The design of equity-based compensation and audit fees Abstract

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1 The design of equity-based compensation and audit fees Abstract This paper investigates how the design of CEO equity-based compensation plans is associated with audit fee pricing decisions, using a sample of ASX 200 companies from the years We find that there is a significant increase in audit fees when firms grant large equity-based compensation to CEOs, which is consistent with the notion that auditors perceive higher risk associated with large equity incentives. By empirically testing auditors responses to the adoption of performance vesting provisions, we document evidence that audit fees are positively associated with the propensity to attach performance hurdles. In particular, accounting-based hurdles are significantly associated with increased audit fees, while market-based hurdles lower audit fees. Further analysis reveals that in order to mitigate the positive effect of accounting-based hurdles on audit fees, firms design longer vesting terms to align the CEOs interests to long-term firm value. Additional tests also report that the positive association between equity-based compensation and audit fees is more pronounced if the CEO is short-term tenured, younger, and more powerful. Our findings suggest that firms can strategically design CEO equity grants to influence auditors risk assessment and thus audit fees. 1

2 1. Introduction The role of executive equity incentives in the auditing process has attracted increasing attention by investors and regulators since the global financial crisis. A number of accounting scandals have raised concerns about the extensive use of equity-based compensation for senior executives when there is a short-term focus on personal financial benefits at the expense of shareholder wealth. Research documents that executive equity incentives are associated with earnings management (Cheng and Warfield, 2005; Bergstresser and Philippon, 2006; Burns and Kedia, 2006; Cohen et al., 2008). Feng et al. (2011) further investigate the issue of equity incentives and financial misreporting in accounting fraud. However, some other studies find no evidence for such an association (Erickson et al., 2006; Armstrong et al., 2010). The mixed results from this research represent an important motivation to further investigate this topic. While executive equity incentives and earnings management are well studied, there is relatively little research on how auditors respond to the various designs of executive equity-based mechanisms. Equity-based compensation is expected to influence auditors risk assessment and audit pricing decisions since executive equity incentives affect risks associated with a business. To the extent executives engage in misreporting when there is an extensive holding of equity, higher audit effort and risk assessment are expected for detection purpose (Gul et al., 2003; Hoitash et al., 2012). However, some previous research counters the argument of undesirable economic consequences of equity incentives. For example, Coles et al. (2006) document that granting equity-based compensation encourages greater managerial effort and better firm decisions, which may substitute for some monitoring services of auditors. Given that the evidence is mixed on the influence of equity incentives, the design and construction of compensation policies are highlighted. We explore this issue by investigating specifically each 2

3 vesting provision of equity pay and the consequent audit fee pricing decisions. To empirically test the association between the design features of CEO equity-based compensation and audit fees, we estimate a standard audit fee regression model on a sample of ASX 200 listed companies (343 firm-year observations) for the years 2009 through to We construct multiple measures for the design of equity-based compensation, including the extent of use of equity-based compensation, the adoption of performance hurdles, the type of performance hurdle, and the exercise of a long-term vesting horizon. The results show a positive association between the use of equity-based compensation and audit fees, suggesting that auditors perceive increased audit risk associated with large equity holdings. To shed light on the setting of equity pay vesting provisions, we further examine the design of performance hurdles and vesting periods on audit fee pricing decisions 1. The empirical analysis reveals that the propensity to use performance hurdles with equity-based compensation is positively and significantly associated with audit fees. This finding indicates that performance hurdles that link executive compensation to performance targets create incentives for managers to exploit any available accounting discretion, and thereby a higher level of audit effort is expected to assess the risk of misreporting. To further explore the incentives provided by performance hurdles, we investigate the impact of two most commonly used performance hurdles, market-based performance hurdles and accounting-based performance hurdles, on audit fees. Market-based performance measures have been argued to be objective in inferring managerial effort (Lambert and Larcker, 1987; Baker, 2000), while accounting-based performance measures evaluate performance under accrual basis of accounting and create the possibility of earnings management (Holthausen, 1990; Watts and Zimmerman, 1986; Dechow, 1 Previous research suggests that client size, complexity, riskiness and other client-specific characteristics (Simunic and Stein 1996; Hay et al., 2006) explain the cross-sectional variation in audit fees 3

