MSc. Thesis Accountancy & Control
The effect of audit quality on variable management
compensation
Name: Chantal Mauricia Student number: 11132191
Thesis supervisor: Dr. J.J.F. van Raak Date: 26th June 2017
Word count: 14.347
MSc Accountancy & Control, variant Accountancy Amsterdam Business School
Statement of Originality
This document is written by student Chantal Mauricia who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
Abstract
Variable management compensation has been an ongoing and highly debated topic that has drawn a lot of attention, since it may induce managers to divert firms’ resources to activities that are detrimental to the objective of maximizing shareholders’ wealth. This paper aims to investigate whether firms with high audit quality can put more weight on a variable management compensation. The data are taken from a sample of 7.965 US listed firms for the period of 2007-2015. Three proxies are used to measure audit quality: auditor industry specialization, abnormal audit fee and big 4 audit firm. Multiple regression analyses are used to find determinants of high audit quality. The empirical results show statistically significant and positive associations between auditor industry specialization and variable management compensation. Both abnormal audit fee and Big 4 audit firms has an insignificant effect on variable management compensation. Audit fee discounts or excessive audit fees generally do not lead to an impaired auditor independence. The empirical findings are subject to several caveats. Audit quality is difficult to measure, especially as it is subject to many factors and can be measured in many forms. Other corporate governance mechanisms such as transparency and disclosure, the separation of chairman and CEO roles and shareholder’s right could be considered. This paper offers new contribution to the important debate about management compensation structure. Contrary to prior research which focused on governance as monitoring mechanism, this paper focuses on audit quality as the main monitoring mechanism and strengthens its effect by using corporate governance mechanisms as control variables.
Keywords: Audit quality; Industry specialization; Abnormal audit fees; Big 4; Board of directors;
Acknowledgement
Praise to God for giving me health, strength and perseverance to finish this master thesis successfully. During the writing of my master thesis I was luckily enough to receive help and support of several people which made this journey easier, enabling me to successfully go through it and finish my master thesis on time. Therefore, I would like to express my gratitude to these people for their support, guidance and motivation.
First of all, I would like to thank my supervisor dhr. Jeroen van Raak for his feedback and support on many occasions throughout the process of writing my thesis. This together with face-to-face thesis-related appointments, valuable comments and suggestions have improved the quality of my thesis and served as an important input to a successfully completed and qualitative strong thesis. Furthermore, I wish to thank PricewaterhouseCoopers for granting me with the tremendous opportunity to do a thesis internship at their office in Rotterdam. The opportunity came along with several advantages such as the use of all office facilities, a pleasant ambience and a motivating working environment provided by the other thesis interns. I am thankful to my coach from PwC, Anton Rijerse, for his support and guidance.
I express my deepest gratefulness to my mother and father for their efforts, dedication, support and great investment in my education. Without their support it were almost impossible to reach this milestone. Additionally, I would also like to thank my family and close friends for their support and motivation in the process of writing my thesis.
Overall, the writing of my thesis was a valuable but especially instructive experience. It provided me an opportunity to amplify my knowledge and further develop my analytical and research skills. Rotterdam, June 2017
Table of Content
1 Introduction ... 6
2 Literature & hypothesis development ... 9
2.1 Agency theory ... 9
2.2 Management compensation ... 11
2.3 Monitoring mechanism ... 14
2.3.1 Audit quality ... 15
2.3.1.1 Industry expertise ... 15
2.3.1.2 Abnormal audit fees ... 18
2.3.1.3 Audit firm ... 20
3 Methodology ... 22
3.1 Sample selection ... 22
3.2 Dependent and independent variables ... 23
3.3 Regression model ... 23 3.3.1 Control variables ... 25 4 Results ... 28 4.1 Descriptive statistics ... 28 4.2 Correlation coefficients ... 29 4.3 Regression analysis ... 32 4.3.1 Sensitivity analysis ... 35 4.3.2 Robustness results ... 36 5 Conclusion ... 37 References... 40
Appendix A: Variable description ... 45
1 Introduction
The information provided in the statements which is prepared by a firm’s management help the users to determine the firm’s performance, predict its future probability and monitor managers’ actions (Bushman & Smith, 2001; 2003). Under U.S. GAAP, a firm’s management is given some discretion as to the timing and classification of certain items. Unfortunately, this discretion can be used to manipulate reported earnings by a selection of reporting methods and disclosures that do not accurately reflects of the firms’ underlying economics (Healy & Wahlen, 1999). To assure that the financial statements provided by management is not excessively optimistic, misleading or false, auditors serve a vital economic purpose in verifying the accounting numbers and providing external users with reasonable assurance about the reliability and credibility of a firm’s financial statements (Bazerman, Morgan & Loewenstein, 1997). The verification of the accounting numbers reported by managers is seen as a market-induced mechanism to reduce agency costs (Jensen & Meckling, 1976; Watts & Zimmerman, 1983). Hence, auditors play an important role in reducing noise and bias in financial reporting by monitoring and controlling earnings management (Kinney & Martin, 1994; Wallace, 1980).
In an effort to improve audit quality, the Sarbanes-Oxley Act of 2002 implemented numerous changes to impact the structure of the audit market and the quality of audit services (DeFond and Lennox, 2011). SOX requires managers to sign off on the accuracy of the financial statements and hold them personally accountable if the financial reports appears to be unreliable. SOX also imposes greater penalties and requires managers of restating firms to forfeit bonuses gained due to overstatements. These requirements for greater management accountability in financial reporting and increased penalties for misreporting are likely to increase the clients demand for higher quality auditors (DeFond and Lennox, 2011). The aim of the enactment of the SOX is to foster more reliable financial reporting and enhance audit quality, to provide investors with assurance regarding management’s representations about the effectiveness of the company’s internal control over financial reporting, by the independent auditor.
Despite the implementation of laws and regulations, fraudulent accounting practices still occur. Numerous of accounting scandals involving once well-respected companies such as Enron, WorldCom (US), Ahold (Netherlands), Parmalat (Italy) and Toshiba (Japan) has drawn a lot attention towards the audit profession, raising criticisms about the financial reporting quality (Agrawal & Chadha, 2005; Brown, Falaschetti & Orlando, 2010). These scandals have weakened the confidence in the management, the financial reports and audit quality. These accounting failures also developed the need to improve the financial information quality and to increase the quality of control of managers by strengthening the currently implemented monitoring
mechanisms (Brown and Caylow, 2006; Firth, Fung & Rui, 2007; Karamanou & Vageas, 2005; Petra, 2007). Some effective disciplinary mechanisms as board of directors, audit committees, external auditors and management compensation serves to align management’s interest with those of shareholders (Essen et al, 2012) and may restrain earning management (Schatt et al., 2016). There has been however a lot of controversy about the way firms determine the structure of their management compensation due to the fact that the variable part of the compensation might excite new potential misalignments of interest between management and shareholders.
