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    Executive Equity Risk-Taking Incentives and Audit Pricing.
    research summary posted January 19, 2016 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, 14.10 CEO Compensation 
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    Title:
    Executive Equity Risk-Taking Incentives and Audit Pricing.
    Practical Implications:

    The study results are important to regulators and audit practitioners as they show an association between executive compensation and auditor compensation. The study results show that high executive risk-taking incentives, as measured by vega, contributes to higher audit fees. These results provide important insights into how incentives designed to compensate and motivate executives can alter the audit fee structure.

    Citation:

    Chen, Y., F. A. Gul, M. Veeraraghavan, and L. Zolotoy. 2015. Executive Equity Risk-Taking Incentives and Audit Pricing. The Accounting Review 90 (6): 22052234.

    Keywords:
    executive compensation, audit fees, vega, misreporting, SOX
    Purpose of the Study:

    This study assesses whether there is an association between executive stock compensation and audit fees. The authors specifically investigate whether the sensitivity of CEO compensation to stock return volatility (vega) and stock prices (delta) are associated with audit fees. Prior literature shows that higher vega leads managers to engage in more financial misreporting. This increase in financial misreporting could in turn influence audit risk assessment and audit fees.  

    The main motivation for this study comes from the PCAOB’s recent related-party standard proposal. The proposed standard requires auditors to perform procedures to evaluate compensation practices when gaining an understanding of relationships between the company and its executive officers. In addition, current audit fee models do not consider executive compensation incentives in the pricing of audit services. Finally, there are extensive literatures on executive compensation and auditor compensation but no evaluation at the intersection of executive compensation practices and their effect on audit fees. This study attempts to address these gaps in the literature.

    Design/Method/ Approach:

    The authors employ an archival research methodology in this study. They obtain audit fee data from the Audit Analytics database and executive compensation from ExecuComp. The sample period is from 2000-2010. Company financial data is from Compustat Fundamentals Annual File.  

    Findings:
    • The authors show that for clients with a high executive vega, audit firms charge higher audit fees. This follows the logic that clients with higher vega have a higher likelihood to misreport and that auditors consider that likelihood when pricing audit services. The authors also found that the increase in fees is not related to the effort needed to audit expenses related to stock-based compensation.
    • The introduction of the Sarbanes-Oxley Act weakens the association between vega and audit fees.
    • CEO characteristics affect the relationship between vega and audit fees. Specifically, the positive association between vega and audit fees is stronger when the CEO is older and when the CEO is the board chair.
    Category:
    Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit Fee Decisions, CEO Compensation, Client Risk Assessment