Board independence, executive compensation and restatement

Abstract

In this article, we use post-Sarbanes–Oxley Act (SOX) restating sample companies to examine the effect of leverage on the probability of restatements. We also explore whether the level of board independence for restating firms has an impact on the probability of restatements. We further analyse the subsequent change of the firms’ executive compensation after they experience these restating events. The results indicate that firms with large debt have a high probability of restating their financial reports, but the likelihood of restatement is reduced if the underlying bankruptcy risk is lower. Contrary to expectations, the results do not indicate that board independence is associated with the probability of restatement. Even restating firms did not appear willing to fortify board independence after restatements. Finally, it is found that having more directors on the board for a company may help to restrain its executive compensation after restatements.

Keywords:

• board independence
• executive compensation
• restatement
• bankruptcy risk

Keywords:

• JEL Classification: M41
• M52
• L25

Notes

1 Ahmed and Goodwin (2007) document earnings restatements for the top 500 Australian firms, examine the characteristics of restating firms and test whether restatements are value relevant. They identify three reasons for earnings restatements, namely accounting policy changes, revisions of estimates and errors and unknown that comprise 49%, 40% and 11% of the sample, respectively. However, the purpose of our article focuses on the restating firms’ characteristics and post-restating executives’ compensation.

2 Their results are consistent with the view that banks use tighter loan contract terms to overcome risk and information problems arising from financial restatements.

3 Burns and Kedia (2006) show that the restating firms have higher leverage and price-earnings ratios than nonrestating firms. We examine whether the post-SOX restating firms still have higher leverage and price-earnings ratios than the post-SOX nonrestating firms.

4 DeFond (1992) finds that changes in management ownership and leverage are associated with changes in audit quality.

5 They find that their prediction of excess CEO compensation, based on firm governance structure, has a negative correlation with future returns in one-, three- and five-year time-horizons.

6 Garcíía Lara et al. (2007) show that firms with strong boards use conservative accounting numbers as a governance tool, even in an institutional setting with low litigation risk such as Spain.

7 Lin et al. (2006) find a negative association between the size of audit committees and the occurrence of earnings restatement.

8 Cheng and Farber (2008) complement studies investigating other monitoring changes in response to financial reporting failures (e.g. Farber, 2005; Srinivasan, 2005; Desai et al., 2006). Overall, they show that the firm can improve a broad spectrum of governance mechanisms to reduce agency problems with respect to financial reporting failures.

9 Prior studies document that compensation plans have a strong association with earnings manipulation. Gao and Shrieves (2002), Bergstresser and Philippon (2006), Cohen et al. (2008), Cheng and Warfield (2005), Cornett et al. (2008) all find that the magnitude of discretionary accruals is greater and earnings management are prevalent at firms whose managers’ compensation is closely tied to the value of the stock, most notably via stock options.

10 They also suggest that a decrease in option-based compensation reduces a CEO's incentives to make excessively risky investments, thus resulting in improved profitability.

11 Yermack (1996) argues that the board's decision-making quality decreases with board size because the more people in the group, the lower the group's coordination and processing skills.