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  • Jennifer M Mueller-Phillips
    The Impact of CEO and CFO Equity Incentives on Audit Scope...
    research summary posted September 17, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 14.0 Corporate Matters, 14.01 Earnings Management, 14.07 Executive Compensation 
    Title:
    The Impact of CEO and CFO Equity Incentives on Audit Scope and Perceived Risks as Revealed Through Audit Fees.
    Practical Implications:

    The findings shed some light on the PCAOB proposal to require auditors to obtain an understanding of executive compensation plans. The PCAOB asserts that auditors may not adequately consider the earnings manipulation risk arising from compensation arrangement. The study finds that auditors do not charge a fee premium for delta risk. Whether that result reflects auditors’ neglect of the risks of delta or their professional diligence and an assessment that delta incentives do not pose a significant risk is unclear. The authors find that auditors charge a premium for vega incentives and that the premium is diminishing with residual auditor business risk. These results suggest that auditors are cognizant of the risk implicit in compensation arrangements and price that risk in a manner that is consistent with incentive-compatible compensation schemes.

    Citation:

    Kannan, Y. H., T. R. Skantz, and J. L. Higgs. 2014. The Impact of CEO and CFO Equity Incentives on Audit Scope and Perceived Risks as Revealed Through Audit Fees. Auditing: A Journal of Practice & Theory 33 (2): 111-139.

    Keywords:
    agency theory, audit fees, earnings manipulation, equity incentives
    Purpose of the Study:

    Consistent with agency theory, research finds that linking CEO wealth to own-firm share price reduces agency costs by aligning manager and shareholder interests. However, equity incentives may also contribute to agency costs through a higher incidence of accounting irregularities. Through an examination of the association between audit fees, and CEO and CFO equity incentives, this paper takes an audit perspective of the risks inherent in equity incentives. If the risk of accounting irregularities increases with equity incentives, the authors would expect audit fees to be positively associated with those incentives.

    In 2013, the Public Company Accounting Oversight Board (PCAOB) proposed an amendment to Auditing Standard No. 12 that would require auditors to consider executive compensation in audit planning because of potential fraud risk associated with equity incentives. The authors use the association between audit fees, and CEO and CFO equity incentives to infer whether auditors increase audit scope and perceive greater risk as equity incentives increase. Equity incentives are defined as the sensitivity of the value of executives’ equity portfolios to changes in share price (delta incentive) and to changes in return volatility (vega incentive).

    Design/Method/ Approach:

    The authors collect data from Audit Analytics, the Standard & Poor’s (S&P) ExecuComp database, S&P’s Compustat annual industrial and research files and the Center for Research in Security Prices (CRSP). The authors collect equity incentive data for both CEOs and CFOs. CEO data are available beginning in 1999; however, CFO compensation data are available only since 2006, following a change to the SEC’s disclosure regulations. Both samples end with fiscal years ending on June 30, 2012. The initial sample is 16,021 firm-years for CEOs and 8,194 firm-years for CFOs.

    Findings:

    The authors find that audit fees do not increase with CEO and CFO delta incentives and that the fee premiums for the audit risk proxies are also independent of delta incentives. These findings suggest that, from the auditor’s perspective, audit risk is not increasing with CEO and CFO delta incentives, and that the auditor’s expected losses from financial statement irregularities, as implied by the fee premiums on discretionary accruals and restatements, are unaffected by delta incentives.

    The results for vega are more complex. The authors find that audit fees increase as CEO and CFO vega incentives increase; however, the fee premium for residual auditor business risk is decreasing as vega increases. These findings lead to varying interpretations.

    The authors find a positive association between audit fees and vega, but not delta. However, when the authors interact vega with proxies for residual auditor business risk, they find that the fee premiums for risk decrease as vega increases. These results suggest that auditors do consider executive compensation in audit planning.

    Category:
    Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit Fee Decisions, Earnings Management, Earnings Management, Executive Compensation
  • Jennifer M Mueller-Phillips
    Internal Control Material Weaknesses and CFO Compensation.
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 14.0 Corporate Matters, 14.07 Executive Compensation 
    Title:
    Internal Control Material Weaknesses and CFO Compensation.
    Practical Implications:

    The results emphasize the importance of the composition of the compensation committee. Specifically, results suggest that boards should consider appointing financial experts to serve not only on the audit committee but also on the compensation committee, as it would improve the oversight of the CFO. The results reveal that CFOs are held accountable not only for their managerial duties as reflected in firm financial performance, but also for their fiduciary duties associated with accurate financial reporting and high-quality internal controls.

