Outside director compensation and earnings quality

Abstract

We examine the impact of outside director compensation on firm's financial reporting quality. Prior studies on outside board directors show mixed results on the impact of outside director compensation on earnings quality (Perry, 1999; Bryan and Klein, 2004; Cullinan et al., 2008; Archambeault et al., 2008; Magilke et al., 2009). We find that total compensation and the portion of equity-based compensation to total compensation are positively related to earnings quality. In addition, independent board leadership enhances the relation between outside director's equity-based compensation and earnings quality. These results suggest that increasing outside director compensation provides stronger incentive to board monitoring and ensures the quality of earnings, which is consistent with optimal contracting hypothesis. Lastly, we find that a greater portion of outsider directors on both the board overall and the audit committee actually hinders the incentive effect of the high compensation to quality of earnings.