ERASMUS UNIVERSITY ROTTERDAM
ERASMUS SCHOOL OF ECONOMICS
MSc ACCOUNTING, AUDITING & CONTROL
Effectiveness of Internal Controls and Managerial Compensation schemes /
Evidence from the financial crisis /
Author:Soleymi Manuela
Student number:315360
Thesis supervisor:Jan Pasmooij RA RE RO
Finish date: August 2014
Acknowledgement
I would like to take this opportunity to briefly thank all the ones whom provided me with all their knowledgeable inputto help me during thislong enduring master thesis path. I am very grateful with the wonderful support system I have,namely my family and friends.A special thank you to Mrs. Franklin for all the helpful thesis tips she provided.
Abstract
Executives of large public companies have the fiduciary responsibility to create, maintain and report on the effectiveness of their internal control system since the implementation of SOX 404 in 2002. Auditorsare also required by SOX 404 to attest on this assertions made by the executives. This can give the shareholders the trust in top management performance to safeguard their assets, especially after the big financial fraud scandals documented.Recently conducted researches showed that an effective internal control system can be seen as a good non-financial measure of top executive’s performance (Hoitash, Hoitash & Johnstone (2012). This thesis examines the association between the possibility ofeffective internal controls and CFO’s equity and cash bonus compensations. The empirical research consists of two sample periods. The first sample period is before the financial crisis from 2004-2006, and the second sample period is during the financial crisis from 2007-2009.Data to conduct the research was collected from Compustat Executive Compensationdatabase, Audit analytics, Risk Metrics and Compustat. TwoLogistic regression modelswere designed to study whether effective internal control systems are positively associated with CFO’s equity and bonus compensations.Finally, the results showed that for the period before the financial crisis, there is a significant positive association for the effectiveness of internal controls and equity compensation. But for both sample periods, there was no significant association found for the effectiveness of companies’ internal controls and CFO’s cash bonus compensation. Also found was that the effectiveness of internal controlsis neither associated with the bonus nor the equity compensationduring the financial crisis,which can be evidence of managerial rent extraction during the financial crisis.
Keywords: Internal controls, SOX 404, Executive compensation & Financial crisis
Table of Contents
Abstract
1.Introduction
1.1Background
1.2Research questions
1.3Contribution
1.4Outline
2.Theoretical background
2.1Introduction
2.2Internal control systems
2.3Executive compensation schemes
2.3.1 Agency theory
2.3.2 Optimal contracting theory
2.3.3 Managerial power theory
2.3.4 Bonus plan hypothesis
2.4Conclusion
3.Literature review
3.1Introduction
3.2Internal controls & Executive compensation Relation
3.2.1 Pay-without performance
3.3The impact of the financial crisis
3.3.1 The Financial crisis Executive Compensations
3.3.2 The financial crisis Internal controls
3.4Conclusion
4.Hypotheses
4.1Introduction
4.2Hypotheses development
4.2.1 The Financial Crisis
4.3Conclusion
5.Methodology
5.1Introduction
5.2Sample & Data collection
5.3Research design
5.3.1 Control variables
5.3.2 Governance independent variables
5.3.2 Dependent variable
5.4Conclusion
6.Results
6.1Introduction
6.2Descriptive statistics
6.2.1 Sample period before financial crisis 2004-2006
6.2.2 Sample period during financial crisis 2007-2009
6.3Main test results
6.3.1 Hypotheses 1a
6.3.2 Hypotheses 1b
6.3.3 Hypotheses 2a & 2b
7.Conclusion & Limitations
7.1Conclusion
7.2Limitations
Reference list
Appendix
Appendix 1: Regression model (3) Bonus before Financial crisis
Appendix 2: Regression model (4) Equity compensation before Financial crisis
Appendix 3: Regression model (3) Bonus during Financial crisis
Appendix 4: Regression model (4) Equity during Financial crisis
Effectiveness of Internal Controls and managerial compensation schemes:
Evidence from the financial crisis
1.Introduction
1.1Background
