Whose Side are You on Anyway? Using Audit Fees to Identify Vigilant vs. Compliant Directors Among Outside Directors Who Serve on Multiple Audit Committees

Abstract

Several reforms of the Sarbanes Oxley Act were designed to strengthen the vigilance exercised by audit committee members in their oversight of independent financial-statement audits of U.S. public companies. After SOX, a shift occurred in the audit committee labor market such that more individuals sought multiple board appointments. While most governance research assumes that outside directors with multiple board memberships have reputations for being vigilant monitors of management’s financial reporting, we contend that compliant directors also exist who have reputations for being lax monitors of management. We categorize outside directors as vigilant or compliant based on whether they negotiate higher or lower audit fees with external auditors, and we focus on the sizable subset of directors who serve on multiple audit committees. As predicted, additional audit committee memberships are associated with higher levels of income-increasing earnings management, but only for compliant directors. Further, CFOs’ equity incentives to overstate earnings amplifies this positive association between additional audit committee memberships and income-increasing earnings management, but again only for compliant directors. Remarkably, the presence of vigilant directors is associated with lower earnings management, despite higher CFO equity incentives to overstate earnings as well as incremental busyness that comes with serving on multiple audit committees.

Keywords: Corporate governance, Audit Committees, Outside directors, Multiple directorships, Earnings quality, Restatements, Director independence