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    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 
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    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