Compensation committee and audit committee overlapping

Does Overlapping Membership on Audit and Compensation Committees Improve a Firm’s Financial Reporting Quality?

Nandini Chandar LeBow College of Business

Drexel University [email protected]

Hsihui Chang* LeBow College of Business

Drexel University [email protected]

Xiaochuan Zheng Accounting Department

Bryant University [email protected]

September 2008 *Please address correspondence to: Hsihui Chang KPMG Professor of Accounting LeBow College of Business Drexel University Matheson Hall, Suite 400 3141 Chestnut Street Philadelphia, PA 19104 Phone: 215.895.6979 Email: [email protected]

Acknowledgement: We appreciate the helpful comments and suggestions of participants at the 2008 annual meeting of the American Accounting Association at Anaheim, CA, and, in particular, those of Phil Stocken, our discussant.

mailto:[email protected]




Does Overlapping Membership on Audit and Compensation Committees Improve a Firm’s Financial Reporting Quality?

ABSTRACT

We investigate whether audit committee members of the board prove to be better monitors if they are also on the compensation committee, as they would be more attuned to compensation related earnings management incentives. Analyzing data on a sample of S&P 500 firms over the period 2003-2005, we find that ceteris paribus, firms with overlapping audit and compensation committees have higher financial reporting quality, proxied for by discretionary accruals than those without such overlap. Further, we find that there is an inverted U shaped relationship between overlapping magnitude and financial reporting quality, with an optimum overlap of about 47%. Our findings are robust to controlling for the percentage of CEOs’ incentive compensation and using accounting restatements as another proxy for financial reporting quality. Overall, our results suggest that there is knowledge spillover from the compensation committee to the audit committee, as reflected in higher financial reporting quality. We interpret this to suggest that some overlapping of the committee memberships may be beneficial to audit committee monitoring effectiveness.

Keywords: overlapping memberships, audit committee, compensation committee, financial reporting quality.

Data Availability: Data are publicly available from sources identified in the paper.

1. Introduction

Recent accounting irregularities in high profile public companies have been

attributed to earnings management practices by corporate managers. These practices

have raised concerns about the quality of public companies’ reported earnings1 and

garnered increasing attention by the Securities and Exchange Commission (SEC). At the

same time, the role of audit committees in ensuring the quality of financial reporting has

come under considerable scrutiny. The Sarbanes Oxley Act of 2002 (SOX) in particular

represents the most sweeping reform of US securities laws relating to corporate

governance, disclosures, and reporting requirements since the 1930s. For instance, SOX

requires that the audit committee be fully independent and financially literate. The role

of audit committees in monitoring a firm’s financial reporting quality is recognized as a

central concern in the smooth functioning of capital markets, and is a primary focus of

corporate governance reform in the post-SOX era.

Audit committee members need information about their company’s business

activities and economic contexts in order to perform their monitoring functions

effectively. An important source of this information to audit committees is senior

management, who possess information that is crucial to the valuation of their firm.

However, management incentives in making representations, disclosures and accounting

choices are likely driven by the structure of their compensation contracts (Watts and

Zimmerman, 1986, 1990). If audit committee members are more attuned to the

incentives provided by management compensation, they are more likely to incorporate

1 In an influential speech in September 1998, SEC Chairman Arthur Levitt raised concerns about firms’ earnings management practices. Following this speech, the SEC staff issued three staff accounting bulletins (SABs) intended to improve financial reporting transparency. These SABs describe several earnings management techniques used by managers and point to the undesirable consequences of earnings decreasing as well as earnings increasing manipulations.

1

them into their monitoring of the firm’s financial reporting process. Membership on the

board’s compensation committee is likely to provide directors with intimate knowledge

of senior management’s compensation-related incentives. We therefore investigate

whether membership on both compensation and audit committees is beneficial to audit

committee members in performing their financial reporting oversight function. We

predict that such overlapping membership is likely to result in higher financial reporting

quality due to this knowledge spillover effect.

The corporate governance consequence of overlapping membership on audit and

compensation committees has been a contentious issue, particularly in the post-SOX

period. In a special comment entitled “Best Practices in Audit Committee Oversight of

Internal Audit,” Moody’s Investors Service (2006) argues in favor of audit committee

members serving on the compensation committee, the rationale being that “…the audit

committee should have a thorough understanding of executive incentives and goals so

that it is aware of management’s motivations.” (p. 8, Moody’s Investors Service 2006).

In contrast, the Higgs Report (2003) considers it undesirable for any one individual to be

placed simultaneously on the audit, remuneration and nomination committees “in order

not to concentrate too much influence on one individual” (p. 59, Higgs 2003). Given the

significant role of audit committees in monitoring financial reporting quality and the

increasing concerns about the effect of compensation arrangements on earnings

management, there are potentially positive monitoring outcomes that can arise with

overlapping membership on the two committees. This study provides evidence on this

issue as it considers the corporate governance consequence of the micro structure of the

board that is yet to be studied in accounting research.

2

The corporate governance implications of board characteristics as well as auditee

characteristics have been investigated in prior accounting research (e.g., Klein 2002a).

However, little empirical research has been conducted to date on board structure and

monitoring effectiveness in general and the consequences of delegating board functions

to committees in particular. Understanding the costs and benefits of the board committee

structure is particularly important as boards typically operate through the use of

committees. We contribute to this area by considering the effect of overlapping

memberships on two of the most active and important board committees – the

compensation and audit committees – on the monitoring effectiveness of the audit

committee.