4 1994). In response to the different natures of market- and accounting- based measures, we find that auditors charge lower audit fees in firms that adopt a market-based performance hurdle, and that auditors perceive a higher client risk and thereby charge higher audit fees when an accounting-based performance hurdle is employed. Since an accounting-based performance hurdle leads to a higher audit assessment risk of misstatements, firms are expected to attach a longer vesting period to increase the efficiency of such performance hurdles. Academic literature notes that long-term vesting equity grants extend the effective life of equity incentives, and restrict executives from gaining personal benefits in the short-run (Bolton et al., 2006; Cadman and Sunder, 2014). Thus, we predict that a long-term vesting horizon has a negative moderating effect on the relationship between the use of an accounting-based performance hurdle and audit fees. We provide evidence that the positive link between accounting-based CEO compensation and audit fees is less pronounced if the accounting-based hurdle is long-term, suggesting that an extended vesting horizon that evaluates performance over time can mitigate managers incentives to manipulate earnings. In our main analysis, we focus on the incentives provided by various equity compensation designs and the auditors resulting adjustment to their pricing decisions. To strengthen the interest alignment interpretation, we investigate the influence of CEO characteristics (including CEO tenure, age and CEO power) on the association between CEO equity pay and audit fees. We find that the positive relationship between CEO equity-based compensation and audit fees is more pronounced if the CEO is short-term tenured, younger, and more powerful, indicating that these CEOs are more likely to enhance their performance through aggressive reporting. Additional tests confirm the significant moderating effect of CEO characteristics on our regression results. Endogeneity is an important concern as the causality between equity-based compensation 4

5 and audit fees may run the other way. To address the issue of endogeneity, we first conduct firm fixed effect estimations to mitigate potential omitted variables bias. The results are robust after controlling for time-invariant unobservable heterogeneity. We also adopt the two-stage least squares (2SLS) method following prior research (Himmelberg et al., 1999; Knopf et al., 2002; Coles et al., 2006; Ortiz-Molina, 2006; Brockman et al., 2010). The results are robust and further confirm that our findings are not driven by endogenous effects. More robustness tests are also conducted with a test of discretionary accruals based on the Jones (1991) model; an alternative measure of CEO equity-based compensation; and a sensitivity check regarding firm size. We find that all of our results hold and our inferences remain unchanged. Our study makes several important contributions. First, our study connects both the executive compensation and audit fee literatures. There is a large literature in each research stream, for example, on equity incentives and on financial misreporting (Cheng and Warfield, 2005; Burns and Kedia, 2006; Cohen et al., 2008); and on discretionary accruals and audit fee pricing decisions (Gul et al., 2003; Hoitash et al.,, 2012; Alali, 2011). More recently, some studies further investigate the link between executive equity incentives and audit fees (Billings et al., 2013; Kim et al., 2014). However, it is unclear whether executive equity incentives are affected by various equity vesting provisions, and how auditors perceive the audit risk of firms and decide the consequent audit fees. Our study extends prior research and adds new dimensions on how to design CEO equity-based compensation and to adjust audit fees accordingly. Second, this study provides new insights on the incentive effects of executive equity pay. Since the global financial crisis, equity granted to top executives (e.g., restricted stocks and stock options) has surrounded with controversy. There are numerous studies documenting adverse incentive effects of executive equity mechanisms in regard to earnings management and even 5

6 financial statement fraud. However, some studies find no evidence to support such links, and a few studies suggest positive incentive effects of equity-based compensation for aligning interest, encouraging effort exertion and lowering inherent risk (Jensen and Murphy, 1990; Coles et al., 2006). In response to the mixed evidence, we investigate the setting/construction of compensation policies and explore the underlying incentive effects of different vesting provisions. Bolton et al. (2006) suggest that while the extent of use of equity compensation influences the overall effort incentive, vesting provisions have unique influences on the decision-making horizon and financial objectives. Third, this study utilises additional hand-collected data that facilitates a detailed analysis of equity payments and audit fees. We manually collected CEO equity-based compensation data from the ASX 200 Australian companies through , after government reforms on setting equity pay since the global financial crisis. Our empirical evidence also facilitates a comparable analysis of executive equity pay and audit fee pricing decisions. Prior studies in the U.K. (for example, Kuang and Qin, 2009) and in the U.S. (for example, Bettis et al., 2010) document that performance-vesting equity grants lead to increased managerial effort, greater interest alignment and better operating performance. Our study contributes to the discussion by providing contrary evidence that the use of performance hurdles leads to higher audit service spending, specifically, when the hurdles are based on accounting performance measures. The paper proceeds as follows. Section 2 discusses prior literature and develops hypotheses. Section 3 presents the research design. Descriptive statistics, empirical results, additional and robustness analyses are reported in Section 4. We conclude in Section 5. 6