The results of previous studies show possible opportunistic managerial behavior through accounting earnings management which is caused by management’s incentive-based compensation (Dechow, Ge & Schrand, 2010; Duellman, Ahmed & Abdel-Meguid, 2013). Almadi and Lazic (2016) argue that that financial incentives are viewed as means whereby self-serving executives skim organizational profits and seize shareholders. Self-serving occurs when firms use accounting based performance measures for the evaluation of executive’s performance. In addition, Brown (1990) reports that besides the motivational aspect of variable compensations it also encourages short-term performance while it is desired that managers focus on long-term objectives. When targets are determined in advanced, managers could make self-interest decisions in order to meet their target at the expense of the shareholders wealth. Moreover, Healy (1985) indicate that under a variable compensation type, managers tend to manipulate earning to distort the firm’s reported performance in order to maximize their compensation. This issue is core on which this paper focuses on.
This research examines whether firms with high auditor quality, exerting a higher monitoring quality, resort to a more variable management compensation. It also examines the joint effect of audit quality along with corporate governance characteristics. This leads to the following research question:
‘Does a higher audit quality enable firms to put a greater weight on the variable reward in relation to the total management compensation?’
This study is motivated by a number of considerations. In contrast with prior research, this study takes a different approach towards monitoring quality and variable management compensation. Rather than examining the effect of corporate governance alone, which is a frequently used monitoring mechanism, this study examines if a higher audit quality enable firms to put more weight on variable management compensation. To the best of my knowledge no prior studies examined this phenomenon thus this approach is a new addition to the existing body of literature
on the topic of audit quality and management compensation. Moreover, the balance between corporate governance and management compensation to align interest of management with shareholders is still an unresolved issue (Core, Guay & Larcker, 2003). Thus it is also interesting to find out whether the misalignment of interest between management and shareholders can be reduced in the presence of high audit quality and gives more insights in the effectiveness of the auditor and the possible effects on the type of management compensation.
The results show a positive relation between abnormal audit fee and variable management compensation, while the effect is negative on the two other audit quality measures: auditor industry specialization and Big 4 audit firms. Although the latter is insignificant in this relationship. Overall, the results suggest that there is no greater reliance on audit quality to put more weight on a variable management compensation. My findings are inconsistent with changes in audit quality to increase monitoring quality and lower the incentives of managers to manage earnings resulting in firms to put more weight on variable management compensation. The findings regarding the control variables document that firms with and independent audit committee, financial experts, large size, low debt and high return on assets are more likely to put more weight on variable management compensation. These findings are consistent with changes in incentives to manage earnings resulting is less earnings management behavior. Further, I find no evidence linking changes in other corporate governance measures as board size, board independence and board meeting attendance to changes in variable management compensation. This suggests that while governance is improved, it is not the driving force behind the change in variable compensation. The results of the restatement sample which tested for industry main effects suggest that industry effects are the impetus for the change. This result indicate a positive relation between auditor industry specialization and variable management compensation in the expected direction, as opposed to the main regression model where auditor industry specialization showed a negative relation.
The remainder of this thesis is organized as follows. The next chapter describes the theoretical background concepts employed in this research such as agency theory, audit quality and management compensation and discusses the hypotheses development. The third chapter describes the sample selection and outline the research design used to test the hypotheses. The results of the effect of audit quality on variable management compensation are presented in the fourth chapter followed by a discussion in chapter 5. The final chapter contains the conclusion and limitations of this research and provides suggestions for future research.
2 Literature & hypothesis development
The first part of this section addresses agency theory and provides an overview of previous studies that has been undertaken regarding management compensation with an emphasis on earnings management. The second part provides literature regarding audit quality and its underlying measures as auditor industry specialization, abnormal audit fee and Big 4 audit firm. Furthermore, the hypotheses formulated for this study are presented.
2.1 Agency theory
The agency theory has been one of the most influential theoretical paradigms in the financial economic literature (Bebchuk & Fried, 2001; Jensen & Murphy, 2010). This theory seeks to explain the relationship between shareholders (principals) and managers (agents) and the possible misalignment of interest between the two parties. The context for this theory is the separation of ownership and control within firms, which in modern corporations is the typical agency problem (Murphy, 1999).
The growth of firms entailed a transition from owner-managed firms to firms where there exist separation of ownership and control. In such situation information asymmetry and conflict of interest between principals and agents arise when the former appoints a group of managers as their agents authorized with decision-making responsibilities and executive tasks (Jensen & Meckling, 1976). This delegation of responsibility by the principal requires trust in the management to act in the best interest of the shareholders, since managers obtain inside information which they can use to pursue their own interest (Jensen & Meckling, 1976; Shleifer & Vishny, 1986). According to Jensen & Meckling (1976) one cannot expect managers to watch over shareholders money with the same apprehensive vigilance and diligence as partners of owner-managed firms would watch over their own money. To deal with this agency problem shareholders need to implement mechanisms to align management’s interest with that of the shareholders and other key stakeholder and to reduce information asymmetry and self-interest behavior.
Factors such as personal and financial gain may influence managers to bias information, be optimistic about the firm’s financial position and make decisions that are not in line with the shareholders interest of maximizing the firm’s value. In many situations shareholders have limited expertise, skills and monitoring capacity to observe management’s performance and responsibilities and have limited access to information about the operations of the firm. Monitoring mechanism used to align the interest of management with shareholders are auditing, board of directors, audit committees and management compensation (Donaldson & Davis, 1991; Watts & Zimmerman, 1981; Benston, 1980). Jensen and Meckling (1976) also portrays the role of
the auditor as a monitoring mechanism to reduce agency cost. Kinney and Martin (1994) argue that auditing reduces positive bias in pre-audit net earnings and net assets. Auditing is a third party certification given by auditors, which certifies the truthfulness of the financial statements (Francis, 2011; Moore et al. 2006). To provide this certification an independent auditor should verify if the accounting numbers provided by management are not excessively optimistic, misleading or false and state that the financial statements are reliable, hence ‘fairly present’ the company's financial position (Bazerman, Morgan & Loewenstein, 1997).