Additionally, prior literature on audit committees has been conducted almost

exclusively in the pre-SOX era. Due to the widespread regulatory changes as a result of

SOX as well as the likely adjustments made by capital market participants in response to

the changed environment, we choose to study audit committee effectiveness in the post-

SOX period. Thus, our study contributes to recent, post-SOX debates on board structure

and composition in practice as well.

Following prior research on audit committee effectiveness like Klein (2002a), we

choose non-financial S&P 500 companies as the starting point for our sample. As SOX

possibly reflects a major inflection point with respect to corporate governance and

disclosure, we examine the post-SOX sample period 2003-2005. Our analysis proceeds

in the following stages. First, we investigate whether firms that have overlapping audit

and compensation committee members have higher financial reporting quality compared

to firms in which there is no overlap of membership between these two committees.

3

Second, we examine whether the magnitude of this overlap is related to financial

reporting quality; in other words, if there is a benefit to overlapping membership, is this a

monotonically increasing effect?

We document several interesting findings. First, we find that after controlling for

other commonly used determinants of financial reporting quality, firms with overlapping

audit and compensation committees have higher financial reporting quality than those

without such overlap. However, we do not find that this association is monotonic; rather,

we find that there is an inverted U shaped relationship between the magnitude2 of the

overlap and financial reporting quality. This suggests that overlapping membership is

beneficial to an extent; beyond a certain point, however, the benefits of committee

overlap decline. Our findings have implications for policy deliberations on the

composition of board committees in general and audit committees in particular, as it

clarifies the benefits of overlapping committee members.

The remainder of the paper proceeds as follows. Section 2 reviews the relevant

literature and formulates the research hypotheses. Section 3 describes the research design

including sample selection and estimation models. Section 4 presents empirical results

and robustness checks. Section 5 concludes.

2. Related Literature and Hypotheses Development

Corporate boards assume an oversight role in mitigating agency problems

resulting from the separation of corporate ownership and managerial control (Jensen and

Meckling 1976; Fama and Jensen 1983). This oversight role involves appointing the

2 The magnitude of overlap is defined as the proportion of audit committee members that is also on the compensation committee.

4

CEO, setting incentive compensation for top management, approving and reviewing

business strategies, monitoring control systems, liaising with external auditors, etc.

Given its diverse responsibilities, the board of directors typically delegates its oversight

activities to different sub-committees. The audit committee is one of the most important

sub-committees and its main responsibility is to oversee financial reporting. Another key

board committee is the compensation committee, which has responsibility for

determining appropriate compensation packages for top management and assessing

executives’ performance.

The finance literature has documented the link between compensation structure

and financial performance, and the accounting literature has demonstrated that corporate

governance and compensation structures have a substantial impact on earnings

management. However, the link between the compensation committee’s oversight on

compensation contracts and performance and the audit committee’s oversight of financial

reporting quality is as yet unexplored. Below we review the literature on these separate

literature strands that we integrate in this paper.

2.1 Literature review

Accounting research has long examined the effectiveness of audit committees in

monitoring the quality of firms’ financial reporting. Early research investigates whether

the existence of an audit committee improves a firms’ financial reporting quality. The

general finding is that there is a positive association between the presence of an audit

committee and the firm’s financial reporting quality. For example, DeFond and

Jiambalvo (1991) document that overstatement errors in annual earnings are less likely

among firms that have an audit committee. Wild (1996) finds that the earnings response

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coefficients for companies with audit committees are higher following the appointment of

the audit committee.

Significant recent changes in regulations relating to audit committees started in

February 1999, when the Blue Ribbon Committee (BRC) made ten recommendations for

improving the effectiveness of audit committees, as well as five guiding principles for

audit committees to follow as they devised company-specific policies. The BRC

recommendations resulted in changes in the audit committee requirements for firms listed

on all major exchanges. The Sarbanes Oxley Act of 2002 has significantly shaped and

restricted corporate board structure with the objective of improving corporate

governance. It has expanded the authority and responsibilities of audit committees, and

increased membership requirements and committee composition to include more

independent and well qualified directors, i.e., those who are designated as “financial

experts.” The SEC and the exchanges also responded to strengthen audit committee

requirements.

Recent research has therefore focused on the characteristics of audit committees

and their association with proxies of financial reporting quality of the firm. Two major

audit committee attributes examined thus far in the literature are independence and

financial expertise (e.g. Klein 2002a, 2002b; DeFond et al. 2005). A common argument

by proponents of independence is that audit committees consisting of independent

directors would lead to higher financial reporting quality, because they would have

reduced conflicts of interest and less incentive to sacrifice objectivity (SEC 1999).

6

Consistent with this argument, Klein (2002a) observes a negative relationship between

board or audit committee independence and abnormal accruals.3

While prior accounting research has focused on attributes like audit committee

independence and found a positive association with a firm’s earnings quality, the post-

SOX environment calls for an investigation of other attributes of audit committees that

potentially determine their effectiveness. This is because, in the post-SOX era, as audit

committees are required to be fully independent (Section 301, SOX), audit committee

independence is not likely to be associated with a firm’s financial reporting quality,

because of lack of variability in the attribute.

Given the complexities of financial reporting particularly for public companies, at

least a subset of audit committees should have financial reporting expertise (BRC 1999).

Consistent with this notion, Xie et al. (2003) document that an audit committee member

with financial expertise enhances committee performance. In addition, DeFond et al.

(2005) provide evidence that it is specific accounting expertise rather than the broadly

defined “financial expertise” that improves the audit committee’s effectiveness. Other

dimensions of audit committees that have been found to be associated with financial

reporting outcomes include audit committee size (DeZoort and Salterio 2001; Anderson

et al. 2004) and number of meetings (Menon and Williams 1994; Beasley et al 2000).

