Journal of Accounting and Economics: Ellen Engel, Rachel M. Hayes, Xue Wang

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Journal of Accounting and Economics 49 (2010) 136154
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Journal of Accounting and Economics

journal homepage: www.elsevier.com/locate/jae
Audit committee compensation and the demand for monitoring of

the nancial reporting process
Ellen Engel a,, Rachel M. Hayes b, Xue Wang c
a
b
c
University of Chicago Booth School of Business, USA

David Eccles School of Business, University of Utah, USA
Goizueta Business School, Emory University, USA
a r t i c l e i n f o
abstract
Article history:
Received 8 March 2008
Received in revised form
31 July 2009
Accepted 19 August 2009
Available online 29 August 2009
We examine the relation between audit committee compensation and the demand for
monitoring of the nancial reporting process. We nd that total compensation and cash
retainers paid to audit committees are positively correlated with audit fees and the
impact of the Sarbanes-Oxley Act, our proxies for the demand for monitoring. Our
results are robust to the inclusion of audit committee quality, measured as the
committee chair nancial expertise. Our results suggest a recent willingness by rms to
deviate from the historically prevalent one-size-ts-all approach to director pay in
response to increased demands on audit committees and differential director expertise.
& 2009 Elsevier B.V. All rights reserved.
JEL classication:
G30
M41
M49
Keywords:
Audit committees
Board of director compensation
Audit fees
1. Introduction
In this paper, we study compensation of audit committee members of public rms. Specically, we examine how crosssectional variation in the demand for monitoring of the nancial reporting process is associated with compensation for
audit committee members. Audit committees play a crucial role in rms nancial reporting processes, and thus have
attracted considerable attention from researchers, especially in the wake of recent high prole nancial reporting scandals.
While there are large literatures both on audit committee characteristics and on compensation for directors, research has
not, to date, examined how pay for audit committee members varies with the rms nancial reporting environment.
Recent literature on audit committees has focused instead on committee characteristics such as size and composition (Deli
and Gillan, 2000; Klein, 2002b), and the relation between these characteristics and various outcomes.1 Meanwhile,
research on compensation for directors has tended to ignore much of the within-rm heterogeneity in director pay,
focusing instead on compensation for a representative director at a given rm (see, for example, Farrell et al., 2008; Linn
and Park, 2005).
We investigate whether rms that face a higher demand for monitoring of the nancial reporting process pay higher
compensation to their audit committees. In addressing this question, we incorporate the effects of audit committee director
Corresponding author.
E-mail address: ellen.engel@chicagobooth.edu (E. Engel).

For example, Klein (2002a) examines the relation between audit committee independence and earnings quality, while Carcello and Neal (2000)
consider the relation between audit committee characteristics and auditor reporting behavior.
1
0165-4101/$ - see front matter & 2009 Elsevier B.V. All rights reserved.
doi:10.1016/j.jacceco.2009.08.001
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E. Engel et al. / Journal of Accounting and Economics 49 (2010) 136154
137
quality. A key part of our analysis also examines within-rm heterogeneity in director compensationin particular, audit
committee pay relative to compensation committee pay (the audit committee pay premium)and how the audit
committee pay premium relates to the demand for monitoring of the nancial reporting process.
A greater demand for monitoring of the nancial reporting process can arise from a number of characteristics of the rm
and its environment or from external forces. In developing proxies for the demand for monitoring, we consider both rmspecic and external forces. Firm-specic forces include the complexity of the business and the rms organizational
structure, the strength of internal control systems, nancial reporting quality and litigation risk. These factors are among
those that impact the overall transparency and riskiness of the nancial reporting process. We argue that the lower the
transparency and the greater the risk of the nancial reporting process, the greater is the demand for monitoring of the
nancial reporting process by investors and other stakeholders. We expect total annual audit fees paid to the external audit
rm for performing audit services to capture these rm-specic and related environmental forces. Accordingly, our rmspecic proxy for the demand for monitoring of the nancial reporting process is rm-size-deated total annual audit fees.
External to the rm, we consider the impact of the requirements of the Sarbanes-Oxley Act (SOX), and the factors that led to
the legislation, on the demand for monitoring of the nancial reporting process. SOX addresses widespread concerns of
regulators and investors about the nancial reporting process, including the role of the audit committee. Specically, SOX
requires that all members of the audit committee be independent and that the companys annual report disclose whether a
member of the audit committee is a nancial expert. These provisions, along with overall investor pressure to improve
corporate governance, are likely to create an increased demand in many rms for audit committee members to monitor the
nancial reporting process more diligently. Accordingly, our second proxy, an indicator variable for the post-SOX time period, is
designed to capture factors relating to the enhanced monitoring environment, greater board accountability and increased
credential requirements directed at audit committee members that are not expected to be fully reected in the audit fee
variable. This variable allows us to capture a potentially important external shift in the demand for monitoring of the nancial
reporting process that is triggered by the provisions of SOX and concurrent higher levels of investor scrutiny.
We expect that the factors that lead to greater demand for monitoring of the nancial reporting process require an
increased commitment of time and effort by audit committee members. We hypothesize that, holding director quality
constant, this effect leads to higher compensation for these directors. We control for director quality because audit
committee compensation is likely related to both the demand for monitoring of the nancial reporting process and the
quality of the audit committee. Including an audit committee quality measurespecically, the nancial expertise of the
audit committee chairallows us to investigate both effects.
To investigate our research questions, we collect compensation data for outside directors from proxy statements for the
sample of ExecuComp rms between 2000 and 2004. We also collect data on the nancial expertise of audit committee
chairs during these years. Our analyses consider two main time periods: the pre-SOX period including 2000 and 2001, and
the post-SOX period from 2002 through the end of 2004. Our descriptive analyses document that total compensation for
audit committees increased signicantly in the post-SOX period, with notable increases in the cash retainer and meeting
fee components. We also nd that a signicantly larger percentage of rms have audit committee chairs with nancial
expertise, and especially accounting expertise, in the post-SOX period.
We conduct two primary regression analyses. Our rst set of regressions examines the determinants of the level of audit
committee compensation, while our second set of regressions explains the difference between compensation of audit
committee members and compensation committee members on the same board. In each regression, we include audit fees,
as well as the post-SOX indicator, to capture the demand for monitoring of the nancial reporting process. While our
prediction is that audit committee compensation is positively related to audit fees because the two variables are
responding similarly to underlying economic factors, we note that it is also possible that audit fees are endogenous in the
compensation regression. Consequently, before we perform our regression analyses, we instrument for audit fees in a twostage least squares regression and conduct a Hausman test to determine whether audit fees are an endogenous regressor.
The Hausman test fails to reject that audit fees are exogenous for all specications. Thus, the use of ordinary least squares
regressions to test our hypotheses will yield consistent coefcient estimates. In the levels regressions, we nd that total
compensation (excluding meeting fees) and cash retainers paid to audit committee members are positively correlated with
annual audit fees, our proxy for the demand for monitoring of the nancial reporting process. These compensation
measures are also positively associated with our measure of audit committee chair expertise. Further, our empirical
evidence indicates that the level of compensation for audit committees has increased substantially in the post-SOX period
compared to the pre-SOX period.
Our regressions examining the differences in compensation between audit committees and compensation committees
are motivated by the idea that audit committees are more likely to be affected by the demand for monitoring of the
nancial reporting process, including the implications of SOX, than compensation committees. By using compensation
committees as a control group, we control for systematic shocks to the market for outside directors and rm-specic
factors. The regression analyses using the difference in compensation support the predictions that rms with a higher
demand for monitoring of the nancial reporting process are likely to pay a higher level of total compensation to audit
committees relative to compensation committees. Further, these analyses document statistically signicant increases in
the differences in total compensation and in the cash retainer component between the two committees from the pre- to the
post-SOX period. Additional analyses indicate that the signicant relations between the audit committee pay premium and
the demand for monitoring of the nancial reporting process exist only in the post-SOX period.
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In studying pay for audit committee members, we control for rm-wide factors that affect the overall level of director
compensation by comparing pay for audit committee members to pay for compensation committee members. Our
regression analyses suggest a pay premium of $1,248 in total compensation earned by audit committee members relative to
compensation committee members in the post-SOX period, in contrast to almost identical pay of the two committees in the
pre-SOX period. We note that this nding is surprisingly small in economic magnitude given the importance that
regulators, politicians, and the media have placed on audit committees in the post-SOX period. However, we argue that the
mere presence of within-rm director pay heterogeneity in the post-SOX period is of interest. Prior studies of director
paysee, for example, Farrell et al. (2008)have noted that rms design outside director compensation for a group of
directors, rather than tailoring compensation packages to the specic characteristics or outside opportunities of individual
directors. Variation in annual director pay at a given rm typically comes through service on different committees or as
committee chair or lead director.2 This approach to pay-setting seems to be quite different from that used for employees; in
many rms, there is substantial across-employee pay heterogeneity even within narrowly dened job categories (see Baker
et al., 1994). We also nd that following SOX, the premiums paid to audit committee members relative to compensation
committee members are related to the rm-specic proxy for the demand for monitoring of the nancial reporting process
and director-specic expertise in nancial reporting. These results suggest that rms are showing a willingness to deviate
from the historically prevalent one-size-ts-all approach to director pay, and to adjust director compensation packages to
the specic characteristics of individual directors. These ndings may be particularly notable in light of recent accounting
scandals that have raised questions about the effectiveness of audit committees. Given the role played by the audit
committee in overseeing the rms nancial reporting process, the incentives provided by compensation arrangements for
these directors seem to be taking on an increased importance.
The remainder of the paper is organized as follows: In Section 2 we review prior studies on compensation for outside
directors, and develop hypotheses. We discuss the sample and research methodology and provide descriptive statistics in
Section 3. We discuss our empirical approach and present the main empirical results in Section 4. Section 5 concludes the paper.
2. Related research and hypothesis development
2.1. Related research
Our research relates to two strands of literature: research on outside directors, and research on audit committees.
The vast majority of research on outside directors has focused on the determinants of board characteristics such as
composition or size and on how these board characteristics affect rm performance or observable actions of the board such
as CEO turnovers, the takeover market and executive compensation (see Hermalin and Weisbach, 2003, for a review).
Another line of research on outside directors, motivated by Fama and Jensens (1983) conjecture that reputation and the
market for directors are the primary incentive mechanisms for outside directors, focuses on directors accumulation of
seats on additional boards and directors turnover around circumstances such as nancial distress. Recently, with the trend
toward more equity-based compensation for outside directors, researchers have begun to examine compensation for
outside directors. Notably, Yermack (2004) studies incentives for outside directors by following a sample of directors for
ve years after election and tracking director compensation, changes in equity ownership by directors, other board seats
obtained and departures from the board. In contrast to Fama and Jensens (1983) hypothesis, he nds that incentives from
compensation and ownership account for more than half of total incentives for outside directors. This indicates the
importance of understanding compensation arrangements for outside directors.
Research on audit committees parallels research on boards of directors, and focuses on the determinants of audit
committee characteristics and how these characteristics are related to nancial reporting quality. Following the passage of
SOX, a growing number of papers have examined another feature of audit committeesthe inclusion of a director with
nancial expertise. For example, Defond et al. (2005) examine the market reaction to the appointment of nancial experts
on audit committees. However, few papers study the compensation and incentives of audit committee members. One
exception is Srinivasan (2005), who investigates whether audit committee members are held accountable for nancial
reporting failure by looking at director turnover and the loss of board positions in other companies when their companies
experience accounting restatements. In general, however, the incentives provided specically to audit committee members
have received little attention in the literature on directors. This is likely because, as noted above, differences in within-rm
director pay were small and relatively uncommon until recently.
Recently, Linck et al. (2009) extend the literature on outside directors by studying the effects of SOX on various
dimensions of corporate boards, including director workload, structure, risk, compensation and turnover. Our paper is
similar to Linck et al. (2009) in that we explore the impact of regulatory rules on director compensation. However, given
that the primary focus of SOX is on strengthening rms nancial reporting processes, the effects appear to weigh most
heavily on audit committees. Thus, we are able to investigate the broader issue by examining a more targeted group of
2
These within-rm sources of pay variation have typically been ignored in prior research. For example, Farrell et al. (2008) and Linn and Park (2005)
analyze pay for a representative director at each rm, and Yermack (2004) notes that he ignores committee fees and meeting fees in order to keep the data
collection and analysis tractable.
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outside directors. More importantly, our paper also addresses a more general question of the relation between
compensation for audit committees and demand for monitoring of the nancial reporting process.
2.2. Hypothesis development
Our primary objective is to examine cross-sectional variation in compensation for audit committees. In particular, we
are interested in how compensation arrangements of audit committees vary with the demand for monitoring of the
nancial reporting process in general and relative to the compensation of members of other board committees. In this
section, we discuss the channels through which the demand might affect the level of audit committee compensation, and
develop hypotheses about this relation. We also discuss the effects of audit committee director quality on audit committee
compensation.
We expect that the demand for monitoring of the nancial reporting process is high when a rm has complex business
operations and is subject to great risk of nancial misstatement. This setting requires outside directors who understand
nancial accounting issues in order to effectively monitor the nancial reporting process. One might expect that these
rms have a high demand for qualied directors and that the overall supply of such directors may be relatively limited. We
expect these forces to lead to higher compensation for directors serving on audit committees of rms with a high demand
for monitoring of the nancial reporting process.
In addition to being nancially literate, the outside directors serving on audit committees of rms with a high demand
for monitoring of the nancial reporting process are likely to spend more time and effort learning, communicating, and
understanding rms nancial reporting processes. Managerial productivity theory (Rosen, 1992) predicts a higher
reservation wage for directors serving on audit committees in this case.
Another channel through which a high demand for monitoring of the nancial reporting process might affect audit
committee compensation is the increased risk of misstatement that is likely to be present in such rms. Previous research
(Srinivasan, 2005) has suggested that audit committee members suffer reputation penalties as a result of nancial
reporting failure. Agency theory predicts that a risk-averse agent requires a higher risk premium when risk exposure is
greater. These arguments all suggest that there will be a positive relation between compensation paid to audit committees
and the demand for monitoring of the nancial reporting process.
The effects described above are likely to be exacerbated by recent nancial reporting failures and the concurrent
passage of SOX. As mentioned in the Introduction, SOX and the events leading to its passage have raised the demand for
monitoring of the nancial reporting process for all public companies: (1) SOX focuses on nancial reporting and audit
committees, requiring that all members of the audit committee be independent, and that the companys annual report
disclose whether a member of the audit committee is a nancial expert. These requirements are likely to lead to a decrease
in supply and an increase in demand for qualied directors serving on audit committees. (2) SOX and recent investor
pressure have increased the workload of audit committees substantially. Linck et al. (2009) nd that audit committees
meet more than twice as often post-SOX as they did pre-SOX, and that the average number of directorships held by a
director on the audit committee decreased signicantly. (3) SOX and the nancial reporting failures leading to SOX have
also increased the risk exposure of audit committees. Again, Linck et al. (2009) document that average Director and Ofcer
insurance premiums increased by more than 150%, and the proportion of rms that experienced audit committee turnover
has increased signicantly in the post-SOX period compared to the pre-SOX period. We therefore expect that compensation
for audit committees increases in the post-SOX period.
Finally, it seems reasonable to expect audit committee compensation to be related to both the demand for monitoring of
the nancial reporting process and the quality or expertise of audit committees. If this is true, one might argue that the
positive relation we hypothesize between audit committee compensation and the demand for monitoring of the nancial
reporting process could also reect a relation between compensation and audit committee quality. Thus, we include a
measure of audit committee nancial expertise in addition to the demand for monitoring of the nancial reporting proxies
in order to separately examine these effects in our regressions. If the relation is actually driven by committee nancial
expertise, we expect this effect to be captured by the expertise variable. We hypothesize that both audit committee
nancial expertise and the overall demand for monitoring of the nancial reporting process will be positively related to
audit committee compensation.
3. Sample, research methodology and descriptive statistics
3.1. Sample and data
We identify the sample of outside directors using ExecuComp rms covering the period from 2000 to 2004.3 Following
previous studies on outside directors (Adams, 2003; Yermack, 2004), we exclude utilities (2-digit SIC 49) and nancial
institutions (1-digit SIC 6) from the sample because these rms tend to have different corporate governance structures than
rms in non-regulated industries (Macey and OHara, 2003).
3
2000 is the rst year that audit fee data are publicly available for US public companies.
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We then collect data on fees paid to members of audit and compensation committees of the board from corporate proxy
statements. Specically, we collect data on the annual cash retainer and equity retainer, the number of stock option grants,
the number of stock grants, and the meeting fees paid to directors serving as chair of the audit committee, members of the
audit committee, chair of the compensation committee, and members of the compensation committee, respectively.4
Following Yermack (2004), we assume that when directors can choose between cash retainer and equity retainer, they
choose the maximum amount of cash pay permitted.5 For equity compensation awarded upon election as directors, we
assume that the awards are made equally through the terms of the directorship. However, we exclude one-time/special/
discretionary equity-based awards made on an irregular schedule, such as the one-time equity award when a director joins
the board. We also do not consider insurance plans, retirement plans and charity matching contributions in the
compensation packages. We value stock grants by multiplying the number of shares by the closing stock price. For the value
of stock option awards, if the proxy statement discloses the number of stock options awarded, we use the BlackScholes
method to compute the value of option awards assuming that rms issue at-the-money options at the end of the scal year
and with a seven-year maturity. Volatility and dividend yields for each rm-year are obtained from the ExecuComp
database. If the proxy statement only discloses the dollar value of options, then we use the dollar value. In addition, we
obtain information on CEO characteristics (i.e., tenure, equity ownership and role on board), other board-related data (e.g.,
director independence and audit committee chair ag) from IRRC (the corporate governance database maintained by the
Investor Responsibility Research Center), and collect number of committee meetingsduring the year, audit fee data, and the
background information of audit committee chairs from proxy statements.
To be included in the sample, nancial and stock return data must be available from Compustat and CRSP, and data on
the parameters of the BlackScholes option pricing model must be available from ExecuComp. This screening procedure
leaves us with an initial sample of 5,465 rm-year observations. We conduct our basic regressions of the key relations with
controls for various rm-specic characteristics on this broader sample. For our analyses that also control for audit
committee nancial expertise and those variables suggested by bargaining theory to explain compensation for audit
committees, we also require that certain CEO and board member data be available from IRRC. This reduces the sample to
3,295 rm-year observations, an average of roughly 660 rms per year over the ve-year sample period.6
3.2. Research methodology

