = 0.04; z =
-1.86, p = 0.03). The odds ratio on PerACLong (0.96) indicates that, holding all else constant, the
odds that managers are allowed to waive qualitatively material misstatements decreases by four
percent with each one percentage point increase in the proportion of total audit committee
member compensation paid in long-term stock options.
10 The hypothesis-testing models in all tables use robust standard errors clustered by company and continuous variables winsorized at the 1st and 99th percentiles.
22
Hypothesis 3 predicts an association between the number of boards on which the audit
committee member serves and the likelihood that managers are allowed to waive qualitatively
material misstatements. Results using both the disaggregated and aggregated audit committee
samples show a negative association between ACDirectorship and Qual_Mat (z = -2.11, p =
0.04; z = -2.28, p = 0.02), respectively. The odds ratios on ACDirectorship in the disaggregated
sample (0.56) and in the aggregated sample (0.23) indicate that, holding all else constant, the
odds that managers are allowed to waive qualitatively material misstatements decreases by 44
percent and 77 percent, respectively, with each one unit increase in the log of directorships held
by audit committee members, where a one unit increase is approximately 3 directorships.
Overall, the results for H3 are consistent with the reputation hypothesis. That is, the market for
directorships serves as a source of incentives for board members to develop reputations as high
quality monitors of managers, so audit committee members with more outside directorships
maintain that reputation by resisting managers’ preference to waive correcting qualitatively
material misstatements.
Control Variables
With regard to control variables in Table 4, results show that the proportion of CEO
compensation paid in short-term stock options (PerCEOShort) is marginally positively
associated with Qual_Mat in the aggregated sample (z = 1.46, p = 0.07). ACTenure is marginally
positively associated with Qual_Mat in the two samples (z = 1.85, p = 0.07; z = 1.64, p = 0.10).
ACExpert or ACExpert% is marginally negatively associated with Qual_Mat in the two samples
(z = -1.51, p = 0.07; z = -1.52, p = 0.06). ACMtgs is positively associated with Qual_Mat in the
aggregated sample (z = 1.90, p = 0.06). Size is positively associated with Qual_Mat in the two
samples (z = 2.05, p = 0.04; z = 2.46, p = 0.01). MTB is positively associated with Qual_Mat in
23
the two samples (z = 1.87, p = 0.06; z = 1.91, p = 0.06). MisType is positively associated with
Qual_Mat in the two samples (z = 2.62, p < 0.01; z = 2.37, p = 0.01), implying that qualitatively
material misstatements arising from complex accounting policies are more likely to be waived.
Alternative Tests of Hypotheses
Table 5 presents tests of hypotheses while controlling for the relative level of audit
committee member (PerACShares) and CEO (PerCEOShares) restricted and unrestricted share
compensation. Hypotheses related to the relative level of audit committee member short-term
stock option compensation (PerACShort: z = 1.61, p = 0.05; z = 1.90, p = 0.03), the relative level
of audit committee member long-term stock option compensation (PerACLong: z = -1.79, p =
0.04; z = -1.93, p = 0.03), and outside directorships (ACDirectorship: z = -3.36, p < 0.01; z = -
3.36, p < 0.01) are robust to controlling for long-term share compensation. However, the relative
levels of audit committee member (PerACShares: z = -0.08, p = 0.93; z = 0.15, p = 0.89) and
CEO (PerCEOShares: z = 1.28, p = 0.20; z = 1.57, p = 0.12) long-term restricted and
unrestricted share compensation are not associated with Qual_Mat in either sample.
Insert Table 5 Here
Table 6 (Table 7) presents tests of hypotheses while classifying stock options for which
vesting data are not stated as short-term (long-term) stock option compensation measures. Table
6 reveals that hypotheses related to the relative level of audit committee member short-term
stock option compensation (PerACShortNS: z = 1.73, p = 0.04; z = 1.57, p = 0.06), the relative
level of audit committee member long-term stock option compensation (PerACLong: z = -1.73, p
= 0.04; z = -1.82, p = 0.03), and outside directorships (ACDirectorship: z = -1.86, p = 0.06; z = -
1.86, p = 0.06) are robust to classifying stock options without vesting data as short-term stock
option compensation. Table 7 reveals that hypotheses related to the relative level of audit
24
committee member short-term stock option compensation (PerACShort: z = 1.77, p = 0.04; z =
1.87, p = 0.03), the relative level of audit committee member long-term stock option
compensation (PerACLongNS: z = -1.31, p = 0.10; z = -1.36, p = 0.09), and outside directorships
(ACDirectorship: z = -2.11, p = 0.04; z = -2.24, p = 0.03) are robust to classifying stock options
without vesting data as long-term stock option compensation.
Insert Tables 6 and 7 Here
Table 8 presents tests of hypotheses while measuring CEO compensation
(PerCEOShortwbonus and PerCEOLongwrestrict) consistent with Archambeault et al. (2008).
Table 8 reveals that hypotheses related to the relative level of audit committee member short-
term stock option compensation (PerACShort: z = 1.87, p = 0.03; z = 2.08, p = 0.02), the relative
level of audit committee member long-term stock option compensation (PerACLong: z = -1.72, p
= 0.04; z = -1.80, p = 0.04), and outside directorships (ACDirectorship: z = -2.44, p = 0.02; z = -
2.62, p = 0.01) are robust to alternative measures of CEO compensation.