This stream of prior research has largely focused on incentives (e.g.,

independence) and information processing abilities (e.g., financial expertise and number

of meetings) of the audit committee in performing monitoring activities. Audit

committee independence and financial expertise are mainly related to how given

3 However, she does not find a significant difference between an audit committee with a majority of independent members and an audit committee made up of the more stringent 100% independent members as required by the NYSE and the NASDAQ.

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information sets are processed; independence is a quality that results in unbiased

information processing, while financial expertise is associated with more effective

information processing. Since effective information processing depends on the

availability of sufficient information and knowledge, the validity of the emphasis on audit

committee independence and financial expertise depends on the accessibility of

information by audit committee members (Nowak and McCabe 2003). We argue that

audit committee members who are also members of the compensation committee of the

board have more direct knowledge of the managements’ compensation related incentives

in making accounting choices. They can therefore prove to be better monitors by

neutralizing managements’ propensity to make accounting choices that are driven by

their incentives to maximize their compensation.

There is a long stream of literature that has examined the relation between

executive compensation and earnings management. Theoretically, providing executives

with incentive compensation, such as stock options should align managers’ and

shareholders’ interests (Jensen and Meckling 1976). However, both conventional

wisdom and prior empirical results suggest that incentive compensation might provide

managers incentives to manage earnings.4 Accounting research has established that

compensation related incentives are associated with opportunistic earnings management

behavior.

Early research focused on accruals management incentives based on bonus plans

(Healy 1985; Healy et al. 1987; Gaver et al. 1995; Holthausen et al. 1995). More recent

research examines stock price based incentives, and the use of earnings management to

4 See, for example, the 9 January, 2004 New York Times article by Gretchen Morgenson: ‘‘Options packages encourage executives to fiddle books.”

8

affect managements’ wealth. Sloan (1996) for instance finds that managers use

aggressive earnings management to increase stock price at least in the short run. Beneish

and Vargus (2002) find that significantly positive abnormal accruals are associated with

insider sales of shares. There is also considerable evidence that stock options and

restricted stock compensation provide incentives for earnings management. Studies have

found that that stock option exercises provide incentives to manage earnings upward. For

example, Bartov and Mohanram (2004) find evidence of earnings management leading

up to option exercises. Cheng and Warfield (2005) find that stock-option exercises and

holdings provide incentives for firms to meet or beat earnings targets. Bergstresser et al.

(2006) find that firms make more aggressive assumptions on their defined benefit pension

plans in the period in which they exercise their options.

Research has also argued that option grants provide managers with an incentive to

manage earnings downward to lower the exercise price at the grant date. The general

argument is that earnings can be used to signal weaker performance before the grant,

indirectly lowering the exercise price of the options (Baker et al. 2003, Balsam et al.

2003). McAnally et al. (2008) extend this research by examining the relation between

option grants and missed earnings targets, an event that could have a large influence on

exercise prices. McAnally et al.’s (2008) results suggest that accruals are used to

intentionally miss earnings targets in advance of option grants.

Other recent studies have found a nondirectional relationship between stock based

incentive compensation and earnings management. Burns and Kedia (2006) find that

firms whose CEOs have significant options exposure are more likely to file earnings

restatements. Similarly, Bergstresser and Philippon (2006) and Cheng and Warfield

9

(2005) find that the level of earnings management is positively related to managements’

stock based incentives, particularly those provided by stock options.

We bring together these two separate streams of prior research by examining whether

audit committee members’ intimate knowledge of compensation related incentives to manage

earnings will improve their ability to monitor the financial reporting process, thereby

reducing earnings management.

2.2 Research hypotheses

Compensation plans are established to generate appropriate incentives to align the

interests of management and shareholders. These incentives are frequently tied to accounting

performance measures (Lambert 1993). Since the compensation committee is responsible for

establishing management’s compensation plan, it is very likely that members of this

committee would have a deep and nuanced understanding of the incentives that the plan

generates. This would also imply that compensation committee members have a more

thorough knowledge of management’s incentives to manipulate earnings. Thus, if an audit

committee member also serves on the firm’s compensation committee, this member could

use the knowledge about management’s compensation-driven incentives to unravel

opportunistic accounting choices that the management might make. Therefore, the overlap

between compensation committee and audit committee might be beneficial in reducing the

information asymmetry between audit committee and management, resulting in higher

financial reporting quality induced by improved monitoring by the audit committee.

Furthermore, directors’ liabilities have been increased substantially after SOX due to

increased accountability of directors (Linck et al. 2008). As a result, audit committee

10

members who also sit on compensation committees likely have greater incentives to use

knowledge and information obtained from serving on the compensation committee. This

may accentuate the positive association between overlapping committees and financial

reporting quality after SOX, which is the time period of our study.

As we have previously argued, overlapping membership with the compensation

committee potentially results in knowledge spillover that is useful to the audit committee’s

financial reporting oversight function. However, there are costs related to the degree of

overlap as well. As Laux and Laux (2007) argue, a potential advantage of delegating board

functions to committees is that using smaller subgroups can reduce the free-rider problem

that plagues larger groups. If there is a complete overlap committee, the subgroup structure

and its advantages break down. Since setting CEO pay and overseeing the financial

reporting system are two major, but different functions of a board (Laux and Laux 2007),

membership in both the audit and compensation committees is very time consuming,

exacerbating the free-rider problem with increased committee overlap. Further, high degree

of committee overlap likely leads to the dilution of effort and diffusion of responsibility

because of multi-accountability, which could mitigate the oversight function of the audit

committee.