Conflict of interest and information asymmetry cause misalignment between management’s interests with those of the shareholder. Cost incurred by the alignment of are identified as agency costs (Jensen & Meckling, 1976; Fama & Jensen; 1983). Agency cost is defined as the sum of the monitoring expenditures by the principal, the binding expenditures by the agent and the residual loss (Jensen & Meckling, 1976, p. 308). In situations where misalignment of interest is present, shareholders are concerned that the independence of the external auditor is not comprised and result in reduced audit quality (Quick & Warming-Rasmussen, 2015). If an auditor is not truly independent, his judgement on the company’s financial statement will be of no value (Firth, 1980). Mautz and Sharaf (1961) & Quick and Warming-Rasmussen (2009) also addresses the requirement that an external auditor should be independent. The latter argue that if auditors are not perceived as independent, users will have little confidence in the auditor’s opinion, financial statements are perceived as more uncertain, and thus social costs are incurred. Botosan & Plumlee (2002) examine the association between the quality of annual reports and the cost of capital. They find that in situations where financial statements are perceived as more uncertain, investments are seen as riskier, investors demand higher risk premiums and thus the cost of capital increases. Audit reports are thus only beneficial if they contain reliable information and provide adequate audit quality.
DeAngelo (1981) defines audit quality as the joint probability that an auditor will both ability to discover breaches and withstand client pressure to “disclose if a breach has been discovered”. The probability to discover a breach is depends on the auditor’s capabilities and audit procedures employed on a given audit. The probability of reporting the breach depends on the auditor’s independence. Auditor independence is a keystone of the auditing profession. It is traditionally regarded as a fundamental principle for the reputation of the auditing profession and is the most demanded element by the users of the financial statements (Melancon, 2002). Therefore, the sustainability of the audit profession firmly relies on how auditors can ensure adherence to the principle of independence.
2.2 Management compensation
There are two competing approaches with regard to effect of management compensation on managerial behavior. On one hand, management compensation via performance-based mechanism is seen, by the optimal contracting approach, as an effective response to the agency problem (Almadi and Lazic, 2016). On the other hand, the managerial approach supports the notion that management compensation and corporate governance practices are a reflection of managerial power and rent-seeking behavior rather than the provision of efficient incentives (Van Essen, Otten and Carberry, 2015).
The purpose of a compensation structure is to compensate managers based on their effort and time. Management compensation consist of different components, which can be divided in fixed compensation such as salary and variable compensation as bonuses and long term compensation including stock options, restricted stock, and long-term incentive plans (Murphy, 1999; Gao & Shrieves, 2002; Frydman & Jenter, 2010). Salary is defined as a fixed amount of money awarded in compensation that is determined at the beginning of an annual pay cycle. Fixed salaries value the quality aspect of the managers, which is determined by their knowledge, skills and ability to solve problems and manage difficult tasks (Baarda, 2003). According to Brown (1990) compensation through fixed salary payments are not tied to personal performance thus effort is not an issue. Through this compensation type firms save monitoring cost and can pay lower wages, however these advantages are counterbalances by management being less productive. The problem arising from a straight salary payment is that this type of compensation provides no incentive to management to exert more effort than necessary. Wang (2016) examines the relationship between idiosyncratic volatility, executive compensation and corporate governance. The result of his study provides evidence that fixed executive compensation is positively related to volatility and information trading. Similarly to the result of Brown, Wang (2016) indicates that the advantage of a fixed income is the accuracy of the compensation, however fixed rewards does not incentives managers to work harder.
Variable compensation, also known as performance related pay, is often a supplement of fixed compensations and should be disclosed in annual reports (Firth et al, 1999; Higgs & Skantz, 2006). The annual bonus is determined at the beginning of the year under a variety of performance scenarios and/or targets (Holthausen, 1995), hence is based on the pay-for-performance. As a result bonus compensation might create incentives for managers to exploit accounting choices. According to Brown (1990), the purpose of a variable compensation is to increase the effectiveness of the fixed compensation type by using an indicator that is directly related to management’s effort. In addition, Hansell et al. (2009) indicates that the annual bonus had two advantages. First, reward
is based on performance regarding internal financial and operational targets over which executives have direct control. Second, because of its thigh link to performance it can be highly motivated.
In consonance with the managerial approach, the results of previous studies (Dechow, Ge & Schrand, 2010; Duellman, Ahmed & Abdel-Meguid, 2013) show possible opportunistic managerial behavior through accounting earnings management which is caused by management’s incentive-based compensation. A recent study of Almadi and Lazic (2016) show that financial incentives are viewed as means whereby self-serving executives skim organizational profits and seize shareholders. Self-serving occurs when firms use accounting based performance measures for the evaluation of executive’s performance. This because accounting-based performance measures are sensitive to manipulation as they are backward looking. In addition, Brown (1990) reports that besides the motivational aspect of variable compensations it also encourages short-term performance while it is desired that managers focus on long-short-term objectives. When targets are determined in advanced, managers could make self-interest decisions in order to meet their target at the expense of the shareholders wealth. Moreover, Healy (1985) indicate that under a variable compensation type, managers tend to manipulate earning to distort the firm’s reported performance in order to maximize their compensation. Indeed, Sun (2013) demonstrate the same by stating that managers tend to manipulate the outcome of their performance by using reporting methods and estimates that do not accurately reflect their firms’ underlying economics in order to increase their compensation.
Gao and Shrieves (2002) examines the influence of the components of compensation on earnings management for US firms. Their finding imply that stock options and bonuses are positively related to earnings management intensity, whereas salaries are negatively related. In addition, their collective finding indicate that compensation contract design does influence earnings management. The study of Carter, Lynch and Zechman (2005) further extends the literature by examining the relation between earnings and bonuses compensation and whether this relation changed after the implementation of SOX. The findings provide evidence that bonuses are positively associated with and both discretionary and non-discretionary accruals. Sun (2013) further elaborate that the lack of adequate and reliable information in the financial markets was a significant contributor to the financial crisis, whereby improperly structured compensation was an important underlying factor to corporate scandals (Sun, 2013). He further indicates that the composition of executive compensation seems to be a central contributor to the extensive practice of earnings management. The study of Wang (2016) examined the relationship between idiosyncratic volatility, executive compensation and corporate governance. The result of his study show that equity-based compensation is negatively associated to volatility and information trading,
hereby indicating the presence of information asymmetry. According to Brown (1990) implementing contracts linking pay and performance run into monitoring problems because variable management compensation could provide opportunities for earnings management. However, the link between pay and performance will be stronger where performance is more accurately monitored through a high quality auditor.
Management compensation has an important function in the alignment of management’s interest with those of shareholders (Essen et al, 2012). Shareholders determine management compensation but cannot observe them perfectly thus don’t know whether certain actions, decision or investment opportunities taken are in line with the increase of shareholders value. The bonding of interest incentives managers to make value-enhancing decisions that benefit shareholders and managers in a similar way. To improve management’s performance they have to be motivated which requires effort and taking risk, however this is associated with disutility. Moreover, firms need to structure their management’s financial rewards in a way that attracts, retains and motivates management (Firth, Tam and Tang, 1999) but also make sure that management does not pursue its own objectives. According to Hanswell et al. (2009) it is a challenge to retain motivational impact while minimizing short-term thinking and behavior that yearly bonus encourage.