7 2. Literature review and hypothesis development 2.1 Equity-based compensation and audit fees Previous literature has extensively studied the influence of executive compensation mechanisms on financial misreporting. One strand of literature documents that equity-based compensation could motivate executives to manipulate firms reported earnings, which could consequently lead to higher audit fees. Cheng and Warfield (2005) find that managers with high equity incentives are more likely to report earnings that meet or beat analysts forecasts. Burns and Kedia (2006) and Efendi et al. (2007) report a significant positive relationship between CEO equity incentives, arising from stock option portfolios, and the likelihood of earnings misstatements. Bergstresser and Philippon (2006) and Cohen et al. (2008) complement their studies by focusing on the use of accruals-based measures of earnings management with the increase in CEO equity compensation. Some recent studies further investigate the issue of equity incentives and earnings manipulation in accounting fraud (Feng et al., 2011); the executives risk-taking incentives (Armstrong et al., 2013); and the consideration of auditor expertise (Jayaraman and Milbourn, 2014). To the extent executives engage in misreporting in order to extract personal benefits through equity-based compensation, a higher level of audit effort is expected for detection purpose. Gul et al. (2003) report a positive relationship between discretionary accruals and audit fees. As discretionary accruals require professional judgement, managers opportunism in accounting for discretionary accruals leads to an increase in auditors inherent risk, and therefore more extensive reviews and supervision responsibilities are expected. Hence, in order to detect potential material misstatements and prepare high quality financial statements, firms are more willing to pay higher audit fees for high quality audit services (Hoitash et al., 2012). Alali (2011) supports the 7

8 relationship between audit fees and discretionary accruals and further examines the moderating effect of compensation structure. Therefore, the preceding arguments support the view that when managers hold more equity, managerial opportunism in accounting may lead to a higher cost of auditing work. However, alternative explanations for the relationship between equity-based compensation and audit fees can be stated as follows. First, while some studies document that equity incentives encourage executives to manage earnings, other studies find no evidence that equity incentives are linked to financial misreporting (Erickson et al., 2006; Armstrong et al., 2010). Second, Jensen and Murphy (1990) show that equity-based compensation can be used as a mechanism to align the interests of managers and shareholders by linking managers wealth to firm value. Granting equity-based compensation can also encourage greater managerial efforts and better firm decision making (Coles et al., 2006). Executives with equity incentives are expected to perform better, which may substitute for some monitoring services provided by an external auditor, leading to lower inherent risk and earnings manipulation. Hence, these arguments may lead to a negative relationship between the use of equity-based compensation and audit fees. Accordingly, since prior empirical evidence provides different perspectives, we propose the hypothesis as follows: Hypothesis 1: There is a significant relationship between the use of equity-based compensation and audit fees. 2.2 Performance-vesting equity grants and audit fees Equity-based compensation is usually attached with certain vesting restrictions to align the 8

9 interests of managers and shareholders. Performance-vested equity grants refer to the stock and stock options that are attached with company-specific performance targets with vesting on the achievement of those targets. Since the mid-1990s, a growing number of companies are adopting such vesting provisions. Prior empirical evidence shows the prevalence of performance-vesting equity grants in the U.S. (Bettis et al., 2010), and in U.K. firms (Kuang and Qin, 2009). As compared to traditional equity grants that are vesting contingent simply upon the passage of time (that is, time-vesting provisions), performance-vesting equity grants have been argued to provide greater incentives for managers to act in confluence with shareholder value (Johnson and Tian, 2000). Kuang and Qin (2009) show that performance-vested stock options can increase managerial effort and encourage better interest alignment when the performance hurdle is not too demanding. Bettis et al. (2010) complement these studies and document that firms that grant performance-vesting grants have significantly better subsequent operating performance than others. Although the claim holds that performance-vesting equity grants provide stronger incentives than traditional equity grants by enhancing the link between pay and performance, the implications of such compensation mechanisms on managerial behaviour are the subject of debate. Some empirical evidence suggests that the design of performance provisions may cause undesirable consequences. Bertrand and Mullainathan (2001) find that risk-averse executives potentially capture the pay-setting process through performance-vesting provisions to maximise their private interests. Further evidence reports rent-extraction behaviour when executives compensation and promotion opportunities depend on the achievement of performance targets (Conyon and Murphy, 2000; Buck et al., 2003; Qin, 2012). Prior evidence has demonstrated an association between the use of performance hurdles and 9