If such overlapping membership is expected to improve financial reporting quality,

we further examine whether the magnitude of this overlap matters. Specifically, if

overlapping membership is positively associated with financial reporting quality, is it true

that the magnitude of overlap is monotonically associated with financial reporting quality?

In the limit, is the best outcome a 100% overlapping of audit and compensation committees?

We do not expect that there is such a monotonic relationship. Instead, we anticipate an

11

inverted U-Shaped relationship between the magnitude of the overlap and financial reporting

quality as there may be costs related to overlap that needs to trade-off against the benefits of

having overlapping committee members. This trade-off is expected to result in an

“optimum” degree of overlap.

Based on the above discussion, we specify the following hypotheses in alternate

form:

H1: Ceteris paribus, a firm with an overlap of audit committee and compensation committee members of the board has higher financial reporting quality than a firm that does not have such overlapping membership H2: Ceteris paribus, there is an inverted U-Shaped relationship between the magnitude of overlap and financial reporting quality.

3. Research Design

3.1 Sample selection

Consistent with prior research on audit committee effectiveness, our sample

consists of all S&P 500 firms that appear in the RiskMetrics database5 from 2003 to

2005. The RiskMetrics database contains corporate governance information on company

directors such as committee membership, independence, qualifications, work experience,

tenure and other such data. We use the Executive Compensation (EXECUCOMP)

database to gather data on CEO incentive pay, CEO tenure and CEO ownership. In

addition, we obtain accounting data from COMPUSTAT. Our sample selection and

distribution is reported in Table 1. Following Klein (2002a), we exclude all financial

institutions and foreign firms. There are 104 firm-year observations missing in the

RISKMETRICS database. We also eliminate 76 firm-year observations because of

missing data in EXECUCOMP, and 25 firm-year observations with missing 5 This database was formerly known as the Investor Responsibility Research Center (IRRC) database.

12

COMPUSTAT data. In addition, to minimize the impact of extreme observations, we

trim our data by removing the extreme one percent of observations based on the

distribution of discretionary accruals. Thus, our final sample as shown in Panel A of

Table 1 contains 1032 firm-year observations relating to 399 public companies and 1782

directors.

Table 1 Panel B provides the distribution of our sample by year and industry. The

number of firm-year observations across our sample years is somewhat uniform. More

than half of our sample firms are manufacturing firms.

[Insert Table 1 about here]

3.2 Empirical models

In our empirical models we use performance matched discretionary accruals (see

Kothari et al. 2005; Francis et al. 2005) as our primary measure of earnings quality since

Kothari et al. (2005) provide evidence that performance-matched abnormal accrual

measures have smaller error rates than abnormal accruals determined by the Jones model

and the modified Jones model. We examine whether our findings are robust to using

accounting restatements as an alternate proxy of financial reporting quality.

Our primary independent variable of interest is OVERLAP which we measure in

two ways – as a dummy specification and as a continuous variable. We provide below

more precise definitions of these and other variables related to audit committee and firm

characteristics.

To test our first hypothesis (H1), we specify the following estimation model:

)1()ln(__/_

___)_ln(

10

98765

43210

itit

itititititit

ititititit

ASSETSLEVNIABSNINEGBVMVHOLDCEO

TENURECEOSIZEBDINDBDOVERLAPPMDAABS

εββββββ

βββββ

+++Δ+++

+++++=

13

where ln(ABS_PMDA)6, the dependent variable, is the natural log of the absolute value

of abnormal accrual measured by the performance matched modified Jones model

(Kothari et al. 2005). In keeping with prior literature, firms with large abnormal accruals

(in absolute value) are assumed to have lower financial reporting quality compared to

firms with smaller absolute accruals. OVERLAP is the main independent variable, which

takes on a value of one if at least one audit committee member sits on the compensation

committee and zero otherwise. BD_IND measures board independence and is defined as

the proportion of independent board directors. We include BD_IND as an additional

independent variable as a strong board environment might influence audit committee

monitoring effectiveness. Further, prior literature documents that board independence is

positively related to financial reporting quality (e.g. Klein 2002a). BD_SIZE is the

number of board directors. We include BD_SIZE as a control variable because prior

studies document that audit committee size is negatively associated with earnings

management and the cost of debt (e.g. Andersen et al. 2004) and smaller boards are

associated with higher governance effectiveness (Yermack 1996). CEO_TENURE is

measured as the number of years the current CEO has been in his or her position.

Shivdasani and Yermack (1999) observe that there are entrenchment effects associated

with CEO tenure. CEO_HOLD is the proportion of common equity owned by the CEO.

MV/BV, measuring firm growth potential, is the ratio of market value to book value

measured at the beginning of the fiscal year. NEG_NI is an indicator for firms having

two or more consecutive years of negative income, ending on the fiscal year prior to the

shareholders’ meeting. ABS_ΔNI is the absolute value of the change in net income

between previous year and current year deflated by last year’s assets. Klein (2002a) 6 For simplicity, we suppress subscripts i and t.

14

documents that both NEG_NI and ABS_ ΔNI are positively related to earnings

management (e.g. Klein 2000a). LEV is financial leverage defined as the long-term debt

divided by last year’s assets. ln(ASSETS) represents firm size measured as the natural

log of total assets. LEV and ln(ASSETS) are included as control variables because

previous studies found that financial leverage and political costs (proxied by firm size)

affect earnings management (e.g. Warfield et al. 1995; Dechow and Sloan 1995).

