The Effect of Auditor Expertise on Executive Compensation

The following post comes to us from  Sudarshan Jayaraman of the Department of Accounting at Washington University in Saint Louis and Todd Milbourn, Professor of Finance at Washington University in Saint Louis.

In our paper, The Effect of Auditor Expertise on Executive Compensation, which was recently made publicly available on SSRN, we examine how auditor expertise influences the amount of equity-based compensation that firms grant to their executives. Our empirical tests are motivated by recent theoretical models that examine how the potential for financial statement manipulation influences managerial equity-based compensation. While more equity incentives may induce better strategic decisions and greater effort, they also encourage the manager to manipulate financial reports to artificially inflate the stock price, especially if the manipulation is unlikely to be detected. These theories predict that managers will be granted more equity-based compensation when financial misreporting is more likely to be detected, as the costs of granting such compensation are lower.

Following prior studies that find that greater auditor expertise reduces the incidence of earnings management and improves audit quality, we expect firms audited by an auditor with greater industry expertise to grant their executives more equity-based compensation. We find strong evidence in favor of our prediction. In particular, greater the expertise of the firm’s auditor, more is the amount of equity-based compensation that firms grant to their CEOs. This result is not only statistically robust, but also economically significant – a one standard deviation increase in auditor expertise increases CEO equity compensation by 1.4% relative to the mean. As most of our sample firms are audited by a Big Five (or Big Four) auditor, our tests effectively compare differences in equity-based managerial compensation between Big Five industry experts versus Big Five non-industry-experts.

Next, we examine the role of institutional ownership in the relation between auditor expertise and CEO compensation. Institutional shareholders, on account of their large ownership stakes, have both the incentives as well as the means to gather costly private information about earnings and to use this information to monitor managers. For example, Ayers et al. (2011) find that firms monitored by institutional investors are less likely to indulge in financial misrepresentation. We, therefore, expect the effect of auditor expertise on CEO equity-based compensation to be weaker in firms with greater institutional ownership. Consistent with our prediction, we find that the effect of auditor expertise on CEO compensation is much stronger in firms with lower levels of institutional ownership than in those with higher levels. For example, a one standard deviation increase in auditor expertise increases CEO compensation by 2.6% in a firm with no institutional ownership, but by only 0.89% in a firm with median institutional ownership.

To bolster our interpretation that the effect of auditor expertise on compensation stems from the effect that these equity-based incentives, in turn, have on financial reporting manipulation, we examine how auditor expertise influences equity-based compensation of the other executives of the firm, viz., the CFO versus all other non-CEO, non-CFO executives. Recent studies find that CFO equity incentives also have an important effect on financial reporting outcomes (e.g., Chava and Purnanandam (2010), Jiang et al. (2010)). Consistent with the role of CFO incentives, we find strong evidence that auditor expertise is also positively associated with CFO equity-based compensation and that the presence of institutional investors attenuates this relation. In contrast, we find no evidence of an association between auditor expertise and equity-based compensation of all other executives and also no role for institutional ownership. These results provide additional assurance that the association between auditor expertise and managerial compensation stems from the effect of equity-based incentives on financial misreporting – which are likely to be relevant only for CEOs and CFOs.

The above within-firm variation tests mitigate concerns that our results could be driven by unobserved factors, as in this case, it should influence all executives and not just the CEO and the CFO. However, they do not address the concern that auditor choice is endogenous and could itself be determined by equity-based compensation. For example, it could be that CEOs and CFOs who are better aligned with shareholders on account of their higher equity-based incentives are more willing to select auditors with greater industry expertise in order to bind themselves to greater monitoring. To address the endogeneity of auditor choice, we employ an instrumental variables approach and use the firm’s proximity to the closest SEC office as our instrument. Following recent studies that show that firms located closer to the SEC are less likely to commit financial statement fraud, we expect firms located farther from the SEC to be more likely to avail the services of an industry expert auditor. We find strong evidence in favor of our predictions. In particular, the distance of the firm’s headquarters from the closest SEC office is strongly and positively related to the firm’s choice of auditor expertise and the partial F-stat comfortably exceeds the commonly accepted “weak-instrument” threshold (Stock, Wright and Yogo (2002)). Further, the predicted value of auditor expertise is strongly and positively related to CEO and CFO equity-based compensation.

As SEC offices are generally located in larger cities, it could be that our results are driven by a “big city” effect, as opposed to proximity to the SEC. To address this concern, we exploit a recent decision by the SEC to elevate six of its district offices to regional office status. We examine the association between auditor expertise and distance to these district offices both before and after they became regional offices. We find no evidence of an association between firms’ choice of auditor expertise and distance to these district offices in the pre-period, but a strong positive effect in the post period, suggesting that it is the distance from the SEC office and not a “big city” effect that is driving our results. Overall, we summarize these results as suggesting that the relation between auditor expertise and equity-based executive compensation is robust to correcting for the endogeneity of auditor expertise.

Our study makes four contributions. First, it helps better evaluate the mixed evidence of the relation between executive incentives and accounting fraud examined in recent studies. Our results suggest that firms consider the information manipulation effects of equity incentives and optimally trade off these costs with the benefits of higher effort when designing compensation contracts. Second, our results point to the important role that auditing plays in influencing the efficient functioning of firms. Third, our study contributes to the literature that examines the relation between executive compensation and corporate governance structures. Finally, our study is one of the first to examine the underlying economic determinants of CFO compensation and how these differ from those of other executives.

The full paper is available for download here.

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