Excessive compensation, CEO power and board quality: incentives to purchase a voluntary review?

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Excessive compensation, CEO power and board quality:

incentives to purchase a voluntary review?

Sander Minnaard S2203588 Supervisor V.A. Porumb Co-assessor C.A. Huijgen MSc Accountancy 22 January 2018 Word count 8,115 ABSTRACT

This study investigate if excessive compensation, CEO power and board quality are determinants of firms’ decision to voluntary purchase an audit review (review) of the quarterly financial statements. Drawing on hand-collected data for 256 firm years from 61 unique firms during 2010 to 2014, my results show that both excessive compensation and board independence are positively associated with the voluntary purchase of the review. In contrast, I find that CEO power is negatively associated with the purchase of the review. Moreover, tests show that the associations become stronger as firm size increases. These results are robust to multiple sensitivity tests. Overall, this study contributes to the auditing literature by investigating managerial incentives and monitoring quality as determinants to commit to timely external verification brought by auditors through the review.

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1. INTRODUCTION

“Minutes before lunchtime on the first working day of the year, Canada’s 100 highest paid chief executive officers had already earned more than the average Canadian will earn in all of 2017” (Kassam, 2017)

The excerpt is from the report of Mackenzie (2017) which analyses ten years of executive compensation in Canada. The document states that the 100 highest paid CEOs earned in 2015 an average of approximately $9.545 million, with a maximum of $182.902 million. Moreover, the average compensation of CEOs has increased by 100%, compared to an increase of 9% for the average worker, over the last ten years. These statistics add to the currently ongoing public debate regarding high compensation of executives1. Criticism against ‘excessive’ compensation structures is rising (Bogle, 2008), with media, shareholders, politicians and researchers giving attention to its extraordinary increase.2_{Therefore, a number of questions are raised, as to whether CEO compensation is excessive} (Core, Holthausen and Larcker, 1999), CEOs are too powerful (Abernethy, Kuang and Qin, 2015) and if monitoring from the board is effective (Brick, Palmon and Wald, 2006).

Given that auditing provides external verification of the financial statements and thereby could reduce the incentive problems (e.g. information asymmetry) between management and shareholder (Jensen and Meckling, 1976; Watts and Zimmerman, 1983)3_{, in this paper I assess if excessive} compensation, CEO power and board quality are determinants of firms’ decision to voluntary purchase a review of the quarterly financial statements. The audit of annual financial statements is mandatory for listed firms almost everywhere in the world, while the review of the quarterly financial statements is not. Since the Securities and Exchange Committee (SEC) mandates the reviews in the US, earlier research focus on small, private US firms to assess the effects of the voluntary purchase of reviews (Ettredge, Simon, Simon and Stone, 1994; Ettredge, Simon, Smith and Stone 2000; Manry, Tiras and

1_{For example, Nortel, a Canadian telecom company, went bankrupt, but still paid out $190 million of retention bonuses to}

the former management, while the former management was under investigation of accounting fraud (but finally not found guilty, due to the lack of evidence) Ireton, J. (2016, October 7). Nortel executives continue drawing bonuses years after bankruptcy. CBC News. Retrieved August 24, 2017, from http://www.cbc.ca/news/canada/ottawa/nortel-bankruptcy-pension-executives-bonuses-1.3792904

2_{Not only in recent years CEOs got paid well, Frydman and Saks (2010) showed in their long-term perspective that since}

the 1970s, CEOs’ compensation in the US has dramatically grown over the years.

3_{The problems with and complexity of setting an appropriate compensation level}_{relies in the agency theory. Due to}

information asymmetry and conflicts of interests, management might not always act in the interest of shareholders (Jensen and Meckling, 1976; Watts and Zimmerman, 1983; Healy and Palepu, 2011). Therefore audit is a tool that helps aligning the interests of managers with the ones of shareholders.

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Wheatley 2003; Bédard and Courteau 2015; Kajüter, Klassmann and Nienhaus, 2016). In this thesis, I therefore test whether CEOs’ compensation, CEO power and board of directors quality is associated with listed firms’ voluntary decision to purchase reviews. I draw on a sample of Canadian firms, since in this setting the review is voluntary for listed firms, in spite of calls for mandating it (Bedard and Courteau 2015). In order to test my contention, I hand-collect data regarding the audit review and excessive compensation from 256 firm year of 61 unique firms during 2010 and 2014.

First, I test if ‘excessive’ executive pay is associated with the purchase of the review. Earlier research shows that excessive pay is associated with poor firm performance (Core et al., 1999). Moreover, as the compensation plans of the CEOs are mostly based on performance targets, some CEOs tend to manage earnings to achieve those performance-based targets (Bergstresser and Philippon 2006; Healy, 1985). When earnings are managed, investors are provided with false information that bias their decision-making process (Xie, Davidson and DaDalt, 2003). Since auditing is a tool to mitigate management manipulation of financial reports (Jensen and Meckling 1976), purchasing a review will likely restrict the ability of CEOs to obtain excessive compensation. In contrast, Kausar, Shroff and White (2016) argued that firms can voluntary be audited and thereby signalling information to shareholders, which reduces information asymmetry. Thereby, the choice to audit conveys information to investors, which reduces information asymmetry. The results shows that excessive compensation is positively associated with the voluntary purchase of the review.

Second, I assess the association between CEO power and the voluntary purchase of the review. Previous literature finds that powerful CEOs tend to avoid activities that could reduce their bargaining power in organizations (Demsetz and Lehn, 1985). Since the review is likely to communicate to the board, in a timely manner, financial misstatements of the management (Bedard and Courteau 2015), powerful CEOs are likely to benefit by not committing to increased monitoring. In line with my expectations, I find a negative association between CEO power and the voluntary purchase of the review.