3.2.1. Variable measurement
In this section, we describe the measurement of audit and compensation committee compensation (our dependent
variables), and our proxies for the demand for monitoring of the nancial reporting process and audit committee quality.
Committee compensation measures. Annual compensation for audit and compensation committees is composed of ve
components: cash retainer, equity retainer, stock grants, option grants and meeting fees. In our empirical analysis, we focus
on total compensation, along with the cash component of total compensation, cash retainer. Total compensation in the
regression analyses is measured as the sum of these components with the exception of meeting fees.7 Since the
compensation variables are highly right skewed, we use a logarithmic transformation. We collect compensation
information for both the audit and compensation committee chairs and the other members of these committees. In many
instances, committee chairs receive additional compensation recognizing the typically substantial additional effort chairs
exert in preparation for meetings. In our main analyses, we focus on the chairs of audit committees (and chairs of
compensation committees, in the difference regressions). Results based on committee members are similar.
Demand for monitoring of the nancial reporting process proxies. We use two proxies to capture the demand for
monitoring of a rms nancial reporting process. Our rst proxy is the amount of audit fees charged by the outside
auditors for performing the rms annual audit services (AuditFee). Our second proxy, PostSOX, captures the demand for
monitoring of the nancial reporting process relating to a regulatory shift in the overall demand for monitoring of the
nancial reporting processthe passage of the Sarbanes-Oxley Act. We elaborate on these proxies below.
4
Stock option awards include options and SARs; stock awards include common stock, restricted stock, deferred stock units and phantom stock units;
meeting fees include attending both board and committee meetings, but special committee meeting fees are excluded. The following committees are
dened as audit committee: audit committee, audit and legal committee, audit review committee, audit and ethics committee, audit and afliated
transactions committee, audit and compliance committee, audit and public policy committee. The following committees are dened as compensation
committee: compensation committee, executive salary committee, compensation and stock option committee, compensation policy committee,
organization and compensation committee, compensation and leadership committee, compensation, benets and stock option committee, compensation
and incentive committee, etc.
5
The retainer paid for special committees formed for special reasons is excluded. We also note that results are not sensitive to instead assuming that
directors choose the maximum amount of equity pay permitted.
6
We note that the use of the ExecuComp and IRRC databases results in a sample of rms that are, on average, larger in size (market value and sales)
than the average Compustat rm. We note that our sample rms, with a mean (median) market value of $7,600 (1,313) million and a mean (median) sales
of $5,000 (1,156) million, are considerably larger than the CRSP/Compustat rms, whose mean (median) market value and sales are $2,475 (98) million
and $1,923 (99) million, respectively. The use of this sample, however, allows for comparability with the large number of related studies that draw from
the ExecuComp and IRRC databases. Nonetheless, our results must be interpreted in the context of our relatively large sample rms.
7
We exclude meeting fees from the compensation variables to avoid a mechanical relation with one of our key control variables, the number of audit
committee meetings. We discuss this and other issues relating to the audit meetings variable in Section 4.
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As discussed earlier, our main hypothesis is that audit committee compensation is positively related to the demand for
monitoring of the rms nancial reporting process. One way to examine this hypothesis would be to identify factors that
affect the demand for monitoring and regress compensation on those factors. While some of these factors are
observablefor example, size and industryothers, such as the risk of nancial misstatement and the complexity of the
rms organizational structure, are more difcult for researchers to capture. As a result, a regression of audit committee
compensation on the observable rm-specic factors that determine the demand for monitoring is likely to omit some
relevant factors.
To incorporate unobservable factors that inuence the demand for monitoring, we consider the relation between audit
committee compensation and the audit fees paid to auditors. We argue that both are likely to be positively related to
factors that increase the demand for monitoring. For example, our earlier arguments suggest that rms with high risk of
misstatement or complex organizational structures will likely ask for more effort from audit committee members, and thus
pay higher compensation. Similarly, we note that the extent of work and billings by the audit rm is expected to be linked
with many rm-specic forces that give rise to the demand for monitoring of the nancial reporting process, including the
complexity of the business and the rms organizational structure, the strength of internal control systems, nancial
reporting quality and litigation risk.8 These factors inuence the overall transparency and riskiness of the nancial
reporting process, which impacts the scope and complexity of the annual audit activities, and the risk premium required by
auditors. A regression of audit committee compensation on audit fees is therefore predicted to yield a positive coefcient,
as audit fees proxy for rm-specic variation in the demand for monitoring of the nancial reporting process.
Such a regression may suffer from simultaneity bias if auditor effort and audit committee effort are substitutes or
complements in the rms objective function. For example, auditor effort might make audit committee effort more
valuable; in this case, the rms optimal choice of audit committee effort would be an increasing function of auditor effort.
This would suggest a direct causal link between audit committee compensation and audit fees. Econometrically, this
scenario would require modeling audit committee pay and audit fees as a system of simultaneous equations. As
Wooldridge (2002) points out, however, a system of equations need not be simultaneous, even when two choice variables
are regressed on similar economic factors.9 It is possible that ordinary least squares (OLS) is appropriate when both audit
fees and audit committee compensation are positively related to factors that increase the demand for monitoring.
Accordingly, as we discuss in more detail later, we perform a Hausman test to assess whether the endogeneity of audit fees
in our setting poses a threat to the OLS estimates.
In determining annual audit fees from corporate proxy statements, we include only fees directly related to auditing
services (including internal control analyses) and exclude fees related to supplemental and tax work. We scale audit fees by
the square root of total asset value of the rm based on the ndings of Simunic (1980) and Kinney et al. (2004) that the
square root function best captures the relation between audit fees and assets. Size deation allows us to ensure that our
ndings are not driven solely by the well established association between compensation and size (see, for example, Rosen,
1992; Murphy, 1985).10
In selecting total assets as a size deator, we are careful not to purge our demand for monitoring proxy of its key
attributes. Audit fees can be viewed as the product of quantity (Q) and price (P) of audit labor hours, where Q captures the
number of audit hours in the engagement and P reects the audit rms price per unit of auditing. The price component is
further impacted by both the mix of labor units (i.e., class of labor) and billing rates for each class of labor chosen by the
audit rm. We can thus expand the basic audit fees equation to be
Total Audit Fees
n
X
i1
Hours
of labor units
for class of labor}i Billing rate per hour for class of labor i
|
{z
|{z}
Quantity
Price
where i audit class of labor (e.g., staff, senior, partner).

