Impact of audit quality on the components of executive cash compensation

Outline

• Abstract
• Keywords
• 1. Introduction
• 2. Literature Review
• 3. Hypotheses Development
• 4. Data and Research Design
• 4.1 Data
• 4.2 Research Design
• 4.2.1 Independent Variables – Measurement of Audit Quality.
• 4.2.2 Dependent Variable – Compensation.
• 4.2.3 Control Variables – Economic Determinants of Executive Compensation.
• 4.2.4 Regression Analysis.
• 5. Results and Analysis
• 5.1 Descriptive Statistics
• 5.2 Regression Results
• 6. Conclusion
• Notes
• References
• Corresponding Author

Conclusions

We use agency theoretic arguments to predict that as audit quality increases, the ability of managers to manipulate performance measures such as earnings and revenues becomes costlier. Hence, the informativeness of earnings and revenues increases with respect to the productive effort of the managers. The frm is therefore able to place a higher weight on these accounting measures of performance in determining the managers’ incentive compensation.

We investigate this prediction empirically. We use auditor specialization to proxy for audit quality and predict that, for clients of specialist auditors, there will be more weight placed on accounting performance measures in determining the cash component of CEO compensation. Using data from the Execucomp and Compustat databases, we show that as auditor quality, proxied by specialization, increases, ROA and sales revenue will become more important in determining executive cash compensation. Furthermore, as auditor specialization increases, the level of cash compensation paid to executives will decrease, denoting a shift from base pay to incentive pay.

Our final set of results shows that the importance of auditor specialization has abated in the post-SOX period. This result can have two explanations. One possibility is that post-SOX, quality differences among auditors, at least at the national level, have diminished to an extent that cross-sectional differences in audit quality do not affect accounting-related research variables to the extent they did in the past. The second possibility is that auditor quality differentials still exist, but that specialization is no longer a valid proxy to test national-level audit quality differences. In fact, audit quality research appears to have moved away from national-level quality differences to office- and partner-level variations (Ferguson et al., 2003; Reichelt and Wang, 2010; Fung et al., 2012). This move away from national-level auditor industry specialization research supports the lack of results we observe for the national-level auditor industry specialization measure in the post-SOX period. The precise explanation as to whether this is due to diminished variation in audit quality at the national level or the inability of the auditor industry specialization to capture such differences, if they still exist, is a matter for future research.

The contribution of this study to accounting literature is threefold. First, to the best of our knowledge, this is the first paper that shows the effects of audit quality on the determinants of executive compensation. We find empirical evidence that audit quality is beneficial in mitigating the agency problem in frms by making executive compensation more responsive to accounting-based performance. Second, this study also investigates the impact of audit quality on sales revenues of a frm. While research on the impact of audit quality on earnings is abundant, research on audit quality impact on the use of sales revenue as a measure of performance is scarce. Finally, we point to how national-level audit specialization has become less relevant in the post-SOX period, and discuss potential explanations for this observation. This paper contributes to our understanding of the changing effects of auditor specialization on the audit clients, and also highlights the differences in the pre- and post-SOX periods.

Our results should be interpreted subject to the following two caveats. First, we use cash compensation in our study. However, cash compensation has been dwarfed by equity compensation in recent times (Core et al., 2003; Bushman and Smith, 2001). Research also suggests that the major part of a CEO’s incentives are equity based (Core et al., 2003); hence, the relevance of cash incentives may not be as important. The second caveat is the measure of industry specialization we use. Although national-level industry specialization has been widely accepted as a proxy for auditor industry expertise, and auditor quality, research has pointed out some issues with this measure (Audousset-Coulier et al., 2016 for a detailed criticism of different proxies). Defond and Zhang (2014) assert that auditor industry specialization is prone to significant measurement error, that there is no consensus on the measurement of specialization and that specialization fails to “capture subtle variations in audit quality” (p. 289). Cahan et al. (2011) also suggest that specialization based on market share maybe an inverse proxy for audit quality, with the market leader maintaining its position by competing on price, and thus lowering the quality of the audit. Cahan et al. (2011) further states that in addition to industry specialization, auditors may also specialize by topical areas such as valuations, acquisitions pensions, etc. These caveats lead to interesting suggestions for future research. One avenue would be to investigate the impact of audit quality on equity compensation. A second avenue would be to consider different proxies for auditor specialization (i.e. city level, partner level, topical, etc.) to investigate their impact on incentive compensation.