Third, I test if board of director quality is positively associated with the purchase of the voluntary review. As board quality increases, I expect that the board is more able to aggressively monitoring management, as they become less dependent on management (Hermalin and Weisbach, 1998; Ryan and Wiggins, 2004). Furthermore, the review supports the board in their responsibility to monitor the action of the management on behalf of the shareholders. As expected, board quality is positively associated with the decision to voluntary purchase the review.

This thesis contributes to the already existing literature by filling the gap of a possible effects of CEO compensation, CEO power and board of director quality on the decision to purchase the voluntary review of the quarterly financial statements. Although research has been conducted

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regarding the benefits of the purchase of voluntary reviews of the quarterly financial statements (Ettredge et al., 2000; Manry et al., 2003; Bédard and Courteau, 2015; Kajüter et al., 2016; Porumb and Karaibrahimoglu, 2017), there has been little research with respect to the incentives of the firms’ management to purchase a voluntary review.

The rest of the thesis is structured as follows: chapter two provides the regulatory background regarding the interim review. Subsequently, chapter three describes the theoretical framework. Thereafter, chapter four addresses the research methods. Finally, chapter five presents the results and six conclusions, limitations and recommendations.

2. REGULATORY BACKGROUND

The audit of the annual financial statements is mandatory for listed firms in most countries, yet the review of quarterly financial statements is not. Following the recommendations of the Blue Ribbon Committee (1999), that the review of quarterly statements by the independent auditor should be mandatory for all firms, the Securities and Exchange Commission (SEC) followed the recommendations and made the interim review mandatory in the US (SEC, 1999). Still, in a lot of countries the audit reviews of quarterly financial statements are not mandatory yet (Germany, Canada, France, the Netherlands). Debates to make interim reviews mandatory in Canada are being held as well (Crawford committee, 2003). But, the ongoing debate is mostly based on the disadvantages of the higher audit fees caused by the interim review, especially for smaller firms (OSC, 2000; TSX Venture exchange, 2002). However, the interim review is not mandatory yet, the voluntary review is recommended by the Canadian Securities Administration (CSA).

Moreover, according to the “National Instrument 51-102 – Continuous Disclosure Obligation”, firms must disclose a notice in their quarterly financial statements if these are not reviewed by the external auditor (OSC, 2004). However, Canadian firms are not allowed to publicly disclose the results of the interim review, the results may only be used for internal purposes.

2.1 Characteristics of the interim review

The review of the quarterly financial statements differs from the annual audit in several aspects. In the annual audit of the financial statements an auditors’ objective is to “enable the auditor to express an opinion on whether the financial statements are presented fairly, in all material respects, in accordance with the applicable reporting framework (CICA, section 7060.A6)”, and thereby give reasonable assurance. In an interim review however, the auditor does not provide such assurance, but

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only provides limited assurance. And the auditors’ objective is to “obtain a basis for reporting to the audit committee as to whether the auditor is aware of any material modification that should be made to the interim financial statements for those statements to be in accordance with the applicable financial reporting framework (CICA, section 7060.03)”

But, according to the CICA (section 7060.A7), the benefits for a firm are twofold. First, it takes care of the audit committees’ responsibility to review the interim financial statements. As auditors could have more expertise in the area of auditing and financial statements, and therefore an auditors judgement could be valuable. Second, it gives the auditor more insight in an entity, as they have more opportunity to observe its procedures and processes during the year. Therefore it is expected that the auditor performs more and/or different actions than regulatory is required for the interim review.

Another aspect, as mentioned before, is that the auditors’ report of the interim financial statements is not allowed to be included in a public document, unless legislation requires so (CICA, section 7060.24). It may only, written or oral, be communicated to the audit committee or board of directors. Therefore, the interim review mostly serves as a monitoring tool, which is used to timely recognize possible accounting changes (Porumb and Karaibrahimoglu, 2017).

3. LITERATURE REVIEW AND THEORETICAL BACKGOUND

Financial reporting and disclosures are a relevant way to communicate financial information on firm performance and governance to outside investors (Healy and Palepu, 2011). However, due to information asymmetry, the relevance and reliability needs to be verified by and external auditor, as an audit should decrease agency problems which arises due to information asymmetry (Watts and Zimmerman, 1983). An audit of the annual financial statements is already mandatory among everywhere in the world, but the interim review is not, as there is still no consensus whether or not to mandate the interim review. The strongest critics are based on an expected increase in the incremental audit fees, especially for smaller firms, while the benefits of the voluntary review are not exceeding these costs. As firms deciding to purchase voluntary reviews of the quarterly financial statements are usually the ones that expect the incremental benefits will exceed the incremental costs (Kajüter et al, 2016; Ettredge et al, 1994). Therefore, most research is based on possible benefits for both firms and shareholders. However, studies regarding the interim review is not extensive, academic literature is available.

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First, addressing the concerns of most critics, Bédard and Courteau (2015) use a Canadian sample and find that firms who voluntarily purchase the review of the quarterly financial statements, pay an approximately 18 percent higher audit fee, while no significant difference for smaller firms was found. A research conducted, based on a German sample, showed an increase of approximately 15 percent in audit fees. Moreover, it shows lower incremental audit costs while firm size increases (Hoehn, 2013). So, based on the setting, it can be concluded that smaller firms faces an higher incremental audit fee.