We argue that both the quantity and price components of audit fees chosen by the audit rm are impacted by rm size,
complexity and risk. The empirical ndings of OKeefe et al. (1994) largely support these relations. Thus, deating audit fees
by rm size preserves the key elements of interestrm complexity and riskthrough both the price and quantity in our
proxy for the demand for monitoring of the nancial reporting process.
Our sample period includes the years 20002004. This sample period allows us to develop an additional proxy for the
demand for monitoring of nancial reporting arising from an important external regulatory eventthe passage of the
Sarbanes-Oxley Act. While audit fees in the post-SOX period can capture some aspects of increased demand for nancial
8
See, for example, prior work by OKeefe et al. (1994), Bell et al. (2001) and Danielsen et al. (2007).
See chapter 9 of Wooldridge (2002) for a discussion of structural models and systems of simultaneous equations. Wooldridge (2002) cites Biddle
and Hamermesh (1990) as an example of a study that considers the responses of two choice variables to the same factors. Biddle and Hamermesh (1990)
conduct an OLS regression of one choice variable (minutes per week spent sleeping) on another (minutes per week working). They note that their results
suggest that the time spent sleeping is changed by the indirect effects of the economic factors on decisions about work time.
10
Because size may also capture the complexity of the rms nancial reporting system, one might argue that the undeated audit fee variable is an
appropriate demand proxy. While our primary model includes a size variable (i.e., market value) in the regressions, we address this issue by also
conducting our analyses using the logarithm of undeated audit fees as the demand proxy. All regression results using the undeated audit fees measure
are qualitatively similar to those in Tables 57.
9
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monitoring due to SOXfor example, requirements relating to internal control disclosures and testingit is possible that
factors relating to the enhanced monitoring environment, greater board accountability, and increased credential
requirements directed at audit committee members are not fully reected in the audit fee variable. Following SOX and
the events leading to its passage, audit committee members are also likely to spend more time communicating with
outside auditors, as well as additional time and effort communicating with and monitoring internal auditors and nancial
executives of the company. SOX was signed into law on July 31, 2002; thus we dene our PostSOX indicator variable to equal
zero for years 2000 and 2001, and to equal one for years 2002 through 2004.11
Audit committee expertise in monitoring of the nancial reporting process. We develop a measure, AC_Expertise, that
captures the extent of audit committee expertise based on information about the audit committee chairs background
described in corporate proxy statements. In classifying the background of audit committee chairs, we are guided in part by
both the proposed and nal denitions of nancial expertise of audit committee members under the Sarbanes-Oxley Act.
Initial SOX proposals dened a nancial expert as a director with prior or current experience as a public accountant,
auditor, principal or chief nancial ofcer, controller or chief accounting ofcer. Final regulations expanded this denition
to include a broader set of experience, including supervision or oversight of employees with nancial reporting duties. This
broader category would include corporate presidents and chief executive ofcers. We also consider the ndings of Defond
et al. (2005), which highlight the distinction between accounting and non-accounting nancial experts. Using a sample of
702 announcements of audit committee director appointments over the period 19932002, Defond et al. (2005) document
a signicant positive market reaction to announcements of accounting nancial expert appointments, while the market
reaction to similar announcements of non-accounting nancial experts is not signicant.
Using biographies included in corporate proxy statements, we categorize the employment experience and background
of audit committee chairs as follows:
Non-nancial director (Non_Financial_Expert)Audit committee chairs with no direct nancial training or experience.

