How do companies react to restatements? - Evidence from audit committee compensation

Abstract

This study examines whether firms react to restatements by adjusting equity-based compensation paid to their audit committees and whether such adjustment is effective in improving the quality of firms` financial reporting. Three major findings are documented. First, larger equity-based compensation aligns the interests between audit committees and shareholders in S&P 1500 firms, leading to lower restatement likelihood. In contrast, larger equity-based compensation induces audit committees to compromise independence in non-S&P 1500 firms, leading to higher restatement likelihood. Second, S&P 1500 firms increase equity-based compensation to both AC chairs and other AC members following restatements to enhance the alignment effect. Differently, non-S&P 1500 firms reduce equity-based compensation paid to audit committee chairs rather than other members following restatements to mitigate the entrenchment effect. Importantly, restating firms adjust equity compensation only to audit committee members but not to CEOs or other board committee members. Finally, reducing (increasing) audit committees` equity-based compensation is effective in improving non-S&P 1500`s (S&P 1500`s) quality of financial statements after restatements. These findings are robust to controlling for endogeneity, including corporate governance variables, dropping firms who discharge auditors and CEOs, and considering nonlinearity. Our empirical results bear important implications for regulators and investors.