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ERASMUS UNIVERSITY ROTTERDAMERASMUS SCHOOL OF ECONOMICSMSc ACCOUNTING, AUDITING & CONTROL

Effectiveness of Internal Controls and Managerial Compensation schemes

Evidence from the financial crisis

Author: Soleymi ManuelaStudent number: 315360Thesis supervisor: Jan Pasmooij RA RE ROFinish date: August 2014


Master Thesis 2013-2014

Acknowledgement

I would like to take this opportunity to briefly thank all the ones whom provided me with all their

knowledgeable input to help me during this long enduring master thesis path. I am very grateful with

the wonderful support system I have, namely my family and friends. A special thank you to Mrs. Franklin

for all the helpful thesis tips she provided.

Abstract

Executives of large public companies have the fiduciary responsibility to create, maintain and report on

the effectiveness of their internal control system since the implementation of SOX 404 in 2002. Auditors

are also required by SOX 404 to attest on this assertions made by the executives. This can give the

shareholders the trust in top management performance to safeguard their assets, especially after the

big financial fraud scandals documented. Recently conducted researches showed that an effective

internal control system can be seen as a good non-financial measure of top executive’s performance

(Hoitash, Hoitash & Johnstone (2012). This thesis examines the association between the possibility of

effective internal controls and CFO’s equity and cash bonus compensations. The empirical research

consists of two sample periods. The first sample period is before the financial crisis from 2004-2006, and

the second sample period is during the financial crisis from 2007-2009. Data to conduct the research

was collected from Compustat Executive Compensation database, Audit analytics, Risk Metrics and

Compustat. Two Logistic regression models were designed to study whether effective internal control

systems are positively associated with CFO’s equity and bonus compensations. Finally, the results

showed that for the period before the financial crisis, there is a significant positive association for the

effectiveness of internal controls and equity compensation. But for both sample periods, there was no

significant association found for the effectiveness of companies’ internal controls and CFO’s cash bonus

compensation. Also found was that the effectiveness of internal controls is neither associated with the

bonus nor the equity compensation during the financial crisis, which can be evidence of managerial rent

extraction during the financial crisis.

Keywords: Internal controls, SOX 404, Executive compensation & Financial crisis

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Table of Contents

Abstract.......................................................................................................................................................1

1. Introduction.........................................................................................................................................4

1.1 Background..................................................................................................................................4

1.2 Research questions......................................................................................................................5

1.3 Contribution................................................................................................................................6

1.4 Outline.........................................................................................................................................6

2. Theoretical background.......................................................................................................................8

2.1 Introduction.................................................................................................................................8

2.2 Internal control systems..............................................................................................................8

2.3 Executive compensation schemes...............................................................................................9

2.3.1 Agency theory...........................................................................................................................10

2.3.2 Optimal contracting theory.......................................................................................................11

2.3.3 Managerial power theory.........................................................................................................11

2.3.4 Bonus plan hypothesis..............................................................................................................12

2.4 Conclusion.................................................................................................................................12

3. Literature review...............................................................................................................................14

3.1 Introduction...............................................................................................................................14

3.2 Internal controls & Executive compensation Relation...............................................................14

3.2.1 Pay-without performance.........................................................................................................16

3.3 The impact of the financial crisis...............................................................................................16

3.3.1 The Financial crisis Executive Compensations...........................................................................16

3.3.2 The financial crisis Internal controls..........................................................................................17

3.4 Conclusion.................................................................................................................................18

4. Hypotheses........................................................................................................................................21

4.1 Introduction...............................................................................................................................21

4.2 Hypotheses development..........................................................................................................21

4.2.1 The Financial Crisis....................................................................................................................22

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4.3 Conclusion.................................................................................................................................23

5. Methodology.....................................................................................................................................24

5.1 Introduction...............................................................................................................................24

5.2 Sample & Data collection...........................................................................................................24

5.3 Research design.........................................................................................................................25

5.3.1 Control variables.......................................................................................................................26

5.3.2 Governance independent variables...........................................................................................28

5.3.2 Dependent variable...................................................................................................................31

5.4 Conclusion.................................................................................................................................31

6. Results...............................................................................................................................................33

6.1 Introduction...............................................................................................................................33

6.2 Descriptive statistics..................................................................................................................33

6.2.1 Sample period before financial crisis 2004-2006.......................................................................33

6.2.2 Sample period during financial crisis 2007-2009.......................................................................34

6.3 Main test results........................................................................................................................36

6.3.1 Hypotheses 1a...........................................................................................................................36

6.3.2 Hypotheses 1b...........................................................................................................................37

6.3.3 Hypotheses 2a & 2b..................................................................................................................39

7. Conclusion & Limitations...................................................................................................................41

7.1 Conclusion.................................................................................................................................41

7.2 Limitations.................................................................................................................................42

Reference list.............................................................................................................................................44

Appendix...................................................................................................................................................47

Appendix 1: Regression model (3) Bonus before Financial crisis...........................................................47

Appendix 2: Regression model (4) Equity compensation before Financial crisis...................................48

Appendix 3: Regression model (3) Bonus during Financial crisis...........................................................49

Appendix 4: Regression model (4) Equity during Financial crisis...........................................................50

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Effectiveness of Internal Controls and managerial compensation schemes:Evidence from the financial crisis

1. Introduction

1.1 Background

CEO’s and CFO’s responsibilities within an enterprise are certainly growing over time. They

need to provide accurate and reliable financial information to their investors and creditors.

Designing an effective internal control system has shown to enhance the reliability of financial

reporting (Hammersley, Myers & Shakespeare, 2008). Section 404(a) of Sarbanes-Oxley Act

(hereafter referred as SOX) gives top management of publicly held companies the legal

responsibility to establish, maintain and report on the adequacy of internal controls in place

(Arens, Elder, & Beasley, 2012). CFO’s are mainly the ones held responsible for this duty. An

effective control environment within a firm is of great importance to achieve company’s

objectives. Internal controls can improve the effectiveness and efficiency of the operational

processes (Arens, Elder, & Beasley, 2012). Managers need to set the tone at the top and

emphasis on the importance of internal controls through companies’ policies to achieve a

strong control environment. Research has shown that internal controls material weaknesses

are mostly related to weak senior management and lack of training (Klamm, Kobelsky, &

Watson, 2012). This means that corporate governance has a strong impact on the effectiveness

of the internal control. With such important corporate responsibilities you would expect huge

executives’ compensations to be appropriate. But is a great compensation a guaranty and

motivation for CEO’s and CFO’s to deliver effective internal controls? Shareholders constantly

complain about the rising salaries of top management, especially considering the latest

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financial crisis.1 Auditors of large public companies, the accelerated filers2, are required by

section 404(b) of SOX to attest on the assertions made by management regarding the

effectiveness of the internal controls. This can give the shareholders the trust in top

management performance to safeguard their assets, especially after the big financial fraud

scandals documented.

1.2 Research questions

Executive compensation schemes are generally dependent upon the financial performance of

the manager’s firm, such as their market returns or earnings. Although, prior research showed

that due to the responsibilities of CFO’s towards their internal control systems (they are

mandated to report on their effectiveness since the implementation of SOX 404), an effective

internal control can be seen as a good non-financial measure of top executive’s performance

(Hoitash, Hoitash & Johnstone (2012). SOX 404 can be seen as an informative tool that can

possibly affect executive compensation schemes. So based on these notions, the compensation

of top executives is nowadays expected to be partially based on the effectiveness of the firm’s

internal controls. But compensation schemes also give managers the incentive to take more risk

which was one of the causes of financial crisis (Landskroner & Raviv, 2010). This study examines

the association between an effective internal control and executive compensation patterns

before and during the financial crisis. The main research questions this thesis will address are as

followed.

i) Is there an association between auditors’ attestation on the effectiveness of internal

control required by SOX 404(b) and CFO’s compensation schemes? 1 http://www.nytimes.com/2012/06/17/business/executive-pay-still-climbing-despite-a-shareholder-din.html?pagewanted=all&_r=02 Accelerated filers are public companies with a market capitalization above $75 million. Non-accelerated filers are exempt from section 404(b) of SOX.