Based on the above, it appears that managers may exert opportunistic behaviour and pursue their own objectives in order to maximize their personal profit (Jensen & Meckling, 1976). They can do this by managing earnings which is described in the literature as earnings management. Healy and Wahlen (1999) define earnings management as the use of manager’s judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the firm or to influence contractual outcomes that depend on reporting accounting numbers. Earnings management exists of big bath restructuring charges, premature revenue recognition, cookie jar reserves and write-offs of purchased in-process R&D and are threats to the credibility of financial reporting. Schatt et al. (2016) provides a similar definition and indicates that earnings management occurs when managers try to alter financial reports in order to mislead stakeholders about the economic performance of the company or to influence contractual outcomes that are dependent of the reported accounting numbers. Bearing this in mind, shareholders recognize the essential role auditors play in achieving effective corporate governance and reliable financial reports through an effective execution of quality audits that contribute to the reliability of more timely and useful financial information (Kueppers & Sullivan, 2010). Through control of management actions, establishing levels of compensation and implementing high quality auditors, the board tries to align managerial
incentives and shareholders interest to improve the efficiency and continuity of the firm (Schatt et al., 2016).
Finally, there is one problem with all forms of variable pay which is the financial upside for executives but no equivalent downside. Executives may not receive a bonus if they do not meet their targets or they may find that their options are worthless if the company’s stock tanks. In neither case their own wealth is a risk, as it is for the shareholders. This risk asymmetry between managers and shareholders reinforces short-term thinking and encourages risk taking (Hansell, et al., 2009). Contrarily, when there is trust in the managers, shareholders are more likely to choose a more performance related compensation, which can consist of a combination of as a low salary and bonuses and share options. However, the variable part of the compensation might excite new potential misalignments of interest between management and shareholders. In such situations shareholders need to determine the extent to which incentives and monitoring mechanisms should be implemented. Some effective disciplinary mechanisms as board of directors, audit committees or an external auditor may restrain earning management (Schatt et al., 2016).
2.3 Monitoring mechanism
Information asymmetries may raise concerns about the reliability of information provided by management. This has an impact on the level of trust that shareholders have in the management. As stated before, management’s performance is not perfectly observable. They could be tempted to pursue their own interest and maximize their own benefit which is not in line with the interest of the shareholders (Quick and Warming-Ramussen, 2009). To reduce this problem management has to account for stewardship by preparing financial statements. The compliance of these financial statements needs to be examined by the external auditor to increase the trust in these statements. The American Institute of Certified Public Accountants (as cited in Goldman & Barlev, 1974) defines auditing as “an examination intended to serve as a basis for an expression of opinion regarding the fairness, consistency and conformity with accepted accounting principles of statements prepared by a corporation or other entity for submission to the public or to other interested parties. To fulfil this role, auditors should be independent.
Because of the potential conflict of interest between management and shareholders, audit services are demanded to service as monitoring devices. In some cases the provision of audited financial statements is the least cost response to agency costs (DeAngelo, 1981). As stated in Rusmin et al. (2009) Watts and Zimmerman (1986) argue that auditor quality depends on the relevance of the auditor’s report in examining contractual relationships and the probability that an auditor will report a discovered breach. Causholli and Knechel (2011) indicate that investors attach
value to firms who hire auditors perceived as being of high quality. They further state that high quality auditors make the firm’s financial statements more credible to markets and lessen the information risk. Bartov, Gul and Tsui (2001) argue that high quality auditors are less inclined to accept questionable accounting practices and more likely to report errors and irregularities once they have been found. Knapp (1985) argue that a high quality auditor has the ability to resist management pressure and embraces the freedom to report findings and give an opinion that is free from external influence such as economic dependence of the client. According to DeFond, Raghunandan and Subramanyam (2002) a high quality auditor must be able to objectively evaluate a firm’s performance and withstand any client pressure to issue an unmodified opinion.
The quality of audits differ among audit firms and depends on factors such as auditor independence, auditor reputation, industry specialization, auditor qualifications, audit firm size and audit fees. Al-Khaddash, Al Nawas & Ramadam, find that factors as audit efficiency, audit fees, size of the audit firms and the proficiency of the auditor affect the auditor quality. Independent financial statement audits are a monitoring device with the intention of counterbracing the information asymmetry between managers and shareholders (Herrbach, 2001). Abbott et al. (2003) argue that high auditor quality demand a higher level of audit quality due to concerns relating to reputation losses arising from financial misstatements. Fan and Wong (2005) provided evidence that firms signal their investment in strengthen governance by choosing high quality auditors. Auditor industry specialization, abnormal audit fees and Big 4 audit firm are used as proxies for audit quality.
2.3.1 Audit quality
2.3.1.1 Industry expertise
Prior auditing studies show that auditor industry expertise improves error detection and increases the financial reporting quality (Balsam, Krishnan & Yang 2003; Krishnan, 2003). Industry specialists are defined as auditors that acquire training and practice experience concentrated in a specific industry (Solomon, Shields and Whittington, 1999). The study of Kend (2008) defines an industry specialist as auditors that developing constructive ideas to add value to their clients businesses and provide new insights or solutions to industry specific issues that clients face. In order to be recognized as in industry specialist, the auditor is required to have industry specific knowledge in order to understand comprehensive industrial issues, the operations of its client, the audit risk they face within a particular industry and be aware of the impact of industrial issues on industry participants (Kend, 2008, p. 57).
that has differentiated itself from its competitors in terms of market share within a particular industry. Firms with the largest market share has the ability to provide higher quality audits because they developed the largest knowledge base within that particular industry. Their large knowledge base comes from their experience gained through serving other clients within the same industry, thereby learning the best practices of the industry (Neal & Riley, 2004; Dunn and Mayhew, 2004). Significant market shares within an industry reflect significant investment by audit firms in developing industry specific audit technologies, personnel and control systems with the expected benefits to detect irregularities and misstatements easily and improving audit quality (Simunic and Stein, 1987; Neal & Riley, 2004; Gul, Fung & Jaggi, 2009).