While many studies tried to link the purchase of voluntary reviews of the quarterly financial statements with an increase in earnings quality, many did not find significant effects. Manry et al., (2003) conduct a study regarding the association between quarterly returns and interim-quarter returns. They find that firms purchasing the timely review had a stronger association between the quarterly returns and earnings. Which implicates less information asymmetry and thus an stronger and more timely reflection in the share price. However, the annually association shows no significant difference. Kajüter et al., (2016) looked for an increase in information quality of interim financial statements based on a German sample, which is similar to the Canadian situation. They found higher abnormal return volatility and abnormal trading volume for firms with voluntary reviews, and therefore an increase in the information quality of those interim reports. However, the increase of information quality is largely driven by a signalling factor, as Kajüter et al., (2016) did not find evidence of an increase in earnings quality. The same conclusion can be drawn from Bédard and Courteau (2015), as they did not find any increase in earnings quality, despite different measures.

On the other hand, Porumb and Karaibrahimoglu (2017) find a negative relation between the purchase of voluntary reviews and the cost of debt. Despite the fact that the results of the review are intended for internal use only, banks have access to inside information (Minnis, 2011). Porumb and Karaibrahimoglu (2017) conclude that the incremental audit fee, caused by the purchase of the review, is lower than the benefits of a lower cost of debt. Therefore, a company could “spent money, to make money” (Porumb and Karaibrahimoglu, 2017).

Boritz and Liu’s (2006) study investigated which firms voluntarily purchased the interim review and find that firms’ complexity is positively associated with the review. On the other hand, firms with growth opportunities are less likely to be reviewed. The assurance and insurance values gave mixed results, as assurance was positive related, while insurance was negatively related to the review.

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But, the first study regarding the interim review has been conducted by Ettredge et al. (1994). They looked for an explanation why US firms voluntarily purchased timely reviews4_{. They find that} the purchase of a voluntary review was positively associated with internal and external agency costs. Agency costs is the result of the assumption that the interests of both the agent and principal are not aligned and is described for the first time by Jensen and Meckling (1976) and referred to as an agency problem (Jensen and Meckling, 1976; Eisenhardt, 1989). The problem arises because the interest of the agent and principal might not be aligned and it is difficult to verify and monitor the management (Eisenhardt, 1989). Furthermore, both the principal and agent are utility maximizes for their own returns (An and Davey, 2009). In order to address these concerns, corporate governance controls are put in place. In order to align the interests of the executives with the shareholders, incentive contracts are given to the executives.

Agency theory

The agency theory could explain the reason for firms to purchase the voluntary review. The theory describes the agency problem that arises due to separation of ownership and control. An agency relationship can be described as, “a contract under which one or more persons (the principal) engage another person (agent) to perform some service on their behalf which involves delegating some decision making authority to the agent (Jensen and Meckling, 1976, p.308)”. Thereby, two ‘agency’ problems arise. These problems can be addressed to (a) both the interests of principal and agents are not aligned, and (b) the problem to monitor the actions of management on behalf of the shareholders (Jensen and Meckling, 1976; Eisenhardt, 1989). First, assuming both the agent and principal maximize their utility, the agent might not always act in the interests of the shareholder. This problem arise due the different attitudes towards risks (Jensen and Meckling, 1976; Eisenhardt, 1989). Second, monitoring the behaviour of the management, it could be hard for principals to monitor the management. Therefore, monitoring activities are involved, which can include the voluntary interim review.

4_{In the US, the voluntary review is called a timely review. This review allows to recognize accounting statements in a}

timely fashion. Instead of a retro-perspective (year-end) review. At the moment of the research, an audit of the interim financial statements was not mandatory in the United States. In 2000, after the report of the Blue Ribbon Commission (1999), the review became mandatory. The situation before the year 2000 could be compared to the current situation in Canada.

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Signalling theory

However, an incentive the purchase the voluntary review also could be found in the signalling theory. Signalling theory, which is originated to address agency problems in the labour market, assumes that firms will signal their excellence to the market (Moris, 1987). By signalling quality, buyers considers others from poorer quality, this process continues until the signalling costs exceeds the benefits. However, the signal must be too costly (benefits do not exceeds the costs) for poor quality firms (Moris, 1987; Kausar et al., 2016). Moreover, Kajüter et al. (2016) already concluded that the investors more heavily rely on reviewed firms, as investors might perceive the interim financial statements that has been reviewed as more reliable. However, they concluded that those firms’ earnings are not of more quality than those that has not been reviewed. And therefore, the firms take the advantages of the signalling value of the interim review. Furthermore, Kausar et al. (2016) scientifically substantiated that firm who voluntary choose to be audited, have significantly higher debt, investment, operating performance and investment efficiency. Whereby can be concluded that the voluntary choice conveys information that reduces information asymmetry.

Both these theories addresses concerns arising from information asymmetry. However, signalling theory suggests that firms can highlight their excellence by signalling to the market, such as voluntary disclosures or voluntary reviews. (An, Davey and Eggleton, 2008).

4. HYPOTHESES DEVELOPMENT

Managers are expected to act in the interests of the shareholder. However, as the agency theory suggests, due to information advantage of the management, which has more understanding of the processes and financial position of the firm, a CEO might not always act in the right interests. To align the interests of both the shareholder and the agent, incentive compensation contracts are used (Fama, 1980; Fama and Jensen, 1983). However, criticism of the appropriate level of CEOs compensation plans is rising5 (Bogle, 2008) as the effectiveness of high executive pay levels will not always leads to better performance of those executives (Jacquart and Armstrong, 2013). Moreover, firms on which CEOs got paid ‘excess’ are the firms with weak governance structures. This argument is being supported by Brick et al. (2006), who found a strong association between excess CEO compensation and excess director compensation. In fact, the evidence showed that it is caused by “cronyism”, and

5_{However, Garbaix and Landier (2008) analyse CEO compensation and look for an explanation of the increase in executive}

compensation. They found that the almost six fold increase of CEO compensation between 1980 and 2003 is mainly caused by the six fold increase in firm size in that period.