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ii) Did the financial crisis of 2007 impact the possible association stated in the research

question (i)?

1.3 Contribution

The results of this study will contribute to the existent literature regarding the effect of

executive compensation schemes and the cost of SOX 404 disclosures. This study is among the

few recent papers that examine the relation between managerial compensations and the

effectiveness of internal controls. The main contribution of this study is that this will be the first

paper to examine the impact of the financial crisis on the association between internal controls

and executive compensation plans. Prior studies have mainly focus on the relation between

ineffective internal controls and market reactions; audit quality and firm performance/ earnings

quality (e.g. Brown & Lim, 2012; Hammersley et al., 2012).

This study will inform regulators and managers on the effectiveness of section 404 of SOX on

whether it provides the right incentives to managers to address their internal control

deficiencies effectively and exert that extra effort due to the possible higher executive

compensations for CFO’s at firms with effective internal controls.

1.4 Outline

The next chapter provides an overview of the relevant theories and concepts that explain the

purpose of managerial compensation schemes as a good incentive for executives to create and

maintain effective internal control systems. Chapter 3 gives a review of the relevant empirical

studies conducted. Different studies that researched the association between internal control

material weaknesses and effectiveness on executive compensation schemes are being

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discussed in this chapter. The impact of the financial crisis on this association will also be

addressed in chapter 3. Chapter 4 explains the different hypotheses that were developed after

carefully reviewing prior relevant research studies in chapter 3. In chapter 5 more inside is

given on the data collection process and the sample periods used. Further on, the research

design will be thoroughly explained in chapter 5. Chapter 6 shows the results of the two logistic

regressions for respectively cash bonus compensation and equity compensation. Lastly, chapter

7 provides the conclusion and possible limitations of this paper.

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2. Theoretical background

2.1 Introduction

There are different theories that hypothesize the relationship between executive

compensations and overall firm performance. This chapter provides an overview of the relevant

theories and concepts that explain why managerial compensation schemes can be a good

incentive for executives to address internal control deficiencies which in turn creates

shareholder value. But before doing so, it’s important to elaborate on the history and

importance of internal control systems. The explanation of the concepts and theories provided

in this chapter are crucial for the remainder of this research.

2.2 Internal control systems

Although internal controls may have existed since ancient times, it was in 1949 that the

American Institute of Accountants first defined this term3. Since 1977 companies are required

by the Foreign Corrupt Practices Act to establish and maintain internal control systems that give

the shareholders and the public at large reasonable assurance over the registration of

transactions and safeguarding of assets. Even so, the frequency of financial reporting fraud was

at an intolerable level. Therefore, in 1985, an independent committee, the Committee of

Sponsoring Organizations (hereafter referred as COSO) was formed. In a later report in 1988,

COSO advocated that companies should be required by SEC to file a management report in

their annual report that stated management’s responsibilities towards the company and their

3 http://www.ehow.com/facts_7203983_history-internal-control-systems.html

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assessment on the effectiveness of their internal control systems. This issue was challenged by

the AICP with valuable arguments at the time (Henry, Shon, & Weiss, 2011).

It was until 2002 when the shareholders’ value (worth billions of dollars) and the trust in the US

capital market was crushed due to the numerous financial scandals in that particular year, that

led to the formation of SOX 404 which mandates managers of a publicly held companies to

issue an report on the effectiveness of their internal controls. This SOX 404 requirement

particularly increases the responsibility of the Chief Financial Officers whom are required to

maintain a healthy financial environment for their firm. The final requirement implemented by

SOX 404 is the attestation rule by the external auditor on management’s report (Arens, Elder, &

Beasley, 2012). SOX 404 can be classified as one of the most complex en costly regulation to

comply with and is therefore seen as a burden for the CFO’s of publicly held companies who

must exert extra effort to determine the effectiveness of their internal control systems. Studies

have shown a positive association between cost of compliance and the presence of material

internal control weaknesses, auditors’ size and firm size (Krishnan, Rama, & Zhang, 2008).

Managerial compensation schemes can be an incentive for CFO’s for the extra effort they need

to take on to fulfill the requirements of SOX 404. Due to the promptly accessible internal

control information, SOX 404 can be seen as a good non-financial measure for executives’ pay

schemes. Recent study has shown that CFO’s compensations are another cross sectional

determinant that increases the chances of a company reporting an effective internal control

system (Henry, Shon, & Weiss, 2011)4.

2.3 Executive compensation schemes

Executive compensation schemes are an important element of corporate governance and are

set by the independent members of the board of directors (Arens, Elder, & Beasley, 2012).

Compensation schemes are the perfect mechanism to appeal, drive and holding on to the top

4 See chapter 3

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qualitative executives, if optimally set by the board5. There are different forms of executive

compensations. In this paper compensation refers to the base salary plus short term incentives

or/and long term incentives. The base salary is the fixed component of the executives’ short

term compensations. The variable short term incentives are usually cash bonuses that top

officers receive above their base salary, at the end of the year, for their performance and

profitability within the organization in that particular year (Hoitash, Hoitash, & Johnstone,

2012). Instead of cash bonuses, managers can also be compensated with shares or stock

options of their company. These are categorized as the long term incentives as they drive

managers to create sustainable firm value. There are different theories explaining the cost

effectiveness of both short term incentives and long term incentives. The agency theory,

discussed in the next paragraph, states why executive compensations are an important element

of corporate governance.

2.3.1 Agency theory

The well-known agency theory of Jensen & Meckling (1976) argues that the interests of

executive management often conflicts with the interest of shareholders. This will lead to the

agency problem where the agents’ (corporate management) will act opportunistically and

therefore carrying solely on their own best interest and not for creating shareholder’s value.

This problem arises due to the agents’ information and control advantages in comparison to the

principals (shareowners). Therefore effective corporate governance is needed to direct and

control the different participants, especially the top officers in the organization. Jensen and

Meckling (1976) mentioned in their paper that executive compensation schemes can be a good

mechanism (among other factors) to mitigate the agency problem. This agency problem is a

bigger issue for larger and complex firms, which means that CFO’s of larger companies require a

higher salary and greater equity incentives as a premium to exert effort (Edmans and Gabaix,

2009). Thus the board of directors has an important task to monitor and set the optimal

contract for their officers to incentivize them to create shareholder value.5 See paragraph 2.3.3 optimal contracting

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2.3.2 Optimal contracting theory

Contracts are a crucial element to incentivize managers to make earnings maximizing choices

for their firm. Contracts are designed in a manner to give executives the incentives to exert

their maximal effort to create an effective internal control system for safeguarding of assets

and growth opportunities (Edmans & Gabaix, 2009). The optimal contracting theory states that

managers are often compensated with stocks or stocks options to provide them with the

incentive to create shareholder value that will benefit both them and the investors and

therefore reducing the agency problem6. So long term incentives can align the interest of the

executives to those of the shareholders, if contracts are made under the arm’s length

condition7.

2.3.3 Managerial power theory

There is also a downfall of the optimal contracting theory. Edmans and Gabaix (2009) argue

that recently studied compensation schemes patterns showed characteristics conflicting with

the optimal contracting theory. A given explanation for this inconsistency was the possible

evidence of rent extraction due to managerial power. The managerial power perspective does

not consider the executive compensation as an incentive to reduce the agency problem. The

managerial power refers to the practice where executives use their power over the board to

extract rents, resulting in high executive pay without a link to their performance (Bebchuk &

Fried, 2005 and Bebchuk et al., 2002). Skaife & Veenman (2012) showed that executives of

companies with ineffective internal control engage more easily in rent extraction practices. An

example given in the study of Skaife & Veenman (2012) was when managers extract rent by

using their companies’ nonpublic information to trade their owned company shares for their

own personal benefit. The next paragraph will give a further explanation of the theory why

6 http://www.law.harvard.edu/faculty/jfried/Executive_comp_Agency_%20Prob.pdf7 Arm’s length condition refers to the principle that all parties involved in the contract negotiation are independent and managers cannot use their power to influence the decision of the board of directors.