This category includes directors with responsibility to oversee the nancial reporting process but who do not have
direct experience in a nancial position themselves. AC_Expertise takes a value of 1 for these directors.
Finance nancial expert (Expert_Finance)Audit committee chairs with nancial training and experience, including
chief nancial ofcers, vice-presidents of nance, and nance professors. AC_Expertise takes a value of 2 for these
directors.
General accounting nancial expert (Expert_Accounting_General)Audit committee chairs with accounting training and
experience, including certied public accountants (CPAs), chief accounting ofcers, controllers, accounting professors
and those who served on accounting standard or other oversight boards. Accounting experts with employment
experience with a Big 5(4) accounting rm are excluded; these directors are separately considered in the next category.
AC_Expertise takes a value of 3 for these directors.
Accounting expert with Big 5(4) employment experience (Expert_Accounting_Big 5)Audit committee chairs with
employment experience at a Big 5(4) accounting rm.12 This category is designed to capture a higher quality accounting
expert, as Big 5(4) accountants are more likely to have direct experience with the nancial reporting process of public
rms. AC_Expertise takes a value of 4 for these directors.
Our classication highlights rms that have explicitly chosen an audit committee chair with nancial reporting
expertise. We note that our classications of both nance and accounting experts are narrower than those of both the
proposed and nal SOX regulations. We have attempted to identify rms that have chosen directors with greater ability to
specically monitor the nancial reporting process vs. those with more broad nance skills and training.
3.2.2. Regression specications
Our rst set of analyses explores factors associated with the level of audit committee compensation. Since our tests use
panel data, we include rm xed effects in our regressions and estimate robust standard errors to mitigate potential
problems with the panel data. We include AuditFee and PostSOX to capture the demand for monitoring of the nancial
reporting process.
Similar to Linck et al. (2009), we select control variables mainly based on agency theory and bargaining theory. While
agency problems are generally dened as the conict between shareholders and managers, agency problems could also
exist between shareholders and outside directors. Agency theory suggests that compensation should provide incentives to
align the interests of the parties. Thus, it predicts relations between compensation and effort, rm performance, job
complexity, and leverage.
We use the number of times the audit committee of the board of directors met during the year (AuditMeet) disclosed in
the rms proxy statement to reect the effort and workload of audit committees. One might argue that the number of
11
The use of annual data determines how we partition the sample period. We nd qualitatively similar results for all of our regression analyses (1)
when we exclude year 2002 observations in the empirical tests to address the concern that the year 2002 is a transition year, and (2) when we dene the
post-SOX period as years 2003 and 2004.
12
Big 5(4) refers to the ve (four) largest global professional accounting rms that perform a substantial majority of audits of publicly traded rms.
The number of global rms was reduced from ve to four during our sample period due to the collapse of Arthur Andersen in 2002 following Enron.
ARTICLE IN PRESS
143
audit committee meetings is also an indicator of the overall demand for monitoring of the rms nancial reporting
process. Firms with greater demand for monitoring of the nancial reporting process are those that are willing to incur the
increased costs of a more active audit committee. Menon and Williams (1994) document that the number of annual audit
committee meetings is positively associated with rm size, suggesting a connection between monitoring complexity and
the need for greater audit committee involvement. The number of audit committee meetings is also often used as a proxy
for audit committee diligence.13
We use industry-median-adjusted stock returns and industry-median-adjusted ROA (return on assets) to control for the
potential impact of rm performance on compensation. We control for rm size (measured as the logarithm of market
value of equity), research and development costs (measured as R&D expenditures deated by total assets), and market-tobook ratio (measured as book value of assets minus book value of equity plus market value of equity divided by book value
of assets). We dene leverage as short term and long term debt scaled by total assets, and we capture cash constraints and
the tax advantages of options by including a zero dividend dummy and a net operating loss carryforward dummy (Yermack,
2004).14 Finally, in regressions without rm xed effects, we include a control for an increased demand for monitoring that
is driven by the strength of the rms internal controls over the nancial reporting process. MatlWeak takes a value of 1 for
all sample rm-years if the rm disclosed the existence of a material weakness in internal control under SOX.15
Alternatively, bargaining theory suggests that director compensation is determined by the negotiation process between
the board and the CEO (see Hermalin and Weisbach, 1998 for theory, and see Ryan and Wiggins, 2004 for empirical
evidence). Following that literature, we use the percentage of independent directors on the board and the ownership of
outside directors to measure the boards negotiation power. To capture the CEOs bargaining power, we use CEO tenure,
ownership, and a dummy variable equal to one if the CEO chairs the board.
Our second set of regression analyses examines audit committee compensation relative to compensation committee
members. One potential challenge in conducting multivariate analyses is the possibility of correlated omitted variables.
Because some data are unobservable or unavailable, we cannot include all rm-specic variables in the regression model. It
is possible that these unobservable factors might contaminate the statistical relationship. To address this concern, we run
difference regressions that analyze the compensation variables for audit committees relative to compensation committees.
Thus, we are able to use outside directors serving on compensation committees as a control group to control for
unobservable rm-specic factors that may be associated with board member compensation across rms.
It is possible that other factors occurring around the time of the SOX legislation, including general macroeconomic
conditions, pressure from more active institutional investors, and changes in the publics view of corporate governance,
may have contributed to the passage of SOX. However, given that the primary focus of SOX is on rms nancial reporting
processes, directors on the audit committee are likely to be affected more by SOX. As such, another appealing feature of the
difference specication is the use of outside directors serving on the compensation committee as a control group to control
for these factors.16
3.3. Descriptive statistics
Table 1 presents summary statistics relating to the compensation of audit committee members.17 Panel A presents the
level of compensation and the key components of the compensation packages for outside directors serving as chair of the
audit committee and other members of the audit committee. We observe that the equity component (equity retainer,
options and equity grants) of total compensation is, on average, greater than the cash component (cash retainer and
meeting fees). We also note that the average and median compensation (in total and by component) is slightly greater for
the audit committee chair than for other members of the audit committee. For example, the average (median) total
compensation is $140,912 ($97,000) for the audit committee chair and $135,451 ($91,459) for other members.
Panel B shows the time series variation in compensation and its components from 2000 to 2004 for the chair of the
audit committee. The average (median) total compensation for the audit committee chair is $138,474 ($104,651) in the
13
See Vera-Munoz (2005) and DeZoort et al. (2002) for insightful discussions and reviews of the related literature on audit committee effectiveness,
including diligence.
14
The zero dividend dummy is equal to one if a rm pays a dividend (Compustat data26). The net operating loss carryforward dummy is equal to one
if a rm has a net operating loss carryforward (Compustat data52).
15
We thank Doyle, Ge and McVay for sharing their dataset of rms disclosing material internal control weakness under Sections 302 and 404 of SOX.
Doyle et al. (2007) use SEC electronic lings of annual 10-Ks and subscription data from Compliance Week to identify material weakness disclosures by
rms over the period August 2002 through the end of our sample period.
16
While SOX focuses mainly on the nancial reporting process, it is possible that other SOX requirements (e.g., independence of compensation
committee members) could impact the level of compensation committee pay in some rms. We would expect any such effect to be less substantial than
the effect on audit committees and not linked with the demand for monitoring of the nancial reporting process. However, if SOX requirements do
increase compensation committee pay, any pay differential for audit committee members would be reduced, making it harder for us to document a link
between the audit committee pay differential and the demand for monitoring. We note that the recent expanded Compensation Discussion and Analysis
disclosures in corporate proxy statements required by the SEC, which would likely have a greater impact on the risk and required effort of compensation
committee members, were implemented subsequent to our 20002004 sample period (specically, these disclosures were required in proxy statements
led after December 15, 2006).
17
All compensation, audit fees, and price-level variables are in real (vs. nominal) terms, adjusted using the GDP price deator index with 2004 as the
base year.
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144
Table 1
Summary statistics: audit committee compensation.
Panel A: Compensation statistics for audit committees
N
Q1
Mean
Median
Q3
Std.
Audit committee chair

Total compensation (incl. meeting fees)
Total compensation (no meeting fees)
Cash retainer
Equity retainer
Options
Equity grants
Meeting fees
5,465
5,465
5,465
5,465
5,465
5,465
5,465
57,176.40
51,000.00
16,500.00
0.00
0.00
0.00
0.00
140,912.20
134,544.21
29,449.76
6,346.22
90,104.43
8,643.79
6,367.99
97,000.00
89,360.02
26,666.60
0.00
37,272.22
0.00
4,746.72
156,488.13
149,774.98
39,762.80
0.00
97,451.42
0.00
9,295.20
290,335.08
290,384.75
19,847.70
17,355.51
291,276.91
23,309.42
7,221.82
Audit committee member

Total compensation (incl. meeting fees)
Total compensation (no meeting fees)
Cash retainer
Equity retainer
Options
Equity grants
Meeting fees
5,465
5,465
5,465
5,465
5,465
5,465
5,465
54,000.00
48,028.55
15,492.00
0.00
0.00
0.00
0.00
135,451.46
129,728.28
26,249.10
5,845.21
88,990.18
8,643.79
5,723.18
91,459.27
84,377.57
24,787.20
0.00
36,901.63
0.00
4,315.20
150,241.28
144,084.60
35,000.00
0.00
96,700.35
0.00
8,454.40
289,279.54
289,393.44
17,385.20
16,216.99
291,236.71
23,309.42
6,229.34
Panel B: Time series compensation statistics for audit committee chair

2000
2001
2002
Total compensation
(incl. meeting fees)
Total compensation
(no meeting fees)
Cash retainer
2003
2004
Pre-SOX
Post-SOX
Pre-/Post-SOX difference
6,833.69
22,135.04a
10,776.35
18,705.54a
8,250.61a
7,980.00a
Equity retainer
Mean
Median
Mean
Median
Mean
Median
Mean
150,278.61
73,615.09
146,589.80
70,175.11
24,090.15
22,020.00
5,464.07
141,236.05
88,187.52
137,286.51
81,848.57
24,186.47
21,576.00
5,776.79
109,560.99
79,260.00
103,718.84
72,070.42
26,497.22
24,306.40
5,851.98
150,629.69
111,489.86
142,394.20
102,887.18
32,754.78
30,596.70
6,572.32
156,107.93
124,337.60
146,792.09
111,804.13
38,170.97
35,000.00
7,839.45
145,307.52
82,515.48
141,475.38
77,228.09
24,143.10
22,020.00
5,635.98
138,473.83
104,650.52
130,699.03
95,933.63
32,393.72
30,000.00
6,740.24
Options
Median
Mean
0.00
111,511.84
0.00
101,957.36
0.00
65,970.46
0.00
93,170.06
0.00
84,578.62
0.00
106,259.32
0.00
81,142.25
Median
Mean
Median
Mean
Median
27,711.35
5,523.75
0.00
3,688.81
3,303.00
878
38,639.65
5,365.89
0.00
3,949.53
3,236.40
1,072
29,971.20
5,399.17
0.00
5,842.16
4,755.60
1,193
47,743.77
9,897.05
0.00
8,235.49
7,229.60
1,178
40,944.41
16,203.06
0.00
9,315.83
8,000.00
1,144
33,626.40
5,436.97
0.00
3,832.14
3,236.40
1,950
38,474.90
10,422.83
0.00
7,774.80
6,340.80
3,515
Equity grants
Meeting fees
N
1,104.25b
0.00
25,117.07b
4,848.50
4,985.86a
0:00a
3,942.65a
3,104.40a
Total compensation includes cash retainer, equity retainer, options, equity grants. Meeting fees are included in the rst total compensation measure but
not the second. Options include stock options and SARs. Equity grants include common stock, restricted stock, deferred stock units and phantom stock
units. Meeting fees include fees for attending both board and committee meetings; special committee fees are excluded. All compensation data are pricelevel adjusted using the GDP price deator index with 2004 as the base year. Pre-SOX = years 2001 and 2001. Post-SOX = years 20022004. t-tests used to
test differences in the pre- and post-SOX mean; Wilcoxon two-sample tests used to test differences in the pre- and post-SOX median. a, b, and c denote
signicance of coefcients at the 1%, 5%, and 10% levels, respectively.
post-SOX period, compared to $145,308 ($82,515) in the pre-SOX period. Despite the decline in average total compensation,
the components of total compensation generally increase over time. We note signicant increases (at better than the 1%
level) from the pre-SOX to the post-SOX period in the levels of each of the components of total compensation, with the
exception of the value of options, which experienced a decline in value from the pre-SOX to the post-SOX period. This
reduction in the value of options granted to committee members is due primarily to the signicant drop in the value of
stock options granted in 2002. The component with the largest percentage increase is the cash retainer: the average total
cash retainer is $32,394 in the post-SOX period, compared to $24,143 in the pre-SOX period.
Table 2 provides summary compensation statistics for compensation committees. Panel A presents the level of total
compensation excluding meeting fees and the level of total cash retainer for outside directors serving as chair of the
compensation committee and other members of the compensation committee. When we compare these statistics for
compensation committees with those for audit committees in Table 1, we note that outside directors on audit committees
are in general paid more than outside directors on compensation committees. For example, mean (median) total
compensation for the chair of the compensation committee is $133,311 ($87,946), compared to $140,912 ($97,000) for the
audit committee chair.
Panel B shows the time series variation in compensation variables from 2000 to 2004 for the chair of the compensation
committee and the difference between audit and compensation committee chairs. We dene the difference variables as
compensation variables for audit committees less compensation variables for compensation committees. When we
compare the ination-adjusted levels of compensation for audit committees and compensation committees, we note that
while the level of compensation for compensation committees is comparable to that for audit committees in the pre-SOX
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Table 2
Summary statistics: compensation committee compensation.
Panel A: Compensation statistics for compensation committees
N
Q1
Compensation committee chair
Total compensation
5,465
Cash retainer
5,465
Compensation committee member
Total compensation
5,465
Cash retainer
5,465
Panel B: Time series compensation statistics
2000
Mean
Median
Q3
Std.
50,090.80
16,182.00
133,311.32
28,566.38
87,945.73
25,891.20
147,640.00
38,500.00
290,272.40
19,344.51
47,931.43
15,492.00
12,9,542.01
26,169.62
84,401.74
24,772.50
14,3,921.16
35,000.00
28,9,441.09
17,519.67
2001
2002
Compensation committee chair

