Based on agency theory, if equity compensation aligns audit committee members’ interests with those of shareholders, the audit committee will provide effective oversight and demand more thorough audit coverage and scope. This will result in higher audit fees paid to the external auditor. This study specifically examines the associations between the types of equity compensation of audit committee members and audit fees. Our findings show differential impacts of equity compensation of audit committee in the forms of option grants and stock awards on audit fees. Specifically, equity compensation using stock awards is more effective than using option grants in aligning the interests of audit committee members with the interests of shareholders to provide better oversight of financial reporting.

Introduction

The audit committee and its members are consistently under scrutiny because, in many respects, they serve as guardians of the integrity of a firm’s financial statements. Prior studies have examined audit committee effectiveness using measures such as committee independence, committee member expertise, committee size, and committee meeting frequency. For an audit committee to execute its fiduciary responsibility effectively, there has to be an incentive to do so. Undoubtedly, equity is playing a larger role in director compensation structures in recent years. However, mixed views exist as to whether equity compensation provides incentives that better align the interests of audit committee with shareholder’s interests or impair the objectivity and effectiveness of the directors. Based on agency theory, if equity compensation aligns audit committee members’ interests with those of shareholders, the audit committee will provide effective oversight and demand more thorough audit coverage and scope. This will result in higher audit fees paid to external auditor. This study investigates the effect of different types of equity compensation of audit committee on the level of audit fees, which is a measure of audit quality. The last decade reveals a substantial shift in director compensation from cash-based to more equity-based compensation.1 According to a global governance survey of S&P 500 firms by Spencer Stuart, the average total compensation of non-employee directors increased by approximately 29% from 2005 to 2015, with an additional increase of 8% from 2015 to 2017.2 In addition, stock awards and option grants represent the largest share of total director compensation with an increase in stock awards (and a decrease in option grants) in the composition of director compensation in recent years.3 The breakdown of director compensation in 2017 shows that 56% was in the form of stock awards and 4% was in option grants (Spencer Stuart, 2018).