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bonuses are less effective than long term incentives as well as what can go wrong with stock or

stock option compensations.

2.3.4 Bonus plan hypothesis

As explained in the previous paragraph, top executives can use their power for their own

benefit. They are basically the ones responsible for electing the accounting method to report

the financial information. The bonus plan hypotheses state that in the presence of a bonus

scheme managers will choose the accounting method that will increase their reported income

and therefore increasing their bonuses (Healy, 1985). This opportunistic behavior will give rise

to the agency problem. Bergstresser and Phillippon (2006) provide evidence that CEO’s with

large equity- based compensation including stocks or options are more like to manipulate

earnings. A weak internal control will facilitate the manager’s discretion to manipulate

accounting figures and therefore proving managers with the desire for weaker internal controls.

Although, Edmans & Gabaix (2009) argued about the controversy evidence founded that

compensations of executives in larger firms are less sensitive to firm value. A loss of $3.25 of

CEO wealth was reported for every $1,000 of firm value drop. As a result managers where not

incentivize to exert effort to create firm value. This was the result of a weakness in the

corporate governance of larger companies which allowed managers to conciliate contracts for

their own benefit due to their managerial power over the board8. This can lead to excessive

compensations for the executives and therefore resulting in the widely discussed phenomena

of ‘pay without performance’ (Bebchuk & Fried, 2005).

2.4 Conclusion

8 Managerial power refers to the practice where executives use their power to extract rents (obtaining extra value than the value they would have gotten under arm’s length condition) and therefore resulting in high executive pay.

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In 2002, the formation of SOX 404 became a fact when the shareholders’ value and the trust in

the US capital market were crushed due to the numerous financial scandals in that particular

year. This regulation mandates managers of publicly held companies to issue a report on the

effectiveness of their internal controls. This SOX 404 requirement particularly increases the

responsibility of the Chief Financial Officers whom are required to maintain a healthy financial

environment for their firm. Different theories explaining the cost effectiveness of both short

term and long term incentives were also discussed in this chapter. Due to the mixed evidence

the different theory and hypotheses provided, it still remains a research problem as to whether

managerial compensation schemes can positively incentive CFO’s to exert extra effort to create

an effective internal control system for their company and therefore avoiding big financial

scandals. The next chapter will elaborate more on this possible association.

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3. Literature review

3.1 Introduction

This chapter will elaborate on the existing literature regarding the effects of an effective

internal control, executive compensations and the financial crisis. Different empirical studies

explaining the association between internal control material weaknesses and internal control

effectiveness and executive compensation schemes, are being discussed in this chapter.

3.2 Internal controls & Executive compensation Relation

CFO’s have the fiduciary duty of setting up, maintaining and evaluating the effectiveness of the

firm’s internal control system (Arens, Elder, & Beasley, 2012). Hoitash, Hoitash & Johnstone

(2012) showed that the duties of the CFO can influence both the financial and strategic choices

made by these mangers. These choices have impact on the firm earnings’, which are in turn

commonly used as indexes for determining CFO compensation schemes (Brown & Lim, 2012).

An effective internal control can therefore be seen as a good non-financial measure for

executive’s performance. Edmans & Gabaix (2009) argued that compensations of executives in

larger firms are less sensitive to firm value. A loss of $3.25 of CEO wealth was reported for

every $1,000 of firm value drop. As a result, managers of large companies where not incentivize

to exert effort to create firm value and therefore are less likely to exert extra effort to create an

effective internal control. A recent study by Brown & Lim (2012) showed that this sensitivity of

firm performance to executives’ compensations schemes, is not only dependent on the firm

size, but varies when firms report internal control material weaknesses. Brown & Lim (2012)

found a weaker executive compensation-firm value association for firms reporting internal

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control material weaknesses. Hoitash, Hoitash & Johnstone (2012) also found evidence

suggesting that CFO compensations are negatively influenced when firms report an ineffective

internal control system. Balsam et al. (2012) researched the association between equity

incentives and the probability of firms having internal control material weaknesses. They found

that firms with higher equity incentives are more likely to report an effective internal control.

This is thus consistent with the optimal contracting theory, where managers where incentivize

to create effective internal control when compensated with stock or stock options. Kobelsky,

Lim, & Jha (2013) researched the effect of performance-based compensation schemes of CEO’s

and CFO’s on the internal control effectiveness. Their results also showed that long term

incentives, excluding vested options9, are negatively associated with internal control material

weaknesses. But found no significant evidence for the association between short term

incentives and internal control material weaknesses. This is consistent with the study of

Hammersley, Myers & Shakespeare (2008), who found a decline in the firm’s stock prices as a

consequence of reporting ineffective internal control systems. But the findings of Kobelsky, Lim,

& Jha (2013) are inconsistent with those of Hoitash, Hoitash & Johnstone (2012) who found

that both equity and bonus (short term incentives) compensations where negatively affected

due to internal control material weakness disclosures. They also found that companies with

stronger corporate governance in place experienced a larger decline in their executive

compensation schemes. This is due to the strong oversight of the CFO by the board. A strong

expertise board can compose the right executive compensation schemes based on the actual

CFO’s performance. So reporting an ineffective internal control system will result in a higher

penalty in the CFO compensation for firms with strong corporate governance (Hoitash, Hoitash,

& Johnstone, 2012).

So creating an effective internal control system incentivizes managers to exert their maximal

effort to safeguard their company’s assets and creating growth opportunities, which in turn can

positively influence their long term compensation incentives. This is especially the case for

9 Executives who are granted with vested options do not gain control over these stock options until the vested period is passed, this period is often 3 to 5 years.

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companies with strong corporate governance. These results are thus consistent with the

optimal contracting theory10.

3.2.1 Pay-without performance

As discussed in chapter 2, managerial power over the board can lead to excessive

compensations for the executives and therefore resulting in ‘pay without performance’

(Bebchuk & Fried, 2005). Henry, Shon, & Weiss (2011) models are based on this notion of

Bebchuk & Fried (2005). In their first model they separate executive compensation into two

parts. The first component is the explained compensation part related to company-specific

economic conditions, and the second component is the unexplained or residual of the total

compensation. As explained before, this residual compensation can be evidence of rent

extration by executives due to their managerial power. Skaife & Veenman (2012) showed that

executives of companies with ineffective internal control engage more easily in rent extraction

practices. In their second model they examine the possible association between internal control

effectiveness and the explained in contrast to the unexplained residual component. Consisted

with prior researches, Henry, Shon, & Weiss (2011) found a significant association between

internal control effectiveness and executive compensation, but only for the explained

component of executive compensation, for both the CEO and CFO compensation. They

explained that this is evidence of exessive pay, possibly due to mangerial rent extraction.

3.3 The impact of the financial crisis

3.3.1 The Financial crisis Executive Compensations

As explained in the previous chapter, Edmans & Gabaix (2009) found evidence that

compensations of executives in larger firms are less sensitive to firm value. Executives of large

10 See chapter 2, paragraph 2.3.2.

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firms were therefore not motivated to create firm value. The firm performances of the majority

of the companies in the US were under a lot of pressure during the financial crisis of 2007-2009.

It’s difficult to predict if high fluctuations of the manager’s compensations of larger firms were

documented during the financial crisis. Landskroner & Raviv (2010) showed that the

composition of executive compensations can also give managers the incentive to take more risk

which was one of the causes of financial crisis. They showed that cash bonusses were worth

much more than equity incentives during the financial crisis due to the decline in the value of

the firms assets. Managers were therefore not incetivize to create firm value. On the contrary,

their compensation were maximised when choosing the highest possible level of asset risk. This

short term incentives led to the increasing risk-taking that the executives engaged in during the

financial crisis. High incentives may only encourage executives to take moderate risk in order to

positively manipulate the value of their shares price if equity compensation dominates the cash

bonus compensation (Landskroner & Raviv, 2010).