Insert Table 8 Here
CEO Variables
With regard to CEO economic incentives, recall that results in Table 4 show that
PerCEOShort is not associated with Qual_Mat in the disaggregated sample (z = 1.17, p = 0.12),
but is positively associated with Qual_Mat in the aggregated sample (z = 1.46, p = 0.07). These
results are consistent across model specifications where our measure of CEO short-term stock
option compensation includes only stock options with vesting periods disclosed as one year or
less (Table 5: z = 1.57, p = 0.06; Table 7: z = 1.39, p = 0.08). However, CEO short-term
compensation is not positively associated with Qual_Mat when this measure includes stock
options with undisclosed vesting periods (Table 6) or cash bonuses generally based on
25
performance targets (Table 8), indicating that these alternative measures represent conceptual
measures that are different from CEO short-term stock option compensation. PerCEOLong in
Table 4 is not associated with Qual_Mat in either sample (z = -0.84, p = 0.20; z = -0.50, p =
0.31). Overall, these results suggest that CEO compensation has some role in managers’ waiving
of qualitatively material misstatements. However, the complexities of CEO compensation plans
in comparison to audit committee member compensation plans likely obscures this relation.
Robustness Test - Additional Incentives
Our study focuses on audit committee member and CEO incentives, but the effects of
stock analyst following and auditor incentives can also be associated with the likelihood of
qualitatively material misstatements. Keune and Johnstone (2012) show that companies with
high security analyst following are more likely to have qualitatively material misstatements that
enable companies to meet or beat analysts’ consensus forecast, but this relationship is weakened
when the audit client is highly visible in terms of relatively high audit fees, i.e., a negative
interaction of security analyst following and audit fees. Further, our dependent variable is a
function of earnings surprise and misstatement size. If earnings surprise is correlated with our
audit committee member incentive variables, our results may be due to this association rather
than any characteristics of the misstatement. Following Keune and Johnstone (2012), we re-
estimate our analyses in Table 4 adding security analyst following, the log of audit fees, the
interaction of security analyst following and audit fees, the absolute value of forecast error, and
the interaction of the log of audit fees and the absolute value of forecast error. We find similar
results on PerACShort (z = 2.11, p = 0.02; z = 1.99, p = 0.02), PerACLong (z = -2.59, p < 0.01; z
= -2.69, p < 0.01), and ACDirectorship (z = -1.71, p = 0.09; z = -1.71, p = 0.09) using both the
aggregated sample and disaggregated samples. In addition, the negative interaction of security
26
analyst following and audit fees reported by Keune and Johnstone (2012) is significant (z = -
2.94, p < 0.01; z = -3.44, p < 0.01) using both the aggregated sample and disaggregated samples.
Thus, our hypothesis-testing results in Table 4 are robust to controlling for these other factors.
Additional Analysis – Quantitative Materiality of Misstatements
We re-estimate our analyses using an alternative quantitative materiality measure as the
dependent variable. Our theoretical dependent variable of interest is the qualitative materiality of
misstatements because we believe that qualitative materiality provides the best setting for
identifying potentially opportunistic or strategic effects of audit committee member economic
incentives and external board service. However, it is possible that audit committee member
economic incentives and external board service also are associated with the magnitude of the
misstatements (i.e., quantitative materiality). It is also possible that our measure of qualitative
materiality is simply a proxy for quantitative materiality, as larger misstatements may be more
likely to enable a company to meet or beat analysts’ consensus forecast.11
To examine these alternative possibilities, we first identify aggregated and disaggregated
audit committee samples with requisite variables for quantitative materiality analyses. We do not
restrict these samples to companies that meet or beat analyst consensus forecast as quantitative
materiality is not dependent upon the forecast benchmark. Next, we re-estimate (results not
tabled) Model 1 using a dependent variable that equals one when the cumulative misstatement is
greater than five percent of normal income and zero otherwise.12 Audit committee compensation
11 Our qualitative materiality measure (Qual_Mat) is significantly and positively correlated with the presence of quantitatively large misstatements that are greater than 5 percent of pretax net income in the disaggregated and aggregated audit committee samples (r = 0.07, p < 0.01; r = 0.11, p = 0.04). However, these two variables are not identical, suggesting that they measure distinct and separate constructs. 12 Five percent of pretax net income is the most common materiality measure (Messier et al. 2005). Normal net income considers that pretax income may arrive at small or nonrepresentative materiality measures for loss or breakeven companies (Leslie 1985). Following Leslie (1985), Gleason and Mills (2002), and Keune and Johnstone (2012), we estimate the “normal income” of our sample companies as the greatest of the industry return on equity
27
in the form of short-term stock options (PerACShort) is not significantly associated with the
quantitative materiality of misstatements in either the disaggregated or aggregated sample (z = -
1.00, p = 0.32; z = -1.13, p = 0.26). Audit committee compensation in the form of long-term
stock options (PerACLong) is not associated with the quantitative materiality of misstatements in
either the disaggregated or aggregated sample (z = 0.06, p = 0.95; z = 0.14, p = 0.89). Finally, the
number of audit committee outside directorships is also not associated with the quantitative
materiality of misstatements in either the disaggregated or aggregated sample (ACDirectorship: z
= -0.00, p = 0.99; z = -0.59, p = 0.56). Overall, these results suggest that quantitative and
qualitative materiality represent different theoretical constructs; audit committee members’
economic incentives and external board service are associated with qualitatively material
misstatements, but are not associated with quantitatively material misstatements.
