We contribute to the scant literature on the relation betweencompensation to audit committee (AC) directors and AC effectiveness by focusingon the total excess compensation, i.e., thedifference between the actual and the predicted total mean compensation. We posit that this refined measure of compensationbetter captures the AC director’s incentives to be more or less effective inmonitoring financial reporting quality than examining the level of totalcompensation. Using a sample of S&P 1500 firms, we find thatfinancial reporting quality is lower, i.e., lower accrual quality and greaterfinancial statement errors when AC directors earn negative excesscompensation. On the other hand, financial reporting quality is higher, i.e.,lower likelihood of earnings manipulation and fraud when AC directorsearn positive excess compensation. Further, measures of realactivities management based on combinations of abnormal discretionary expenses,abnormal production, and abnormal cash flows are also lower when AC directorsearn positive excess compensation. Further, the mean level of directorcompensation by itself is not significantly associated with financial reportingquality, underscoring the importance of focusing on excess compensation todirectors. Overall, the results reassureregulators, investors, boards of directors, and others that paying above-marketcompensation to AC directors does not necessarily impair financial reportingquality. However, underpaying AC directors undermines directors’ motivation toconstrain managerial opportunism.
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