Our second hypothesis examines whether the extent of overlapping membership

between audit and compensation committees matters. As we argue in Section 2, because

there are costs and benefits to such overlap, we expect an inverted U-Shaped relationship

between the percentage of overlap and financial reporting quality. Thus, we specify the

following estimation model to test our second hypothesis (H2):

)2()ln(__/____

__)_ln(

1110987

6543

2210

ititititititit

itititit

ititit

ASSETSLEVNIABSNINEGBVMVHOLDCEOTENURECEOSIZEBDINDBD

POVERLAPPOVERLAPPMDAABS

εβββββββββ

βββ

+++Δ++++++

+++=

where OVERLAP_P is measured as the proportion of audit committee members who also

sit on the compensation committee. OVERLAP_P2 is the square of OVERLAP_P. All

other variables are as defined in model (1).

Table 2 summarizes the variable definitions used in the above estimation models.


4. Empirical Results

4.1 Descriptive statistics

Table 3 presents descriptive statistics for the key variables used in our study. A

typical board has approximately 10 directors, 4 of whom, on average, sit on the audit

15

committee.7 Practically all of the boards and audit committees in our sample are

independent, which is not surprising given the fact that we examine S&P 500 firms,

which are required to have independent directors. The mean OVERLAP is 0.64, which

means that almost two-thirds of the companies in our sample have at least one director

who is on both the audit and compensation committees. The average OVERLAP_P is

about 31%, indicating that about a third of the members of audit committees are also

members of the compensation committee. The average CEO tenure is around 6 years and

most of the CEOs have a very small percentage ownership (the upper quartile is 0.004) in

the company. Regarding accounting variables, the average absolute abnormal accrual is

4% of previous years’ total assets; the average market to book ratio is 3.71; around 15%

of our observations have two or more years of consecutive losses; and the average long

term debt is about 21% of the previous years’ total assets.


Table 4 presents spearman correlations between all sets of variables. The

correlation between OVERLAP and the natural log of absolute value of abnormal

accruals (ln(ABS_PMDA)) is negative but not statistically significant. Similarly, the

magnitude of the overlap (OVERLAP_P) is insignificantly and negatively correlated with

ln(ABS_PMDA) before controlling for other contextual variables. In addition,

OVERLAP is negatively (p-value<0.01) correlated with BD_SIZE. Also, OVERLAP is

negatively (p-value<0.01) correlated with BD_IND, which is probably due to the fact that

both audit committee and compensation committee are now required to be 100%

independent .


7 The NYSE and the NASDAQ require that each company at least has three audit committee members.

16

4.2 Regression results

Since we have unbalanced panel data, we run fixed-effects regressions for all of

our estimation models.

4.2.1 Overlapping committees and financial reporting quality

Table 5 reports the fixed-effects regression results of relating financial reporting

quality to the presence of overlapping committee members and other control variables.

The coefficient on OVERLAP is highly significant at conventional levels, providing

strong support to our hypothesis H1. This suggests that firms with at least one audit

committee member who also sits on the compensation committee have, on average, lower

levels of discretionary accruals than firms without such overlap in the post-SOX period.

The coefficients on the control variables are generally consistent with prior literature.

For example, as in Klein (2002a), we also find that firm size is negatively associated with

the discretionary accruals.


4.2.2 Overlapping magnitude and financial reporting quality

Given that our hypothesis H1 is confirmed, we evaluate H2 to examine whether

the extent of overlap of membership between the audit and compensation committees

matters. The results, presented in Table 6, indicates that the coefficients for both

variables of interest, the percentage of overlap, OVERLAP_P and the square of the

overlap percentage, OVERLAP_P2 are statistically significant (p-value <0.05); however,

they have opposite signs (-0.7871 and 0.8385 respectively), indicating that there is an

inverted U-shaped relation between overlapping magnitude and financial reporting

quality. This suggests that overlapping membership is beneficial only to certain extent;

17

beyond that the costs of overlapping membership outweigh the benefits, resulting in

deterioration in financial reporting quality.8

To determine the kink point in the relationship between financial reporting quality

and overlapping percentage (the optimal overlapping level), we use the first order

condition (FOC) of the function [-0.7871*OVERLAP_P+0.8385*OVERLAP_P2 ]. Since

the FOC is: -0.7871 +2*0.8385 OVERLAP_P=0, we solve to obtain OVERLAP_P

=0.4694. That is, on average, holding everything else constant, when the overlapping

percentage is 47% in the post-SOX period, the abnormal accruals are the lowest,

implying that the financial reporting quality at that point is highest. Thus, our second

hypothesis (H2) is supported.


4.3 Robustness checks

If knowledge of compensation related incentives in general makes audit

committee members better monitors of the financial reporting outcomes of the firm, a

concern might arise regarding whether the magnitude of CEOs’ incentive compensation

affects the association between overlapping committee membership and financial

reporting quality. Prior research has shown that a greater level of incentive compensation

provides management with higher incentives to manage earnings, resulting in a larger

monitoring benefit from the transfer of incentive-related information to audit committee

members. To address this concern, we introduce a new control variable, INCE, the

proportion of CEOs’ non salary compensation and its interaction term, OVERLAP*INCE

into our estimation models. The results are reported in Panel A of Table 7.

8 Our results remain qualitatively unchanged when we use a reduced sample comprised of only observations with overlapping committee members to evaluate the relationship between overlapping magnitude and financial reporting quality.

