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.
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.
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.
Hoitash, R., Hoitash, U., & Johnstone, K. M. 2012. Internal Control Material Weaknesses and CFO Compensation. Contemporary Accounting Research 29 (3): 768-803.
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.
Balsam, S., Jiang, W., Lu, B. 2014. Equity Incentives and Internal Control Weaknesses. Contemporary Accounting Research 31 (1):178-201.
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.
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