CONCLUSIONS AND LIMITATIONS
This paper investigates the role of audit committee members’ economic incentives and
external board service in qualitative materiality judgments relating to detected financial
statement misstatements. We first report results supporting the idea that the relative level of audit
committee member short-term (long-term) stock option compensation is positively (negatively)
associated with the likelihood that managers are allowed to waive misstatements that, if they had
been corrected, would have caused the company to miss its analyst forecast (i.e., qualitatively
material misstatements). These results are consistent with the idea that audit committee member
compensation that encourages a longer-term focus is more likely to be associated with stronger
audit committee oversight of the financial statements, while audit committee member
compensation that encourages a shorter-term focus is associated with the potential for agency
(ROE) multiplied by the company’s stockholders’ equity, the ROE of one percent for companies in the overall market multiplied by the company’s stockholders’ equity, or the company’s reported pretax income.
28
conflicts and questionable judgments regarding the disposition of detected misstatements. Prior
research has been unable to examine audit committee members’ materiality judgments
concerning detected misstatements, so our results are important in that they reveal that the time
horizon of audit committee member compensation may have real consequences in terms of those
judgments. From a compensation policy standpoint, these results should be of interest to
compensation committees as they make decisions about the mix of audit committee
compensation.
Second, our empirical tests enable distinguishing between the validity of the busyness
hypothesis (more outside directorships will be associated with weaker manager oversight
because of over-commitment issues) versus the reputation hypothesis (more outside directorships
will be associated with stronger manager oversight because of reputation concerns). The results
are consistent with the reputation hypothesis, revealing that audit committee members are less
likely to allow managers to waive qualitatively material misstatements when an audit committee
member has greater reputation risk for weak governance oversight. In some ways this is not
surprising, given the high visibility of audit committee members, the market for such positions in
the board member community, and the fact that external auditors are obligated by auditing
standards to discuss materiality issues and detected misstatements with the audit committee.
These factors logically should make audit committee long-term fiduciary duties to shareholders
salient to audit committee members.
Together, the results are consistent with audit committees performing an important role in
monitoring the financial statements. Although SAS No. 89 requires audit committees to be
informed of detected misstatements and SAB No. 99 requires consideration of qualitative
materiality, the requirements of these standards appear to be more effective when the audit
29
committee member’s incentives are aligned with the long-term value of shareholders and when
the audit committee member has outside board memberships that encourage reputation
management. Thus, our results paint a complex picture of audit committee member judgment in
this context, wherein they appear to consider long-term shareholder interests, along with their
own reputational interests. Thus, while Keune and Johnstone (2012) illustrate the importance of
managers and external auditors in this decision setting, our results provide a significant extension
of that research by illustrating the oversight role of audit committee members. Further,
robustness tests show that the results of our primary hypothesis tests are still significant after
controlling for the effects of security analyst following and auditor incentives identified in Keune
and Johnstone (2012).
We acknowledge certain limitations of our analyses. First, we acknowledge that the
number of misstatements in our final sample is relatively small number in relation to the overall
number of transactions occurring for publicly traded entities during our sample period. However,
the unique nature of these misstatement data allow us to examine judgments that were previously
not publicly available. Second, we recognize that audit committee member compensation is a
function of the overall governance structure of the company. While our results are robust to
many audit committee and board member governance controls and various specifications of audit
committee member compensation, we acknowledge that our study, as with other studies on
corporate governance, is subject to concerns regarding the potentially endogenous nature of our
variables of interest.
30
APPENDIX Illustration of Dependent Variable Calculation
Description
Qualitatively Material
Qualitatively Immaterial
Reported EPS [A] $ 0.05 $ 0.05Analyst consensus forecast [B] 0.03 0.03Reported earnings surprise [A] - [B] 0.02 0.02SAB No. 108 misstatement in income statement [C] -0.03 -0.01Revised earnings surprise [A] – [B] – [C] $-0.01 $ 0.01Dependent variable Qual_Mat 1 0 Notes: Qual_Mat equals one if correcting the misstatement is qualitatively material because it would have caused a company that reported meeting or beating the last analysts’ median consensus forecast before the earnings report to miss that consensus forecast, and equals zero otherwise. The dependent variable is calculated by subtracting analyst consensus forecast [B] from reported EPS [A] to arrive at the amount by which the company reported meeting or beating analyst consensus forecast ([A] – [B]). This earnings surprise is compared to the SAB No. 108 misstatement in the income statement [C] to arrive at the revised earnings surprise. When the revised earnings surprise is negative, the company misses analyst consensus forecast when the misstatement is corrected, and the dependent variable equals one. When the revised earnings surprise is positive or zero, the company meets or beats analyst consensus forecast when the misstatement is corrected, and the dependent variable equals zero.