18

After controlling for the proportion of CEOs’ compensation-related incentives, we

still find a significantly (p-value <0.05) negative relation between overlapping

committees and the financial reporting quality. Also, we find that there is a significant

(p-value <0.1) mediating effect of OVERLAP on the association between INCE and

financial reporting quality. A joint test of the coefficients of OVERLAP and the

interaction term, OVELAP*INCE, shows negative and significant (p-value <0.05)

results, which indicates that, overall, there is a significantly positive relation between

OVERLAP and financial reporting quality, even after controlling for the percentage of

incentive compensation to CEOs.

To further evaluate the robustness of our empirical results, we repeat our tests of

H1, and H2 using another proxy for financial reporting quality, namely, the incidence of

accounting restatements (REST).9 REST is a dummy variable that takes on a value of 1

if the current year’s final statements need to be restated and zero otherwise. The results

are presented in Panel B of Table 7. Consistent with our prior results, we find a

significantly (p-value <0.1) negative relation between OVERLAP and the incidence of

accounting restatement. Also, as with our discretionary accrual measure of financial

reporting quality, we find a U shape relationship between OVERLAP_P and the

incidence of accounting restatement (p-value<0.05). These results indicate that our

previous findings regarding the association between overlapping memberships,

overlapping magnitude and financial reporting quality are robust to an alternate

specification of financial reporting quality.


9 Only the restatements caused by the violation of GAAP are considered. In other words, those restatements due to routine accounting changes are excluded. We get the data from Audit Analytic database.

19

There may be reasons to believe that overlapping membership on audit and

compensation committees is affected by financial reporting quality. For example, it is

possible that a firm with better financial reporting quality is more likely to structure

boards with overlapping membership between the two committees. Thus, our analyses

suffer from a potential endogeneity issue. We address this self-selection or reverse

causality problem using the Heckman (1979) two step treatment effects model.10 In the

treatment effects model, we model OVERLAP as an endogenous choice. Note that the

first-stage probit model includes the proxy for financial reporting quality (the absolute

value of performance matched discretionary accruals) and all other control variables that

also enter the second-stage (outcome) regression. Results (untabulated) of the second-

stage regression show that the OVERLAP (treatment) coefficient is negative and

significant at the 5% level using absolute value of performance matched discretionary

accruals as dependent variable. In brief, the Heckman model estimations support our

main analysis, thereby providing robust evidence to suggest that on average, firms with

overlapping memberships between the audit and compensation committees have higher

financial reporting quality than firms without such overlapping membership.

Furthermore, our empirical results remain qualitatively unchanged even when we control

for number of audit committee meetings.11

5. Conclusion

This study investigates whether overlapping membership on the audit and

compensation committees is positively associated with financial reporting quality. In

contrast to prior literature on audit committee effectiveness, our study focuses on the 10 We choose Heckman model since the endogenous repressor (overlapping) is dichotomous. 11 Results after controlling for the frequency of audit committee meetings are available upon request.

20

post-SOX era as a way to enhance our understanding of the monitoring role of audit

committees in the new regulatory regime. Based on a sample of S&P 500 firms, we find

that firms with such overlapping members are associated, on average, with higher

financial reporting quality. In addition, we find that the magnitude of the overlap

matters. The relationship between overlapping magnitude and financial reporting quality

is non-linear and inverted U-shaped. This suggests that the benefits of overlapping

membership decline after a certain point. Additional overlapping beyond that point

appears to provide detrimental effects, as the costs of overlapping exceed the benefits.

Our results help clarify some of the on-going debate surrounding board structure

and have important practical implications. Given the limited number of qualified board

members available, the optimal allocation of individual board members to committees is

important. The findings of this study provide some guidance in implementing this task.

For instance, for a firm with four (the average audit committee size in our sample is 3.99)

audit committee members, assigning two12 audit committee members to the

compensation committee seems to be the optimal choice.

Audit committees, and their role in monitoring financial reporting practices of

firms have occupied center stage in the post-SOX era. In such a vastly changed

environment, extrapolating pre-SOX evidence into the future must be done with care. By

providing evidence that relies exclusively on data subsequent to SOX, our study takes an

initial step in understanding the effectiveness of audit committee governance in this new

stage of the evolution of our capital markets.

12 This is derived as follows: 4*0.4694 (the optimum overlap proportion) ≈2.

21

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TABLE 1 Sample Selection

Panel A: Sample selection process

Firm-YearsInitial S&P 500 Sample for 2003–2005 1500

Financial Institutions (four-digit SIC code: 6000–6999) (230)Foreign firms (11)Missing data in RISKMETRICS Directors Database (104)Missing data in ExecuComp Database (76)Missing data in Compustat (25)Trimming top and bottom 1% on discretionary accruals (22)

Final sample 1032 Panel B: Sample distribution by year and industry

Year Construction Industries Manufacturing Mineral

Industries Retail Trade Service Industries

Transportation and Communication Wholesale Trade Total

2003 3 199 12 28 47 52 9 350

2004 5 195 11 31 45 51 9 347

2005 5 191 15 29 41 47 7 335

Total 13 585 38 88 133 150 25 1032

26

TABLE 2 Variable Definitions

Variables Operationalization Acronym Sources 1.Dependent variable Earnings quality Absolute value of performance matched abnormal

accruals measured as abnormal accrual minus the median abnormal accrual for a portfolio of firms (with the same 2- digit SIC code Year) in the same ROA decile

ABS_PMDA

COMPUSTAT

2. Test variables Overlap between audit and compensation committees Extent of committee overlap

Dummy variable which takes value 1 if at least one audit committee member sits on compensation committee, and zero otherwise Total number of audit committee members who also sit on the compensation committee divided by the audit committee size

OVERLAP OVERLAP_P

RISKMETRICS RISKMETRICS

3. Board characteristics Board independence Proportion of independent board director BD_IND RISKMETRICS Size of board Number of board directors BD_SIZE RISKMETRICS 4.Other control variables

CEO ownership Proportion of common equity owned by the CEO CEO_HOLD ExecuComp

CEO power

Number of years the current CEO has been in the position

CEO_TENURE

ExecuComp

Firm growth Market value over book value of assets, measured at the beginning of the fiscal year

MV/BV COMPUSTAT

Firm leverage Long-term debt divided by previous year’s assets LEV COMPUSTAT Firm financial distress

An indicator if the firm had two or more consecutive years of negative income, ending on the fiscal year prior to the shareholders’ meeting.