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therefore, monitoring is ineffectively. As the review can be seen as an element of monitoring, excessive compensation could have a negative impact on the choice to purchase the review.

On the other hand, executives that receives ‘excessive’ compensation could want to justify their compensation levels by signalling excellence via the review of the interim financial statements. Moreover, firms with more voluntary disclosures, ensure higher standards and welcome closer monitoring, and thereby shows unobservable management quality (Chung et al., 2015). Therefore, the interim review can be seen as mechanism to show shareholders they have nothing to hide. Furthermore, Kausar et al. (2016) argued that firm who voluntary have their financial statements audited, are firms who have an higher debt, investment, operating performance and investment efficiency. Thereby, the choice to audit conveys information to investors, which reduces information asymmetry. So, in order to justify their compensation, executives could signal their excellence throughout the purchase of the voluntary review.

Hence, an association the between voluntary review and the level executive compensation has not yet been made in academic literature, based on prior literature, I expect that excessive compensation is associated with the purchase of the voluntary review. Moreover, as there is an persistent criticism to mandate the review, especially for smaller firms, as the might face significant higher audit fees, I expect that firm size is positively enhances this association.

H1: Excessive CEO compensation is associated with the voluntary purchase of the review.

H1a: The association between excessive CEO compensation and the voluntary purchase of reviews is stronger for larger relative to smaller firms.

Powerful CEOs tend to be more opaque with respect to information disclosure (Liu and Jiraporn, 2010) and it is expected that self-interested CEOs tend to avoid monitoring (Demsetz and Lehn, 1985). Furthermore, Stoughton and Talmor (1999) argue that self-interested managers will not participate in activities that can reduce their bargaining power in the organization. While participating in an activity as the review could make it easier for shareholders and stakeholder to assess firm value and verify actions taken by management (Liu and Jiraporn, 2010), which reduces the information asymmetry between manager and shareholders. Furthermore, Jensen (1993) concluded that boards might be ineffective, as they tend to avoid conflicts, which reduce their monitoring ability within an organization. Moreover, as CEOs have more information about the operations and performance of the organization, which they might not willing to share with the board, it will be harder to access management (Armstrong, Guay and Weber, 2010).

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Therefore, a negative association between CEO power and the purchase of the voluntary review of the quarterly financial statements is expected. As firm size might be influence choice, I expect that as firm size increase, the effects of CEO power on the purchase of the voluntary review will be stronger.

H2: CEO power is negatively associated with the purchase of the voluntary review of the quarterly financial statements.

H2a: The association between CEO power and the purchase of the voluntary review of the quarterly financial statements is stronger for larger firms relative to smaller firms.

Agency theory suggests that board of directors are necessary to mitigate the information asymmetry between management and shareholders. By monitoring management, the board holds the uppermost position in a firm (Eisenhardt, 1989). The interim review assists the board of directors in their objective to review the firms’ interim financial statements. In order to assess management, board of directors evaluate the actions of management (Fama and Jensen, 1983). Therefore, the effectiveness of boards in fulfilling this responsibilities are related to the interim review.

The quality of board monitoring is subject in a large number of academic literature6_{. As} academics argue that the board monitoring may not always be as effective as could be expected, the quality of board monitoring could influence the decision the purchase the voluntary review.

Therefore, based on prior academic literature (Dechow et al., 1996; Beasley, 1996; Yermack, 1996; Hermalin and Weisbach, 1998; Sundgren and Wells, 1998; Vafeas, 1999; Klein, 2002; Xie et al., 2003; Ryan and Wiggins, 2004), I expect that the quality of the board of directors will influence a firms choice to purchase the voluntary review. As board of director quality increases, I expect that

6 _{Several aspects of board of director characteristics has been reviewed in academic literature. Hermalin and Weisbach}

(1998) found that the quality of the board declines over time, as the CEO gains power of the board. Moreover, it shows that as CEO tenure increase, the percentage of outside directors decreases. While Ryan and Wiggins (2004) found that independent directors set compensation levels for the CEO that is more closely aligned with shareholders’ objectives, as they have a bargaining advantages over the CEO. Moreover, the independence of the board is significant negatively associated with abnormal accruals (Klein, 2002) and a reduction in the in board independence results in large increases in those abnormal accruals. Furthermore, firms with more independent board are less likely to become involved in the financial statement fraud (Dechow et al, 1996; Beasley, 1996). Besides the independence of the board, board meetings are important in the monitoring function of the board. Board meeting frequency has been linked to less earnings management, as the board could more actively monitor management (Xie et al., 2003). Furthermore it is positively associated with firm value and operational performance (Vafeas, 1999; Brick and Chidambaran, 2010). Finally, the size of the board has been subject of governance literature as well. Results regarding effectively monitoring and board size gave mixed results. Yermack (1996) found an inverse relationship between the size of the board and firm performance. Similar results were found by Eisenberg, Sundgren and Wells (1998).

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board will more aggressively monitor the CEO (Hermalin and Weisbach, 1998; Ryan and Wiggins, 2004), and therefore will engage in activities that helps them asses the actions taken by management, as a review provides.

Concluding, the third hypothesis expects a positive association between board quality and the purchase of voluntary review of the quarterly financial statements. Moreover, I expect that the association will be enhanced when firm size increases. As smaller firms might have the incentive not to purchase the review, as they bear significant higher audit fees.