10 misreporting. As executives can access private information about the firm, they may opportunistically choose to meet the vesting hurdles through manipulation. For example, Gaver et al. (1995) and Murphy (2000) find managers may exploit their discretion over accounting to achieve performance targets on firm objectives. Managers with large performance-vesting grants potentially reduce reported earnings when economic performance is higher than the targets, while they may boost earnings in the future reporting period (Healy, 1985). Kuang (2008) supports the argument and further confirms that performance-vesting option grants are positively associated with earnings management, and the incentive to manipulate reported earnings increases with the importance of such grants in the total compensation package. Accordingly, earnings management arising from the use of performance hurdles is expected to lead to a higher level of audit effort in analysing firms financial reporting, and thus auditors price audit fees higher. We therefore propose a directional hypothesis as follows: Hypothesis 2: There is a positive relationship between the propensity to use performance hurdles (on equity-based compensation) and audit fees. 2.3 Market- and accounting-based performance hurdles and audit fees While performance-vesting provisions make equity grants conditional on the achievement of specified performance targets, such performance targets typically consist of accounting-based hurdles (for example, cumulative earnings per share growth), stock market-based hurdles (for example, total shareholder return), or other non-financial hurdles (for example, non-financial metrics or achievement of a strategic milestone). To further explore the effects of different performance hurdles on audit fees, we investigate individually the two major performance 10

11 hurdles: market-based performance hurdles and accounting-based performance hurdles. Equity grants with a market-based performance hurdles are devised to reward executives if they achieve a target improvement in stock returns or exceed a certain percentage of peer group performance. For example, if they outperform their competitors by achieving above-median performance compared to industry peers. Lambert and Larcker (1987) note the differences in the accounting and market performance measures in executive compensation contracts, and suggest that the use of market-based measures is less noisy in evaluating the performance of managers. Baker (2000) shows that rewarding executives in accordance with their performance relative to macroeconomic circumstances and industry peers reduces the noise in observed performance, which increases the precision in inferring managerial effort. Performance targets based on stock-market conditions appear to be fairer and more objective as compared to the accounting-based targets, and thereby increase the difficulty for executives in predicting and manipulating reported earnings. Therefore, compensation contracts designed on the basis of market-based performance measures incur relatively lower inherent risk for auditors, and they have direct effort implications in motivating managers to improve performance. Alternatively, firms sometimes opt to grant equity awards based on an accounting-based performance hurdle. Equity grants with an accounting-based hurdle require executives to meet or beat an inflation-adjusted accounting performance growth target (such as, earnings per share (EPS) growth, return on assets or equity (ROA, ROE) growth). The accounting earnings measure is a summary measure of firm performance which is the output from the accrual basis of accounting (Dechow, 1994). The use of accruals may empower management to use discretion over the recognition of accounting performance. As such, accounting-based hurdles can be captured by executives to signal their private information or to opportunistically manipulate 11

12 earnings (Holthausen, 1990; Watts and Zimmerman, 1986). Lambert and Larcker (1987) also provide evidence that accounting numbers provide less useful informative signals regarding the value of the firm and the evaluation of managerial actions. Therefore, managers would be likely to manipulate earnings to increase the chances that performance targets are met and the awards vest early. For instance, Healy (1985) finds that managers are likely to undertake income-increasing manipulation or big bath according to manage earnings downwards if performance targets are not expected to be achieved. Therefore, on the basis of the interest alignment interpretation, we expect a significant negative association between the use of a market-based performance hurdle and audit fees. Furthermore, to the extent that managers use their discretion to manipulate accruals, accounting-based performance hurdles may represent a less reliable performance measure and thus higher audit effort and higher audit costs are expected. Accordingly, we test the following hypotheses with directional predictions: Hypothesis 3a: There is a negative relationship between the use of a market-based performance hurdle and audit fees. Hypothesis 3b: There is a positive relationship between the use of an accounting-based performance hurdle and audit fees. 2.4 The moderating effect of the vesting horizon Based on agency theory, managers with a short-term decision horizon might not make decisions that are in the best long-term interests of shareholders (Jensen and Meckling, 1976). Antia et al. (2010) find a shorter CEO decision horizon is associated with higher agency costs 12