NEG_NI COMPUSTAT

Volatility The absolute value of the change in net income between previous year and current year (deflated by last year’s assets)

ABS_∆NI COMPUSTAT

Firm size The natural log of the book value of assets.

Ln(ASSETS) COMPUSTAT

27

28

Variable Mean Std DevLower

Quartile MedianUpper

Quartile

This See Table 2 for all variable definitions.

TABLE 3

Descriptive Statistics of Variables (N=1032)

ABS_PMDA

OVERLA P

OVERLA P_P

BD_SIZE

BD_IND

CEO_TENURE

CEO_HOLD

0.041

0.641

0.306

10.199

0.715

6.091

0.008

0.039

0.480

0.295

2.103

0.183

6.550

0.027

0.013

0.000

0.000

9.000

0.625

2.000

0.000

0.028

1.000

0.250

10.000

0.750

4.000

0.001

0.055

1.000

0.500

11.000

0.833

8.000

0.004

7

0

4

4

5

MV/BV

NEG_NI

ABS_∆NI

LEV

ln(ASSETS)

3.708

0.152

0.045

0.207

9.040

12.626

0.359

0.115

0.154

1.158

1.812

0.000

0.008

0.095

8.146

2.949

0.000

0.021

0.191

8.987

4.40

0.00

0.04

0.30

9.81

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Variabl

TABLE 4 Spearman Correlations of Major Variables

e ln(ABS_PMDA)

OVERLAP OVERLAP_P

BD_IND BD_SIZE CEO_TENURE

CEO_HOLD

MV/BV Neg_NI ABS_∆NI LEV ln(ASSETS)

ln(ABS_PMDA) 1.00

OVERL

OVERL

BD_IN

BD_SIZ

CEO_T

CEO

AP -0.05 1.00

AP_P -0.01 0.85*** 1.00

D 0.00 -0.13*** -0.18*** 1.00

E -0.12*** -0.14*** -0.23*** 0.04 1.00

ENURE 0.00 0.05* 0.10*** -0.05 -0.13*** 1.00

_HOL

MV/BV

Neg_NI

D 0.00 0.10*** 0.11*** -0.14*** -0.16*** 0.50*** 1.00

0.05 -0.02 0.00 -0.04 -0.03 0.03 -0.06** 1.00

0.08*** 0.04 0.03 0.01 -0.09*** -0.13*** -0.08*** -0.25*** 1.00

NI 0.22*** -0.02 0.00 -0.01 -0.16*** 0.00 -0.06* 0.05 0.39*** 1.00

-0.15*** 0.09*** 0.05* 0.08** 0.21*** -0.11*** -0.02 -0.23*** 0.05* -0.18*** 1.00

ET S) -0.18*** -0.09*** -0.11*** 0.09*** 0.44*** -0.1*** -0.25*** -0.22*** -0.02 -0.19*** 0.31**

*

1.00

ABS_∆

LEV

ln(ASS

This table reports the Spearman correlations of major variables. See table two for all variable definitions. *, **, ***, indicate significance at the 10, 5 and 1 percent level respectively.

TABLE 5 Association between Overlapping Committees and Financial Reporting Quality

Variables Pred. Signs

Estimated Coefficients p-value

INTERCEPT -2.3951 0.0049

OVERLAP - -0.2111 0.0073

BD_IND - 0.0548 0.4020

BD_SIZE ? -0.0059 0.3950

CEO_TENURE + 0.0002 0.4892

CEO_HOLD + 2.3405 0.0768

MV/BV + -0.0009 0.3894

NEG_NI + 0.1897 0.0552

ABS_NICHANGE + 0.7565 0.0192

LEV ? 0.1196 0.7100

ln(ASSETS) - -0.1442 0.0006

Adj R-Sq

N

0.1015

1032

.

This table presents the fixed effects (year & industry ( SIC two digits)) regression results for following cross-sectional model:

itit

itititititit

ititititit

ASSETSLEVNIABSNINEGBVMVHOLDCEO

TENURECEOSIZEBDINDBDOVERLAPPMDAABS

εββββββ

βββββ

+++Δ+++

+++++=

)ln(__/_

___)_ln(

10

98765

43210

See table 2 for variable definitions. P-values are based on one tailed (two tailed) tests in instances where we have directional (nondirectional ) predictions.

TABLE 6 Association between Overlapping Magnitude and Financial Reporting Quality

Pred. Signs

Estimated Coefficients p-value

INTERCEPT -2.5321 0.0033

OVERLAP_P - -0.7871 0.0194

OVERLAP_P2 + 0.8385 0.0275

BD_IND - 0.0821 0.3563

BD_SIZE ? 0.0028 0.4519

CEO_TENURE + -0.0012 0.4338

CEO_HOLD + 2.5621 0.0601

MV/BV + -0.0007 0.4125

NEG_NI + 0.1862 0.0589

ABS_NICHANGE + 0.7622 0.0186

LEV ? 0.1026 0.7499

ln(ASSETS) - -0.1461 0.0006

Adj R-Sq 0.0990

N

1032

.