H3: Board of director quality is positively associated with the purchase of the voluntary reviews of the quarterly financial statements.

H3a: The association between board of director quality and the purchase of the voluntary review of the quarterly financial statements is stronger for larger firms relative to smaller firms.

5. RESEARCH METHODOLOGY

5.1 Data collection and sample

To test the hypotheses, a sample of Canadian listed firms has been selected, as the review of the interim financial statements is not mandatory in Canada and firms are obligated to note if there quarterly financial statements has not been reviewed by an auditor. The sample initially started with 4,895 firm year observations of which an indicator variable for the review was available, but 702 observations were excluded as a result of missing data in order to calculate the excessive compensation variable. Furthermore, I wave 2,147 firm year observations which were bonded to the time period 2004-2009, of which compensation data and board characteristics data were almost impossible to collect. From the remaining 2,046 firm year observations, 1,790 firm years are excluded due to missing compensation data.

Therefore, the final sample consists of 256 firms years of 61 unique firms during the years 2010 and 2014. Consistent with prior literature, the sample is excluded from banking, insurance and other financial services firms (Kajüter et al, 2016, Porumb and Karaibrahimoglu, 2017). The data regarding the voluntary purchase of the review of the quarterly financial statements is gathered through an internal database provided by the University of Groningen. The review data is initially hand collected through publicly available interim financial statements, in which a firm needs to disclose if the report has not been reviewed by an auditor. Moreover, the compensation data is hand-collected from the proxy statements of the specific company.

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Finally, out of the sample of 256 firm years, 183 firm years have voluntary review, while the other 73 consists of firm years without the voluntary review. Therefore, the final sample consists of 71.5 percent review firms years, which is comparable to prior literature (Bédard and Courteau, 2015; Kajüter et al, 2016; Porumb and Karaibrahimoglu, 2017).

[ Insert table 1 about here ]

5.2 Review model

In order to test the hypotheses formulated above, statistical models are developed based on prior literature. The hypothesis all contains the purchase of the voluntary review, therefore a PROBIT regression model has been adopted.

REVIEW = α + β₁IVi,t + β₂SIZEi,t + β₃INCREVi,t + β₄MBi,t + β₅LEVi,t + β₆ROAi,t + ε (1) REVIEW = α + β₁IVi,t + β₂SIZEi,t + β₃IV*SIZEi,t + β4INCREVi,t + β5MBi,t + β6LEVi,t (2) + β7ROAi,t + ε

In the models, the dependent variable is REVIEW. Following earlier research regarding the voluntary purchase of a review, I will use a dummy variable that takes the value of 1 if a firm has voluntarily reviewed their quarterly financial statements by an external auditor, and 0 otherwise (Etteredge et al., 1994; Bédard and Courteau, 2015; Kajüter et al., 2016 and Porumb and Karaibrahimoglu, 2017). The difference between model (1) and (2) is the use of an indicator variable, which includes the effect of firm size. In order to test the hypotheses, the measures of the independent variables (IV) needs the be established, I will start by explicating how the independent variables are composed.

5.2.1 Excessive compensation

The first independent variable of interest, EXCESS, is included to test whether or not it will influence the choice to voluntary purchase the review. Excessive compensation is measured by the model of Core et al. (1999). This calculation is used widely in prior academic literature (Brick et al., 2006; Palia, 2001; Hill, Lopez and Reitenga, 2016). Their model measures excessive compensation as the sum of:

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whereby the actual CEO compensation (CEOCOM) is obtained via annual reports or proxy statements. The actual CEO compensation consists of a base salary, bonuses, stocks, options, pensions and other compensation. The expected compensation (EXPCOM) is calculated based on economic, governance and CEO determinants as shown by Core et al. (1999). A fixed effects panel regression give the expected compensation for each firm year. The formula (3) calculates the expected compensation, based on economic, governance and CEO determinates.

EXPCOM = α + β1SALESi,t + β2INVESTi,t + β3 ROAi,t + β5INDEPi,t+ β6BOARDSIZEi,t (4) + β7DUALITYi,t + β8GENDERi,t + β9FOUNDERi,t + β10TENUREi,t+ ε

The economic determinants of the expected compensation are SALES, INVEST and ROA. In the formula is firm size (SALES) taken into account, measured by firm sales, as larger firms need managers of higher quality due to a more complex organization. Those managers are expected to have higher salary standards (Core et al, 1999; Rosen, 1982; Smith and Watts, 1992). Firms’ investment opportunity (INVEST) is measured by the market-to-book ratio. Firm performance is measured by the ROA (Core et al, 1999).

Governance determinants included in the regression models are INDEP, BOARDSIZE, CEODUA. The independence variable (INDEP) is measured as the number of independent directors divided by the total number of directors. BOARDSIZE is the number of directors in the board. Finally, recent literature shows that executive compensation is higher when CEOs are also chairman of the board of directors (Core et al., 1999). CEODUA is a dummy variable which takes the value of 1 when the CEO is also the chairman of the board and 0 otherwise.

Furthermore, the CEO determinants are take into account. The variable TENURE, is calculated as the number of years the CEO held the position as CEO of the firm, as tenure might influence the compensation level (Hill and Phan, 1991). Moreover, as gender might influence the level of compensation (Mohan, 2014), a dummy variable GENDER is included in the model, which take the value of 1 if the CEO is a male, and 0 if the CEO is female. Finally, FOUNDER, indicates whether the CEO is the founder of the firm, or is familiarly connected to the founder, as academic literature shows that founder CEOs compensation might deviate (He, 2008).

Finally, the model is controlled for year and industry effects by including dummy variables to the model. Eventually, a fixed effects panel regression results in a new variable (EXCESS) which indicates whether the CEOs’ compensation is more than could be expected based on the economic, governance and CEO determinants.