13 and information risk. They find information risk, as manifested in the quality of accruals (Francis et al., 2005), is highlighted when CEOs with a shorter decision-making horizon attempt to manage near term earnings and thereby impede accruals quality. Executive compensation packages that place an emphasis on short-term equity grants may cause a horizon problem, that is, managers may focus on short-term financial results at the expense of long-run prosperity. In such cases, managers are likely to manipulate current earnings to increase their short-term benefits, and as a result auditors need to charge higher audits fees to prevent those manipulations (Vafeas and Waegelein, 2007). In response, a natural way to mitigate such a problem is through designing executive compensation contracts that offer sufficient horizon incentives (Dikolli et al., 2009). Under a typical equity grant arrangement, the length of the vesting term is a vital contracting mechanism to align the horizon incentives of managers and shareholders (Bolton et al., 2006). The vesting period determines when the ownership of firm stocks transfers to the managers. With the adoption of a long vesting term, executives do not own the stocks/stock options outright when the options are granted, but they vest over time, encouraging the executive to remain within the firm (Bebchuk and Fried, 2010). Cadman and Sunder (2014) document that long-term vesting equity grants can benefit firms by extending the effective life of equity incentives, and restrict executives from gaining personal benefits in the short-run. The divergence of decision horizons between managers and shareholders induces managers to sacrifice long-term value creation for short-term profitability. Accordingly, we expect that long-term equity grants, which evaluate accounting performance over several years, can redirect managerial objectives towards long-term firm value. When executives interests are better aligned with shareholders, they will have fewer incentives to manipulate accounting earnings. Therefore, we expect a longer vesting 13

14 horizon can increase the efficiency of an accounting-based performance hurdle and thus reduce the auditing spend. The hypothesis is proposed as follows: Hypothesis 4: A long-term vesting horizon has a significant negative moderating effect on the relationship between the use of an accounting-based performance hurdle and audit fees. 3. Research design 3.1 Data collection and sample selection The initial sample includes ASX 200 listed companies (1,000 firm-year observations) for the years 2009 through to The sample selection procedures are as follows. First, 220 firm-year observations from the financial sector (GICS code ) have been excluded as the business structure of financial companies is different from that of non-financial companies. We then extract financial data from the Morningstar DatAnalysis Premium database and gather audit fees, non-audit fees and auditor data from the SIRCA Corporate Governance database. After merging the two sets of data and requiring that firms have necessary financial information for multivariate analyses, we are left with 713 firm-year observations. We merge this data with executive compensation data that were hand-collected from company s annual reports. The sample size is further reduced to 373 firm-year observations. Finally, we delete the 1st and 99th percentiles of all test variables. The final sample consists of 343 firm-year observations from 144 unique companies. Table 1 below outlines the sample selection procedures. [Insert Table 1] 2 The Australian top 200 companies were chosen based on the S&P/ASX 300 index as at S&P/ASX 200 is a market-capitalisation weighted and float-adjusted stock market index of Australian stocks listed on the Australian Securities Exchange provided by Standard & Poor's. The index incorporates all of the companies in the top 200. The companies in the index are reviewed quarterly by Standard & Poor's. 14