Total compensation
Mean
146,870.51 137,032.81 103,249.79
Median
70,175.11
81,596.33
71,808.54
Cash retainer
Mean
24,314.02
24,192.78
26,202.07
Median 22,020.00
21,576.00
23,778.00
Difference between audit and compensation committee chairs
Total compensation
Mean
280.71
253.70
469.04
Median
0.00
0.00
0.00
Cash retainer
Mean
223.87
6.30
295.15
Median
0.00
0.00
0.00
N
878
1,072
1,193
2003
2004
Pre-SOX
Post-SOX
140,450.65
102,127.34
31,363.21
28,402.00
143,415.24
109,984.97
35,513.94
33,166.65
141,462.30
77,046.06
24,247.37
22,020.00
128,789.45
94,723.92
30,962.41
28,000.00
12,672.85
17,677.86
6,715.04a
5,980.00a
1,943.56
0.00
1,391.58
0.00
1,178
3,376.85
0.00
2,657.03
0.00
1,144
13.08
0.00
104.27
0.00
1,950
1,909.59
0.00
1,431.31
0.00
3,515
1,896.51a
0:00a
1,535.57a
0:00a
Total compensation includes cash retainer, equity retainer, options, and equity grants, but excludes meeting fees. Options include stock options and SARs.
Equity grants include common stock, restricted stock, deferred stock units and phantom stock units. All compensation data are price-level adjusted using
the GDP price deator index with 1,998 as the base year. Pre-SOX = years 2001 and 2001. Post-SOX = years 20022004. t-tests used to test differences in
the pre- and post-SOX mean; Wilcoxon two-sample tests used to test differences in the pre- and post-SOX median. a, b, and c denote signicance of
coefcients at the 1%, 5%, and 10% levels, respectively.
period, the level of compensation for audit committees exceeds that of compensation committees in the post-SOX period.
The mean (median) difference in total compensation excluding meeting fees between the two committees is $13 ($0) in the
pre-SOX period, and $1,910 ($0) in the post-SOX period. The increase in the difference from the pre-SOX period to the postSOX period is statistically signicant at better than the 1% level. We note that while the $1,910 premium is small in
magnitude, the presence of within-rm director pay heterogeneity in the post-SOX period appears to represent a shift in
director pay patterns. We also note that the pay premium in those rms that do deviate from the historically prevalent
uniform pay to directors is larger than the mean of $1,910, given that the median of the pay premium is zero.
Table 3 displays the summary statistics (Panel A) and the time-series trend (Panel B) of audit fees, board/committee
meetings, and audit committee chair expertise. Panel A notes that the average (median) number of audit committee
meetings is 6.6 (6.0) per year, which exceeds that of the compensation committee (4.3 (4.0)). Consistent with Linck et al.
(2009), we nd overall increases in the number of annual committee meetings over the sample period (20002004). Panel
B shows that the average number of total committee meetings is 16.88 in the post-SOX period, signicantly higher than the
11.38 meetings in the pre-SOX period. The number of audit committee meetings shows a similar impressive increase: the
average number of audit committee meetings is 7.71 in the post-SOX period, compared to 4.52 in the pre-SOX period.18
These differences are statistically signicant at better than the 1% level. While we also observe a signicant increase in the
number of compensation committee meetings from the pre-SOX to the post-SOX period, the magnitude of the increase is
much smaller (average of 3.8 meetings pre-SOX vs. 4.6 in the post-SOX period) than that of the audit committee. Another
notable trend is in audit fees: Audit fees have increased signicantly from an average of $1.164 million in the pre-SOX
period to $2.289 million in the post-SOX period, and the ratio of audit fees to the square root of total assets has increased
signicantly from 0.61 in the pre-SOX period to 1.17 in the post-SOX period (see Ghosh and Pawlewicz, 2008; Grifn and
Lont, 2008 for similar ndings on changes in audit fees around SOX).
Table 3 also reports signicant increases in the number of audit committee chairs that have both nance and accounting
expertise, with the largest increase in Expert_Accounting_Big5, the category of audit committee chairs with employment
experience at a Big 5(4) accounting rm. While the vast majority of sample rms continue to have audit committee chairs
without nancial expertise, the percentage of rms with non-nancial chairs has declined signicantly from 83% in the
pre-SOX period to 73% in the post-SOX period. The percentage of rms with nance nancial experts increased from 11% in
the pre-SOX period to 15% in the post-SOX period. The percentage of rms with accounting experts (both general and Big
5(4)) doubled from 6% to 12% from the pre-SOX period to the post-SOX period with the largest increase in the Big 5 expert
18
The increase in the number of audit committee meetings per year is likely due, in part, to the new required communication between auditors and
audit committees.
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Table 3
Summary statistics: rms audit fees and board committee meetings.
Panel A: Summary statistics
N
Q1
Mean
Median
Q3
Std.
Audit fees and board meetings

Audit fees (undeated)
AuditFee
Total board meetings
Audit committee meetings
Compensation committee meetings
5,465
5,465
5,465
5,465
5,465
377.58
0.43
9
4
3
1,887.5
0.97
14.92
6.57
4.31
779.64
0.72
14
6
4
1,859.04
1.22
19
8
6
3,830.97
0.89
7.98
3.38
2.55
Audit committee chair expertise

Non_Financial_Expert
Expert_Finance
Expert_Accounting_General
Expert_Accounting_Big5
AC_Expertise
3,473
3,473
3,473
3,473
3,473
1
0
0
0
1
0.76
0.14
0.04
0.06
1.40
1
0
0
0
1
1
0
0
0
1
0.43
0.35
0.21
0.23
0.81
Panel B: Time series statistics
Audit fees and board meetings