31
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35
FIGURE 1 The Role of Audit Committee Members in the Resolution Process for Detected Misstatements
36
TABLE 1 Sample Selection and Descriptive Statistics
Panel A: Sample Selection Disaggregated
Audit Committee
Aggregated Audit
Committee Audit committee observations with misstatements
2,852 810
Less: Corporate Library, Audit Analytics, Compustat, ExecuComp, and proxy missing data
545 167
2,307 643 Less: IBES missing data and companies that reported missing consensus forecast
943 267
Final sample 1,364 376 Panel B: Sample Frequency by Industry Disaggregated
Audit Committee (n = 1,364)
Aggregated Audit
Committee (n = 376)
Agriculture, Forestry, Mining 6% 7% Manufacturing 25% 28% Transportation, Communications, Utilities 8% 7% Wholesale and Retail 10% 9% Banks, Insurance, Real Estate 24% 20% Hotels and Services 22% 25% Health, Legal, Education, Engineering Services 3%
3%
Total 100% 100%
37
TABLE 2 Variable Definitions
Variable Name Description Dependent Variable: Qual_Mat = 1 if company reported basic annual EPS that meet or beat last analysts’
median consensus forecast before earnings report, but would have missed the annual forecast if it corrected the income statement misstatements; 0 otherwise [10-Ks, 10-Qs, and IBES].
Hypothesis Testing Independent Variables: PerACShort = percentage of total audit committee member compensation in the form of
stock options with a vesting period one year or less *100 [Proxy Statements]. PerACShortwNS = percentage of total audit committee member compensation in the form of
stock options with a vesting period one year or less and for which vesting data are not stated * 100 [Proxy Statements].
PerACLong = percentage of total audit committee member compensation in the form of stock options with a vesting period greater than one year *100 [Proxy Statements].
PerACLongwNS = percentage of total audit committee member compensation in the form of stock options with a vesting period greater than one year and for which vesting data are not stated * 100 [Proxy Statements].
PerACShares = percentage of total audit committee member compensation in the form of restricted and unrestricted shares * 100 [Proxy Statements].
ACDirectorship = ln (number of directorships held by audit committee member + 1) [Corporate Library and Proxy Statements].
Control Variables: PerCEOShort = percentage of total CEO compensation in the form of stock options with a
vesting period one year or less * 100 [Proxy Statements]. PerCEOShortwbonus = percentage of total CEO compensation in the form of stock options with a
vesting period one year or less and cash bonus * 100 [Proxy Statements]. PerCEOShortwNS = percentage of total CEO compensation in the form of stock options with a
vesting period one year or less and for which vesting data are not stated * 100 [Proxy Statements].
PerCEOLong = percentage of total CEO compensation in the form of stock options with a vesting period greater than one year * 100 [Proxy Statements].
PerCEOLongwrestrict = percentage of total CEO compensation in the form of stock options with a vesting period more than one year and restricted shares * 100 [Proxy Statements].
PerCEOLongwNS = percentage of total CEO compensation in the form of stock options with a vesting period greater than one year and for which vesting data are not stated * 100 [Proxy Statements].
PerCEOShares = percentage of total CEO compensation in the form of restricted and unrestricted shares * 100 [Proxy Statements].
ACTenure = ln (audit committee member tenure on board + 1) [Corporate Library and Proxy Statements].
38
TABLE 2 - Continued ACExpert = 1 if audit committee member is a financial expert; 0 otherwise. We define
financial experts as Certified Public Accountants, Chartered Accountants, chief accounting officers, vice presidents of finance, controllers, treasurers, Big N or national audit firm employees or partners, business school faculty, bankers, investment bankers, Certified Financial Analysts, and venture capitalists [Proxy Statements].
ACExpert% = Percentage of audit committee comprised of financial experts, as defined by ACExpert * 100.
ACMtgs = Number of audit committee meetings during the year [Proxy Statements]; BoardNum = Number of board members [Corporate Library]. CEOCOB = 1 if CEO is the chair of the board of directors; 0 otherwise [Proxy Statements]. Block = 1 if any holders of more than five percent of outstanding shares; 0 otherwise
[Corporate Library]. Merger = 1 if a merger of acqusition in the current year; 0 otherwise [Compustat]. Age = ln (data year – first year company listed + 1) [Compustat]. ROA = net income / beginning of year total assets * 100[Compustat]. Size = ln (total assets) using at [Compustat]. MTB = (market value of common stock + preferred stock) / total assets (using csho,
prcc_f, pstk, and at) [Compustat]. Lev = Long-term debt (using dltt) /total assets (using at) [Compustat]. Seg = ln(number of business segments from Compustat segment file). MisType = 1 if revenue, reserve, tax, derivative, business combination, lease, pension, or
stock option misstatement, 0 otherwise. Industry = industry indicator variables are SIC 01–14, SIC 15–19, SIC 20–21, SIC 22–
23, SIC 24–27, SIC 28–32, SIC 33–34, SIC 35–39, SIC 40–48, SIC 49, SIC 50–52, SIC 53–59, SIC 60–69, and SIC 70–79 [Compustat].