    Citation:

    Hoitash, R., Hoitash, U., & Johnstone, K. M. 2012. Internal Control Material Weaknesses and CFO Compensation. Contemporary Accounting Research 29 (3): 768-803.

    Keywords:
    executive compensation, CFO compensation, material weakness, internal controls
    Purpose of the Study:

    The purpose of this paper is to help fill the void in the literature by examining the association between internal control material weakness (ICMW) disclosures and CFO compensation. Under the Sarbanes-Oxley Act of 2002 chief executive officers (CEOs) and chief financial officers (CFOs) are required to establish, maintain, and evaluate internal control effectiveness and to report on this evaluation in both quarterly and annual financial statements. CFOs play a leading role in the oversight of internal control compliance, and research shows that in the post-SOX period CFOs are being held more accountable for their actions. As a result, CFO compensation outcomes are likely to depend in part on reported internal control quality.

    In recent years there has been a trend toward including nonfinancial performance measures in compensation decisions, particularly given the fact that internal control information has become readily available with the implementation of SOX. Therefore, the tests will detect an association between internal control quality and CFO compensation outcomes only if boards and compensation committees incorporate this new nonfinancial performance measure into their compensation decisions.

    Design/Method/ Approach:

    The authors obtain compensation data from ExecuComp, firm characteristic data from COMPUSTAT, and internal control quality data from Audit Analytics. A final sample of 604 firms from the fiscal year 2005 was developed. The authors conduct ordinary least squares regressions in which they use as the dependent variable the change in various components of CFO compensation: total compensation, bonus, equity, and salary. 

    Findings:
    • The basic finding is that the change in CFO total compensation, bonus compensation, and equity compensation, but not base salary, are each negatively associated with ICMW disclosures.
    • These results are economically significant. ICMW disclosures are associated on average with a 14.9 percent decrease in CFO bonus (as a percentage of salary) compared to the prior year.
    • Although the CEO is also responsible for certifying internal control reports, robustness tests reveal no significant association between ICMW disclosures and changes in any of the CEO compensation measures.
    • Account specific ICMWs (as opposed to general, company-wide ICMWs) drive the effects on CFO compensation, which highlights the importance of CFO-specific job responsibilities in relation to compensation outcomes.
    • Results also reveal that CFOs at firms with stronger corporate governance experience larger bonus compensation decreases upon an ICMW disclosure compared to CFOs at ICMW-disclosing firms with weaker corporate governance.
    • CFOs in firms with greater cost of misreporting experience larger declines in bonus compensation and total compensation compared to CFOs in firms with lower costs of misreporting.
    Category:
    Corporate Matters, Internal Control, Standard Setting
    Sub-category:
    Executive Compensation, Impact of SOX, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Equity Incentives and Internal Control Weaknesses.
    research summary posted July 28, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 14.0 Corporate Matters, 14.05 Earnings Targets and Management Behavior, 14.07 Executive Compensation, 14.10 CEO Compensation 
    Title:
    Equity Incentives and Internal Control Weaknesses.
    Practical Implications:

    The analysis shows that (1) equity incentives are more effective in reducing company-level control problems; (2) restricted equity provides greater incentives than unrestricted equity; and (3) CFO incentives have a more significant impact on the quality of internal control than CEO incentives. These insights have important implications for compensation committees who make compensation recommendations and the full board of directors who ratifies those recommendations. They suggest that both the level and type of equity incentives should be considered in compensation design to motivate managers to invest in strong internal controls.

    Citation:

    Balsam, S., Jiang, W., Lu, B. 2014. Equity Incentives and Internal Control Weaknesses. Contemporary Accounting Research 31 (1):178-201. 

    Keywords:
    Internal auditing, equity incentives, stock options, internal controls, material weakness (auditing), CEO compensation, CFO compensation, executive compensation
    Purpose of the Study:

    The authors address the empirical question of whether incentives associated with equity ownership induce managers to maintain strong internal controls. If managers believe adverse internal control opinions negatively affect the value of their equity holdings, equity incentives may provide the motivation for them to strengthen internal controls. The negative wealth consequences associated with the disclosure of internal control weaknesses suggest that equity-based incentives should motivate managers to develop and maintain effective internal controls over financial reporting, though some prior work has shown that equity incentives can lead to opportunistic actions by management. To the extent that lax internal controls provide the opportunity for earnings management, the link between accounting earning and share prices, along with the motivation provided by equity incentive to increase share prices, may provide an incentive for managers to want weaker internal controls. The study adds to the literature on equity incentives by focusing on specific aspect of managerial performance- the effectiveness of internal controls and the literature examining the determinants of internal control deficiencies. The results of the study provide insight into the role equity incentives play in improving the quality of internal control.