Other studies provide evidence that industry specialist auditors have better knowledge and broader understanding of their clients’ business, which improves the accuracy of error detection thereby increasing audit quality (Maletta & Wright, 1999; Solomon, Shields and Whittington, 1999; Owhoso, Messier & Lynch, 2002; Romanus, Fleming & Maher, 2008). U.S. Government Accountability Office, hereafter GAO acknowledged the importance of industry specialization stating that: “a firm with industry expertise may exploit its specialization by developing and marketing audit related services which are specific to clients in the industry and provide a higher level of assurance” (GAO, 2008, p.111). Also, Taylor (2000) argues that auditor industry specialization enhances the auditor’s risk assessment. The finding of other researches (Low, 2004; Hegazy, Sabagh & Hamdy, 2015) are similar and indicate that besides the enhancement of the auditor’s risk assessment, industry specialization also influences the choice of audit tests and the allocation of audit hours, thereby enhancing the efficiency of audit tasks performed.
The study of Sun and Lui (2011) examines the relationship between industry specialist auditors, outside directors and financial analyst. They suggest that industry specialist auditors provide expertise services to their clients because they have great industry specific knowledge (Solomon et al, 1999; Balsam et al., 2003). As a result, outside directors are more likely to hire industry specialist auditors who can effectively monitor the financial reporting process. They also suggest that financial analyst are also industry experts and possess industry-specific knowledge like industry specialist auditors, thus may compete with industry specialist auditor in the monitoring financial process. Romanus et al. (2008) studied the impact of auditor industry specialization on restatements and found that auditor industry specialization reduces the likelihood of issuing restatements affecting the core operating accounts, suggesting that industry specialization adds value in auditing which is a particular critical area of the firm’s continuing operations. They explained the underlying reasoning as “restatements in core operating accounts are more likely to have a powerful effect on the perception of a firms permanent earnings as compared with noncore
operating accounts because the estimation of permanent earnings is a critical part of valuation and investment analyses, (p. 390)”.
Ahmand, Mohamed and Nelson (2016) show that the presence of industry specialist auditor is more likely to reduce audit report lag and enhance financial reporting timeliness. Yu (2008) and Knyazeva (2007) discuss that industry experts are positively associated with low earnings management, due to their monitoring role. Dunn and Mayhew (2004) found that clients with industry-specialized auditors is associated with higher analyst evaluations and increased disclosure quality compared to clients with non-specialist auditors. Fan and Wong (2005) argue that the choice of choosing industry specialist auditors instead of non-specialists may be used as a signal to investors about the firm’s concern towards a high standard of corporate governance. In addition, Minutti (2013) presents evidence that auditor industry specialization has benefits for companies, regulators and audit firms. He argues that understanding the benefits of industry expertise is relevant for companies choosing among auditors, regulators concerned with competition in the audit market and to audit firms aiming to perform high-quality audits. Bonner and Lewis (1990) state that on average, industry specialized auditors outperform less experienced auditors. The findings of Berdard and Biggers (1991) are similar and indicate that more experienced auditor are more able to identify errors than auditors with less experience.
While the above studies indicates the ability of industry specialist auditors to increase audit quality, there are studies whose findings disagree with the assumption that an industry specialist auditor improve audit quality. Caneghem (2004) studied the impact of audit quality on earnings rounding-up behavior, by using auditor industry specialization as a proxy to measure audit quality. The results of his study show that the findings are only weakly consistent with specialist Big 5 auditors constraining earning management practices. Turning to another research, Minutti (2013) examined whether auditor industry specialization improves audit quality and find that no significant differences exist in the audit quality between specialist and non-specialist auditors. Minutti’s findings are based on the examination of pre- and post-differences in discretionary accruals, propensity to meet or beat analyst forecast and audit fees for Arthur Andersen’s clients that switched to auditors with a different degree of specialization in 2002. However, Minutti (2013) state that his findings do not imply that industry knowledge is not important for auditors, but that the methodology used may not fully parse out the effects of auditor industry specialization from client characteristics.
Most of the research studies above provide evidence that industry specialized auditors help to improve the quality of the financial statements. Based on the above discussion, I expect that industry specialist auditors may provide higher monitoring quality than less experienced auditors,
which means that there is a positive relationship between auditor industry specialization and the provision of a variable management compensation. Thus this leads to the expectation that a high monitoring quality, will reduce the information asymmetry thereby allow clients to increase the share of the variable reward in relation to the total management compensation. This results in the following hypothesis:
H1: Firms with an industry specialist auditor can put more weight on the variable part of the management compensation
2.3.1.2 Abnormal audit fees
Abnormal audit fees is defined as the difference between actual audit fees paid to the auditors for their financial statement audits and the expected normal level of audit fees that reflects the auditors’ effort costs, litigation risk and normal profits (Choi, Kim and Zang, 2010). The theory provides two views that differently describes the relationship between abnormal audit fees and audit quality. Prior research investigates the impact of abnormal audit fees on auditor independence and audit quality. It could be argued that abnormal high fees may impose an incentive on auditors to allow the managers to engage in opportunistic earnings management and thus impair their independence. There is support for this notion in the audit literature, whereby this assumption stems from the view that abnormal high audit fees are an indication of attempted bribes, economic rents earned by the auditor or an auditor’s economic bond to a client (Kinney and Libby, 2002). This view is referred as the economic bonding view (Eshleman and Guo, 2014).
Krauß, Pronobis and Zülch (2015) investigates the relationship between abnormal audit fees and audit quality in a German market setting. The results show a negative association between abnormal audit fees and audit quality and imply that the audit fee premium is a significant indicator of compromised auditor independence due to the economic auditor-client relationship. In addition, the findings of Hoitash, Markelvich and Barragato (2007) are also consistent with the economic bonding view and documents a significant negative association between abnormally high audit fees and audit quality. Subsequent research examined the relationship between abnormal audit fees and audit quality proxied by the magnitude of absolute discretionary accruals. In line with the results of Krauß et al., (2015), Choi et al. (2010) shows that positive abnormal audit fees are negatively associated with audit quality. Their findings suggest that auditors’ incentives to deter biased financial reporting depends on whether audit fees are above an auditor’s expectation of the normal fee level and they are below. If auditors receive high abnormal audit fees, their benefit of retaining the profitable client may outweigh the costs associated with allowing questionable
declines in the presence of abnormally high audit fees, based on the findings that clients with abnormal high audit fees record higher magnitudes of discretionary accruals and are more likely to meet or beat analysts’ forecasts. In addition, Hribar, Kravet and Wilson (2013) found a negative relationship between abnormal audit fees and audit quality. The results provide evidence that that abnormal audit fees are incrementally informative for predicting restatements, fraud and SEC comment letters.
