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    CEO Financial Background and Audit Pricing
    research summary posted October 12, 2016 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 14.0 Corporate Matters, 14.09 CEO Tenure and Experience 
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    Title:
    CEO Financial Background and Audit Pricing
    Practical Implications:

     The findings of this study suggest that the training and functional expertise of the CEO can affect the auditor’s perception of engagement risk, observed through a reduction in audit fees. They add to the growing literature of CEO characteristics which highlight how top managers influence firm outcomes.

    Citation:

     Kalelkar, R., S. Khan. 2016. CEO Financial Background and Audit Pricing. Accounting Horizons 30 (3): 325-339.

    Keywords:
    CEO financial expertise; audit fees
    Purpose of the Study:

     Theory suggests that the audit pricing decision is a function of a client’s audit risk and business risk. Recent literature has suggested that CEO characteristics can affect how auditor’s perceive the firm’s audit risk and the resulting audit pricing decision. This paper addresses how the financial expertise of Chief Executive Officer influences audit fees. The authors hypothesize that a CEO’s financial expertise can affect the level of audit fees through two channels:

    • Reducing the firm’s business risk through greater performance and profitability and

    • Reducing the firm’s audit risk by improving the quality of the firm’s financial reporting.

    Specifically, they suggest that a CEO’s financial expertise will lower both the firm’s audit risk and business risk resulting in lower audit effort and a corresponding reduction in audit fees.

    Design/Method/ Approach:

    The authors use a sample of firms with changes in CEO financial expertise between 2004 and 2013.  Specifically, they look at firms that switched from a CEO with financial expertise to a CEO with no financial expertise and vice versa, resulting in a sample of 77 firms and 81 changes in financial expertise.

     

    Alternatively, to address the unobservable characteristics of the firm which may influence both accounting outcomes and CEO selection, the authors utilize an instrumental variables two-stage model.  They use the local density of financial firms as an instrument for the financial expertise of the focal firm.  The location of the firm can influence the financial expertise of the board of directors.  When the board holds greater financial expertise this can limit the demand for a CEO with similar functional expertise within the firm.

    Findings:
    • The authors find that audit fees for firms with a financial expert CEO are lower by 8.5 percent, or $310,000.  The results are robust to controlling for CEO voluntary turnover, the simultaneous turnover of the CFO, firm fixed effects, as well as an instrumental variables approach.
    • Consistent with their predictions, results suggest that a CEO’s financial expertise results in lower audit fees, potentially due to decreased audit risk and lower audit effort.
    Category:
    Corporate Matters, Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations, CEO Tenure & Experience