Audit committee members are more likely to support the auditor over management in an accounting disagreement when the compensation of members of the board audit committee includes long-term stock options, according to a new study.

Jim Bierstaker

The research, led by Villanova School of Business professor Jim Bierstaker, asked 56 public company audit committee members to complete a theoretical written case study describing an accounting disagreement between management and the external auditor. The audit committee member participants were told that their compensation was either one of three conditions: 100 percent cash, 20 percent cash and 80 percent short-term stock options vesting this year, or 20 percent cash and 80 percent long-term stock options vesting in five years.

The study found that audit committee members are more likely to support the auditor, as opposed to management, in an accounting disagreement when audit committee compensation includes long-term stock options. The members perceive that failure to record the auditor’s adjustment is less fair to current shareholders.

On the other hand, audit committee members are less likely to support the auditor when they perceive they have more personal control over the outcome of the disagreement. If they feel they can influence the outcome, they tend to go with management.

“I teach financial auditing, and my students are amazed that audit committee members can receive stock options,” said Bierstaker. “They’re amazed that that’s not an independence issue.”

He noted that other researchers have found similar findings. Companies whose audit committee members or directors received more stock options and short-term compensation tended to have more earnings restatements.

Bierstaker and the study co-authors decided to design an experiment with a hypothetical company case study, and still found a bias among the audit committee members who completed the survey. The compensation affects their feelings about fairness and whether they think an adjustment recommended by the auditors should be made.

“That’s kind of the amazing,” said Bierstaker. “It’s just a hypothetical case, yet we still find this highly significant effect.”

He hopes to conduct a follow-up study examining the effect of other forms of compensation, such as restricted stock. But he believes the study has implications, not only in the context of financial reporting scandals such as Enron and WorldCom, but also in terms of the subjectivity of professional judgment in accounting.

“People tend to think of accounting as very black and white,” said Bierstaker. “Certainly there are some accounting issues where there is a clear issue that needs to be followed, but a lot of times it comes down to some judgment.”