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Are Independent Audit-Committee Members Objective?

By Harvard Law School Program on Corporate Governance

(Editor?s Note: This post comes to us from Matthew Magilke of the University of Utah, Brian W. Mayhew of the University of Wisconsin-Madison, and Joel Pike of the University of Illinois at Urbana-Champaign.)

In our forthcoming Accounting Review paper, Are Independent Audit-Committee Members Objective? Experimental Evidence, we use an experimental economic setting to explore whether bonuses tied to current and future investor wealth similar in nature to stock based compensation affects an audit committee member?s (ACM) preference for biased financial reporting.

Our motivation to examine ACM preference arises from three sources. First, the Sarbanes-Oxley Act requires that audit committees appoint, compensate and oversee the external auditor (Sarbanes Oxley 2002 section 301). Second, while it is considered a violation of auditor independence for auditors to own stock in the company they audit, it is considered preferable to have ACM to own stock to align their interests with shareholders. Third, we seek to examine the impact of investor selection of auditors on auditor objectivity. An experimental setting enables us to directly observe ACM objectivity, and to explore the impact of clearly defined incentive schemes on ACM decisions. Our ability to observe objectivity directly provides stronger tests than is possible using crude measures of independence such as inside versus outside directors.

We employ three treatments to examine ACM incentives to prefer biased financial reporting: no stock-like incentives, stock-like incentives linked to future shareholders, and stock-like incentives linked to current shareholders. We observe the highest objectivity levels when there are no stock-like incentives. In contrast, when we link ACM incentives to current shareholders, the ACMs bias their reports toward the current shareholders at the future shareholders? expense. In a similar sense, when we tie ACM?s compensation to future shareholders, they bias their reporting toward future shareholders at the current shareholders? expense. We observe that ACMs respond to their incentives, and that direct cash compensation creates the strongest incentive for unbiased financial reporting. Taken as a whole, our study suggests that stock-like compensation can impact audit committee member preferences for biased financial reporting.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on July 06, 2009 (boomark / email).