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5.2.2 CEO power

The second hypothesis predicts that powerful CEOs will not purchase the voluntary review, in order to remain their power. In order to perform the analysis, I created a CEO power index of power signals, which consists of: duality, founder, tenure, pay slice and board independence. The first component, duality, is coded 1 if the CEO is also the chairman of the board, as duality is a way to acquire power (Combs, Ketchen, Perryman and Donahue, 2007; Haynes and Hillman, 2010). Second, founder, which is coded 1 if the CEO is also the founder or related to the founder of the firm, and 0 otherwise, as founder status is positively associated with power (Adams, Almeida and Ferreira, 2005). During the tenure of the CEO, their influence within the firm can increase (Hill and Phan, 1991). Therefore, tenure is included within the analysis, whereby it is been coded 1 if the tenure exceeds the mean tenure of the sample and 0 otherwise. Furthermore, the CEO pay slice is taken into account, as it is a signal power, which captures both observable as unobservable effects (Feng, Luo and Shelvin, 2011; Hill et al., 2016). Whereby the component takes the value of 1 when the CPS is above the sample means, and 0 otherwise. Finally, the last measure, board independence, is taken into account, as CEOs have more influence over the board as independence decreases (Ryan and Wiggins, 2004). It is coded 1 if the board independence is below mean sample and 0 otherwise.

The value of the CEO power index ranges between zero to five. Whereby, zero reflects CEOs that are, according to the power index measures the least powerful. The created variable (CEOPOWER) is included in the review model.

5.2.3 Board of director quality

The last hypothesis analyse whether board quality influence a firms’ choice to purchase the voluntary review. The measure the impact of board quality, I created a board quality variable which consists the components: board independence, board size, board meetings and duality (Johl, Subramaniam and Cooper, 2013). The board independence variable is codded 1 if the independence ratio exceeds the mean of the sample and 0 otherwise. The variable board size has been measured as the number of board members and is coded 1 if it was below mean and 0 otherwise, because larger board tend to be less effectively in monitoring firms (Eisenberg et al., 1998; Yermack, 1996). Finally, the board meetings variables is calculated as the number of board meetings, when this exceeds the mean of the sample, it was coded 1 and 0 otherwise.

The board quality variable can take the values zero to four, whereby zero reflects the less qualified board of directors. The created variable (BOARDQUALITY) is included in the review model.

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5.2.4 Control variables

The review models (e.g. equation 1 and 2) are included with control variables, as those may influence the choice whether or not to purchase a review of the quarterly financial statements. Following Ettredge et al. (1994), I add a variable SIZE, measured as the natural logarithm of the total assets and INCREV, measured by the formula; current assets/ total assets. Both these variables control for the complexity of a firm, which is significantly associated with the demand of audit review hours (Kajüter et al, 2016; Hribar, Kravet and Wilson, 2014). The market-to-book ratio (MB) is used as a proxy for growth opportunities of firms (Porumb and Karaibrahimoglu, 2017). LEV (leverage) is included because highly leveraged firms deals with higher agency conflicts, and therefore the need for monitoring is higher (Jensen and Meckling, 1976, Minnis, 2011). More profitable firms does less needs monitoring, therefore ROA is added in order to control for profitable organizations. YEAR is added to control for time-series. An industry variable (IND) is added, because some industries have more litigation than others (Kajüter et al., 2016; Francis, Philbrick and Schipper, 1994). Table 2 provides an overview of all the variable definitions which are included in the analyses. All variables are winzorised at 1 percent level.

6. RESULTS

6.1 Descriptive statistics

Table 3 provides information regarding the variables which are used in the regressions. The results shows that the most overpaid CEO receives approximately 15.5 million Canadian dollar more than could be expected based on the determinants, while the most underpaid CEO receives approximately 4.8 million Canadian dollars to less than could be expected based on the economic, governance and CEO determinants. Furthermore, the summary statistics shows that board independence vary from 40 percent to 92.9 percent. Finally, the sample shows that approximately 28,5% does not purchase the review and 71,5% have purchased the review of the quarterly financial statements.

The correlation matrix, table 3, provides information of the correlations between the variables. Within this correlation matrix, there are no indications off possible multicollinearity issues. The highest correlation between board independence and board quality (r = 0.744, p < 0.01). Moreover,

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the size of a company is correlated with the size of the board of directors (r = 0.560, p < 0.01). This can be explained, as board size increases when firms grow (Boone, Field, Karpoff and Raheja, 2007).

6.2 Results

To test whether excessive compensation influence the decision to purchase the voluntary review of the quarterly financial statements, robust PROBIT regressions are performed. Each of the subheads will provide the results regarding the specific hypotheses as constructed in chapter 4.

Excessive compensation

Table 4 presents the results of the PROBIT regression regarding the excessive compensation. The results shows that excessive compensation is positively associated with the purchase of the voluntary review (β = 0.701, p < 0.01). In other words, firms with CEOs that receives more compensation than can be expected based on economic, governance and CEO characteristics, are more likely to purchase the voluntary review of the interim financial statements. Moreover, in line with the expectations, the model suggests that firm size is highly associated with the purchase of the voluntary review (β = 0.730, p < 0.01), these results are similar with previous research (Porumb and Karaibrahimoglu, 2017; Hoehn, 2013), who also found enhanced effects when firm size increases. Furthermore, the ROA is negatively associated, and highly significant (β = -6.695, p < 0.01), which is also in line with previous research. Concluding, both hypotheses 1 and 1a are supported by the results.