39
TABLE 3 Descriptive Statistics
Panel A: Audit Committee Compensation (in thousands)
Qualitatively Material
Misstatementsa
Qualitatively Immaterial
Misstatementsa
Variablesb Mean Std. Dev. Med Mean
Std. Dev. Med statc
p-valuec
Disaggregated Sample ACCashComp 42.23 19.45 45.00 44.89 29.02 41.00 1.44 0.15 ACSTOptions 14.61 26.91 0.00 11.85 38.75 0.00 -0.82 0.41 ACLTOptions 2.09 6.27 0.00 14.56 38.58 0.00 10.19 <0.01 ACNSOptions 5.83 13.40 0.00 6.48 17.62 0.00 0.53 0.60 ACRestricted 8.65 20.18 0.00 21.39 206.49 0.00 0.73 0.47 ACStock 4.39 10.55 0.00 9.54 41.97 0.00 3.45 <0.01 ACTotal 77.79 40.03 72.04 108.71 221.83 84.75 4.30 <0.01 n 139 1,225 Aggregated Sample ACCashComp 41.17 17.81 42.00 44.40 28.76 40.56 0.99 0.32 ACSTOptions 15.25 28.29 0.00 12.28 36.70 0.00 -0.49 0.63 ACLTOptions 1.92 6.04 0.00 14.61 37.64 0.00 5.60 <0.01 ACNSOptions 5.89 13.73 0.00 6.10 17.19 0.00 0.07 0.94 ACRestricted 8.47 19.53 0.00 20.57 197.12 0.00 0.38 0.70 ACStock 2.90 8.98 0.00 8.73 40.14 0.00 0.90 0.37 ACTotal 75.59 37.81 72.04 106.69 211.31 87.07 0.92 0.36 n 39 337 Notes: a Qualitatively material (immaterial) misstatements that cause the company to miss analyst consensus forecast when corrected are Qual_Mat = 1 (0). b ACCashComp is member cash compensation. ACSTOptions, ACLTOptions, and ACNSOptions are the values of stock options granted to members with vesting periods of one year or less, with vesting periods more than one year, and without vesting data. ACRestricted is the value of restricted shares granted to members, and ACStock is the value of shares granted to members. ACTotal is the value of all member compensation. c Continuous variable statistics are t-stats from means tests. Indicator variable statistics are Chi-Squares with continuity corrections. All p-values are two-tailed.
40
TABLE 3 - Continued Panel B: Disaggregated Audit Committee Sample
Qualitatively Material
Misstatementsa (n = 139)
Qualitatively Immaterial
Misstatementsa (n = 1,225)
Variablesb Mean
Std. Dev. Med Mean
Std. Dev. Med statc
p-valuec
PerACShort 13.61 22.34 0.00 7.39 17.54 0.00 -3.18 <0.01 PerACShortwNS 18.11 22.39 7.46 12.44 21.51 0.00 -2.84 0.01 PerACLong 2.13 7.26 0.00 10.13 22.34 0.00 9.02 <0.01 PerACLongwNS 6.62 12.61 0.00 15.23 25.09 0.00 6.68 <0.01 PerACShares 13.60 21.13 0.00 12.59 19.24 0.00 -0.53 0.59 ACDirectorship 0.97 0.42 1.01 1.12 0.48 1.20 3.84 <0.01 PerCEOShort 5.55 11.44 0.57 4.26 10.61 0.00 -1.34 0.18 PerCEOShortwbonus 26.67 19.41 28.89 24.83 25.78 21.23 -1.02 0.31 PerCEOShortwNS 6.74 12.06 1.06 7.88 15.86 0.00 1.02 0.31 PerCEOLong 9.17 14.41 0.00 11.45 21.62 0.00 1.66 0.10 PerCEOLongwrestrict 25.27 22.13 23.73 22.62 28.04 0.00 -1.30 0.20 PerCEOLongwNS 10.37 14.60 1.71 15.10 23.60 0.00 3.35 <0.01 PerCEOShares 15.79 19.29 0.00 10.96 17.04 0.00 -2.83 0.01 ACTenure 2.15 0.45 2.20 2.02 0.50 2.11 -3.04 <0.01 ACExpert 47.42 23.39 37.50 55.79 26.18 57.14 3.61 <0.01 ACMtgs 9.14 3.41 9.00 8.92 3.70 8.00 -0.67 0.50 BoardNum 9.03 3.36 9.00 9.79 2.68 9.00 3.06 <0.01 CEOCOB 0.53 0.50 1.00 0.67 0.47 1.00 3.15 <0.01 Block 0.83 0.37 1.00 0.84 0.36 1.00 0.27 0.79 Merger 0.50 0.50 1.00 0.58 0.49 1.00 1.80 0.07 Age 2.51 0.36 2.64 2.59 0.36 2.71 2.40 0.02 ROA 4.90 6.33 3.88 4.57 6.88 4.29 -0.55 0.58 Size 7.35 1.42 6.96 7.56 1.62 7.94 1.49 0.14 MTB 0.56 0.43 0.43 0.41 0.37 0.36 -4.27 <0.01 Lev 0.10 0.17 0.01 0.18 0.28 0.07 5.36 <0.01 Seg 1.25 0.67 1.10 1.26 0.79 1.10 0.15 0.88 MisType 0.63 0.48 1.00 0.47 0.50 0.00 -3.67 <0.01 Notes: a Qualitatively material (immaterial) misstatements that cause the company to miss analyst consensus forecast when corrected are Qual_Mat = 1 (0). b Variable definitions are in Table 2. c
Continuous variable statistics are t-stats from means tests. Indicator variable statistics are Chi-Squares with continuity corrections. All p-values are two-tailed.