15 3.2 Model specification To examine whether the design of CEO equity-based compensation is associated with the pricing of audit services, we estimate standard audit fee regression models that include variables to capture CEO equity-based compensation and control variables that are identified to be determinants of audit fees by prior studies. Our basic model is as follows: AuditFee it = β 0 + β 1 Equity% it + β 2 SIZE it + β 3 FOREIGN it + β 4 QUICK it + β 5 LEVERAGE it + β 6 BIG4 it + Β 7 RECINV it + β 8 ROA it + β 9 LOSS it + β 10 BTM it + β 11 NAF it +Year dummy + Industry dummy + ε.model (1) All variables are defined in Appendix I. The dependent variable, audit fees (AuditFee), is measured by the natural logarithm of the dollar amount disclosed in the annual report. In order to improve the linear relationship with audit fees, the size measure is transformed by taking the natural logarithm of the raw data in this study. We include year dummies to control for year-fixed effects. To avoid industry-specific effects from tampering with variations in audit fees, we also control for industry-fixed effects. All standard errors are clustered to account for possible time-series and cross-sectional correlations. Proxy for the use of equity-based compensation (independent variable) The proxy to measure CEO equity-based compensation, Equity%, is the value of equity-based compensation divided by CEO total compensation. For an average CEO in our sample, equity-based compensation accounts for 28 percent of the total compensation. 15

16 Control variables Previous research has identified a variety of factors including client size, complexity, riskiness and other client-specific characteristics (Simunic and Stein 1996; Hay et al., 2006) that explain the cross-sectional variation in audit fees. We use total assets (SIZE) to control for the effect of firm size and whether the company has foreign operations (FOREIGN) to proxy for complexity. We include the quick ratio (QUICK) and leverage (LEVERAGE) to control for liquidity risk. A number of researchers suggest that audit fees are positively associated with inherent risk because the audit engagement with riskier organisations will have a higher possibility of error (Hay et al., 2006). Inventory and receivables are two areas cited as the most difficult to audit. Thus, we include a ratio of accounts receivable and inventory to total assets (RECINV) to represent inherent risk. We also include return on assets (ROA), net loss (LOSS) and the book-to-market ratio (BTM) to proxy for profitability and operating risk. Last, we control for audit characteristics such as non-audit fees (NAF) and audit quality (BIG4). We further investigate the effects of the use of performance hurdles on external audit fees with the following variables: (a) the propensity to use performance hurdles; (b) the accounting-based performance hurdle; and (c) the market-based performance hurdle. Accordingly, we use the following fixed-effect models: AuditFee it = β 0 + β 1 Use_Hurdle it + β 2 SIZE it + β 3 FOREIGN it + β 4 QUICK it + β 5 LEVERAGE it + β 6 BIG4 it + Β 7 RECINV it + β 8 ROA it + β 9 LOSS it + β 10 BTM it + β 11 NAF it + Year dummy + Industry dummy + ε.model (2) AuditFee it = β 0 + β 1 Hurdle_Acct it + β 2 SIZE it + β 3 FOREIGN it + β 4 QUICK it + β 5 LEVERAGE it + 16

17 β 6 BIG4 it + Β 7 RECINV it + β 8 ROA it + β 9 LOSS it + β 10 BTM it + β 11 NAF it +Year dummy + Industry dummy + ε.model (3) AuditFee it = β 0 + β 1 Hurdle_Stock it + β 2 SIZE it + β 3 FOREIGN it + β 4 QUICK it + β 5 LEVERAGE it + β 6 BIG4 it + Β 7 RecInv it + β 8 ROA it + β 9 LOSS it + β 10 BTM it + β 11 NAF it + Year dummy + Industry dummy +ε..model (4) First, we include an indicator variable (Use_Hurdle) in model (2), which takes the value of one if any type of performance hurdle is used, and zero otherwise (Bettis et al., 2010). We expect that the adoption of performance-vesting conditions on equity grants leads to an increase in audit fees, therefore the sign of the coefficient on Use_Hurdle is predicted to be positive. To further capture the design of performance vesting conditions, another two indicator variables are included in model (3) and (4) to examine the use of the two most commonly used performance hurdles, accounting-based hurdles (Hurdle_Acct) and market-based hurdles (Hurdle_Stock). Hypothesis 3 further examines whether the vesting horizon has a moderating effect on the association between accounting-based performance hurdles (Hurdle_Acct) and audit fees. We introduce a variable in model (5) that measures the length of the vesting period. Vest_Long is an indicator variable that takes the value of one if the vesting duration is longer than the median of the sample vesting duration, and zero otherwise. We calculate the vesting duration as the weighted average vesting period in a given year (Cadman et al., 2013). Therefore, the coefficient of interest is on the interaction term between Hurdle_Acct and Vest_Long. We expect that companies that use accounting-based performance hurdles with a comparatively longer vesting horizon incur lower audit fees. Thus, the coefficient β 3 in model (5) is expected to be negative. 17

