While the literatures are abundant in both two strands analyzing the relationships between the design of CEO compensation contract and earnings management, and the effect of firm’s risk of misreporting on audit fees,there is little research directly examines the association between executive compensation and audit fees.
The main purpose of my study is to examine how auditors respond, in terms of audit fees, to risk-taking incentives induced by the performance periods of CEOs’
performance-contingent equity compensation.I build on prior studies arguing that shorter performance is likely to induce managers to be less risk averse and engage in financial misreporting. The higher likelihood of financial misreporting, in turn, is likely to affect audit risks and audit fee.
To deal with the increasing concerns on time-based awards that cannot reward executive officers by their efforts and abilities, the use of performance-contingent awards has appeared since early 1990s and becomes greater share of the compensation contracts. It is believed to make the link stronger between CEO compensation and manager’s performance.As a performance-contingent equity award is intended for long-term purpose, one will expect the corresponding performance period for the
34
executives should be align with the spirit of measuring their “long-term” performance and likely to be longer than the typical one year cycle of the short-term cash bonus.
However, Gao et al. (2013) indicate that about one-fifth of S&P 500 industrial firms between 2006 and 2008 have chosen one-year period for their performance-contingent restricted share grants. The fact contradicts our general recognition of long-term performance and concerned many investors as well.
Therefore,, I focus on performance-contingent equity awards and examine the effect of performance horizon of performance-contingent awards on auditor’s risk assessments as reflected in audit fees. Prior literatures show ample evidence that short-term incentive plans will provide managers incentivesto manage earnings, which can help trigger the payout or increase the payout in the incentive zone. I expect that if there is a performance-contingent equity award that is contingent on a short horizon, auditors will perceive a highermisreporting risk of the firm than if equity award is based on a long horizon.
The results show that audit fee ispositively related to those firms with performance-contingent equity award that has performance periods shorter than 12 months. The results support that if the firm has any performance-contingent equity award with shortperformance period, the risk of misreporting is higher for auditors. I further testhow the number of performance measures of the longer performance period equity awards affects audit fees. The result shows that the number of long-term performance measures is negatively related with audit fees, supporting that for auditors, different performance measures can effectively lower down the risk of earnings management.
The results in this paper show evidences that the performance horizon will affect the assessment of audit risks for auditors. Due to the growing importance of the usage
35
of performance-contingent equity awards in long-term incentive plans, the alignment between the performance-contingentequity awards and the performance periods is also important to auditors.
36
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TABLE 1 Descriptive Statistics
Full Sample (N=2,847)
Mean Std Q1 Median Q3
LAF 15.079 0.921 14.418 15.046 15.636
ST 0.556 0.497 0.000 0.000 1.000
N_LT 6.681 14.146 0.000 0.000 9.500
SIZE 8.626 1.392 7.614 8.470 9.637
LEV 0.233 0.161 0.111 0.226 0.338
GROWTH 3.116 2.708 1.629 2.372 3.726
ROA 0.136 2.937 0.027 0.058 0.108
RET 0.132 0.487 -0.148 0.099 0.336
LOSS 0.133 0.339 0.000 0.000 0.000
VAROA 0.088 0.108 0.028 0.056 0.107
INVREC 0.194 0.136 0.085 0.164 0.268
CURRENT 2.025 1.380 1.168 1.653 2.450
QUICK 1.704 1.281 0.944 1.327 2.019
SEG 0.012 0.029 0.001 0.004 0.012
FOREIGN 0.912 0.283 1.000 1.000 1.000
MA 0.832 0.374 1.000 1.000 1.000
ZSCORE 0.005 0.013 0.002 0.006 0.011
DA 0.091 0.104 0.029 0.059 0.112
BIG4 0.986 0.116 1.000 1.000 1.000
DUALITY 0.325 0.468 0.000 0.000 1.000
CEOOWN 0.010 0.039 0.001 0.002 0.004
BOARDSIZE 17.061 4.775 14.000 17.000 20.000
IND 0.667 0.108 0.600 0.679 0.750
AUDEXPERT 0.291 0.345 0.000 0.200 0.500
This table presents the mean, standard deviation (Std), 25-percentile (Q1), median, and 75-percentile (Q3) of each variable.