3.3.2 The financial crisis Internal controls

Kirkpatrick (2009) documented that executive were able to take more risk during the financial

crisis due to a weak internal control environment. Managers didn’t fulfill their duties of

safeguarding their assets against excessive risk taking. The board of directors was unsuccessful

at creating a good incentive system/ compensation schemes to motivate the managers’. So also

taking into account the results found by Hoitash, Hoitash & Johnstone (2012) that suggests that

CFO compensations are negatively influenced when firms report an ineffective internal control

system, consistent with the optimal contracting theory, differences in manager’s

compensations and governance components should be documented in the period before and

during the financial crisis, especially for companies with an ineffective internal control system.

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3.4 Conclusion

This chapter gave a review of the different empirical studies done regarding the effects of an

effective or not effective internal control on executive compensation schemes. Studies

examining the causes of the financial crisis of 2007-2009 were also discussed in this chapter.

The discussion emphasized on the association between the financial crisis and internal controls,

and executive compensation schemes. Table 3.1 illustrated below, provides a summary of the

relevant research studies discussed in this chapter and conducted prior to this paper.

Table 3.1 Summary of the relevant studies discussed

Authors Purpose of study Sample Results

Hoitash, Hoitash

& Johnstone

(2012)

Study the association

between CFO

compensation schemes

and the disclosure of

internal control

material weaknesses

Sample consists of

604 firms after the

removal of firms with

CFO turnover and

removal of utility and

financial firms.

Sample period: 2004-

2005

They found evidence

suggesting that CFO bonus,

equity, and total

compensations are negatively

influenced when firms report

an ineffective internal control

system. They found no

significant change in both

CEO’s compensations and

executives’ base salary (short

term incentive).

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Henry, Shon, &

Weiss (2011)

Examines whether

managers

compensation

schemes, incentive

managers to create

effective internal

control systems

They observed 2128

firm-years, 1938

observations reported

effective internal

control, and 190

reported an

ineffective internal

control. Sample

period: 2004-2006.

Only the explained

component (pay for

peformance) of executive

compensation, for both CEO

and CFO, have a positive

significant association with

effective internal control

systems. The unexplained part

is therefore evidence of pay-

without performance due to

rent extraction.

(Brown & Lim,

2012)

Researches the effect

of internal control

material weakness on

the association of

earnings and executive

compensation.

Data collection: 391

observations

reporting ICMW and

3648 with NOMW.


2007.

Brown & Lim (2012) found a

weaker executive

compensation-firm

performance association for

firms reporting internal

control material weaknesses.

(Kobelsky, Lim &

Jha, (2013)

Examine the effect of

performance-based

compensation schemes

of CEO’s and CFO’s on

the internal control

effectiveness.

Data collection: CEO,

302 observations with

ICW and 3352 data

with NOMW. For CFO

data, 267 ICW and

2918 NOMW

observations. Sample

Results showed that long term

incentives of CFO’s and CEO’s,

excluding vested options, are

negatively associated with

ICMW’s.

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period: 2004-2006.


Balsam et al.

(2012)

They researched the

association between

equity incentives and

the probability of firms

having internal control

material weaknesses.

Data collection, 272

company-level

material weakness

and 297 observations

for account-specific

material weakness.


2005.

They found that firms with

higher equity incentives are

more likely to report an

effective internal control than

an ineffective internal control,

especially when the reason of

ineffectiveness is at company

level.

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4. Hypotheses

4.1 Introduction

This chapter will discuss the different hypotheses that were developed after carefully reviewing

prior relevant research studies in the previous chapter. The different relevant theories and

concepts explaining the purpose of managerial compensation schemes as incentives, which

were explained in chapter 2, are also considered in this chapter for the hypothesis

development.

4.2 Hypotheses development

As discussed in the previous chapter, prior studies found a decline in the long term incentives

(i.e., a decline in the stock prices) for companies that reported material weaknesses in their

internal controls (e.g Hammersley, Myers & Shakespeare, 2008; Kobelsky, Lim & Jha, 2013). So

based on the optimal contracting theory and bonus plan hypothesis, managers will have the

motivation to address internal control issues more effectively when they are compensated with

stocks and stock options than in comparison to when they are compensated with bonus

compensation. Firms with greater long term compensation schemes in place are less likely to

have a material weakness in their internal control system (Kobelsky, Lim & Jha, 2013). Due to

the fact that executives compensated with equity were incentivized to exert the extra effort

needed to establish and maintaining an effective internal control (Henry, Shon, & Weiss, 2011).

As discussed in the previous chapter, Kobelsky, Lim, & Jha (2013) showed that long term

incentives, excluding vested options11, are negatively associated with internal control material

weaknesses. But they found no significant evidence for the association between short term 11 Executives who are granted with vested options do not gain control over these stock options until the vested period is passed, this period is often 3 to 5 years.

23



incentives and internal control material weaknesses. This is consistent with the study of

Hammersley, Myers & Shakespeare (2008), who found a decline in the firm’s stock prices as a

consequence of reporting ineffective internal control systems. But the findings of Kobelsky, Lim,

& Jha (2013) are inconsistent with those of Hoitash, Hoitash & Johnstone (2012) who found

that both equity and bonus (short term incentives) compensations where negatively affected

due to internal control material weakness disclosures. Thus, mixed evidence was found when

the association between short term incentives and effective internal control were studied. Due

to the mixed results by prior studies and based on the notion that an effective internal control

can be seen as a good non-financial measure of top executive’s performance12, I postulate that

the effectiveness of a firms internal control reported under SOX 404(b) is positively associated

with their equity compensations. Due to the mixed evidence for short term incentives, I expect

a weak positive association (or no association at all) between the effectiveness of the internal

control and cash bonuses compensation.

H1a: Internal control effectiveness has a weak positive association with CFO’s cash bonus

compensation for the period before the financial crisis 2004-2006.

H1b: Internal control effectiveness has a strong positive association with CFO’s equity

compensations for the period before the financial crisis 2004-2006.

4.2.1 The Financial Crisis

There is also evidence that managers engage more frequently in earnings management during

the financial crisis, and are more likely to use excessive risk-taking and income-increasing

manipulation strategies to increase their short term incentives13. Kirkpatrick (2009)

documented that executive were able to take more risk during the financial crisis due to a weak

internal control environment. A weak internal control will facilitate the manager’s discretion to

manipulate accounting figures and therefore proving managers with the desire for weaker

12 See footnote 4.13 http://blogs.worldbank.org/allaboutfinance/executive-pay-and-the-financial-crisis

24



internal controls. So based on the managerial power theory, managerial compensations that

are based on pay without performance is not expected to be associated with the effectiveness

of the internal controls, especially for companies with weak governance where managers can

manipulate earnings and contracts more easily and extract rent.

The second hypothesis is also based on the notion that an effective internal control can be seen

as a good non-financial measure of top executive’s pay for performance. So the compensation

of top executives nowadays is expected partially to be based on the effectiveness of the firm’s

internal controls if there is no evidence of rent extraction due to managerial power. This

hypothesis is formulated considering the effect of the financial crisis and managerial power

theory on executive compensations and the effectiveness of their internal controls. Due to the

possible evidence of rent extraction and earnings manipulation, is difficult to postulate if the

association between internal control material weakness disclosures and managerial

compensation schemes is stronger or weaker during the financial crisis. Considering all the

above discussed concepts, leads to the following hypotheses.

H2a: The positive association between internal control effectiveness and CFO’s cash bonus

compensation schemes is weaker during the financial crisis of 2007-2009.

H2b: The positive association between internal control effectiveness and CFO’s equity

compensation schemes is weaker during the financial crisis of 2007-2009.