Literature however offers contradictory results. Mitra, Deis and Hossain (2009) examine the association between reported earnings quality, measured by discretionary accrual adjustments and expected and abnormal audit fees. They find that abnormal audit fees are associated with a decline in accrual management and thus a reduction of financial reporting biases. In addition, Xie, Cai and Ye (2010) investigated whether opinion shopping is associated with abnormal audit fees. They assume that firms engage in audit opinion shopping and pay abnormal audit fees when their degree of accounting quality is low. They however found no significant relation between abnormal audit fees and audit opinion improvement. Furthermore, the study of DeFond et al. (2002) failed to find significant relationship between abnormal audit fees and audit quality. However, they examined the effect of non-audit fees on audit quality, which is a different focus than the focus of this study is on audit fees.
Turning to the second view whereas higher audit fees are indicative of greater auditor effort which results in better audit quality. Contrarily, low audit fees are an indication of less audit work done and hence lower audit quality. This view is referred as the effort view, which indicates that higher audit fees are a result of the audit firm doing more audit work and preventing accounting irregularities to take place (Eshleman and Guo, 2014, Blankley, Hurtt and MacGregor, 2012; Higgs and Skantz, 2006). Blankley et al. (2012) examined the relationship between audit fees and subsequent financial statement restatements. According to the researchers restatements represent both reporting failure by the management and audit failure by the auditor. The findings of Blankley et al. (2012) show that abnormal audit fees are negatively associated with future restatements.
Low abnormal audit fees might reflect low audit effort or incorrect risk assessment whereby both are negatively associated to audit quality. Conversely, high abnormal audit fees reflect more effort, less reliance on client’s controls which lowers the likelihood of restatement since the auditor is more likely to detect material misstatements. In addition, Whisenant, Sankaraguruswamy and Raghunandan (2003) supports the notion that fees represent the level of service provided by the auditor, whereas higher audit fees are associated with greater levels of effort. Higgs and Skantz (2006) examined whether between earnings quality proxied by earnings response coefficient (ERC) is associated with engagement profitability. Their findings are consistent with the notion that
abnormally high audit fees as a signal of a firm’s commitment to high earning quality.
As mentioned before, prior literature offers conflicting evidence on whether high audit fees are a signal of more effort exerted by the auditor (effort view) or a signal that the auditor may be losing his independence (bonding view). The discussion above denotes that high audit fees may indicate higher auditor effort, but when audit fees reach a certain point indicated as abnormally high audit fees, I assume that the latter is more likely to impair auditor independence instead of increasing effort. This study thus adopts the bonding view. This leads to the expectation that abnormal high audit fees is negatively associated with audit quality resulting in a low monitoring quality thereby decreasing the possibility for firms to provide a more variable management compensation. This leads to the second hypothesis:
H2: Firms who pay their auditor an abnormal audit fee can put less weight on variable management compensation
2.3.1.3 Audit firm
The Big 4/non-Big 4 categorization is often used as a measure of audit quality. Large audit firms are assumed to perform more powerful tests. This is based on the assumption that the litigation and reputation exposure to big 4 firms encourage them to exert stronger monitoring and oversight of management’s reporting behavior (Evans et al., 2015). Based on the assumption above, the results of Chi, Lisic and Pevzner (2011) provide evidence that Big 4 auditors constrain real earnings management and therefore are more likely expected to restrict reporting discretion than non-Big 4 auditors. According to Caneghem (2004) the aforementioned assumption is predicted on the fact that large audit firms have a large client base and hence have more to lose in terms of termination of other clients, reduced fees for remaining clients and loss of reputation when they do not withstand client’s pressure to not report a discovered breach. Chung et al. (2005) argue that Big 6 auditors have greater opportunity to deploy significant resources to auditing such as recruitment, training and systems and have the independence to insist that clients need to make necessary adjustments to their financial statements.
DeAngelo (1981) implies that larger audit firms are perceived to provide higher quality audits because they have less incentive to behave opportunistically in order to ensure retention of their clients compared with smaller firms. Similarly, Watts and Zimmerman (1981) argue that large audit firms can provide higher quality audits because they have a comparative advantage in monitoring management’s behavior. Big 4 auditors are identified as higher quality auditors, as they have technological capability in detecting earnings management, and when detected, there is a higher
state that financial information audited by Big N firms are being perceived as more credible by the users. Chung et al. (2005) studies the effect of Big 6 audit firms and institutional investors with substantial shareholdings in mitigating the low or negative earnings. They assume that Big 6 auditors have strong incentives to provide high audit quality in order to protect their hard-won reputation. Their results show that Big 6 audit firms, which are suggested as external monitoring, is effective in deterring managers’ opportunistic earning management.
Krishnan and Schauer (2000) studied the relationship between audit firm size and audit quality, measured on the entities’ compliance with GAAP reporting requirements, for a sample of nonprofit-entities and find a positive association between auditor size and audit quality. They divided their sample based on a three-tier classification of auditors: Big 6 firms, large non-Big 6 firms and small non-Big 6 firms. Their findings indicate a decrease in the extent of noncompliance as one moves from the small non-Big 6 to the large non-big 6 and from the large non-big 6 to the Big 6 firms group. Also Krishnan and Schauer (2000) used another proxy to measure audit firm size, namely the number of professionals employed by the firm, and the results provide evidence that further confirms the findings.
While many researches provide evidence that support the assumption of a positive association between audit firm size and audit quality, as stated in Krishnan and Schauer (2000), regulators (AICPA, 1980) have maintained that audit quality is independent of accounting firm size. Caneghem (2004) studied based on a sample of listed UK companies, the association between Big 5 audit firms and the employment of earning rounding-up behaviors as an indication of earning management. His findings are inconsistent with the hypothesis that Big 5 audit firms are more likely to provide higher audit quality by the constringent of earnings management practices.
The above discussion give rise to the expectation that firms audited by high quality Big 4 auditors benefit from a higher monitoring quality, than firms that have lower quality auditors thereby allowing clients to increase the share of the variable reward in relation to the total management compensation. This leads to the following hypothesis:
H3: Clients of Big 4 audit firms are more likely to have higher audit quality thereby increasing their possibility to put more weight on a variable management compensation
3 Methodology
The first section of this chapter explains the process for the sample selection and the databases used. The following section describes how audit quality and audit fee are measured. Audit quality is measured by examining auditor industry specialization, abnormal audit fee and Big 4 audit firm. Abnormal audit fee is measured by using a modified version of the model of Hay, Knechel and Wong (2006). Further, the regression model used to statistically test the hypotheses is presented and the chapter is concluded with a description of variables.
