Comp and Audit: The Yin and Yang of Corporate Governance
Analysis of the benefits…versus bandwidth issues…resulting from overlapping Compensation and Audit Committee membership in the US corporate boardroom. My thoughts, and others’, as captured by Stephanie Forshee.
Select board directors are quick to point out the positive aspects of serving on both compensation and audit committees.
After all, academic research confirms that an overlap of compensation and audit committee members results in the company’s demonstrating a higher quality of financial reporting.
But, depending on the board, directors must carefully consider the bandwidth required for each and determine how viable it is to lead one of the committees while serving on the other.
Agenda spoke with a group of directors about their views on how the two committees inform one another and whether the overlap works better in theory than in practice.
The Overlap
About 10.4% of directors in the S&P 500 serve on both the compensation and audit committees, according to data provided by Equilar. There is overlap between these two committees at companies such as Accenture, Altria Group, Carnival Corp. and General Motors.
Among the proponents of serving on both the comp and audit committees is Donna Wells, who is currently a member of both committees at Mitek Systems, an identification verification software company. “Comp and audit are the yin and yang of corporate governance,” Wells tells Agenda .
Over the years, Wells has served on boards where there has been a comp chair serving on audit and an audit chair serving on comp.
“I’ve found that having overlapping audit and compensation membership is very helpful for improving data-sharing and decision-making across the full board,” she says.
Indeed, existing research out of Drexel University from 2012 supports the idea that firms with overlapping audit and compensation “have higher financial reporting quality than those without such overlap.” But the same study recognized that the upside of the relationship will decline at a certain point. In other words, the two committees should not have identical membership, but perhaps only one or two directors who work on both compensation and audit.
Taylor Simonton, a director at Surna, Advanced Emissions Solutions and Master Chemical, acknowledges there can be benefits for some overlapping membership on the committees. For instance, he finds that crossover between audit and comp “better informs the comp committee about subjective accounting decisions or other earnings management,” which he warns can sometimes “unduly affect compensation performance measures.”
Plus, when compensation committee members have an increased knowledge of accounting transactions, it “will allow it to construct bonus plans with metrics that better evaluate a CEO’s decisions,” he says.
In his view, the overlap should come for committee members but not either of the committee chairs. The risk, aside from burnout, is that “such an arrangement is problematic in that excessive influence at the board level rests with one or two directors.”
Simonton feels the overlap could be especially helpful in “industries that have a preponderance of subjective accounting areas such as revenue recognition with contract accounting and asset impairments in extractive companies.”
For Gary Kremen, the overlap adds an extra layer of accountability. He sits on both compensation and audit at security company Identiv.
Kremen says, as one example, if the comp committee uses earnings per share, or EPS, as one of its quantitative metrics, it would be helpful to see that executives performed by hitting their EPS goals, but committee members would also have a window to see if perhaps the company is “losing tons of money” if the CEO is focused on a lot of new capital expenditures.
“You do need to understand the numbers and understand the accounting treatments of that,” he says.
Similarly, a comp director who also serves on the audit committee may be better positioned to recognize when there could be a misalignment between incentive metrics and company performance, such as if revenue is a performance metric but the company is “gaining revenue at the expense of profitability.”
Even so, “it’s a like or want, but maybe not a need,” says Kremen.
Even though Kremen serves on both committees, it was not a deliberate choice, per se. He started on Identiv’s comp committee and added audit responsibilities after the company ran into some “accounting challenges,” as he described it. “We really needed to step up the game, and I just happened to have a good accounting background.”
Indeed, Sheila Hooda would argue that compensation committee members should be able to spot these red flags whether they serve on the audit committee or not. As a director for both public and private boards, she can see how it would be beneficial to have some overlap between audit and comp committee members, but it’s not by any means a must, in her view. “Every board member needs to have a deep understanding of the company’s financials,” Hooda says.
Plus, as other directors mentioned, Hooda thinks the expanding role of the compensation committee could inhibit the individual’s abilities to commit to both areas 100%. She explains how compensation now has to take the lead on retention and motivation, as well as succession and talent. “In such a disruptive environment,” Hooda says, that talent is “a strategic lever” to remain competitive.
While board directors may debate the issue, Jennifer Christensen, founder of executive and director search firm JWC Partners, says that she has never had a board specifically request that a director be willing to concurrently serve on both committees.
From a management perspective, though, Christensen is seeing that chief financial officers are becoming more involved in discussions with the compensation committee. She views that rationale to be in line with what boards — and investors — are ultimately hoping to achieve: a strong alignment between executive pay and performance.
“Exec comp has gotten much more complex in the last five to 10 years. I think most board directors and executives feel that HR execs are out of their league on comp.”
In her opinion, taking on both compensation and audit doesn’t seem like “sharing the load, just because those are really two really difficult committees that require heavy lifting.”
Middle Ground
“These two committees typically have the highest workload of all of the board committees,” according to Mitek’s Wells. Therefore, she advises that directors holding multiple roles “have the time, expertise and commitment required to perform both roles well and simultaneously.”
For boards looking for other ways to strengthen the synergies among the two committees, Wells says it’s important that directors take advantage of other committees’ “open door” policies, which she has had on all of the boards where she has served.
“All board members have a standing invitation to all committee calls and meetings,” she explains. “And most board members frequently did attend other committee meetings, which led to a well-informed and highly engaged board.”
One of her audit committees has added to its calendar an annual “deep dive” session into compensation and HR issues. “This has been effective in improving transparency and collaboration across these critical, and interrelated, areas of oversight,” says Wells.
“But also, given audit’s increasing role in risk oversight, this practice ensures that our understanding of pay equity, racial and gender diversity, employee satisfaction and any legal matters remains current and appropriately detailed.”
Wells continues, “There’s a great deal to be shared and gained between both committees.”