4.3 Conclusion

This chapter discussed the development of the hypotheses that will be tested in next chapters.

The hypotheses were developed after carefully reviewing prior relevant research, and relevant

theories and concepts explaining the association between compensation schemes and internal

controls. The last hypothesis was developed considering the impact of the financial crisis on this

association.

25



5. Methodology

5.1 Introduction

This chapter will provide more inside on the sample periods used, and the process of how data

was collected to conduct the research. Next, the research design will be thoroughly explained in

this chapter. The control variables used in the logistic regression will be briefly motivated. A

Libby box is illustrated at the end of this chapter to give a clearer view of the link between the

dependent, independent and control variables.

5.2 Sample & Data collection

The dataset for executives’ bonus and equity compensations were gathered from Compustat

Executive Compensation. Data for internal control disclosures in section 404 of SOX is obtained

from Audit Analytics to assess the effectiveness of the internal controls of the firms reported by

the auditor. Data needed for the calculation of the returns and other control variables were

gathered from Compustat. Lastly, data regarding the independence of the board and CEO also

functioning as the chairman were obtained from Risk Metrics. Consistent with the study of

Hoitash, Hoitash & Johnstone (2012), companies with a CFO turnover in the current or

following year, where eliminated from the collected data by using the variable ‘date left

company & date joined company’ from Compustat Executive Compensation. This is due to the

effect of severance pay and resigning cash bonus on the executive’s compensations when CFO

turnover occurs (Hoitash, Hoitash, & Johnstone, 2012). Prior studies also eliminated utility and

financial companies from their data due to the unique regulation system for these type of

26



industries, so firms in this type of industry were also eliminated from our samples using the SIC

code of these two industries. And finally, firms with missing financial/compensation data were

also eliminated from our data. Table 5.1 gives an overview of the sample data derivation.

Table 5.1 Sample selection & eliminations

Description N1 N2

Data gathered from Compustat Executive Compensation 1989 2695

Data eliminated: Utility and financial companies (315) (808)

Data eliminated: CFO turnover (143) (213)

Data eliminated: companies with missing data after merging 4 databases (962) (421)

Final sample period1 before the financial crisis (2004-2006) 569

Final sample period2 during the financial crisis (2007-2009) 1253

This research study has two sample periods. This study examines the association between an

effective internal control and executive compensation patterns before and during the financial

crisis. The first sample period states the timeline before the financial crisis and the second

sample period states the timeline during the financial crisis.

Sample period1: Before financial crisis (2004-2006)

Sample period2: During financial crisis (2007-2009)

5.3 Research design

The main model of this thesis will estimate a logistic regression of the effectiveness of the

internal control on the equity and cash compensations of CFO’s. The regression model will

27



examine the effect of internal control systems on these two different types of executive

compensation schemes. The cash compensation consists of the CFO annual cash bonus

received. The equity compensation reflects the total value of the (restricted) stocks and stock

options granted to the executives, valued respectively at fair value grant date and Compustat

Black Scholes value. This model will consist of the following variables, which are partly

consistent with the first stage- model of Henry, Shon, & Weiss (2011) and with the model used

in the study of Hoitash et al. (2012). These variables are motived and explained in the following

paragraphs. Year t represents the year that firms reported an effective internal control system

under SOX 404(b).

(1) Ln(Cash bonus Compensation t) = α + β₁ (ICEFF t) +β₂ (Firm Size t) + β3 (Firm Performance

t) + β4 (Growth t) + β5 (Risk t) + β6 (Loss t) + ἐ

(2) Ln(Equity Compensation t) = α + β₁ (ICEFF t) +β₂ (Firm Size t) + β3 (Firm Performance t) + β4

(Growth t) + β5 (Risk t) + β6 (Loss t) + ἐ

5.3.1 Control variables

Consistent with prior studies, several control variables where included that may have an impact

on the executive compensation schemes and which could therefore affect the association

between the effectiveness of internal controls and compensation schemes. Factors that can

influence executive compensation but are not linked with performance were also controlled for

to exclude ‘pay without performance’14. The possible impact and relevance of these variables

are discussed and motivated in Table 5.2 below. These are all control variables used by prior

studies that incorporated these variables into their regression due to the possible impact of

these variables on the executive’s compensation. So executive compensation is the dependent

variable and everything else that can impact the dependent variable must be controlled so that

14 See chapter 3, paragraph 3.2.1.

28



the regression can only measure the effects of the effectiveness of internal controls for a higher

validity of the results.

Table 5.2 Variables (1) definitions

Variable used Explanation

Firm size The natural log of total assets (LnTOTAL ASSETS) will be a

proxy for firm size, as prior studies showed that larger

companies need expensive high qualitative manager’s

who’s salaries are expected to be positively linked with

total assets (Hoitash, Hoitash, & Johnstone, 2012) &

(Henry, Shon, & Weiss, 2011). Firm size is therefore

expected to be positively related to CFO’s

compensations.

Firms accounting performance Consistent with the model of Brown & Lim (2012); and

Hoitash, Hoitash, & Johnstone (2012), return on assets

(ROA) will be proxy for firm’s accounting performance.

Return on assets is shown to be positively associated

with executive compensations based on performance.

ROA =Total Assets/Net income

Growth The MARKET TO BOOK ratio is used as proxy for growth.

Executive’s have the duty to create growth opportunities

for their firm which in turn can positvely impact their

compensations. Market to book ratio= (Market value)/

(Total assets – Total liabilities)

29




Firms risk Executives of risky firms are compensated for their

company’s risks. So increasing firms’ risks means an

increase in the CFO’s compensations. A positive

association is expected. So to control for firm risks, the

standard deviation of return on assets (ROA) will be used

as proxies.

Loss Consistent with Brown & Lim (2012), this study controls

for the years where companies reported a negative net

income due the possibility of financial distress. The

expectation is that losses will negatively affect the CFO’s

and CEO’s compensation schemes.

5.3.2 Governance independent variables

In the first stage compensation model of Henry, Shon, & Weiss (2011), several governance

variables, such as board structure and its independency, where not included when analyzing

the CFO compensation patterns. Henry, Shon, & Weiss (2011) found no significant change in

their results when they included these variables in their robustness tests for CEO compensation

schemes. An explanation for no qualitative change in their results was the high correlation

between CEO and CFO compensation schemes. Hoitash, Hoitash & Johnstone (2012) found that

both equity and bonus (short term incentives) compensations where negatively affected due to

internal control material weakness disclosures. They also found that companies with stronger

corporate governance in place experienced a larger decline in their executive compensation

schemes. This is due to the strong oversight of the CFO by the board. As discussed in chapter 3,

a strong expertise board can compose the right executive compensation schemes based on the

actual CFO’s performance. So reporting an ineffective internal control system will result in a

30



higher penalty in the CFO compensation for firms with strong corporate governance (Hoitash,

Hoitash, & Johnstone, 2012).

So in contrast to the model of Henry, Shon, & Weiss (2011), this paper does include some of

the relevant independent variables for firm governance. Consistent with the model of Brown &

Lim (2012), the independence of the board members and CEO chair on the board are controlled

for. Incorporating these independent governance variables in model (1) & (2) will result in the

following logistic regressions that will be used to test the hypotheses for the two sample

periods. These variables are explained and motivated in table 5.3 below.

(3) Ln(Cash bonus Compensation t) = α + β₁ (ICEFF t) + β₂ (Firm Size t) + β3 (Firm Performance

t) + β4 (Growth t) + β5 (Risk t) + β6 (Loss t) + β7 (Independence Board t) + β8 (CEO Chair) + ἐ

(4) Ln(Equity Compensation t) = α + β₁ (ICEFF t) +β₂ (Firm Size t) + β3 (Firm Performance t) + β4

(Growth t) + β4 (Growth t) + β5 (Risk t) + β6 (Loss t) + ἐ β7 (Independence Board t) + β8 (CEO

Chair) + ἐ

Table 5.3 Variables (2) definitions


Internal Control

Effectiveness (ICEFF)

The independent variable of the regression models we are interested in

is the effectiveness of the internal controls. Disclosure of one or more

material weakness in the internal controls of a firm will give indication

of an ineffective internal control. This variable will be equal to one if

the firm reports an effective internal control (ICEFF) in section 404 of

SOX, and zero if an internal control material weakness is reported

31



(ICMW). Based on the notion explained in the previous chapter that

SOX 404 is informative as a good non-financial measure for executive

compensation schemes, effectiveness of internal control is expected to

be positively associated with CFO compensations.