41
TABLE 3 - Continued Panel C: Aggregated Audit Committee Sample
Qualitatively Material
Misstatementsa (n = 39)
Qualitatively Immaterial
Misstatementsa (n = 337)
Variablesb Mean
Std. Dev. Med Mean
Std. Dev. Med statc
p-valuec
PerACShort 14.42 23.48 0.00 8.47 18.59 0.00 -1.53 0.13 PerACShortwNS 18.82 23.90 0.24 13.55 22.38 0.00 -1.38 0.17 PerACLong 1.94 7.10 0.00 10.53 22.20 0.00 5.18 <0.01 PerACLongwNS 6.33 13.52 0.00 15.65 25.15 0.00 3.64 <0.01 PerACShares 12.06 21.05 0.00 12.69 19.21 0.00 0.19 0.85 ACDirectorship 0.98 0.40 1.01 1.14 0.49 1.22 2.00 0.05 PerCEOShort 5.54 12.15 0.41 4.23 10.04 0.00 -0.75 0.45 PerCEOShortwbonus 27.92 21.41 30.70 26.66 26.27 22.48 -0.29 0.77 PerCEOShortwNS 6.73 12.72 1.06 8.29 15.81 0.00 0.59 0.55 PerCEOLong 9.21 14.16 0.00 12.11 21.72 0.00 1.13 0.26 PerCEOLongwrestrict 10.40 14.34 1.71 16.18 23.65 0.00 -0.24 0.81 PerCEOLongwNS 24.13 22.41 23.73 23.21 27.82 9.49 2.20 0.03 PerCEOShares 14.18 19.58 0.00 10.82 16.75 0.00 -1.17 0.25 ACTenure 2.15 0.46 2.20 1.99 0.52 1.98 -1.79 0.07 ACExpert% 48.10 24.17 37.50 55.24 27.13 57.14 1.57 0.12 ACMtgs 9.31 3.42 9.00 8.98 3.64 8.00 -0.54 0.59 BoardNum 8.54 2.98 8.00 9.48 2.54 9.00 2.16 0.03 CEOCOB 0.56 0.50 1.00 0.69 0.46 1.00 1.93 0.12 Block 0.87 0.34 1.00 0.85 0.36 1.00 0.01 0.92 Merger 0.46 0.51 0.00 0.59 0.49 1.00 1.88 0.17 Age 2.48 0.37 2.64 2.58 0.34 2.71 1.66 0.10 ROA 5.05 6.64 3.88 4.77 7.60 4.42 -0.23 0.82 Size 7.26 1.42 6.96 7.50 1.60 7.90 0.89 0.37 MTB 0.58 0.46 0.40 0.41 0.36 0.33 -2.61 0.01 Lev 0.09 0.19 0.01 0.18 0.28 0.07 2.60 0.01 Seg 1.32 0.67 1.39 1.29 0.79 1.10 -0.17 0.86 MisType 0.62 0.49 1.00 0.47 0.50 0.00 2.23 0.14 Notes: a Qualitatively material (immaterial) misstatements that cause the company to miss analyst consensus forecast when corrected are Qual_Mat = 1 (0). b Variable definitions are in Table 2. c
Continuous variable statistics are t-stats from means tests. Indicator variable statistics are Chi-Squares with continuity corrections. All p-values are two-tailed.
42
TABLE 4 Logit Regression – Qualitative Materiality
Dependent Variable = Qual_Mat
Disaggregated
Sample (n = 1,364)
Aggregated Sample
(n = 376)
Variable a Sign Odds Ratio Coef. z Prob.b
Odds Ratio Coef. z Prob.b
Constant -3.20 -1.50 0.13 -3.18 -1.36 0.17PerACShort (H1) + 1.02 0.02 1.80 0.04 1.02 0.02 1.93 0.03PerACLong (H2) - 0.96 -0.04 -1.77 0.04 0.96 -0.04 -1.86 0.03ACDirectorship (H3) +/- 0.56 -0.57 -2.11 0.04 0.23 -1.46 -2.28 0.02PerCEOShort + 1.02 0.02 1.17 0.12 1.02 0.02 1.46 0.07PerCEOLong - 0.99 -0.01 -0.84 0.20 0.99 -0.01 -0.50 0.31ACTenure +/- 1.27 0.24 1.85 0.07 2.52 0.92 1.64 0.10ACExpert or ACExpert% - 0.77 -0.27 -1.51 0.07 0.99 -0.01 -1.52 0.06ACMtgs +/- 1.05 0.05 0.76 0.45 1.14 0.13 1.90 0.06BoardNum + 0.82 -0.20 -1.13 0.26 0.74 -0.30 -1.36 0.17CEOCOB + 0.55 -0.60 -1.21 0.23 0.65 -0.43 -0.92 0.36Block - 1.22 0.20 0.27 0.79 1.11 0.10 0.14 0.89Merger + 0.96 -0.04 -0.06 0.95 1.24 0.21 0.28 0.39Age +/- 0.73 -0.31 -0.44 0.33 0.43 -0.85 -1.06 0.29ROA +/- 1.03 0.03 0.96 0.34 1.04 0.04 1.22 0.22Size +/- 1.49 0.40 2.05 0.04 1.63 0.49 2.46 0.01MTB +/- 2.89 1.06 1.87 0.06 3.31 1.20 1.91 0.06Lev +/- 0.22 -1.51 -1.12 0.26 0.40 -0.91 -0.59 0.56Seg + 0.99 -0.01 -0.02 0.98 1.18 0.17 0.61 0.27MisType + 2.57 0.94 2.62 <0.01 2.58 0.95 2.37 0.01Qualitatively material n 139 39Qualitatively immaterial n 1,225 337Pseudo R2 0.16 0.21Area under ROC curve 0.79 0.83
Notes: a Variable definitions are located in Table 2. Models include industry indicator variables. b All p-values are two-tailed except those with directional predictions.
