Audit Committee Compensation, Fairness, and the Resolution of Accounting Disagreements

Abstract

An emerging body of research examines the relation of incentive-based audit committee compensation with accounting outcomes (e.g., Archambeault et al. 2008; Magilke et al. 2009). We extend this literature by examining the effects of audit committee compensation and perceived fairness to shareholders on actual public company audit committee members’ judgments in accounting disagreements. Fifty-six highly experienced public company audit committee members participated in an experiment involving an accounting disagreement between management and the external auditor, with three types of audit committee compensation (i.e., cash only, cash and short-term stock options, or cash and long-term stock options) manipulated between subjects. We also measured the participants’ perceptions of the fairness to shareholders if the auditor’s adjustment is not recorded. We find that audit committee members are more likely to support the auditor in an accounting disagreement when audit committee compensation includes long-term stock options and when members perceive that failure to record the auditor’s adjustment is less fair to shareholders. Most significantly, we find that the relation between long-term incentive compensation and support for the auditor is fully mediated by a sense of fairness to shareholders. We offer implications and suggestions for future research.

Keywords: Audit Committee, Incentive Compensation, Fairness, Responsibility

JEL Classification: G30, G34, M10, M40, M41