Independence Board Consistent with the model of Brown & Lim (2012), the independence of

the board members is controlled for because of the board’s direct

influence on executive compensation schemes and their duty to create

an optimal contract for the executive pay. This indicator variable is

equal to one if committee consists of independent parties, and zero

otherwise. A dependent board can engage in rent extraction practices.

Therefore the expectation for this variable is a negative association

with CFO’s compensation.

CEO chair CEO chair on the board are also controlled for because of the CEO’s

direct influence on executive compensation schemes as a chairman.

This can lead to managerial power over the board and therefore result

in rent extraction and pay without performance. This indicator variable

is equal to one if CEO is also a chairman on the board, and zero

otherwise. A positive association is expected.

The governance variables included in the logistic regression are both a dummy variable.

INDEPENDENCE_BOARD is equal to one if more than half of the board members are

independent and zero otherwise. For the second governance control variable, CEO_CHAIR is

equal to one if the CEO doesn’t have a chair on the board and zero otherwise. The main

independent variable of the regression models is the existence of an effective internal control

or an internal control material weakness resulting into ineffective internal controls. Disclosure

of one or more material weakness in the internal controls of a firm will give indication of an

ineffective internal control.

32



5.3.2 Dependent variable

If the internal control quality is indeed a non-financial measure of CFO compensation schemes

as argued by Hoitash, Hoitash, & Johnstone (2012), then we would expect a significant

association between CFO compensation and the effectiveness of internal controls. Interesting

to study to inform regulators of whether executive compensation incentivize CFO’s to create

effective internal controls. So consistent with the study of Henry, Shon, & Weiss (2011) this

paper will also focus on the natural log of the CFO’s equity and bonus compensation for better

comparison and outliers. This will test if compensations are indeed a cross sectional

determinant that can increase the chances of executives creating an effective internal control

system. So to measure managerial incentives we will use the natural log of total equity

compensations and the natural log of the bonus compensation.

5.4 Conclusion

This chapter provided information on the sample periods used, and data collection to conduct

the research in the next chapter. The logistic regressions that will be used to test the

hypotheses discussed in the previous chapter, were also discussed in this chapter. The control

variables used in the regressions were explained. The Libby box15 illustrated on the next page,

gives a clearer view of the link between the dependent, independent and control variables.

15 Predictive validity framework (Source: seminar Introduction to accounting research)

33



Table 5.4 Libby Boxes

Independent variables: Dependent Variables:

Control variables:

34

Concept A:

Internal control Effectiveness reported in SOX 404(b)

Concept B:

Cash bonus compensation

Equity compensation

ICEFF = 1 if effective internal control, or 0 for ICMW

Independence Board = 1, (I) Independent, or 0 (E) Employee not dependent.

CEO Chair Independent = 1 if the CEO don’t have a chair on the board, 0 otherwise

LnBonus compensation

LnEquity compensation

Firm size = LnTOTAL ASSETS Firm performance = RETURN on ASSETS Growth = MARKET TO BOOK ratio Risk = the standard deviation of ROA

Conceptual

Operational



6. Results

6.1 Introduction

This chapter gives information about the results obtained from the regression models (designed

and discussed in the previous chapters) used to test the hypotheses of this study. First the

descriptive statics for both sample periods are explained. The ‘data analysis adds in’ in

Microsoft excel is used to run the logistic regressions and also to obtain the descriptive statistics

and correlation information of the different variables used. The next chapter will give a proper

conclusion on the findings discussed in this chapter and the consistency of our findings with

prior studies.

6.2 Descriptive statistics

6.2.1 Sample period before financial crisis 2004-2006

Table 6.1 shows the descriptive statistic of the sample period before the financial crisis 2004-

2006. The descriptive data shows that from our final sample of 569, 540 of those companies

had an effective internal control (ICEFF) reported by the auditor, and 29, which is 5.1% of the

sample, reported an ineffective internal control (ICMW). Furthermore, the mean equity

compensation for firms not reporting internal control material weaknesses is 125% higher than

the mean equity compensation of companies reporting internal control material weakness. In

comparison, the mean bonus compensation is only 39.1% higher than the mean bonus

compensation of companies reporting an ineffective internal control. The mean firm size shows

also that firms with no material weaknesses in their internal control system are larger than

firms reporting internal control material weakness. Furthermore, respectively 55.1% and 68.9%

of the CEO’s are not a chairman of the board for firms with an effective internal control (ICEFF)

system and, firms with an internal control material weakness (ICMW). For the independence of

the board of directors, 46.7% of the firms with an effective internal control have an

35



independent board and for firms with an ineffective internal control, 37.9% of the firms have an

independent board.

Table 6.1 Descriptive Statistics (1)

Sample period1 (2004-2006)

Variable Mean Median Std. Dev. Sum ICEFF CountEquity Compensation 1212,706 689,175 1767,884 654861,75 540Bonus Compensation 275,773 124,412 561,105 148917,82

Firm Risk 11,503 5,840 25,439 6211,667ACC- performance 11,304 11,972 65,455 6104,265

Firm Growth 3,316 2,763 7,633 1790,505Firm Size 5453,946 1455,131 11401,516 2945131,2

Loss 0,1 0 0,3 54CEO Chair Independent 0,552 1 0,498 298

Board Independent 0,467 0 0,499 252

Variable Mean Median Std. Dev. Sum ICMW CountEquity Compensation 537,203 392,912 963,478 15578,89 29Bonus Compensation 198,204 79,937 328,518 5747,904


Firm Growth 2,341 2,133 0,989 67,888Firm Size 1335,903 604,018 2992,181 38741,19

Loss 0,276 0 0,455 8CEO Chair Independent 0,690 1 0,471 20

Board Independent 0,379 0 0,494 11

6.2.2 Sample period during financial crisis 2007-2009

Table 6.2 shows the descriptive statistic of the sample period during the financial crisis 2007-

2009. The descriptive data shows that from our final sample of 1.253, 1.214 of those firms have

36



an effective internal control (ICEFF) reported by the auditor under SOX 404, and 39, which is

3.2% of the sample, reported an ineffective internal control ( ICMW). Furthermore, the mean

equity compensation for firms not reporting internal control material weaknesses is 90.3%

higher than the mean equity compensation of companies reporting internal control material

weakness. In comparison, the mean bonus compensation is only 113% higher than the mean

bonus compensation of companies reporting an ineffective internal control. The mean firm size

for this sample period also shows that firms with no material weaknesses in their internal

control system are relatively larger than firms reporting internal control material weakness.

Respectively 20.3% and 23.1% of the CEO’s are not a chairman of the board for firms with an

effective internal control (ICEFF) system and, firms with an internal control material weakness

(ICMW). For the independence of the board of directors, 5% of the firms with an effective

internal control have an independent board and for firms with an ineffective internal control,

35.9% of the firms have an independent board. Standing out is the relatively smaller

independence percentage for the board of directors and CEO chair. Interesting is also the

negative mean accounting performance for firms reporting internal control material weakness.

This is due to the negative net income for these firms16.