43
TABLE 5 Logit Regression – Controlling for Share Compensation
Dependent Variable = Qual_Mat
Disaggregated
Sample (n = 1,364)
Aggregated Sample
(n = 376)
Variable a Sign Odds Ratio Coef. z Prob.b
Odds Ratio Coef. z Prob.b
Constant -2.84 -1.16 0.24 -2.20 -0.72 0.47PerACShort (H1) + 1.02 0.02 1.61 0.05 1.02 0.02 1.90 0.03PerACLong (H2) - 0.96 -0.04 -1.79 0.04 0.96 -0.04 -1.93 0.03PerACShares - 1.00 0.00 -0.08 0.93 1.00 0.00 0.15 0.89ACDirectorship (H3) +/- 0.49 -0.72 -3.36 <0.01 0.14 -1.98 -3.36 <0.01PerCEOShort + 1.02 0.02 1.30 0.10 1.03 0.03 1.57 0.06PerCEOLong - 0.99 -0.01 -0.68 0.50 1.00 0.00 -0.16 0.88PerCEOShares - 1.02 0.02 1.28 0.20 1.02 0.02 1.57 0.12ACTenure +/- 1.27 0.24 2.06 0.04 2.87 1.05 2.12 0.03ACExpert or ACExpert% - 0.75 -0.28 -1.46 0.07 0.99 -0.01 -1.36 0.09ACMtgs +/- 1.04 0.04 0.63 0.53 1.14 0.13 2.04 0.04BoardNum + 0.83 -0.18 -1.04 0.30 0.74 -0.30 -1.36 0.17CEOCOB + 0.51 -0.66 -1.37 0.17 0.58 -0.54 -1.16 0.25Block - 1.23 0.21 0.28 0.78 0.98 -0.02 -0.03 0.49Merger + 0.92 -0.08 -0.14 0.89 1.21 0.19 0.26 0.40Age +/- 0.70 -0.36 -0.51 0.61 0.34 -1.07 -1.29 0.20ROA +/- 1.03 0.03 1.10 0.27 1.04 0.04 1.41 0.16Size +/- 1.43 0.36 1.66 0.10 1.54 0.43 1.98 0.05MTB +/- 2.70 0.99 1.61 0.11 3.11 1.14 1.74 0.08Lev +/- 0.20 -1.59 -1.11 0.27 0.41 -0.89 -0.56 0.57Seg + 0.97 -0.03 -0.09 0.93 1.20 0.18 0.64 0.26MisType + 2.55 0.94 2.66 <0.01 2.57 0.94 2.34 0.01Qualitatively material n 139 39Qualitatively immaterial n 1,225 337Pseudo R2 0.16 0.22Area under ROC curve 0.79 0.83
Notes: a Variable definitions are located in Table 2. Models include industry indicator variables. b All p-values are two-tailed except those with directional predictions.
44
TABLE 6 Logit Regression – Stock Options without Vesting Data Classified as Short-Term
Dependent Variable = Qual_Mat
Disaggregated
Sample (n = 1,364)
Aggregated Sample
(n = 376)
Variable a Sign Odds Ratio Coef. z Prob.b
Odds Ratio Coef. z Prob.b
Constant -2.75 -1.34 0.18 -2.74 -1.26 0.21PerACShortwNS (H1) + 1.01 0.01 1.73 0.04 1.01 0.01 1.57 0.06PerACLong (H2) - 0.96 -0.04 -1.73 0.04 0.96 -0.04 -1.82 0.03ACDirectorship (H3) +/- 0.58 -0.54 -1.86 0.06 0.28 -1.27 -1.86 0.06PerCEOShortwNS + 1.01 0.01 0.55 0.29 1.01 0.01 0.97 0.17PerCEOLong - 1.00 0.00 -0.46 0.32 1.00 0.00 -0.15 0.44ACTenure +/- 1.24 0.21 1.72 0.09 2.30 0.83 1.53 0.13ACExpert or ACExpert% - 0.82 -0.19 -0.97 0.17 0.99 -0.01 -0.99 0.16ACMtgs +/- 1.06 0.06 0.98 0.33 1.14 0.13 1.94 0.05BoardNum + 0.81 -0.21 -1.19 0.23 0.75 -0.29 -1.37 0.17CEOCOB + 0.55 -0.60 -1.26 0.21 0.63 -0.46 -1.04 0.30Block - 1.17 0.16 0.22 0.83 1.09 0.08 0.12 0.90Merger + 0.94 -0.06 -0.10 0.92 1.09 0.08 0.11 0.46Age +/- 0.61 -0.49 -0.73 0.47 0.36 -1.02 -1.33 0.18ROA +/- 1.03 0.03 1.05 0.29 1.04 0.04 1.32 0.19Size +/- 1.44 0.37 1.91 0.06 1.57 0.45 2.23 0.03MTB +/- 2.77 1.02 1.81 0.07 3.30 1.19 1.99 0.05Lev +/- 0.23 -1.48 -1.07 0.28 0.42 -0.87 -0.56 0.57Seg + 1.04 0.04 0.14 0.44 1.20 0.18 0.70 0.24MisType + 2.74 1.01 2.70 <0.01 2.79 1.03 2.52 0.01Qualitatively material n 139 39Qualitatively immaterial n 1,225 337Pseudo R2 0.15 0.19Area under ROC curve 0.78 0.81
Notes: a Variable definitions are located in Table 2. Models include industry indicator variables. b All p-values are two-tailed except those with directional predictions.