CEO’s and CFO’s responsibilities within an enterprise are certainly growing over time. They need to provide accurate and reliable financial information to their investors and creditors. Designing an effective internal control system has shown to enhance the reliability of financial reporting (Hammersley, Myers & Shakespeare, 2008). Section 404(a) of Sarbanes-Oxley Act (hereafter referred as SOX) gives top management of publicly held companies the legal responsibility to establish, maintain and report on the adequacy of internal controls in place (Arens, Elder, & Beasley, 2012). CFO’s are mainly the ones held responsible for this duty. An effective control environment within a firm is of great importance to achieve company’s objectives. Internal controls can improve the effectiveness and efficiency of the operational processes (Arens, Elder, & Beasley, 2012). Managers need to set the tone at the top and emphasis on the importance of internal controls through companies’ policies to achieve a strong control environment. Research has shown that internal controls material weaknesses are mostly related to weak senior management and lack of training (Klamm, Kobelsky, & Watson, 2012).This means that corporate governance has a strong impact on the effectiveness of the internal control. With such important corporate responsibilities you would expect huge executives’ compensations to be appropriate. But is a greatcompensation a guaranty and motivation for CEO’s and CFO’s to deliver effective internal controls? Shareholders constantly complain about the rising salaries of top management, especially considering the latest financial crisis.[1] Auditors of large public companies, the accelerated filers[2], are required by section 404(b) of SOX to attest on the assertions made by management regarding the effectiveness of the internal controls. This can give the shareholders the trust in top management performance to safeguard their assets, especially after the big financial fraud scandals documented.
1.2Research questions
Executive compensation schemes are generally dependent upon the financial performance of the manager’s firm, such as their market returns or earnings. Although, prior research showed that due to the responsibilities of CFO’s towards their internal control systems (they are mandated to report on their effectiveness since the implementation of SOX 404), an effective internal control can be seen as a good non-financial measure of top executive’s performance(Hoitash, Hoitash & Johnstone (2012).SOX 404 can be seen as an informative tool that can possibly affect executive compensation schemes. So based on these notions, the compensation of top executives is nowadays expected to be partially based on the effectiveness of the firm’s internal controls. But compensation schemes also give managers the incentive to take more risk which was one of the causes of financial crisis (Landskroner & Raviv, 2010).This study examines the association between an effective internal control and executive compensation patterns before and during the financial crisis. The main research questions this thesis will address are as followed.
i)Is there an association between auditors’ attestation on the effectiveness of internal control required by SOX 404(b) and CFO’s compensation schemes?
ii)Did the financial crisis of 2007 impact thepossible association stated in the research question (i)?
1.3Contribution
The results of this study will contribute to the existent literature regarding the effect of executive compensation schemes and the cost of SOX 404 disclosures. This study is among the few recent papers that examine the relation between managerial compensations and the effectiveness of internal controls. The main contribution of this study is that this will be the first paper to examine the impact of the financial crisis on the association between internal controls and executive compensation plans. Prior studies have mainly focus on the relation between ineffective internal controls and market reactions; audit quality and firm performance/ earnings quality (e.g. Brown & Lim, 2012; Hammersley et al., 2012).
This study will inform regulators and managers on the effectiveness of section 404 of SOX on whether it provides the right incentives to managers to address their internal control deficiencies effectively and exert that extra effort due to the possible higherexecutive compensations for CFO’s at firms with effective internal controls.
1.4Outline
The next chapter provides an overview of the relevant theories and concepts that explain the purpose of managerial compensation schemes as a good incentive for executives to create and maintain effective internal control systems. Chapter 3 gives a review of the relevant empirical studies conducted. Different studies that researched the association between internal control material weaknesses and effectiveness on executive compensation schemes are being discussed in this chapter. The impact of the financial crisis on this association will also be addressed in chapter 3. Chapter 4 explains the different hypotheses that were developed after carefully reviewing prior relevant research studies in chapter 3. In chapter 5 more inside is given on the data collection process and the sample periods used. Further on, the research design will be thoroughly explained in chapter 5. Chapter 6 shows the results of the two logistic regressions for respectively cash bonus compensation and equity compensation. Lastly, chapter 7 provides the conclusion and possible limitations of this paper.