CEO power

With respect to the CEO power hypotheses, table 5 display the results. These shows that there is a significant negative association between CEO power and the purchase of the voluntary review (β = -1.512, p < 0.01), and thereby supporting hypothesis 2. Moreover, when firm size is taken into account, this relationship becomes stronger (β = -1.986, p < 0.01), which is in line with hypothesis 2a. Thus, CEO power is negatively associated with the purchase of the voluntary review and this association is becomes stronger when firm size increases.

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Board of director quality

Finally, the results of the board of director quality hypotheses shows that board quality is highly associated with the purchase of the interim review (β = 0.730, p < 0.01). This relationship becomes stronger as firm size increases. Thus, when the quality of the board increases, it is more likely that the firm purchases the voluntary review. Moreover, the results suggests that this holds for larger firms more than smaller firms (β = 0.585, p < 0.01). Which supports both hypothesis 3 and 3a.

[ Insert table 7 about here]

6.3 Sensitivity analysis

In order to access whether these results are robust. The analyses are re-estimated based on other measures of excessive compensation, CEO power and board of director quality. Each of the subheads will provide alternative measures and the results of the regressions for the hypotheses.

Excessive compensation

Excessive compensation can be measured based on the CEO pay slice (CPS). The CPS is ‘slice’ that CEOs compensation take as to the total of the top five executives in a firm (Bebchuk, Cremers and Peyer, 2011). Following Bebchuk et al. (2011), the CPS is measured by the total of the compensation of each of the top three executives, including every component of the compensation plans. According to Bebchuk et al. (2011), a higher CPS is negatively associated with firm performance, accounting profitability, stock returns, higher odds of the CEO receiving a lucky option grant at the lowest price of the month and lower performance sensitivity of CEO turnover. In other words, it leads to higher agency problems.

Table 5 provide the results for the PROBIT regressions regarding the CEO pay slice. Column (1) shows no significant association between the CPS and the purchase of voluntary reviews. However, column (2) indicates that firms size will influence this relation at such level that the when firm size increase, the CPS is highly significant positively associated with the purchase of the voluntary review (β = 5.934, p < 0.01). Thus, large firms with CEOs that takes a higher percentages of the CPS, are more likely to purchase the voluntary review. These results are in line with the previous results of the excessive compensation. Furthermore, originally the CPS methods takes the top five executives, but the sample consists of firms with data of maximum three executives. In order to test the robustness, the CPS with five executives is executed and presented in tables (3) and (4), the sample is smaller due to missing data. The results displays the same effects with smaller coefficients (β = 3.665, p < 0.01)

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CEO power

The composed CEOPOWER variable exists of five components, in order to address sensitivity issues, I re-estimated the regressions with the variables included separately. Thereby, all the variables reflect the actual numbers, instead of being codded as 1 or 0 as it exceeds the mean of the sample. Column (1) displays the initial variables, while columns (2) to (6) shows the different variable including the interaction with firm size. The results suggests that all duality, tenure, CPS and independence is significant related with respect to the voluntary choice to purchase the review. Moreover, based on the results, all the significant components are significant associated when firm size is taken into account. Only CEO founder is not significant associated with the review.

Board of director quality

In the initial analysis all the board quality variables are composed as one single variable (BOARDQUALITY). In order to test the robustness of the variable, all parts are tested separately, whereby variables board size and board meetings reflects the actual numbers. The results indicates that the all the variable, except the number of board meetings, is associated with the purchase of the voluntary review. Moreover, firm size enhances these effects. In the initial analysis, board size is not associated, but when it is interacted with firm size, it becomes highly negative associated with the voluntary review (β = -0.348, p < 0.01). Which is consistent with prior literature, suggesting that larger boards are ineffective in monitoring management (Yermack, 1996; Eisenberg et al., 1998; Raheja, 2005).

7. CONCLUSION

7.1 Conclusion

This study analyses whether executive compensation, CEO power and board of director quality influences the choice to voluntary purchase of the review, drawing on a sample of 256 firm years of 61 unique Canadian firms, during the period 2010-2014. Based on the model of Core et al. (1999), the results shows that excessive compensation is positively associated with the purchase of the voluntary review, although this might not be expected, as ‘excessive’ suggests that the CEO receives more than is expected, based on the economic, governance and CEO determinants. So, an explanation could be found in the signalling effect of the voluntary purchase of the review. Kajüter et al. (2016) already

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concluded that the increase of the information content of the interim financial statements is largely driven by the signalling value of the review. This is caused by the so called “audit expectation gap”, as users of the interim review have unreasonable expectations of a review (Gay, Schelluch and Baines, 1998). Furthermore, investors believe reviews gave the same assurance as an annual audit (Pany and Smith, 1982). However, Kausar et al. (2016), argued that firms who voluntary purchased an annual audit, are the ones that outperform other firms. Concluding, excessive paid CEOs might use the interim review in order to verify their excessive compensation levels, by signalling unobservable excellence. Furthermore, the CEO power index, which is composed by duality, tenure, founder, CPS and board independence, shows a negative association. Even the sensitivity analysis showed that almost every component has an significant impact on the choice whether or not to purchase the review. The results supports the argument that powerful CEOs will not participate in activities that might reduce their abilities and bargaining power within the organization.

Finally, the study shows that board quality is highly associated with the purchase of the interim review. Indicating that more qualified boards will be able to more actively monitor management on behalf of the shareholder, and therefore will commit to activities in order to achieve those objectives (Ryan and Wiggins, 2004).

This study extends the existing literature regarding the voluntary purchase of the quarterly financial statements. As most literature is focussed on the possible costs and benefits of the outcome of the review, I investigated whether managerial incentives and monitoring quality are determinants to commit to timely external verification brought by auditors through the review.