45
TABLE 7 Logit Regression – Stock Options without Vesting Data Classified as Long-Term
Dependent Variable = Qual_Mat
Disaggregated
Sample (n = 1,364)
Aggregated Sample
(n = 376)
Variable a Sign Odds Ratio Coef. z Prob.b
Odds Ratio Coef. z Prob.b
Constant -2.84 -1.36 0.17 -2.75 -1.15 0.25PerACShort (H1) + 1.02 0.02 1.77 0.04 1.02 0.02 1.87 0.03PerACLongwNS (H2) - 0.99 -0.01 -1.31 0.10 0.99 -0.01 -1.36 0.09ACDirectorship (H3) +/- 0.57 -0.57 -2.11 0.04 0.23 -1.45 -2.24 0.03PerCEOShort + 1.02 0.02 1.02 0.15 1.02 0.02 1.39 0.08PerCEOLongwNS - 0.98 -0.02 -1.32 0.19 0.99 -0.01 -0.75 0.23ACTenure +/- 1.28 0.24 1.93 0.05 2.52 0.92 1.66 0.10ACExpert or ACExpert% - 0.74 -0.30 -1.66 0.05 0.99 -0.01 -1.76 0.04ACMtgs +/- 1.05 0.04 0.65 0.52 1.15 0.14 1.84 0.07BoardNum + 0.83 -0.19 -1.07 0.28 0.75 -0.29 -1.32 0.19CEOCOB + 0.54 -0.61 -1.22 0.22 0.67 -0.41 -0.85 0.40Block - 1.09 0.08 0.11 0.92 1.06 0.06 0.08 0.94Merger + 0.97 -0.03 -0.05 0.96 1.26 0.23 0.32 0.37Age +/- 0.72 -0.34 -0.46 0.65 0.39 -0.94 -1.10 0.27ROA +/- 1.02 0.02 0.62 0.54 1.03 0.03 0.92 0.36Size +/- 1.50 0.40 2.08 0.04 1.63 0.49 2.42 0.02MTB +/- 2.71 1.00 1.72 0.09 2.96 1.08 1.64 0.10Lev +/- 0.21 -1.54 -1.12 0.26 0.37 -1.00 -0.62 0.53Seg + 0.95 -0.05 -0.17 0.43 1.19 0.17 0.60 0.27MisType + 2.31 0.84 2.24 0.01 2.34 0.85 2.09 0.02Qualitatively material n 139 39Qualitatively immaterial n 1,225 337Pseudo R2 0.15 0.20Area under ROC curve 0.78 0.82
Notes: a Variable definitions are located in Table 2. Models include industry indicator variables. b All p-values are two-tailed except those with directional predictions.
46
TABLE 8 Logit Regression – Alternative Measures of CEO Compensation
Dependent Variable = Qual_Mat
Disaggregated
Sample (n = 1,364)
Aggregated Sample
(n = 376)
Variable a Sign Odds Ratio Coef. z Prob.b
Odds Ratio Coef. z Prob.b
Constant -3.25 -1.47 0.14 -3.00 -1.27 0.20PerACShort (H1) + 1.02 0.02 1.87 0.03 1.02 0.02 2.08 0.02PerACLong (H2) - 0.96 -0.04 -1.72 0.04 0.96 -0.04 -1.80 0.04ACDirectorship (H3) +/- 0.54 -0.61 -2.44 0.02 0.20 -1.62 -2.62 0.01PerCEOShortwbonus + 1.00 0.00 0.48 0.32 1.00 0.00 0.23 0.41PerCEOLongwrestrict - 1.00 0.00 0.54 0.59 1.01 0.01 1.10 0.27ACTenure +/- 1.31 0.27 2.00 0.05 2.87 1.05 1.79 0.07ACExpert or ACExpert% - 0.76 -0.27 -1.43 0.08 0.99 -0.01 -1.45 0.07ACMtgs +/- 1.05 0.05 0.68 0.50 1.13 0.12 1.78 0.08BoardNum + 0.82 -0.20 -1.21 0.23 0.76 -0.28 -1.38 0.17CEOCOB + 0.53 -0.63 -1.24 0.21 0.62 -0.48 -1.02 0.31Block - 1.16 0.15 0.21 0.83 1.02 0.02 0.02 0.98Merger + 1.09 0.09 0.14 0.89 1.33 0.29 0.39 0.70Age +/- 0.79 -0.23 -0.32 0.75 0.39 -0.95 -1.18 0.24ROA +/- 1.03 0.03 0.90 0.37 1.03 0.03 1.08 0.28Size +/- 1.39 0.33 1.54 0.12 1.54 0.43 1.87 0.06MTB +/- 3.21 1.17 2.10 0.04 3.45 1.24 2.11 0.04Lev +/- 0.24 -1.43 -1.03 0.30 0.41 -0.89 -0.54 0.59Seg + 1.00 0.00 0.00 0.50 1.21 0.19 0.65 0.26MisType + 2.50 0.91 2.34 0.01 2.59 0.95 2.26 0.01Qualitatively material n 139 39Qualitatively immaterial n 1,225 337Pseudo R2 0.15 0.21Area under ROC curve 0.79 0.83
Notes: a Variable definitions are located in Table 2. Models include industry indicator variables. b All p-values are two-tailed except those with directional predictions.