    Design/Method/ Approach:

    The study was conducted using a sample comprised of firms filing SOX Section 404 reports during 2004 and 2005. The authors obtained the data on internal control opinions from Audit Analytics, the financial data from COMPUSTAT, and the compensation and governance variables from Equilar Inc, yielding a sample of 569 firms. The control sample contained 3,798 observations. They used firm size, loss proportion and firm age to capture the level of investment in the internal control systems.

    Findings:
    • Equity incentives motivate managers to implement effective controls.
    • Evidence suggests that firms where the CEO and CFO have higher levels of equity incentives are less likely to have internal control problems.
    • The equity incentives of the CFO play a more significant role in determining internal control quality than those of the CEO.
    • The bonus is significantly lower, and salary significantly higher, as a percentage of total compensation, for firms with material internal control weaknesses.
    • Firms with material internal control weaknesses are smaller, younger, more likely to have had a loss, have more segments and are more likely to have experienced a restructuring, than firms without weaknesses.
    • Material weakness firms had fewer independent directors, smaller audit committees and boards, are less likely to engage a Big 4 auditor, had shorter auditor tenures, and were more likely to have experienced a recent auditor change.
    • Lax internal controls provide the opportunity for earnings management, which may allow managers to meet targets to maintain a higher share price than otherwise warranted. When the authors partition based upon type of opinion, they find that equity incentives are more effective in mitigating company-level internal control risk.
    Category:
    Corporate Matters, Internal Control
    Sub-category:
    CEO Compensation, Earnings Targets & Management Behavior, Executive Compensation, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    CEO and CFO Equity Incentives and the Pricing of Audit...
    research summary posted October 20, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 14.0 Corporate Matters, 14.01 Earnings Management, 14.07 Executive Compensation 
    Title:
    CEO and CFO Equity Incentives and the Pricing of Audit Services
    Practical Implications:

    Our study highlights the importance of taking into account executive incentive plans in improving the understanding of auditors’ risk assessment and pricing decisions, in support of the current professional audit standards. The findings that auditors respond to CEO and CFO equity incentives differently have significant implications for the corporate governance reforms and the design of optimal corporate executive compensation policies. Following the accounting scandals in the early 2000s, there has been increased regulatory and legislative scrutiny on corporate governance. Especially, regulators have recognized CFOs as the individuals bearing responsibilities for the integrity of financial information. Our paper lends support to the regulatory inclusion of CFOs as accountable individuals, and to concerns that firms should exercise caution in compensating CFOs using equity-based tools.

     

    For more information on this study, please contact Yonghong Jia.

    Citation:

    Billings, B. A., X. Gao, and Y. Jia. 2014. CEO and CFO Equity Incentives and the Pricing of Audit Services. AUDITING: A Journal of Practice & Theory 33 (2): 1-25

    Keywords:
    Audit fees; auditor risk assessment; equity incentive; accounting manipulation
    Purpose of the Study:

    The alleged perverse role of managerial incentives in accounting scandals and the distinctive role of auditors in identifying and intervening in attempted earnings manipulation, highlight the importance of explicitly considering executive incentive plans by auditors in the auditing process. However, there is little systematic evidence on auditors’ responses to the sizable holdings of equity by executives, a phenomenon that is particularly common in US public companies. In this paper, we investigate the association between executive equity incentives and auditors’ risk assessment and consequently audit pricing decisions. We examine auditors’ responses to equity incentives for CEOs and CFOs separately and jointly and inquire whether the responses are different.  

    Design/Method/ Approach:

    We gather information on audit fees, non-audit fees, auditors, internal control information from AuditAnalystics, executive compensation data from ExecuComp, and financial variables from Compustat, for the years 2002 through 2009. We estimate standard audit fee regression models that include variables to capture executive equity incentives and control variables that are identified to be determinants of audit fees by prior studies. 

    Findings:

    Using different measures of executive equity incentives and following standard audit service pricing research designs, we document compelling evidence that auditors adjust the price of their audit services upward in response to CFO equity incentives, suggesting that auditors perceive heightened audit risk associated with CFO equity incentives. We find some evidence that auditors view CEO equity incentives as innocuous or even beneficial in term of audit risk. We further demonstrate that the presence of internal control problems augments the positive relation between CFO equity incentives and audit fees, suggesting particularly elevated risk concerning CFO equity incentives perceived by auditors when internal controls are flawed. 

    Category:
    Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment, Earnings Management, Executive Compensation

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