Table 6.2 Descriptive Statistics (2)


Variable Mean Median Std. Dev. Sum ICEFF CountEquity Compensation 2013,095 1267,098 3220,634 2443897,451 1214Bonus Compensation 88,565 0 689,323 107517,52


Firm Growth 1,526 2,140 28,526 1852,202

16 Performance is measured using ROA, which is total assets/net income

37



Firm size 9115,137 1829,506 49607,702 11065775,72Loss 0,172 0 0,378 209

Board independence 0,05 0 0,219 61CEO Chair Independent 0,203 0 0,403 247

Variable Mean Median Std. Dev. Sum ICMW CountEquity Compensation 1057,861 843,829 784,005 41256,577 39Bonus Compensation 41,557 0 56,680 1620,706

Firm Risk 28,328 12,433 81,335 1104,790ACC- performance -81,113 5,675 445,524 3163,398

Firm Growth 2,465 1,985 1,985 96,148Firm size 1935,193 627,347 3466,164 75472,545

Loss 0,462 0 0,505 18Board independent 0,359 0 0,486 14

CEO Chair Independent 0,231 0 0,427 9

6.3 Main test results

6.3.1 Hypotheses 1a

Table 6.3 presents the results of the logistic regression model (3) for the sample period before

the financial crisis 2004-2006 using a combined model of Henry et al (2011) and Hoitash et al

(2012) to study the association between the effectiveness of internal control and CFO cash

bonus compensation. As expected the coefficient of variable FIRM RISK is significant at p< 0.10

in the predicted direction. Consistent with Brown and Lim (2012) and Henry et al (2011) the

coefficient of control variable FIRM SIZE is significant and in the predicted direction. This means

that executives of larger companies are more likely to receive larger cash bonus compensation.

Finally, the coefficient of variable BOARD INDEPENDENCE is significant and positive at p<0.01.

However the coefficient of this variable is not as predicted. This means that for the companies

sampled in this study, board independence does influence CFO’s cash bonus compensation

however not as predicted. Previous studies have found that companies with weak corporate

38



governance enable managers to opportunistically extract rents. The results of this study show

the opposite. On the other hand the coefficients of variable LOSS, ACCOUNTING

PERFORMANCE, FIRM GROWTH and CEO CHAIR are not statistically significant but in the

predicted direction. Most importantly the Independent variable (ICEFF) of this study is neither

significant nor reaching significance. This means that for the period before the financial crisis

for the companies sampled in this study, an effective internal control does not affect CFO’s cash

bonus compensation. Therefore hypothesis H1a is not rejected because an effective internal

control is weakly associated with cash bonus compensation of CFO’s.

Table 6.3: Regression model (3) Bonus before Financial crisis


Output Regression model (3) Cash Bonus Compensation

Coefficients t Stat P-valueIntercept 4,690 16,098 0,000ICEFF 0,296 1,079 0,281FIRM RISK 0,005 -1,870 0,062*ACC- PERFORMANCE -0,002 -0,990 0,323FIRM GROWTH 0,002 0,276 0,783FIRM SIZE 0,000 6,276 0,000*LOSS -0,074 -0,299 0,765CEO CHAIR INDEPENDENT 0,120 0,957 0,339BOARD INDEPENDENCE 0,345 2,748 0,006*

* = significant with the compensation regressed at p<0.01; p<0.05 or p<0.10

6.3.2 Hypotheses 1b

Table 6.4 listed below shows the results of the logistic regression model (4) used to analyze the

relationship between internal control effectiveness and CFO equity compensation. Consistent

with Henry et al (2011) the coefficient of variable FIRM RISK is significant and positive at p<0.05.

39



Meaning, CFO’s of riskier firms do earn higher equity compensations. Furthermore coefficient

of variable FIRM GROWTH is also significant at p<0.01 and in the predicted direction. Meaning

that CFO’s who create growth opportunities are expected to receive higher equity

compensation. Finally FIRM SIZE is also significantly positively associated with CFO equity

compensation. So as predicted, CFO’s of larger firms receive higher equity compensation than

smaller firms with lower total assets. However, the coefficient of variable CEO CHAIR is

significant at p<0.10 but not in the predicted direction. This is not necessarily a negative

observation. Firm with strong corporate governance may be better able to select highly

qualified managers and these may require higher equity compensation. Furthermore, variables

ACCOUNTING PERFORMANCE, LOSS, and BOARD INDEPENDENCE were not significant. More

importantly there is a positively significant association at p<0.05 between the effectiveness of

the internal control (ICEFF) and equity compensation. This is consistent with the optimal

contracting theory discussed in chapter 2 and consistent with Henry et al (2012) results that

conclude that managers who maintain effective internal controls exert greater effort and

therefore receive higher compensation. Therefore hypothesis H1b is accepted because there is

a stronger association between effectiveness of internal control and CFO equity compensation

unlike the cash bonus compensations of CFO’s.

Table 6.4: Regression model (4) Equity before Financial crisis


Output Regression model (4) Equity Compensation

Coefficients Standard Error P-valueIntercept 5,785 0,250 0,000ICEFF 0,530 0,237 0,025*FIRM RISK 0,004 0,002 0,033*ACC_PERFORMANCE 0,000 0,001 0,903FIRM GROWTH 0,024 0,008 0,004*FIRM SIZE 0,000 0,000 0,000*

40



LOSS 0,031 0,172 0,858CEO CHAIR INDEPENDENT 0,194 0,099 0,052*BOARD INDEPENDENCE -0,070 0,099 0,483


6.3.3 Hypotheses 2a & 2b

Table 6.5 and 6.6 presented below shows respectively the results of the logistic regression used

to study the association between the effectiveness of internal control and CFO bonus and

equity compensation for the sample during the financial crisis 2007-2009. The regression model

(4) for equity compensation during the financial crisis has the highest adjusted R Square of

0.5095, meaning that 51 percent of the dependent variable, equity compensation, is explained

by this model. Consistent with the first sample period before the financial crisis, the coefficient

of the variable FIRM SIZE is significant at p <0.01 for both equity compensation and bonus

compensation. The positive coefficient for FIRM SIZE shows that total assets are positively

related to CFO’s equity and bonus compensations. Furthermore, FIRM GROWTH is not

significant in this sample period for equity compensation but reaching significance for bonus

compensations during the financial crisis, unlike the results found for the significance of FIRM

GROWTH with equity and bonus compensation for the sample before the financial crisis. On

the other hand, the coefficient of the variable FIRM RISK and ACC-PERFORMANCE for equity

compensations are significant at p<0.10, and are also in the positive predicting direction.

Meaning, equity compensations are positively associated with FIRM RISK and ACC-

PERFORMANCE. Risky firms and better performing firms, have higher equity compensations for

CFO’s during the financial crisis.

Inconsistent with the study of Henry et al (2011) that although used a different sample period,

there is no significant association for the effectiveness of the internal control (ICEFF) and equity

compensation during the financial crisis. The sample before the financial crisis did found a

significant association for the effectiveness of internal controls and equity compensation.

Consistent with the results found for the first sample period for cash bonus compensation,

there was no significant association found with the effectiveness of internal controls during the

41



financial crisis. This means that the effectiveness of internal control material weaknesses does

not affect either the bonus or the equity compensation of CFO’s during the financial crisis.

There is no evidence to support the notion of a significant association between effectiveness of

internal control and CFO compensations during the financial crisis. Therefore hypothesis 2a and

2b is rejected.

Table 6.5: Regression model (3) Bonus during Financial crisis



Coefficients Standard Error P-valueIntercept 2,261 0,468 0,000ICEFF -0,411 0,393 0,297FIRM RISK 0,000 0,001 0,579ACC- PERFORMANCE 0,000 0,001 0,535FIRM GROWTH 0,007 0,005 0,122FIRM SIZE 0,377 0,046 0,000*LOSS 0,008 0,196 0,969CEO CHAIR INDEPENDENT 0,006 0,373 0,988BOARD INDEPENDENT -0,012 0,194 0,950

* = significant with the compensation regressed at p<0.01

Table 6.6: Regression model (4) Equity Financial crisis



Coefficients Standard Error P-valueIntercept 4,189 0,125 0,000ICEFF 0,038 0,101 0,703FIRM RISK 0,000 0,000 0,059*ACC- PERFORMANCE 0,000 0,000 0,064*FIRM GROWTH -0,000 0,001 0,929FIRM SIZE 0,391 0,011 0,000*

42



LOSS -0,033 0,046 0,474CEO CHAIR INDEPENDENT -0,023 0,074 0,756BOARD INDEPENDENCE 0,001 0,042 0,982


7. Conclusion & Limitations

7.1 Conclusion

This study examined the association between an effective internal control and CFO’s

compensation patterns before and during the financial crisis. The main research questions this

thesis addressed were as follows.

i) Is there an association between auditors’ attestation on the effectiveness of internal

control required by SOX 404(b) and CFO’s compensation schemes?

ii) Did the financial crisis of 2007 impact the possible association stated in the research

question (i)?