Optimal OVERLAP_P 0.4694

This table presents the fixed effects (year & industry ( SIC two digits)) regression results for following cross-sectional model:

ititititititit

itititit

ititit


POVERLAPPOVERLAPPMDAABS


βββ

+++Δ++++++

+++=

)ln(__/____

__)_ln(

1110987

6543

2210

See table 2 for variable definitions. P-values are based on one tailed (two tailed) tests in instances where we have directional (nondirectional) predictions. By using the first order condition (FOC) of the function [-0.7871*OVERLAP_P+0.8385*OVERLAP_P2 ], we find that the optimal OVERLAP_P is 0.4694. That is, on average, holding everything else constant, when the overlapping percentage is 47% in the post-SOX period, the abnormal accruals are the lowest.

31

TABLE 7

Robustness Checks Panel A: Controlling for the level of CEO’s incentive compensation (INCE )

Without Interaction With Interaction

Variables

Pred.

Signs

Estimated

Coefficients p-value

Estimated


INTERCEPT -2.4241 0.0047 -2.7750 0.0022

OVERLAP - -0.2107 0.0074 0.3476 0.2220 0.0527 OVERLAP*INCE - -0.6807

INCE + 0.0745 0.3934

0.4059

0.3964

0.4986

0.0734

0.3887

0.0549

0.0200

0.7070

0.0006

0.5026 0.1261

0.3859

0.3846

0.4558

0.0523

0.3844

0.0555

0.0211

0.6811 0.0005

BD_IND - 0.0527 0.0642 BD_SIZE ? -0.0058 -0.0065 CEO_TENURE + 0.0000 -0.0008 CEO_HOLD + 2.4123 2.7289 MV/BV + -0.0009 -0.0009 NEG_NI + 0.1903 0.1895 ABS_∆NI + 0.7518 0.7433 LEV ? 0.1210 0.1323 ln(ASSETS) - -0.1459 -0.1483 Adj R-Sq 0.1007 0.1010

N 1032 1032

Joint test: OVERLAP+OVERLAP*INCE=0

-0.3330

0.0053

32

Panel B: Accounting restatements (REST) as a proxy for financial reporting quality

Equation (a) Equation (b)

Variables

Pred.

Signs

Estimated


Estimated


INTERCEPT -5.4990 0.4574 0.0816

-5.3800 0.4583

OVERLAP - -0.2715

OVERLAP_P - -1.6307 0.0270

0.0572

0.2020

0.1330

0.1274

0.3855

0.2059

0.4823

0.0015

0.8148 0.0671

OVERLAP_P2 + 1.4947 BD_IND - -0.4230 0.2004

0.1126

0.1137

0.3686

0.1944

0.4835

0.0015

0.8095 0.0548

-0.4254 BD_SIZE ? -0.0619 -0.0594 CEO_TENURE + 0.0179 0.0172 CEO_HOLD + -1.2253 -1.0701 MV/BV + -0.0051 -0.0049 ABS_∆NI + -0.0269 -0.0293 NEG_NI + 0.7121 0.7143 LEV ? 0.1738 0.1690 ln(ASSETS) - 0.1572 0.1480 N 1032 1032

Likelihood-Ratio-Pr>Chi-Sq <0.0001 <0.0001

Pseudo R-Sq 0.1364 0.1381

Panel A of this table presents the results of robustness checks by controlling for the magnitude of CEO’s incentive compensation. The results are from the fixed effects (year & industry ( SIC two digits)) regression for following cross-sectional models: (i) Without interaction of OVERLAP and INCE

ititit

itititititit

ititititit

ASSETSLEVNIABSNINEGBVMVHOLDCEOTENURECEO

SIZEBDINDBDINCEOVERLAPPMDAABS

εβββββββ

βββββ

+++Δ++++

++++=

)ln(__/__

__)_ln(

1110

98765

43210

(ii) Including interaction of OVERLAP and INCE

ititititit

itititititit

ititititit


INCEINCEOVERLAPOVERLAPPMDAABS


ββββ

+++Δ++++++

++++=

)ln(__/____

*)_ln(

1211109

87654

3210

INCE is the proportion of CEOs’ non salary compensation. See table 2 for other variable definitions. P-values are based on one tailed (two tailed) tests for variables whose relation to the dependent variables is (is not) predicted.

33

Panel B shows the results when we use the incidence of accounting restatement as an alternative proxy for earning quality. The results are from following fixed effects (year & industry ( SIC two digits)) logistic regression models:

)()ln(__/_

___

10

98765

43210

aASSETSLEVNIABSNINEGBVMVHOLDCEO

TENURECEOSIZEBDINDBDOVERLAPREST

itit

itititititit

ititititit

εββββββ

βββββ

+++Δ+++

+++++=

)()ln(__/__

____

1110

98765

432

210

bASSETSLEVNIABSNINEGBVMVHOLDCEOTENURECEO

SIZEBDINDBDPOVERLAPPOVERLAPREST

ititit

itititititit

ititititit

εβββββββ

βββββ

+++Δ++++

+++++=

REST is a dummy variable that takes on a value of 1 if current year’s final statements need to be restated and zero otherwise. See table 2 for other variable definitions. P-values are based on one tailed (two tailed) tests for variables whose relation to the dependent variables is (is not) predicted.

34

Compensation committee and audit committee overlapping

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