2.Theoretical background
2.1Introduction
There are different theories that hypothesize the relationship between executive compensations and overall firm performance. This chapter provides an overview of the relevant theories and concepts that explain why managerial compensation schemes can be a good incentive for executives to address internal control deficiencies which in turn creates shareholder value. But before doing so, it’s important to elaborate on the history and importance of internal control systems. The explanation of the concepts and theories provided in this chapter are crucial for the remainder of this research.
2.2Internal control systems
Although internal controls may have existed since ancient times, it was in 1949 that the American Institute of Accountants first defined this term[3]. Since 1977 companies are required by the Foreign Corrupt Practices Act to establish and maintain internal control systems that give the shareholders and the public at large reasonable assurance over the registration of transactions and safeguarding of assets. Even so, the frequency of financial reporting fraud was at an intolerable level. Therefore, in 1985, an independent committee, the Committee of Sponsoring Organizations (hereafter referred as COSO) was formed. In a later report in 1988, COSO advocated that companies should be required by SEC to file a management report in their annual report that stated management’s responsibilities towards the company and their assessment on the effectiveness of their internal control systems. This issue was challenged by the AICP with valuable arguments at the time (Henry, Shon, & Weiss, 2011).
It was until 2002 when the shareholders’ value (worth billions of dollars) and the trust in the US capital market was crushed due to the numerous financial scandals in that particular year, that led to the formation of SOX 404 which mandates managers of a publicly held companies to issue an report on the effectiveness of their internal controls. This SOX 404 requirement particularly increases the responsibility of the Chief Financial Officers whom are required to maintain a healthy financial environment for their firm. The final requirement implemented by SOX 404 is the attestation rule by the external auditor on management’s report (Arens, Elder, & Beasley, 2012). SOX 404 can be classified as one of the most complex en costly regulation to comply with and is therefore seen as a burden for the CFO’s of publicly held companies who must exert extra effort to determine the effectiveness of their internal control systems. Studies have shown a positive association between cost of compliance and the presence of material internal control weaknesses, auditors’ size and firm size (Krishnan, Rama, & Zhang, 2008). Managerial compensation schemes can be an incentive for CFO’s for the extra effort they need to take on to fulfill the requirements of SOX 404. Due to the promptly accessible internal control information, SOX 404 can be seen as a good non-financial measure for executives’ pay schemes. Recent study has shown that CFO’s compensations are another cross sectional determinant that increases the chances of a company reporting an effective internal control system (Henry, Shon, & Weiss, 2011)[4].
2.3Executive compensation schemes
Executive compensation schemes are an important element of corporate governance and are set by the independent members of the board of directors (Arens, Elder, & Beasley, 2012). Compensation schemes are the perfect mechanism to appeal, drive and holding on to the top qualitative executives, if optimally set by the board[5]. There are different forms of executive compensations. In this paper compensation refers to the base salary plus short term incentives or/and long term incentives. The base salary is the fixed component of the executives’ short term compensations. The variable short term incentives are usually cash bonuses that top officers receive above their base salary,at the end of the year, for their performance and profitability within the organization in that particular year (Hoitash, Hoitash, & Johnstone, 2012). Instead of cash bonuses, managers can also be compensated with shares or stock options of their company. These are categorized as the long term incentives as they drive managers to create sustainable firm value. There are different theories explaining the cost effectiveness of both short term incentives and long term incentives. The agency theory, discussed in the next paragraph, states why executive compensations are an important element of corporate governance.