Audit fees (undeated)
AuditFee
Total board meetings
Audit committee meetings
Compensation committee meetings
2000
2001
2002
2003
2004
Pre-SOX
Post-SOX
Mean
Median
Mean
Median
Mean
Median
Mean
Median
Mean
Median
1,121.74
509.21
0.59
0.47
11.06
10
4.24
4
3.87
4
878
1,198.81
530.68
0.63
0.52
11.64
10
4.75
4
3.75
4
1,072
1,641.66
685.93
0.84
0.69
14.18
13
6.52
6
4.04
4
1,193
1,968.5
835.73
0.97
0.79
17.2
16
7.83
8
4.56
4
1,178
3,293.51
1,645.1
1.71
1.47
19.37
18
8.84
8
5.2
5
1,144
1,164.11
523.79
0.61
0.49
11.38
10
4.52
4
3.8
4
1,950
2,288.81
978.06
1.17
0.9
16.88
16
7.71
7
4.59
4
3,515
1,124.70a
454.27a
0.56a
0.41a
5.51a
6.00a
3.20a
3.00a
0.79a
0.00a
Mean
Median
Mean
Median
Mean
Median
Mean
Median
Mean
Median
0.85
1
0.1
0
0.03
0
0.03
0
1.23
1
385
0.81
1
0.12
0
0.03
0
0.04
0
1.29
1
657
0.8
1
0.13
0
0.03
0
0.04
0
1.32
1
746
0.75
1
0.14
0
0.05
0
0.06
0
1.42
1
826
0.66
1
0.18
0
0.07
0
0.09
0
1.6
1
859
0.83
1
0.11
0
0.03
0
0.03
0
1.27
1
1,042
0.73
1
0.15
0
0.05
0
0.07
0
1.45
1
2,431
0.10a
0.00a
0.04a
0.00a
0.02a
0.00a
0.03a
0.00a
0.18a
0.00a
N
Audit committee chair expertise
Non_Financial_Expert
Expert_Finance
Expert_Accounting_General
Expert_Accounting_Big5
AC_Expertise
N
Audit fees are in thousands of dollars and include annual fees directly related to auditing services. Audit fees do not include audit-related fees, tax fees,
and all other fees. AuditFee audit fees/square root of total assets. Audit fees and total assets are price-level adjusted using the GDP price deator index
with 2004 as the base year. Non_Financial_Expert 1 if the audit committee chair has no direct nancial training or experience. Expert_Finance 1 if the
audit committee chair has nancial training and experience. Expert_Accounting_General 1 if the audit committee chair has accounting training and
experience, but excludes those with Big 5(4) accounting rm employment experience. Expert_Accounting_Big5 1 if the audit committee chair has
employment experience at a Big 5(4) accounting rm. AC_Expertise 1 if Non_Financial_Expert 1; 2 if Expert_Finance 1; 3 if
Expert_Accounting_General 1; and 4 if Expert_Accounting_Big5 1. Pre SOX years 2001 and 2001. Post SOX years 20022004. t-Tests used to
test differences in the pre- and post-SOX mean; Wilcoxon two-sample tests used to test differences in the pre- and post-SOX median. a, b, and c denote
signicance of coefcients at the 1%, 5%, and 10% levels, respectively.
category (increased from 3% to 7%). The increases in the percentage of experts in each category result in the aggregate
expertise variable, AC_Expertise, increasing from 1.27 in the pre-SOX period to 1.45 in the post-SOX period. These increases
are statistically signicant at better than the 1% level, suggesting that more boards have chosen to increase the level of
nancial expertise of their audit committees by appointing directors with nance and, especially, accounting experience
after the passage of SOX.
Table 4 lists summary statistics for the control variables capturing the determinants of directors compensation
suggested by contracting theory and bargaining theory. With regard to the determinants related to contracting theory, we
rst note that our sample rms perform better than their industry peers, with an average industry-adjusted accounting
return of 6% and industry-adjusted stock return of 17%.19 On average, our sample rms spend 4% of their total assets on
19
Industry adjustments are computed using CRSP/Compustat rms as a comparison group, dening industry based on two-digit industry codes.
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Table 4
Summary statistics: control variables.
N
Q1
Mean
Median
Q3
Std.
ROA_Ind
Return_Ind
RD
MV
Leverage
DivDum
NOLDum
M=B
MatlWeak
5,465
5,465
5,465
5,465
5,465
5,465
5,465
5,465
5,465
0.00
0.15
0.00
527.00
0.01
0.00
0.00
1.21
0.00
0.06
0.17
0.04
7,600.34
0.19
0.46
0.36
2.06
0.16
0.05
0.07
0.00
1,312.73
0.17
0.00
0.00
1.59
0.00
0.11
0.34
0.05
4,153.60
0.29
1.00
1.00
2.32
0.00
0.19
0.60
0.07
26,876.59
0.18
0.50
0.48
1.59
0.37
IndDirOwn%
CEOTen
CEOOwn%
CEO=Chair
BdInd%
3,295
3,295
3,295
3,295
3,295
0.19%
3.00
0.09%
0.00
57.14%
3.80%
7.59
1.93%
0.66
68.18%
6.84%
5.00
0.28%
1.00
70.00%
2.39%
10.00
1.00%
1.00
80.00%
9.57
7.03
5.50
0.47
15.65
ROA_Ind industry-median-adjusted return on assets. Return_Ind industry-median-adjusted stock return. RD research and development
expenditures/total assets. MV market value ($millions, price-level adjusted using the GDP price deator index with 2004 as the base year).
Leverage short term and long term debt)/total assets. DivDum 1 if rm pays a dividend. NOLDum 1 if rm has a net operating loss carryforward. M=B market value/book value. MatlWeak 1 if rm disclosed material weaknesses in internal controls in response to SOX Sections 302
and 404. IndDirOwn % percentage ownership of independent directors. CEOTen CEO tenure. CEOOwn % percentage ownership of CEO. CEO=Chair 1 if
CEO is chairman of board. BdInd % percentage of independent directors on board.
research and development. The mean (median) market value is $7.60 ($1.31) billion, and the mean (median) market-tobook is 2.06 (1.59). In addition, the average rm leverage is 0.19, 46% of the sample rms issue dividends, and 36% of the
sample rms have a net operating loss carryforward. Finally, 16% of our sample rms disclosed material weaknesses in
internal controls after the passage of SOX.
Turning to the variables suggested by bargaining theory literature, we nd that the mean percentage of independent directors
on the board is 68%, and these outside directors hold on average 3.8% of the equity of the rm. Table 4 also notes that the average
tenure of a CEO in the sample is 8 years, 66% of CEOs also chair the board, and these CEOs average ownership is 1.93%.
4. Empirical results
4.1. Hausman test for endogeneity
As discussed earlier, we include audit fees in the audit committee compensation regression as a proxy for the demand
for monitoring of the nancial reporting process. Audit fees and audit committee compensation are predicted to respond to
the same set of economic factors. We note, however, that OLS is inappropriate if audit fees are endogenous in the audit
committee compensation regression. In this case, audit fees would be correlated with the residual from the regression,
resulting in inconsistent estimates of the regression coefcients. To address this possibility, we run a Hausman test to
determine whether audit fees are endogenous in our compensation regressions.
The Hausman test provides a formal test for the endogeneity of a regressor by comparing the OLS estimate with a two
stage least squares (2SLS) estimate. As Wooldridge (2002) notes, if the potentially endogenous variable is uncorrelated with
the residual from the regression, then OLS and 2SLS estimates should differ only by sampling error. Consequently, the rst
step in running a Hausman test is to identify one or more exogenous instruments that will allow us to run 2SLS. An
instrumental variable needs to satisfy two requirements: the instrument should be partially correlated (after the other
exogenous variables in the regression have been netted out) with the potentially endogenous variable, and the instrument
should be uncorrelated with the regression residual (Wooldridge, 2002; Greene, 2000). While the rst requirement can be
tested statistically, the second requirement needs to be satised on theoretical grounds.
The endogeneity concern in our setting stems from the possibility that audit fees are correlated with the residual from
the audit committee compensation regression. In considering potential instruments, we note that many rm-level
variables are correlated with audit fees, but they are also likely to be correlated with audit committee compensation. For
example, we would expect a company with M&A or restructuring transactions to pay both higher audit fees and higher
audit committee compensation as a result of these transactions. Consequently, we will have to go beyond the traditional
audit fee model to identify an instrument.
As our instrument, we use an indicator variable for whether the rm has a December scal year end.20 As prior work on
audit fees has found (see, for example, Francis, 1984; Craswell and Francis, 1999), audit fees are lower, all else equal, for
20
Variation in scal year ends has been used as an identication technique by other researchers, most notably Oyer (1995). He uses variation in scal
year ends to identify incentive effects of nonlinear incentive contracts.
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rms with off-peak scal year ends. Francis (1984) hypothesizes that the higher peak fees relate to the auditor production
function; higher audit fees for these rms appear to reect the increased auditor workload during the busy season. A
majority of U.S. rms (63% in our sample) have December scal year ends, so we use December scal year end to capture
auditors peak period. We do not expect a corresponding response to calendar year-end busy season in audit committee
compensation. Unlike auditors, directors tend to serve on relatively few rms boards (for example, Yang and Krishnan,
2005, nd that audit committee members average 1.3 outside directorships in their sample of randomly chosen Compustat
rms). Thus, while auditors busy season is determined by the scal year ends of auditees, which tend to be concentrated in
December, any additional effort required by audit committee members will be related to the rms own scal year end.
In the rst stage of 2SLS, we regress audit fees on all of the explanatory variables from the second stage (i.e., the
explanatory variables other than audit fees in our tabulated regressions) and the December scal year end instrument.21
The December scal-year indicator is signicantly positive with a t-statistic of 10.04 in this regression, indicating that the
instrument is partially correlated with the potentially endogenous variable, as required for a valid instrument.22 The R2 in
the rst stage regression is 0.20. In the second stage, we include the predicted value of AuditFee in the compensation
regression and compute the 2SLS estimates. We then conduct a Hausman test that compares the OLS and 2SLS estimates of
AuditFee to test the null hypothesis that this variable is exogenous. The Hausman test fails to reject the null hypothesis that
audit fees are exogenous in both the levels and difference regressions and for both total compensation and cash retainer.
For example, in the levels (difference) regression of total compensation that controls for audit committee expertise, the test
statistic is 0.113 (0.037), corresponding to a p-value of 0.74 (0.85), which indicates that the audit fee variable is uncorrelated
with the residual from the audit committee compensation regression.23 Similar results hold for the Hausman tests on
AuditFee in our other specications. These results from Hausman tests indicate that OLS will generate consistent estimates
in the audit committee compensation regression. As such, we use OLS in the analysis that follows (see Wooldridge, 2002,
2004).
4.2. Levels regression results
We proceed by estimating an OLS regression for the compensation variables of interest. Columns (1)(3) of
Table 5 present our rst set of regression analyses, which examine the relation between the level of total compensation and
proxies for the demand for monitoring of the nancial reporting process. Given that there is a mechanical relation between
meeting fees and AuditMeet, we use the level of total compensation excluding meeting fees in all regression analyses.24 We
predict that rms with a higher demand for monitoring of the nancial reporting process are likely to pay higher
compensation to audit committees. In Column (1), we consider the demand for monitoring of the nancial reporting
process proxies and also include rm level control variables suggested by contracting theory. We nd a signicantly
positive relation between the level of total compensation and our rm-specic proxy for the demand for monitoring of the
nancial reporting process, AuditFee. We also document a signicantly positive relation between the level of total
compensation for audit committees and the post-SOX indicator variable, PostSOX, which proxies for an external shift in the
overall demand for monitoring of the nancial reporting process.
In addition to evaluating the statistical signicance of our results, we can use the coefcients from the regression to
calculate economic effects. Using the estimates in Column (1), we compute that the predicted total compensation of the
audit committee chair is $78,523 for a rm in the 10th percentile of AuditFee (0.28), and $83,756 for a rm in the 90th
percentile of AuditFee (1.89), where all other explanatory variables take their median values.25 Again using the estimates in
Column (1) to illustrate the economic effects, the predicted total compensation of the audit committee chair of a median
rm (i.e., holding all other explanatory variables at their medians) is $71,084 in the pre-SOX period, and $79,907 in the
post-SOX period. While one might argue that these numbers are small in economic magnitude compared to the total