3.1 Sample selection
This study focuses on publicly listed companies in the US. A quantitative research is used to examine whether the strength of audit quality can explain an increase in weight on variable management compensation. The sample selection process starts by using WRDS to retrieve an overview of all firms that are listed in the U.S. The initial sample of this study originated from an intersection of three databases which results in a sample of 13.328 firm-year observations. The sample period is from 2007 to 2015 since the minimum allowed date to obtain data on management compensation is 2007. Information regarding auditor industry specialization, audit fees, audit firm size and several control variables is obtained from Audit Analytics. One measure in this study require SIC codes in order to identify the industries the firms operate. In order to determine the industry specialization measure, I require at least 3 observations per auditor-industry combination. Any auditor-industry combination with less than 3 observations are deleted in order to have a more reliable measurement. This results in 1242 firms. Data on corporate governance for variables as board size, board independence, directors’ meeting attendance, financial specialist and effective audit committee are collected from the Institutional Shareholder Services (ISS). Data for management compensation is collected from Execucomp. Incomplete and missing data from the databases leads to the exclusion of 5.663 observations which leads to a final sample of 7,965 observations. Table 1 shows the amount missing and/or incomplete data and the remaining available observations for this study.
Table 1: Sample selection
Observations
Starting sample size 13.328
Less missing compensation data (3.375)
Less missing audit fees data or too few observations per industry-year combination (1.830)
Less missing debt and ROA data (138)
3.2 Dependent and independent variables
The dependent variable in this study is variable management compensation. This study uses audit quality as independent variable to predict the frequency of providing a higher share of variable compensation. Audit quality is measured by auditor industry specialization, abnormal audit fees and Big 4 audit firms. It is expected that the higher the audit quality the more likely it is that a firm can put more weight on a variable management pay.In addition to the independent variable for which the three hypotheses are formed, I control for the effect of other factors that are likely to influence the overall monitoring quality of the firms’ management.
3.3 Regression model
In order to measure abnormal audit fee, the predicted (normal) audit fee should be estimated. Previous studies have been mainly based on the audit pricing model developed by Simunic (1980), with certain modifications. These studies have included different measures as independent variables. The study of Hay et al. (2006) summarizes the large body of audit fee research and use meta-analysis to test the combined effect of the most commonly used independent variables. They developed an estimation model that regresses fees against a variety of measures surrogating for attributes that are hypothesized relating to audit fees, either negatively or positively. The estimation model of Hay et al. (2006) used to measure the normal audit fee is as follows:
Ln ƒi = 𝛽0 + 𝛽1 ln Ai + Σbkgik + Σbegie + ei (1)
where gik and gie are two groupsof potential fee drivers such as client and auditor attributes. Most
commonly used measures of client attributes in previous studies are size, risk, leverage and governance. The variable auditee size, commonly measured by total assets, have been found to be the most explanatory variable in determining audit fees in most previous studies (Chou and Lee, 2005). With regard to asset composition, inventory and receivables are two areas that are frequently indicated as difficult to audit or might involve more work than others (Simunic, 1980; Chou and Lee, 2005). Johnstone and Bedard (2001) have suggested that audit fees are positively associated with asset composition because certain parts of the audit may have higher risk of error and require specialized audit procedures. Asset composition measured as the combination of inventory and receivables divided by total assets is tested in this study. Leverage is the ratio of debt to total assets and indicates the risk of a client failing which may potentially expose the auditor to loss (May et al, 2006). Prior research support the expected relationship between leverage and audit fees thus this variable is included in this study. In addition, governance measured as the existence of an audit
committee is expected to affect audit fees because improved corporate governance indicates that the control environment of a firm is more effective (Hay et al., 2001). This study will elaborate more on this variable by examining the proportion of independent audit committee members and hereby strengthen the effect of this variable on audit fees.
According to prior research, auditor attributes such as auditor tenure should be considered in models of audit fees due to the reasoning that clients change auditors to obtain a reduced fee from a new audit firm (Hay, 2006). Lower fees may indicate that audit firms intentionally offer services at a discount in order to win new clients, which is often referred to as low balling1.
Furthermore, auditor specialization was found to be significant in previous studies and will also be considered in this study. In light of the discussion above, this research uses a modified version of Equation (1) and takes the following form:
Ln FEEi = 𝛽0 + 𝛽1 ln TA + 𝛽2 INRETA + 𝛽3 LEVR + 𝛽4 ACOMIND + 𝛽5 AISPE (2)
where ln FEE is the natural log for audit fees, ln TAis the natural log of total assets, INRETA is the asset composition variable, namely inventory plus receivables divided by total assets, LEVR is the ratio of debt to total assets, ACOMIND is the proportion of independent audit committee members and AISPE is auditor specialization .
The following regression model is used to test the hypotheses. This model tries to find whether firms with high audit quality can put more weight on variable management compensation.
VMCOMP = 𝛽0 + 𝛽1 AISPE + 𝛽2 ABNAFEE + 𝛽3 ABNPAFEE + 𝛽4 PABAFEE
+ 𝛽5 BIG4 + 𝛽6 BDSIZE + 𝛽7 BDIND + 𝛽8 BDMATN + 𝛽9 ACOMIND
+ 𝛽10 ACOFINEXP + 𝛽11 CLSIZE + 𝛽12 DEBT + 𝛽13 ROA
+ industry and year fixed effects + ε
(3) where VMCOMP is the variable management compensation measured as the proportion of variable compensation part pertaining to the total management compensation, AISPE is the auditor industry
specialization measured as the ratio of the sum of the square root of the total assets of the clients of
an auditor in a two digit SIC industry to the total sum of the square root of the total assets of all clients of the auditor (Behn, Choi and Kang, 2008; Sun and Liu, 2011), ABNAFEE the abnormal
audit fee is the second proxy for the monitoring quality and measured as the difference between
actual audit fees paid by firms to the external auditor and the normal audit fees estimated denotes by equation (2), ABNPAFEE the abnormal positive audit fee is an indicator variable that takes the value of 1 if the abnormal audit fee is positive and 0 otherwise, PABAFEE is an interaction term of ABNAFEE*ABNPAFEE for the overall effect of positive abnormal audit fees, BIG4 audit firms, coded as 1 for firms audited by Big 4 auditors and 0 otherwise, BDSIZE the board size, measured as the total number of directors on the board, BDIND the board independence, measured as the proportion of outside directors on the board, BDMATN the board meeting attendance, measured as the proportion of directors on the board of directors who attend less than 75 percent of board meetings, ACOMIND the audit committee independence, measured as the proportion of member of the audit committee who are independent directors, ACOFINEXP the financial experts, measured as the amount of financial experts on the audit committee, CLZISE the client size, measured as the natural logarithm of total assets, DEBT the debt ratio, measured as long-term debt and common share capital divided by total assets and ROA the return on asset, measured as income before extraordinary items dived by total assets.