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TABLE 2 Correlation Matrix
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 1_laudit_fee 1.00 0.13 -0.10 -0.06 0.78 0.12 0.03 -0.03 0.00 -0.07 -0.08 0.15 -0.22 -0.23 -0.07 0.11 -0.04 0.00 -0.08 0.10 . (0.00) (0.01) (0.11) (0.00) (0.00) (0.39) (0.46) (1.00) (0.09) (0.05) (0.00) (0.00) (0.00) (0.09) (0.01) (0.33) (0.97) (0.05) (0.01) 2_St 0.14 1.00 -0.24 -0.20 -0.01 -0.10 0.09 0.12 -0.03 0.03 0.02 0.27 0.16 0.13 0.12 0.01 -0.02 -0.17 -0.02 0.03
(0.00) . (0.00) (0.00) (0.71) (0.01) (0.02) (0.00) (0.46) (0.46) (0.62) (0.00) (0.00) (0.00) (0.00) (0.84) (0.64) (0.00) (0.62) (0.37) 3_lnlt -0.07 -0.28 1.00 0.68 -0.02 0.02 -0.01 -0.06 0.03 -0.08 0.01 -0.12 -0.06 -0.02 -0.09 0.00 0.04 -0.08 0.01 0.07
(0.07) (0.00) . (0.00) (0.57) (0.61) (0.75) (0.10) (0.43) (0.05) (0.87) (0.00) (0.12) (0.62) (0.01) (0.91) (0.35) (0.04) (0.87) (0.06) 4_lslt_weig -0.04 -0.22 0.74 1.00 -0.08 -0.10 0.07 0.05 0.01 -0.04 0.03 0.05 0.05 0.06 0.05 0.00 0.06 0.08 0.03 0.03
(0.28) (0.00) (0.00) . (0.05) (0.01) (0.09) (0.18) (0.77) (0.26) (0.40) (0.24) (0.16) (0.15) (0.19) (0.97) (0.15) (0.03) (0.40) (0.48) 5_size 0.79 -0.01 0.02 -0.02 1.00 0.34 -0.11 -0.11 0.01 -0.15 -0.17 -0.22 -0.44 -0.42 -0.20 0.18 0.00 -0.16 -0.17 0.12
(0.00) (0.74) (0.64) (0.58) . (0.00) (0.00) (0.01) (0.77) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.99) (0.00) (0.00) (0.00) 6_lev 0.10 -0.08 0.03 -0.07 0.27 1.00 -0.17 -0.35 -0.05 -0.01 -0.22 -0.24 -0.51 -0.52 -0.40 0.03 -0.09 -0.47 -0.22 0.00
(0.01) (0.04) (0.44) (0.07) (0.00) . (0.00) (0.00) (0.20) (0.70) (0.00) (0.00) (0.00) (0.00) (0.00) (0.45) (0.03) (0.00) (0.00) (0.97) GROWTH 0.05 0.04 -0.02 0.04 -0.04 0.07 1.00 0.54 0.29 -0.16 0.05 0.22 0.15 0.16 0.53 0.06 -0.03 0.44 0.05 0.02
(0.18) (0.30) (0.58) (0.30) (0.30) (0.06) . (0.00) (0.00) (0.00) (0.18) (0.00) (0.00) (0.00) (0.00) (0.14) (0.52) (0.00) (0.19) (0.64) ROA -0.01 0.09 -0.08 0.02 0.00 -0.23 0.23 1.00 0.08 -0.48 0.00 0.26 0.27 0.26 0.83 0.20 0.04 0.74 0.00 0.01
(0.88) (0.02) (0.04) (0.63) (0.90) (0.00) (0.00) . (0.04) (0.00) (0.92) (0.00) (0.00) (0.00) (0.00) (0.00) (0.33) (0.00) (0.92) (0.86) RET -0.03 -0.02 -0.01 -0.01 -0.03 -0.07 0.19 0.12 1.00 -0.08 0.16 0.00 0.07 0.05 0.03 -0.02 0.05 0.05 0.16 -0.02
(0.39) (0.56) (0.76) (0.80) (0.48) (0.07) (0.00) (0.00) . (0.05) (0.00) (0.91) (0.09) (0.20) (0.38) (0.66) (0.22) (0.22) (0.00) (0.59) LOSS -0.06 0.03 -0.07 -0.07 -0.14 -0.03 -0.08 -0.58 -0.05 1.00 0.16 0.00 0.14 0.13 -0.04 -0.43 0.01 -0.31 0.16 0.03
(0.08) (0.46) (0.08) (0.08) (0.00) (0.48) (0.05) (0.00) (0.18) . (0.00) (0.99) (0.00) (0.00) (0.25) (0.00) (0.84) (0.00) (0.00) (0.42) VAROA -0.05 -0.00 0.00 0.05 -0.11 -0.11 0.01 -0.04 0.21 0.18 1.00 0.21 0.16 0.14 0.09 -0.08 0.01 0.05 1.00 0.02
(0.18) (0.93) (0.95) (0.21) (0.00) (0.01) (0.81) (0.34) (0.00) (0.00) . (0.00) (0.00) (0.00) (0.02) (0.05) (0.88) (0.20) (0.00) (0.66) INVREC 0.14 0.24 -0.12 0.02 -0.19 -0.21 0.09 0.14 0.01 -0.01 0.16 1.00 0.40 0.19 0.28 -0.04 0.05 0.44 0.21 -0.13
(0.00) (0.00) (0.00) (0.64) (0.00) (0.00) (0.02) (0.00) (0.80) (0.88) (0.00) . (0.00) (0.00) (0.00) (0.36) (0.20) (0.00) (0.00) (0.00)
44
CURRENT -0.26 0.07 -0.05 0.03 -0.40 -0.42 0.03 0.11 0.06 0.12 0.08 0.15 1.00 0.92 0.36 -0.11 0.00 0.46 0.16 -0.08 (0.00) (0.07) (0.23) (0.42) (0.00) (0.00) (0.38) (0.01) (0.11) (0.00) (0.05) (0.00) . (0.00) (0.00) (0.00) (0.95) (0.00) (0.00) (0.04) QUICK -0.27 0.03 -0.02 0.03 -0.38 -0.40 0.06 0.09 0.06 0.10 0.04 -0.02 0.96 1.00 0.35 -0.11 -0.04 0.40 0.14 -0.02