wealth of these directors, Adams and Ferreira (2008) present evidence that directors are more likely to attend board
meetings when board meeting fees are higher, suggesting that corporate directors appear to perform for even very small
nancial rewards. As such, our results are consistent with the prediction that rms respond to the increased demand for
monitoring of the nancial reporting process from both rm-specic and external forces by providing more nancial
rewards.
We also note a signicantly positive coefcient on AuditMeet in Column (1), consistent with the notion that audit
committees are paid for their time and effort. While AuditMeet is not our main variable of interest, its economic effects on
21
As noted in Larcker and Rusticus (2008) (footnote 8), if we are only interested in one equation in a potentially simultaneous system, we do not need
to estimate both equations with exogenous instruments. The simultaneous equation estimator is identical to an independent application of the 2SLS
procedure to each equation. See also Wooldridge (2002, p. 192).
22
Because scal year ends may be similar for rms in a given industry, we also run 2SLS with industry xed effects. The t-statistic on December scal
year end is 7.73 when indicators for two-digit industry are included in the rst stage.
23
We conduct the Hausman test on a levels regression with industry xed effects rather than rm xed effects, since the December scal year end
indicator would be subsumed by rm xed effects.
24
We obtain qualitatively similar results when we include meeting fees in the level of total compensation as the dependent variable.
25
Because we calculate these values with all other explanatory variables at their median values, these numbers appear low in comparison to the
descriptive statistics presented earlier. Similar calculations using the means of other variables produce values more similar to the means of our descriptive
statistics.
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Table 5
OLS regressions of audit committee compensation.
Total compensation
Cash retainer
(1)
(2)
(3)
(4)
(5)
(6)
0:040a
(3.71)
0:117a
(7.76)
0:037a
(3.15)
0:121a
(6.54)
0:031a
(2.85)
0:106a
(5.61)
0:072a
(5.79)
0:146a
(13.76)
0:069a
(4.16)
0:131a
(9.28)
0:064a
(4.05)
0:128a
(8.88)
0:037b
(2.19)
0:014a
(4.19)
0:218c
0:017a
(7.12)
0.020
0:032b
(2.20)
0:015a
(4.90)
0:029b
(2.05)
0:014a
(4.61)
ROA_Ind
0:011a
(3.96)
0.040
0:041b
(2.47)
0:014a
(3.97)
0:247c
(1.81)
0.026
(1.65)
0.025
(0.52)
0:025a
0:264b
(2.46)
0:235b
(2.23)
Return_Ind
(0.61)
0:023c
(1.78)
(1.26)
0.171
(1.16)
0.107
(3.13)
0.028
0:029b
(1.99)
0.264
0:030b
(2.09)
0.230
(0.52)
0:463a
(15.30)
0:234c
(0.33)
0:455a
(14.72)
(0.23)
0:112a
(8.23)
0.021
(1.01)
0:141a
(5.88)
0.087
(0.91)
0:149a
(6.54)
0.093
(0.36)
0:130a
(4.86)
(0.92)
0:185a
(4.55)
0.028
(0.96)
0:188a
(4.15)
0.029
(1.35)
0.001
(0.08)
(1.36)
0.003
(0.20)
0.001
(0.60)
0.010
(0.88)
0.001
(0.42)
0:065a
(3.22)
0:218a
(2.79)
8:643a
(49.34)
3,100
0.82
AuditFee
PostSOX
AC_Expertise
AuditMeet
R&D
LogMV
Leverage
DivDum
NOLDum
M=B
0:534b
(2.43)
0:471a
(22.52)
0:263a
(2.75)
0.014
(0.36)
(1.87)
0.041
(0.88)
0.009
0:061b
(2.42)
0:069a
(8.19)
(0.30)
0:079a
(5.08)
7:543a
(51.52)
5,465
0.81
7:406a
(33.83)
3,473
0.82
IndDirOwn%
LogCEOTen
CEOOwn%
CEO=Chair
BdInd%
Intercept
N
Adjusted R2
0:259b
(2.01)
0.032
(0.66)
0.007
(0.23)
0:082a
(5.50)
0.002
(1.42)
0.010
(0.71)
0.003
(0.74)
0.043
(1.46)
0:341a
(3.42)
7:247a
(30.94)
3,295
0.83
0:040b
(2.52)
0.007
(1.18)
9:048a
(94.46)
5,002
0.81
8:810a
(50.86)
3,263
0.82
The dependent variables are the logarithm of total compensation in Columns (1)(3), and the logarithm of cash retainer in Columns (4)(6). Total
compensation includes cash retainer, equity retainer, options, and equity grants, but excludes meeting fees. AuditFee audit fees/square root of total
assets. PostSOX 1 for years 20022004. AuditMeet number of yearly audit committee meetings. See Table 3 for AC_Expertise denition, and Table 4 for
other control variable denitions. Regressions are estimated with rm-level xed-effects. t-Statistics calculated using heteroskedasticity robust standard
errors are in parentheses. a, b, and c denote signicance of coefcients at the 1%, 5%, and 10% levels, respectively.
audit committee compensation are similar to those of AuditFee. Using the estimates in Column (1), we compute that the
predicted total compensation of the audit committee chair is $77,313 for a rm in the 10th percentile of AuditMeet (3), and
$84,425 for a rm in the 90th percentile of AuditMeet (11), where all other explanatory variables take their median values.
Recall that the relation between audit committee total compensation and AuditMeet is not simply a mechanical effect, since
meeting fees paid to committee members are excluded from the computation of total compensation.26 We observed earlier
that AuditMeet could be viewed as an alternative proxy for the demand for monitoring of the nancial reporting system.
The number of audit committee meetings captures the rms response to a need for additional monitoring by the audit
committee. We note, however, that this conclusion should be interpreted cautiously due to potential concerns about the
26
We also consider the more subtle mechanical effect that some rms may not have explicit meeting fees, but instead may pay a cash retainer based
on the expected number of audit meetings. Approximately 20% of our sample rm-years do not have a separate disclosure of meeting fees, suggesting that
these rms either do not provide additional compensation for meeting attendance or the meeting fees are implicit in the cash retainer. In the latter case,
our measure of total compensation excluding explicit meeting fees may still include implicit meeting fees, confounding our goal of measuring total
compensation without meeting fees. Since rms that do not pay or separately disclose meeting fees do so uniformly for all board members, our primary
difference regressions effectively control for this concern. The issue, however, may be present in our levels regression. As a sensitivity test, we conduct our
levels regression analyses after excluding the observations for which meeting fees are not separately reported in proxy statements. We nd that our
results are robust to the exclusion of these rm-years.
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endogeneity of the number of audit meetings. To assess these concerns, we also consider a version of our model of the audit
committee compensation/demand for monitoring of nancial reporting relation that excludes AuditMeet. We nd that the
coefcients are similar and the statistical signicance of both AuditFee and PostSOX remains unchanged when we exclude
AuditMeet from our models in our primary analyses. This suggests that the inclusion of AuditMeet does not have a material
adverse econometric impact on the interpretation and signicance of the coefcients of our key demand proxies. Finally,
with regard to other control variables, we nd that larger rms (high LogMV) and rms with higher investment
opportunities (high M/B) and leverage award their audit committees higher total compensation.27
As discussed before, it seems reasonable to expect both the demand for monitoring of the nancial reporting process
and the quality of audit committees to be related to compensation arrangements of audit committees. To separately
examine these effects, we additionally include a measure of audit committee quality, AC_Expertise, in Column (2). The
results show that AC_Expertise is signicantly and positively related to the level of total compensation. At the same time,
the coefcients on the key proxies for the demand for monitoring of nancial reporting remain signicantly positive. These
results support the notion that both audit committee quality and the overall demand for monitoring of the nancial
reporting process are positively related to the level of audit committee compensation.
We also include control variables suggested by bargaining theory in Column (3). Consistent with prior research (Ryan
and Wiggins, 2004), our results indicate that directors serving on outsider dominated boards (high BdInd%) receive more
compensation. This result is consistent with the notion that director compensation varies systematically with barriers to
effective monitoring. We note that the inclusion of these control variables does not alter the results of the proxies for the
demand for monitoring of nancial reporting and the quality of audit committees.
We continue our analysis by examining the level of total cash retainer. Columns (4)(6) report our results. In all three
columns, we nd a positive and statistically signicant relation between the level of total cash retainer for audit
committees and the two proxies for the demand for monitoring of the nancial reporting process, AuditFee and PostSOX. We
also note that the coefcients in Columns (4)(6) are higher and more signicant than those in Columns (1)(3). Using the
estimates in Column (4) to present economic effects, we compute (1) the predicted cash retainer of the audit committee
chair is $24,698 for a rm in the 10th percentile of AuditFee (0.29), and $27,761 for a rm in the 90th percentile of AuditFee
(1.91), where all other explanatory variables take their median values; and (2) the predicted cash retainer for the audit
committee chair of a median rm (i.e., holding all other explanatory variables at their medians) is $22,033 in the pre-SOX
period, and $25,496 in the post-SOX period.
Similar to the total compensation analyses, we nd that AC_Expertise is signicantly and positively related to the level of
cash retainer. Regarding other explanatory variables, we continue to observe signicantly positive coefcients on AuditMeet
and rm size (LogMV). We note the following differences in control variables from those reported earlier: (1) The coefcient
on industry-adjusted market returns is now negative and signicant, suggesting that the weak positive correlation between
total compensation and market returns is driven by the equity compensation component. (2) The coefcient on M/B is now
negative and loses signicance, in contrast to the positive and signicant coefcients reported earlier, supporting the view
that growth rms are more likely to use equity-based compensation relative to cash compensation. (3) The zero dividend
dummy and the leverage variable are positively associated with the level of total cash retainer, supporting predictions from
nancial contracting theory (John and John, 1993) that rms award more equity compensation when they face a scarcity of
cash (DivDum equal to 0), and when the conict between creditors and shareholders is not severe (low Leverage). (4) The
CEO/Chair dummy is now negative and signicant. These results suggest that the demand for monitoring of the nancial
reporting process also plays an important role in determining the cash retainer component of audit committee pay.
4.3. Difference regression results
In our next set of regressions, we employ a unique feature of our dataset to control for correlated omitted variables.
Since we have compensation data for both audit committees and compensation committees, we are able to use
compensation committees to control for unobservable rm-specic variables. Thus, we conduct a difference regression in
which the dependent variables now capture the differences between audit committee compensation and compensation
committee compensation. In our base case, we include both the proxies for demand for monitoring of the nancial
reporting system and control variables suggested by contracting theory (Column (1)). Similar to Table 5, we also estimate
the difference model with AC_Expertise (Column (2)) and other rm-specic controls suggested by bargaining theory
(Column (3)).
Columns (1)(3) of Table 6 present the results when the difference in the level of total compensation excluding meeting
fees is the dependent variable. In all models, we nd that the difference in the level of total compensation is positively
related to AuditFee, the rm-specic proxy for the demand for monitoring of the nancial reporting process, and has
increased signicantly in the post-SOX period compared to the pre-SOX period. These results support the prediction that
rms with a higher demand for monitoring of the nancial reporting process are likely to pay a higher level of total
compensation to audit committees relative to compensation committees.
27
As a robustness check, we have replaced LogMV with MV, MV-Squared, and MV-Cubed. We obtain qualitatively as those reported in the paper,
suggesting that our results are not affected by the functional form of MV.
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Table 6
Difference regressions.
Total compensation
(1)
AuditFee
0:004a
PostSOX
(3.35)
0:014a
(5.78)
MatlWeak
ROA_Ind
Return_Ind
RD
LogMV
Leverage
DivDum
NOLDum
M=B
(3)
(4)
(5)
(6)
0:003b
(2.34)
0:013a
(4.20)
0:008a
(2.95)
0:004a
0:009a
0:009a
0:010a
(2.92)
0:013a
(4.01)
0:008a
(2.73)
(3.65)
0:030a
(8.12)
(3.17)
0:027a
(5.15)
0:018a
(4.65)
0:001b
(2.28)
0.001
(0.27)
0.018
(1.25)
0.001
(0.54)
0.028
(0.92)
0.001
0:003a
(4.28)
0.002
(0.68)
0.007
(1.44)
0.002
(1.47)
0.024
(1.56)