2.3.1 Agency theory
The well-known agency theory of Jensen & Meckling (1976) argues that the interests of executive management often conflicts with the interest of shareholders. This will lead to the agency problem where the agents’ (corporate management) will act opportunistically and therefore carrying solely on their own best interest and not for creating shareholder’s value. This problem arises due to the agents’ information and control advantages in comparison to the principals (shareowners). Therefore effective corporate governance is needed to direct and control the different participants, especially the top officers in the organization. Jensen and Meckling (1976) mentioned in their paper that executive compensation schemes can be a good mechanism (among other factors) to mitigate the agency problem. This agency problem is a bigger issue for larger and complex firms, which means that CFO’s of larger companies require a higher salary and greater equity incentives as a premium to exert effort (Edmans and Gabaix, 2009). Thus the board of directors has an important task to monitor and set the optimal contract for their officers to incentivize them to create shareholder value.
2.3.2 Optimal contracting theory
Contracts are a crucial element to incentivize managers to make earnings maximizing choices for their firm. Contracts are designed in a manner to give executives the incentives to exert their maximal effort to create an effective internal control system for safeguarding of assets and growth opportunities(Edmans & Gabaix, 2009). The optimal contracting theory states that managers are often compensated with stocks or stocks options to provide them with the incentive to create shareholder value that will benefit both them and the investors and therefore reducing the agency problem[6]. So long term incentives can align the interest of the executives to those of the shareholders, if contracts are made under the arm’s length condition[7].
2.3.3 Managerial power theory
There is also a downfall of the optimal contracting theory. Edmans and Gabaix (2009) argue that recently studied compensation schemes patterns showed characteristics conflicting with the optimal contracting theory. A given explanation for this inconsistency was the possible evidence of rent extractiondue to managerial power. The managerial power perspective does not consider the executive compensation as an incentive to reduce the agency problem.The managerial power refers to the practice where executives use their power over the board to extract rents, resulting in high executive pay without a link to their performance (Bebchuk & Fried, 2005 and Bebchuk et al., 2002). Skaife & Veenman (2012) showed that executives of companies with ineffective internal control engage more easily in rent extraction practices. An example given in the study ofSkaife & Veenman (2012) was when managers extract rent by using their companies’ nonpublic information to trade their owned company shares for their own personal benefit.The next paragraph will give a further explanation of the theory why bonuses are less effective than long term incentives as well as what can go wrong with stock or stock option compensations.
2.3.4 Bonus plan hypothesis
As explained in the previous paragraph, top executives can use their power for their own benefit. They are basically the ones responsible for electing the accounting method to report the financial information. The bonus plan hypotheses state that in the presence of a bonus scheme managers will choose the accounting method that will increase their reported income and therefore increasing their bonuses (Healy, 1985). This opportunistic behavior will give rise to the agency problem. Bergstresser and Phillippon (2006) provideevidence that CEO’s with large equity- based compensation including stocks or options are more like to manipulate earnings. A weak internal control will facilitate the manager’s discretion to manipulate accounting figures and therefore proving managers with the desire for weaker internal controls. Although, Edmans & Gabaix (2009) argued about the controversy evidence founded that compensations of executives in larger firms are less sensitive to firm value. A loss of $3.25 of CEO wealth was reported for every $1,000 of firm value drop. As a result managers where not incentivize to exert effort to create firm value. This was the result ofa weakness in the corporate governance of larger companies which allowed managers to conciliate contracts for their own benefit due to their managerial power over the board[8].This can lead to excessive compensations for the executives and therefore resulting in the widely discussed phenomena of ‘pay without performance’ (Bebchuk & Fried, 2005).
2.4Conclusion
In 2002, the formation of SOX 404 became a fact when the shareholders’ value and the trust in the US capital market were crushed due to the numerous financial scandals in that particular year. This regulation mandates managers of publicly held companies to issue a report on the effectiveness of their internal controls. This SOX 404 requirement particularly increases the responsibility of the Chief Financial Officers whom are required to maintain a healthy financial environment for their firm. Different theories explaining the cost effectiveness of both short term and long term incentives were also discussed in this chapter. Due to the mixed evidence the different theory and hypotheses provided, it still remains a research problem as to whether managerial compensation schemes can positively incentive CFO’s to exert extra effort to create an effective internal control system for their companyand therefore avoiding big financial scandals. The next chapter will elaborate more on this possible association.