3.3.1 Control variables
The regression model includes several variables that control for potential cofounding influences on variable management compensation as documented by previous research. These are board size, board independence, directors’ meeting attendance, audit committee effectiveness, financial experts on the audit committee, client size, debt and return on assets (ROA). Detailed descriptions for the measures of all the variables are provided in table 2.
Good corporate governance should provide proper incentives management to pursue objectives that are in the interest of the company and its shareholder (Obigemi, 2016). The function of the board of directors is facilitate effective monitoring of the management and act as steward for the shareholders, by defending the interest of those shareholders and seek alignment for their interest (Fama & Jensen, 1983). Previous research finds that more independent board members are more likely effective monitors than boards with few independent members (Byrd & Hickman, 1992; Ryan & Wiggins, 2004). A study conducted Epps and Ismail (2009) shows firms with 75 percent to 90 percent independent board member or firms with a board size of between nine and 12 members have higher discretionary accruals. Indicating that the higher the board size, the lower the earnings management and vice versa. Based on these findings BDSIZE and BDIND are included in the model. The inclusion of BDIND is further enhanced by the study of Beasley and Petroni (2001) which suggest that high quality board of directors are more likely to hire an
auditor industry specialist. They suggest that auditor industry specialization enhances the effectiveness of the financial reporting monitoring process. In addition, Carcello et al. (2002) state that outside directors have an incentive to ensure high financial reporting quality because of litigation and reputation exposures. BDMATN is included as the study of Xie, Davidson and DaDalt (2003) provide evidence that lower level is earnings management is associated with the meeting frequency of the board of directors, hence, board meeting activity influences the members’ ability to serve as active and effective monitors. Audit committee independence is also considered and to be an important effective monitor (Klein, 2002). ACOMIND is included as the evidence of his results shows that independent audit committees reduce the likelihood of earnings management. In line with the results of Klein (2002), Abbot and Parker (2000) and Carcello and Neal (2000) argue that an audit committee demands a high level of audit quality and plays an important monitoring role in assuring the quality of financial reporting. Also, the composition of audit committee is associated with the level of earnings management thereby allowing the audit committee to perform a higher monitoring quality (Xie et al., 2003). ACOFINEXP is included as Xie et al. (2003) state that earnings management is less likely to occur in companies whose board include more independent outside directors and directors with financial expertise. Bédard, Chtourou and Courteau (2004) indicate that audit committee members are in charge with overseeing internal control and financial reporting, so they should possess a certain level of financial expertise. CLSIZE and DEBT are included in the model as Sun and Lui (2011) suggest that large firms and firms with low debt ratio are more likely to hire high quality auditors. In addition, ROA is added in the model as the study of Abbott and Parker (2000) indicates that return on assets might by positively associated with a high quality auditor because a more profitable client is more inclined to pay the fee premium to qualitative auditors. Finally the model is estimated using industry-fixed effects as well as year-fixed-effects in order to control for potential industry- and year heterogeneity.
Table 2: Variable description
Variables Label Predicted effect Definition
Dependent variable
Variable management compensation
VMCOMP The proportion of the variable reward as
part of the total compensation
Independent variables
Audit quality AQUAL ± Audit quality proxies: industry expertise, abnormal audit fees and Big 4audit firm Industry
specialization
AISPE + The ratio of the sum of the square root
of the total assets of the clients of an auditor in a two digit SIC industry to the total sum of the square root of the total assets of all clients of the auditor. Abnormal audit fees ABNAFEE - The actual audit fee paid to the auditor
minus the predicted (normal) audit fee deflated by the total audit fee revenue of the auditor office that audits the client Big 4 audit firms BIG4 + 1 for firms audited by Big 4 auditors and
0 otherwise
Control variables
Board size BDSIZE + Total number of directors on the board
Board composition BDIND + Proportion of outside directors Board meeting
attendance
BDMATN + Proportion of directors on the board
who attend less than 75% of board meetings
Audit committee independence
ACOMIND + Proportion of audit committee members
who are independent directors
Financial experts ACOFINEXP + Amount of financial experts on the audit committee
Client size CLSIZE + Logged total assets
Debt DEBT - Debt ratio ((long-term debt + common
share capital)/by total assets) Return on asset ROA + Net income divided by total assets.
Equation 1
Normal fee FEE Natural log for audit fees, measured by
equation (1)
Total assets TA + Natural log of total assets
Asset composition INRETA + (Inventory + receivables)/total assets Notes independent variables: “+”, Positive relationship between variable management compensation and independent variable predicted; “-”, negative relationship between variable management compensation and independent variable predicted.
4 Results
The result section of the study starts with the descriptive statistics of the sample followed by an analysis of the Pearson correlation matrix. Subsequently, the main results regarding the effect of audit quality on variable management compensation are given in the coefficient table. Lastly, sensitivity and robustness checks are performed to strengthen the confidence in the results.
4.1 Descriptive statistics
The descriptive statistics of the variables used in Equation (3) are presented in Table 3. All continuous variables at the 1%, and respectively, 99% level are winsorized to control for potential outliers. Auditor industry specialization is estimated for each 2-digit SIC codes with at least 3 observations for each auditor-industry combination in order to have undiluted measurements which contribute to a more reliable auditor industry specialization. Auditor industry specialization is measured as the ratio of the sum of the square root of the total assets of the clients of an auditor in a two digit SIC industry to the total sum of the square root of the total assets of all clients of the auditor.
With regard to the distribution of variables shown in Table 3, it is worth noting the following facts. First, the mean (median) value of the variable compensation measure (VMCOMP) amounts to 4.5 (4.1) % of total management compensation. Second, it can be shown that the average (median) auditor in the sample is an industry expert 19.7 (16.5) %, indicating that the majority of firms are audited by a non-specialist. The descriptive statistics shows that the standard deviation for abnormal audit fee (ABNAFEE) is significantly larger compared to auditor industry specialization (AISPE). This indicates that there is a higher amount of variation in abnormal audit fee relative to auditor industry specialization. The sample also shows plausible frequencies for binary variables. The binary variable for abnormal audit fee (ABNPAFEE) amounts 49.7 %, which shows that the sample has an almost equal distribution of firm observations with positive and negative abnormal audit fees. Moreover, it is also worth highlighting that 96.1 % of the sample firms are audited by a BIG4 audit firm. These descriptive figures indicate market power among the Big 4 audit firms since they dominate the US audit market.2
Turning to the controlling variables, it can be shown that board size (BDSIZE) has an average of 9.6 board member and board of directors (BDIND) has a mean of 0.798, indicating that on average 79.8 % of the sample has a board that is independent. Regarding board meeting attendance (BDMATN) 0.60 percent of the sample firms have directors on the board who attend