0.001
0:001b
(2.54)
0.002
(0.64)
0.023
(1.60)
0.002
(0.66)
0.041
(1.33)
0.000
(2.89)
0:027a
(5.52)
0:018a
(4.86)
0:003a
(1.25)
0.003
(0.58)
0:004c
(0.06)
0.006
(0.63)
0.005
(1.14)
0.007
(0.71)
0.004
(1.66)
0.001
(0.49)
0.001
(0.60)
(1.40)
0.004
(1.43)
0.003
(0.92)
(1.08)
0.003
(1.17)
0.001
(0.43)
0:000c
(1.75)
AC_Expertise
AuditMeet
(2)
Cash retainer
0:001a
IndDirOwn%
LogCEOTen
Intercept
0.001
0:017c
0:003b
(2.29)
0.000
(1.55)
0:015a
(4.99)
0:013c
(1.87)
0.015
N
Adjusted R2
(0.16)
5,464
0.02
(1.67)
3,472
0.03
(1.63)
3,295
0.04
CEOOwn%
CEO=Chair
BdInd%
(4.66)
0.006
(1.20)
0.007
(0.91)
0:004c
(1.76)
0.034
(1.14)
0:003b
(2.22)
0:017c
(1.77)
0:012a
(2.94)
0:007c
(1.89)
0:003c
(1.90)
(2.74)
0.007
(0.97)
0.029
(1.23)
0.003
(0.73)
0.015
(0.31)
0.002
0:002b
(2.48)
0.009
(1.28)
0.019
(0.78)
0.003
(0.65)
0.016
(0.32)
0.000
(0.94)
0:028c
(1.81)
(0.10)
0:027c
(1.75)
0:013b
(2.06)
0.005
(1.11)
0.005
(1.52)
0:013b
(2.05)
0.006
(1.16)
0.003
(0.84)
0:001a
(2.77)
0:005c
(1.93)
0.001
(1.60)
0:024a
(4.79)
0.001
(0.06)
0.003
0:025c
(0.34)
4,990
0.05
(1.79)
3,258
0.05
0:032b
(1.99)
3,097
0.06
The dependent variables are differences between audit committee compensation and compensation committee compensation: differences in logarithm of
total compensation in Columns (1)(3), and differences in logarithm of cash retainer in Columns (4)(6). Total compensation includes cash retainer, equity
retainer, options, and equity grants, but excludes meeting fees. AuditFee audit fees/square root of total assets. PostSOX 1 for years 20022004.
AuditMeet number of yearly audit committee meetings. See Table 3 for AC_Expertise definition, and Table 4 for other control variable denitions. tStatistics calculated using heteroskedasticity robust standard errors are in parentheses. a, b, and c denote signicance of coefcients at the 1%, 5%, and 10%
levels, respectively.
Similar to the level regressions, we use the coefcients from the regression to calculate economic effects. Using the
estimates in Column (1), we compute that the predicted difference in total compensation between audit committee chairs
and compensation committee chairs is $1,089 for a rm in the 10th percentile of AuditFee (0.28), and $1,675 for a rm in the
90th percentile of AuditFee (1.89), where all other explanatory variables take their median values. Again using the estimates
in Column (1) to illustrate the economic effects, the predicted difference in total compensation between audit committee
chairs and compensation committee chairs of a median rm (i.e., holding all other explanatory variables at their medians)
is close to 0 in the pre-SOX period, and $1,248 in the post-SOX period.
We also include our measure of audit committee quality, AC_Expertise, in the difference regressions. Because
it is not clear ex ante how audit committee quality will affect the differences in compensation across committees, including
this variable allows us to address two plausible scenarios. First, we note that the denition of audit committee
quality is driven by recent regulatory calls for nancial experts on the audit committee. Although recent regulation has
specied that compensation committee chairs be independent, there is not a comparable measure of compensation
committee chair quality. As a result, the quality issue appears to be specic to audit committees, so a higher quality audit
ARTICLE IN PRESS
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Table 7
Difference regressions: pre- and post-SOX.
Total compensation
AuditFee
AC_Expertise
AuditMeet
MatlWeak
ROA_Ind
Return_Ind
RD
LogMV
Leverage
DivDum
NOLDum
M=B
Pre-SOX
Post-SOX
p-Value
Pre-SOX
Post-SOX
p-Value
0.005
(0.83)
0.003
(1.65)
0.001
(0.69)
0.003
(0.63)
0.009
(0.79)
0.001
(0.50)
0:061a
(3.05)
0.004
(1.50)
0.005
(0.35)
0:005a
(3.06)
0:009a
(2.58)
0:001a
(2.20)
0.001
(0.13)
0.038
(1.53)
0.001
(0.35)
0.071
(1.61)
0.001
(0.51)
0.006
(0.54)
0.001
0.052
0.003
(0.48)
0.004
(1.59)
0.001
(0.39)
0.002
(0.26)
0.016
(0.67)
0.003
(0.49)
0:108a
(3.40)
0.003
(0.95)
0.016
(0.75)
0.013
0:010a
(3.03)
0:021a
(4.50)
0:003a
(2.48)
0.012
(1.35)
0.032
(0.91)
0.002
(0.35)
0.022
(0.29)
0.001
(0.27)
0.033
(1.56)
0.013
0.038
(1.63)
(1.57)
0:016b
(2.48)
0.007
(1.11)
0:012b
(2.08)
0:013b
(2.09)
0.944
0.007
0.294
0.968
0.136
0.226
0.849
(1.57)
0.000
0.014
(1.22)
0.002
LogCEOTen
(1.48)
0:005a
(0.86)
0.000
(1.11)
0:007c
(1.83)
(2.72)
0.000
(1.25)
0:018a
(4.58)
0.011
N
Adjusted R2
0.085
0:019b
(2.37)
0.004
(0.79)
0.002
0:019b
(2.38)
969
0.01
0.575
0.054
IndDirOwn%
BdInd%
0.375
(0.16)
0.004
(0.70)
0.000
CEO=Chair
0.045
(0.20)
0.000
0:003b
(1.99)
0.000
CEOOwn%
Cash retainer
(1.13)
2,326
0.03
0.697
0.047
0.549
(0.78)
0.000
(0.69)
0.006
(1.02)
0:029b
(2.08)
894
0.01
0.001
0.166
0.447
0.258
0.992
0.112
0.352
0.575
1.000
0.001
0.107
0:001b
(2.46)
0.317
0:008b
(2.01)
0.001
(1.58)
0:031a
(4.68)
0.011
0.038
0.294
0.004
0.112
(0.52)
2,203
0.05
Dependent variables are differences between audit committee compensation and compensation committee compensation. Total compensation includes
cash retainer, equity retainer, options, and equity grants, but excludes meeting fees. Pre-SOX includes observations from years 20002001. Post-SOX
includes observations from years 20022004. p-Value is presented for test of difference between coefcients for pre- and post-SOX regressions (one-sided
test for AuditFee; AC_Expertise, and AuditMeet, and two-sided for other variables). AuditFee audit fees/square root of total assets. AuditMeet number of
yearly audit committee meetings. See Table 3 for AC_Expertise denition, and Table 4 for other control variable denitions. t-Statistics calculated using
heteroskedasticity robust standard errors are in parentheses. a, b, and c denote signicance of coefcients at the 1%, 5%, and 10% levels, respectively.
committee may be associated with a differential compensation level between the two committees. Second, one might
argue that rms with higher quality audit committees are more likely to also have higher quality compensation
committees. In this case, the audit committee quality variable will not be related to differential audit committee
compensation.
Column (2) presents the results when we include AC_Expertise in the difference regression model. The results show that
AC_Expertise is signicantly and positively related to the difference in the level of total compensation, while the coefcients
on the proxies for the demand for monitoring of nancial reporting remain signicantly positive. These results are
consistent with the expectation that rms with high quality audit committees pay a higher level of total compensation to
audit committees relative to compensation committees. When we include other control variables in Column (3), our
inferences regarding the proxies for the demand for monitoring of nancial reporting and audit committee quality are
unchanged.
The results for the difference in the level of cash retainer are presented in Columns (4)(6). We nd similar results as
those presented in the total compensation regressions of Columns (1)(3), while we note that the coefcients on AuditFee,
PostSOX, and AC_Expertise in Columns (4)(6) are of higher magnitudes and signicance levels. We also observe that the
coefcients on AuditMeet continue to be positive and signicant in both the total compensation (Columns (1)(3)) and cash
ARTICLE IN PRESS
153
retainer models (Columns (4)(6)), consistent with the notion that audit committee pay captures the time and effort of
committee members.
The results in Table 6 indicate that audit committee compensation is signicantly different from compensation
committee compensation in the post-SOX period. In our nal set of regressions, we investigate whether these post-SOX
changes in the audit committee pay differential can be explained, in part, by AuditFee and AC_Expertise. In other words, do
rms with a greater rm-specic demand for monitoring of nancial reporting and with a higher director-specic expertise
in nancial reporting offer a larger audit committee pay premium in the post-SOX period? We conduct separate regressions
for the pre-SOX and post-SOX periods and report these results in Table 7. We nd positive and signicant coefcients on
AuditFee and AC_Expertise only in the post-SOX period for total compensation and cash retainer. The pre- and post-SOX
coefcients are signicantly different from each other in both regressions.
The results in Table 7 suggest that the signicant relations between the audit and compensation committee pay
premium and AuditFee, and between the pay premium and AC_Expertise reported in Table 6, are attributable to board
compensation decisions in the post-SOX period. While the insignicant coefcient on audit fees in the pre-SOX period in
the difference regressions likely reects the historical lack of within-rm pay variation for directors, these results provide
evidence of rms increased willingness to offer differential compensation to board members following SOX and the events
leading up to its passage. Further, this post-SOX pay differential is related to variation in rm-specic demand for
monitoring and director-specic expertise in nancial reporting.
5. Conclusion
In this paper, we have examined how cross-sectional variation in the demand for monitoring of the nancial reporting
process is associated with compensation for audit committees. Audit committees have become an important part of rms
nancial reporting process; thus it is important to investigate the internal governance mechanisms for audit committees.
We add to the literature on audit committees by exploring the determinants of audit committee compensation. We also
contribute to research on board compensation by documenting an increasing trend toward differences in annual pay
among board members within a rm.
We focus our analyses on the demand for monitoring of the nancial reporting process. Specically, we predict a
positive association between audit committee compensation and the demand for monitoring of the nancial reporting
process. In conducting the empirical analyses, we control for director quality because audit committee compensation is
likely related to both the demand for monitoring of nancial reporting and the quality of the audit committee.
We examine audit committee compensation, both in absolute terms and relative to compensation committee
compensation. We nd that total compensation and cash retainers are positively correlated with proxies for the demand for
monitoring of the nancial reporting process and measures of audit committee quality. Our empirical evidence is
consistent with the notion that the demand for monitoring of the nancial reporting process is an important determinant
of the compensation paid to audit committees. In addition, our ndings that pay is increasingly different for audit and
compensation committee members suggest a new-found willingness on the part of boards and rms to acknowledge the
differential contributions and outside opportunities of board members.
We view our study as a rst step toward understanding the compensation arrangements for audit committees. One
important area for future research is to examine how compensation incentives interact with reputation incentives to
impact the effectiveness of the audit committees in monitoring nancial reporting.
Acknowledgment
We thank an anonymous reviewer, Brian Cadman, Jeff Chen (AAA discussant), Mike Lemmon, Clive Lennox, Scott
Schaefer, Peter Wysocki (discussant), Jerry Zimmerman, and workshop participants at the University of Notre Dame, the
2007 Southeast Summer Accounting Research Conference, the 2008 American Accounting Association Annual Meeting, and
the 2008 Journal of Accounting and Economics Conference for comments, and Jeff Wooldridge for helpful correspondence
on econometric methods. We thank Chun Wang for excellent research assistance.
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Contents lists available at ScienceDirect

Journal of Accounting and Economics

Audit committee compensation and the demand for monitoring of

University of Chicago Booth School of Business, USA

E-mail address: ellen.engel@chicagobooth.edu (E. Engel).

E. Engel et al. / Journal of Accounting and Economics 49 (2010) 136154

E. Engel et al. / Journal of Accounting and Economics 49 (2010) 136154

3.2. Research methodology

where i audit class of labor (e.g., staff, senior, partner).

E. Engel et al. / Journal of Accounting and Economics 49 (2010) 136154

E. Engel et al. / Journal of Accounting and Economics 49 (2010) 136154

Audit committee chair

Audit committee member

Panel B: Time series compensation statistics for audit committee chair

Compensation committee chair

E. Engel et al. / Journal of Accounting and Economics 49 (2010) 136154

Audit fees and board meetings

Audit committee chair expertise

Panel B: Time series statistics

Audit fees and board meetings

E. Engel et al. / Journal of Accounting and Economics 49 (2010) 136154

E. Engel et al. / Journal of Accounting and Economics 49 (2010) 136154

E. Engel et al. / Journal of Accounting and Economics 49 (2010) 136154

E. Engel et al. / Journal of Accounting and Economics 49 (2010) 136154

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