(0.00) (0.42) (0.67) (0.44) (0.00) (0.00) (0.11) (0.02) (0.13) (0.01) (0.27) (0.63) (0.00) . (0.00) (0.00) (0.32) (0.00) (0.00) (0.55) SEG -0.09 0.10 -0.16 -0.07 -0.13 -0.29 0.24 0.38 0.07 0.08 0.06 0.11 0.27 0.26 1.00 -0.05 0.06 0.63 0.09 0.03
(0.02) (0.01) (0.00) (0.06) (0.00) (0.00) (0.00) (0.00) (0.07) (0.03) (0.11) (0.01) (0.00) (0.00) . (0.19) (0.13) (0.00) (0.02) (0.49) FOREIGN 0.11 -0.01 0.00 0.00 0.17 0.04 0.04 0.30 -0.02 -0.43 -0.09 -0.03 -0.12 -0.11 -0.11 1.00 0.04 0.10 -0.08 -0.03
(0.00) (0.84) (0.98) (0.93) (0.00) (0.33) (0.26) (0.00) (0.55) (0.00) (0.03) (0.41) (0.00) (0.00) (0.01) . (0.29) (0.01) (0.05) (0.48) MA -0.05 0.02 0.06 0.06 -0.01 -0.13 0.02 0.04 0.05 0.01 0.00 0.08 0.02 0.01 0.06 0.04 1.00 0.08 0.01 0.07
(0.21) (0.64) (0.13) (0.10) (0.72) (0.00) (0.56) (0.25) (0.21) (0.84) (1.00) (0.05) (0.59) (0.75) (0.11) (0.29) . (0.03) (0.88) (0.07) Z SCORE 0.02 0.11 -0.06 0.02 -0.06 -0.42 0.14 0.55 -0.02 -0.33 0.00 0.31 0.20 0.13 0.29 0.11 0.05 1.00 0.05 -0.04
(0.59) (0.00) (0.14) (0.58) (0.11) (0.00) (0.00) (0.00) (0.65) (0.00) (0.98) (0.00) (0.00) (0.00) (0.00) (0.01) (0.23) . (0.20) (0.30) DA -0.05 -0.00 0.01 0.05 -0.11 -0.11 0.01 -0.04 0.21 0.18 1.00 0.16 0.08 0.05 0.07 -0.09 0.00 0.00 1.00 0.02
(0.19) (0.95) (0.85) (0.17) (0.00) (0.01) (0.77) (0.36) (0.00) (0.00) (0.00) (0.00) (0.04) (0.23) (0.09) (0.02) (0.95) (0.99) . (0.66) BIG4 0.08 -0.03 0.06 0.03 0.12 0.00 0.03 0.01 -0.01 0.03 0.01 -0.13 -0.03 0.01 0.04 -0.03 0.07 -0.03 0.01 1.00
(0.03) (0.37) (0.12) (0.41) (0.00) (0.94) (0.44) (0.73) (0.83) (0.42) (0.86) (0.00) (0.47) (0.74) (0.26) (0.48) (0.07) (0.47) (0.86)
This table presents the correlations between the main variables used in the models. Correlation coefficients calculated by Spearman method are provided at the lower portion of the table while Correlation coefficients calculated by Pearson method are provided at the upper portion of the table. Two-tailed p-values are in parentheses.
Variable definitions are presented in Appendix A.
45
TABLE 3
The relation between short-term performance period and audit fees
(1) LAF (2)LAF (3)LAF
Intercept 14.302 9.150 8.751
(16.45)*** (56.26)*** (54.22)***
ST (indicator<12 months) 0.344 0.124 0.116
(3.51)*** (2.48)* (2.30)*
Industry fixed effects Included Included Included
Year fixed effects Included Included Included
N 1976 1550 1507
Adjusted R2 0.114 0.771 0.785
This table presents the regression results for the relation between CEO performance period and audit fees.***, **, and * denote significance at the 1%, 5%, and 10% levels, respectively. Variable definitions and sources are presented in Appendix A
46
TABLE4
The relation between long-term performance measure and audit fees (number of LT measures)
Industry fixed effects Included Included
Year fixed effects Included Included
N 1507 1507
Adjusted R2 0.812 0.837
This table presents the regression results for the relation between CEO long-term measures and audit fees.
***, **, and * denote significance at the 1%, 5%, and 10% levels, respectively. Variable definitions and sources are presented in Appendix A
47
TABLE 5
The relation between long-term performance measure and Audit Fees (sum of weighted LT measures)
Industry fixed effects Included Included
Year fixed effects Included Included
N 1507 1507
Adjusted R2 0.813 0.839
This table presents the regression results for the relation between CEO long-term measures and audit fees.
***, **, and * denote significance at the 1%, 5%, and 10% levels, respectively. Variable definitions and sources are presented in Appendix A
48