7.2 Limitations and discussion

As with every academic literature, this study comes with some limitations. First, the measurement of excessive compensation is based on the model of Core et al. (1999). However, they use more explanatory variables to determine the level of excessive compensation. As indicated, the ownership structure, which measures the CEO ownership, block holder ownership and director ownership, is not included due to unavailability of data. Furthermore, Core et al. (1999) distinguishes different types of independent directors. In this study, there is only one variable included which measures if an director is independent. While Core et al. (1999) also included the variables busy directors, interlocked directors, grey directors and directors who are older than 69. Finally, they included a stock market return variable in their model, which is not included in this study due to missing data. Therefore, when these variables are added, the results may vary from the results which are presented in this thesis.

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Second, due to time limitations, the sample size of this study is somewhat limited, as the sample consists of 256 observations from 61 different firms, during 2010-2014. The study of Core et al. (1999) use a sample which is approximately two times larger, while the diversification of firms is even four times bigger. Moreover, Brick et al. (2006) used an sample which consisted of at least 4108 observations from 1163 firms. However the sample in this study is chosen randomly, there is an inherent risk that a different or a larger sample might present results that deviate from the results as presented in this thesis.

7.3 Future research

Due to the ongoing debate, the interim review is not mandatory yet in some jurisdictions. Scientific research about the advantages and disadvantages gave mixed results. Most criticasters argue that, especially smaller, firms faces significant increase in audit fees. As a result, especially smaller firms, do not purchase the review. The motives for firms and executives to purchase the interim review has barely bin subject of research. This thesis investigates the link between managerial incentives and monitoring quality to the purchase of the review. However, the applications and further research possibilities are almost inexhaustible.

First, as mentioned in the limitations, this research could be re-performed. Increasing the sample size and adding the missing variables to calculate the excessive compensation, following Core et al. (1999), could provide new insides in managerial incentives and results as provided in this research. Also, the effect of switching between review and no review would be interesting, especially to see what effects it has on excessive executive compensation.

Furthermore, in this thesis, only the compensation level of CEOs is taken into account. However, CFOs are primarily responsible for the financial reporting processes. Jiang, Petroni and Wang (2010) find that CFOs’ equity incentives are more sensitive than CEOs’ equity incentives for accruals and the likelihood of beating analyst forecasts. Furthermore, CFOs option portfolio value to stock price is significantly associated with future stock price crash risk, while this association with CEOs option sensitivity was weak (Kim, Li and Zhang, 2011). Concluding, CFOs compensation structure could be an important factor when analysing managerial incentives towards the voluntary purchase of the review.

Moreover, as mentioned, a possible explanation of the positive association between excessive compensation and the purchase of voluntary reviews, could be director compensation. According to Brick et al. (2006), excessive executive compensation is closely related to excessive director compensation. Therefore, the interests of the directors, who should monitoring the management, and

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shareholders might not be aligned. Therefore, it would be interesting to evaluate director compensation compared to executive compensation in relation with the purchase of the voluntary review. Moreover, excessive director compensation could be an element of board quality, as excess director compensation reduces monitoring effort from directors.

Finally, although earnings quality has been subject of research in combination with the voluntary review, there are still possibilities to test whether the review has an increasing effect on earnings quality. As the results of the interim review are not publicly available, the monitoring function needs to work optimal. Klein (2002) found a negative relation between board independence and abnormal accruals, meaning board independence increases earnings quality. Therefore, it could be interesting to evaluate the relationship between the earnings quality and the voluntary review with a moderating effect of board quality.

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TABLES

Table 1: Sample selection

Reason Firm years

Initial sample 4,895

Missing data: determinants - 702

Missing data: time period - 2,147

Missing data: executive compensation - 1,790

Final sample 256

Review 183 (71,5%)

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Table 2: Variable definitions

Variable Description

REVIEW Am indicator variable that equals 1 if the firm voluntary purchased the review, and 0 otherwise.

EXCESS A variable which indicates the amount of excessive compensation, based on the economic, governance and CEO determinants (Core et al., 1999). CPS The slice of the total compensation that the CEO takes from the top three

executives (Bebchuk et al., 2011).

BOARDQUALITY A variable which value ranges between 0 and 4, based on the board size, board independence, board meetings and CEO duality.

CEOPOWER A variable which value ranges between 0 and 5, based on the CPS, CEO duality, CEO founder, CEO tenure and board independence.

SALES Reflects the size of the firm and is measured as the total sales of the firm, in millions in year t.

SIZE Reflects the size of the firm and is measured as the natural logarithm of the total assets in year t.

INCREV Is measured by inventory plus total receivables divided by total assets in year t, and reflects firm complexity

INVEST Measures the investment opportunity of the firm. Calculated as the market-to-book ratio in year t.

ROA Measures the profitability of the firm and is measured by the net income, divided by the total assets in year t.

LEV Leverage is calculated as the total liabilities divided by the total assets in year t.

INDEP Reflects the percentage of board members in the board of director that is independent in year t.

BOARDMEET Board meetings is calculated as the number of meetings held by the board of directors during year t.

BOARDSIZE Board size reflects the number of board members on the board of directors during year t.

DUALITY A dummy variable which takes the value of 1 when the CEO is also the chairman of the board, and 0 otherwise.

FOUNDER A dummy variable which takes the value of 1 when the CEO is the founder, or familiar related to the founder of the firm, and 0 otherwise. TENURE Reflects the number of years the CEO holds the position of CEO in the

Excessive compensation, CEO power and board quality: incentives to purchase a voluntary review?