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of other committees. However, as discussed below, equity-based compensation may be a
potential threat to the effectiveness of the audit committee.
2.2 Equity-based Compensation of Audit Committee
Starting from the 1990s, stock options have become an increasingly popular executive
compensation component in many countries (Murphy, 1999; Jones, Kalmi, and Makinen,
2006). Although stock options were initially used to reward top executive officers, this
practice changed later as more and more companies worldwide started to issue stock and
options more broadly (Blasi, Kruse, and Bernstein, 2003). The growth in the use of stock and
options has attracted public attention. Based on agency theory, some regard the practice
beneficial to shareholders, while others claim that it may bring potential risks to the firm.
Agency theory suggests that equity compensation helps to align the incentives of
principals (shareholders) and their agents (executives, board members, audit committee
members) (Jensen and Meckling, 1976; Monks and Minow, 2001; Dalton et al., 2003;
Hillman and Dalziel, 2003). Board members, including the audit committee, who receive
more equity-based compensation are more likely to carry out their responsibility to monitor
the CEO and other top managers. For instance, Morck, Shleifer, and Vishny (1988) find that
equity ownership by outside directors is positively associated with a firm’s performance.
On the other hand, although stock and option plans should align the interests of
directors with shareholders’ interests, prior research provides much evidence suggesting that
the negative effects of giving stocks and stock options to audit committee members may
surpass its advantages. For example, Zong (2004) finds that director options may be contrary
to the long-term perspective considered appropriate for boards because the use of options in
board pay programs promotes a short-term focus, similar to the effect of large option grants
on senior executive pay. Carcello and Neal (2003) find that the stock ownership of audit
committee members may create incentives for them to affiliate with the executives, hence
increasing the likelihood that the audit committee concedes to management. Similarly,
Ezzamel and Watson (1997) discover that because audit committee members play conflicting
roles in managing business operations and overseeing board decisions at the same time,
equity compensation may affect the committee’s monitoring effectiveness.
Monitoring ineffectiveness as a result of equity compensation for audit committee
members could lead to further harmful outcomes. Magilke et al. (2009) suggest that the
compensation of the audit committee may affect members’ preference for biased financial
reporting. They use experimental markets to examine the impact of equity-based