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    Equity Incentives and Internal Control Weaknesses.
    research summary posted July 28, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 14.0 Corporate Matters, 14.05 Earnings Targets and Management Behavior, 14.07 Executive Compensation, 14.10 CEO Compensation 
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    Title:
    Equity Incentives and Internal Control Weaknesses.
    Practical Implications:

    The analysis shows that (1) equity incentives are more effective in reducing company-level control problems; (2) restricted equity provides greater incentives than unrestricted equity; and (3) CFO incentives have a more significant impact on the quality of internal control than CEO incentives. These insights have important implications for compensation committees who make compensation recommendations and the full board of directors who ratifies those recommendations. They suggest that both the level and type of equity incentives should be considered in compensation design to motivate managers to invest in strong internal controls.

    Citation:

    Balsam, S., Jiang, W., Lu, B. 2014. Equity Incentives and Internal Control Weaknesses. Contemporary Accounting Research 31 (1):178-201. 

    Keywords:
    Internal auditing, equity incentives, stock options, internal controls, material weakness (auditing), CEO compensation, CFO compensation, executive compensation
    Purpose of the Study:

    The authors address the empirical question of whether incentives associated with equity ownership induce managers to maintain strong internal controls. If managers believe adverse internal control opinions negatively affect the value of their equity holdings, equity incentives may provide the motivation for them to strengthen internal controls. The negative wealth consequences associated with the disclosure of internal control weaknesses suggest that equity-based incentives should motivate managers to develop and maintain effective internal controls over financial reporting, though some prior work has shown that equity incentives can lead to opportunistic actions by management. To the extent that lax internal controls provide the opportunity for earnings management, the link between accounting earning and share prices, along with the motivation provided by equity incentive to increase share prices, may provide an incentive for managers to want weaker internal controls. The study adds to the literature on equity incentives by focusing on specific aspect of managerial performance- the effectiveness of internal controls and the literature examining the determinants of internal control deficiencies. The results of the study provide insight into the role equity incentives play in improving the quality of internal control.

    Design/Method/ Approach:

    The study was conducted using a sample comprised of firms filing SOX Section 404 reports during 2004 and 2005. The authors obtained the data on internal control opinions from Audit Analytics, the financial data from COMPUSTAT, and the compensation and governance variables from Equilar Inc, yielding a sample of 569 firms. The control sample contained 3,798 observations. They used firm size, loss proportion and firm age to capture the level of investment in the internal control systems.

    Findings:
    • Equity incentives motivate managers to implement effective controls.
    • Evidence suggests that firms where the CEO and CFO have higher levels of equity incentives are less likely to have internal control problems.
    • The equity incentives of the CFO play a more significant role in determining internal control quality than those of the CEO.
    • The bonus is significantly lower, and salary significantly higher, as a percentage of total compensation, for firms with material internal control weaknesses.
    • Firms with material internal control weaknesses are smaller, younger, more likely to have had a loss, have more segments and are more likely to have experienced a restructuring, than firms without weaknesses.
    • Material weakness firms had fewer independent directors, smaller audit committees and boards, are less likely to engage a Big 4 auditor, had shorter auditor tenures, and were more likely to have experienced a recent auditor change.
    • Lax internal controls provide the opportunity for earnings management, which may allow managers to meet targets to maintain a higher share price than otherwise warranted. When the authors partition based upon type of opinion, they find that equity incentives are more effective in mitigating company-level internal control risk.
    Category:
    Corporate Matters, Internal Control
    Sub-category:
    CEO Compensation, Earnings Targets & Management Behavior, Executive Compensation, Reporting Material Weaknesses