Prior researches showed that due to the mandated responsibilities of CFO’s towards their

internal control to report on their effectiveness since the implementation of SOX 404, an

effective internal control can be seen as a good non-financial measure of top executive’s

compensations (Hoitash, Hoitash & Johnstone (2012). So the compensation of top executives is

nowadays expected to be partially based on the effectiveness of the firm’s internal controls. But

compensation schemes also give managers the incentive to take more risk which was one of the

causes of financial crisis (Landskroner & Raviv, 2010).

The logistic regression for the sample period before the financial crisis did found a significant

association for the effectiveness of internal controls and equity compensation. Managers who

maintain an effective internal control exert greater effort and therefore receive higher

compensations during the period before the financial crisis. Cash bonus compensation does not

43



create similar long term incentives and therefore does not incentivize managers to exert the

extra effort needed to create and maintain effective internal control systems, which in turn

leads to higher executive compensations.

For both the sample periods before and during the financial crisis, there was no significant

association found for the effectiveness of company’s internal controls and CFO’s cash bonus

compensation. This means that the effectiveness of internal control material weaknesses does

affect neither the bonus nor the equity compensation of CFO’s during the financial crisis.

Possible explanation for the no significant association found for effectiveness internal control

and CFO’s compensation schemes during the financial crisis, maybe due to the possibility of

rent extraction, which was also found in the study of Henry et al. (2011). The independence of

board of directors and CEO chair were relatively smaller during the financial crisis. This can be

evidence of managerial power and weak corporate governance which can result in rent

extraction. The mean equity compensation for the period 2007-2009 during the financial crisis

is significantly higher than mean equity compensation for the period 2004-2006 before the

financial crisis for both firms reporting effective and not an effective internal control system.

This is not the case when comparing the mean bonus compensation for the two sample

periods. Which is strange due to the fact that firm values, linked with equity compensation,

where under allot of pressure during the financial crisis.

7.2 Limitations

Finally, possible limitations of this study need to be explained. As mentioned in chapter 1, there

was no empirical study conducted that studied the association of the effectiveness of internal

controls and executive compensation schemes during the financial crisis. Therefore it was quite

challenging to research which test to perform and how to combine the test variables, most

importantly the control variables of the few empirical studies related to this thesis research for

44



the period during the financial crisis. However, different theories explained the different

purposes of an optimal compensation schemes for the executives were helpful to address the

possible impact of the financial crisis in the association studied in this thesis. More specifically,

the two sample periods used for before and during the financial crisis are only two years long.

This makes the measurement of the association between the effectiveness of internal controls

and CFO compensations susceptible to other factors affecting this relation before and during

the financial crisis, which might not be considered. A limitation is that the higher or lower CFO’s

compensations for before and during the financial crisis could be explained by other variables

that were not included. This thesis tried to eliminate this problem by carefully selecting multiple

control variables explained in paragraph 5.3.1 which were consistent with prior studies, but

there are still omitted variables that could explain the composition of the CFO’s bonus and

equity compensation.

These limitations should be considered for further studies and improvement measurements for

the period during the financial crisis should be taken into account for a higher validity of the

results.

45



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Appendix

Appendix 1: Regression model (3) Bonus before Financial crisis



Regression StatisticsMultiple R 0,384R Square 0,147Adjusted R Square 0,129Standard Error 1,204Observations 392

ANOVA

df SS MS FSignificanc

e FRegression 8 95,957 11,995 8,277 2,3135E-10Residual 383 555,016 1,449Total 391 650,974

Coefficients

Standard Error t Stat P-value Lower 95%

Upper 95,0%

Intercept 4,690 0,291 16,098 0,000 4,118 5,263ICEFF 0,296 0,274 1,079 0,281 -0,243 0,835FIRM RISK 0,005 0,002 -1,870 0,062* -0,009 0,000ACC- PERFORMANCE -0,002 0,002 -0,990 0,323 -0,005 0,002FIRM GROWTH 0,002 0,009 0,276 0,783 -0,015 0,020FIRM SIZE 0,000 0,000 6,276 0,000* 0,000 0,000LOSS -0,074 0,248 -0,299 0,765 -0,562 0,413CEO CHAIR INDEPENDENT 0,120 0,125 0,957 0,339 -0,126 0,366BOARD INDEPENDENCE 0,345 0,125 2,748 0,006* 0,098 0,591

* = significant with the compensation regressed at p<0.01 ; p<0.05 or p<0.10

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Appendix 2: Regression model (4) Equity compensation before Financial crisis




ANOVA



Coefficients


Upper 95%

Intercept 5,785 0,250 23,123 0,000 5,294 6,277ICEFF 0,530 0,237 2,241 0,025* 0,065 0,995FIRM RISK 0,004 0,002 -2,138 0,033* -0,008 0,000ACC_PERFORMANCE 0,000 0,001 0,122 0,903 -0,002 0,002FIRM GROWTH 0,024 0,008 2,875 0,004* 0,008 0,040FIRM SIZE 0,000 0,000 8,944 0,000* 0,000 0,000LOSS 0,031 0,172 0,179 0,858 -0,307 0,369CEO CHAIR INDEPENDENT 0,194 0,099 1,948 0,052* -0,002 0,389BOARD INDEPENDENCE -0,070 0,099 -0,702 0,483 -0,264 0,125

* = significant with the compensation regressed at p<0.01 or p<0.05

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Appendix 3: Regression model (3) Bonus during Financial crisis




ANOVA



CoefficientsStandard

Error t Stat P-value Lower 95%Upper 95%

Intercept 2,261 0,468 4,830 0,000 1,340 3,181ICEFF -0,411 0,393 -1,045 0,297 -1,183 0,362FIRM RISK 0,000 0,001 -0,555 0,579 -0,002 0,001ACC- PERFORMANCE 0,000 0,001 0,621 0,535 -0,0001 0,001FIRM GROWTH 0,007 0,005 1,551 0,122 -0,002 0,016FIRM SIZE 0,377 0,046 8,143 0,000* 0,286 0,468LOSS 0,008 0,196 0,039 0,969 -0,378 0,394CEO CHAIR INDEPENDENT 0,006 0,373 0,015 0,988 -0,727 0,738BOARD INDEPENDENT -0,012 0,194 -0,063 0,950 -0,393 0,369

* = significant with the compensation regressed at p<0.01

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Appendix 4: Regression model (4) Equity during Financial crisis




ANOVA



Coefficients


Upper 95%

Intercept 4,189 0,125 33,538 0,000 3,945 4,435ICEFF 0,039 0,101 0,382 0,703 -0,159 0,237FIRM RISK 0,000 0,000 -1,884 0,059* -0,001 0,000ACC- PERFORMANCE 0,000 0,000 1,851 0,064* 0,000 0,000FIRM GROWTH -0,000 0,001 -0,089 0,929 -0,001 0,001FIRM SIZE 0,391 0,011 34,635 0,000* 0,369 0,413LOSS -0,033 0,046 -0,716 0,474 -0,124 0,058CEO CHAIR INDEPENDENT -0,023 0,074 -0,311 0,756 -0,169 0,123BOARD INDEPENDENCE 0,001 0,042 0,023 0,982 -0,082 0,084


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