18 AuditFee it = β 0 + β 1 Hurdle_Acct it + β 2 Vest_Long it + β 3 Hurdle_Acct*Vest_Long it + β 4 SIZE it + β 5 FOREIGN it + β 6 QUICK it + β 7 LEVERAGE it + β 8 BIG4 it + β 9 RECINV it + β 10 ROA it + β 11 LOSS it + β 12 BTM it + β 11 NAF it + Year dummy + Industry dummy +ε...model (5) 4. Empirical results 4.1 Descriptive statistics Table 2 shows descriptive statistics for all variables in the models. The mean audit fees for companies in the sample is $AUD 8.26 million. For an average CEO in our sample, equity-based compensation accounts for 28 percent of the total compensation. The descriptive statistics also show that the sample covers a wide range of companies, some very small (minimum of $AUD 3.96 million), some relatively large (maximum of $AUD 149 billion). The average size of the sample companies is $AUD 8.19 billion. Companies in the sample have total liabilities of approximately 53 percent of their total assets and liquid assets that are 1.40 times their current liabilities. On average, the companies in the sample have receivables and inventories comprising 19 percent of their total assets. In terms of the profitability of these companies, on average, the ROA ratio is eight percent, which indicates that more than half of the companies in our sample are profitable. The sample companies have a book-to-market ratio averaging Panel B shows that around nine percent of firms have incurred a net loss in either the previous or the current year while 89 percent of firms have foreign operations. As for the CEO compensation variables, the statistics show that 91 percent of sample companies attached performance hurdles to their equity grants. While 48 percent of the sample companies used accounting-based performance hurdles, 59 percent of companies used the market-based 18

19 performance hurdles. Panel C compares the mean of audit fees from different sub-samples of companies. We find that, first, audit fees from companies that granted equity-based compensation are significantly higher than those of firms that did not grant equity-based compensation (t-stat=5.90). Second, while accounting-based performance hurdles are positively associated with audit fees (t-stat=4.58), the market-based performance hurdles are negatively related to audit fees (t-stat=-3.86). These findings indirectly support our hypotheses. [Insert Table 2] Table 3 presents the industry distribution of the firm-year observations in regard to various vesting features. Industry classification is based on the two-digit GICS code. The majority of the sample is in the Consumer Discretionary and Materials sectors. In addition, most of the firm years that have a longer vesting period are in the Materials sector, followed by Energy and Industrials, while none are in the Utilities sector. The industry distribution of observations that use market-based performance hurdles indicates that a large proportion of firms are in the Materials, Energy and Industrials sectors, while accounting-based hurdles are most widely used in the Industrials, Materials and Consumer Discretionary sectors. [Insert Table 3] Table 4 provides correlations among variables used in our analysis. Audit fees are positively associated with Equity% as expected. The correlation matrix also shows that, while audit fees are positively associated with accounting-based hurdles, they are negatively associated with market-based hurdles. The findings are consistent with our expectations. Consistent with prior 19

20 research, audit fees are positively correlated with the variables: size, receivable and inventory ratio (recinv), leverage, foreign, loss, Big 4 and non-audit fees, while audit fees are negatively associated with the quick ratio and ROA. [Insert Table 4] 4.2 Regression results Equity-based compensation and audit fees In this subsection, we test whether auditors price into their audit fees the potential risk implications of CEO equity-based compensation. We estimate the audit fee regression model (Model 1). We predict that, if auditors perceive that CEO equity-based compensation increases the level of audit risk and audit effort, a positive coefficient on the executive equity-based compensation variable should be expected. On the other hand, if auditors view CEO equity-based compensation as beneficial in aligning the interests of the CEO and shareholders, a negative coefficient should be expected. Table 5 reports empirical results of the association between audit fees and CEO equity-based compensation (Equity%). Results show that the coefficient of interest on Equity% is positive and statistically significant at the 1% level (coefficient= 0.986, t= 3.30). As for economic significance, the coefficient on Equity% is 0.986, suggesting that CEOs with equity-based compensation above the 75th percentile have audit fees that are, on average, 23.3 percent higher than audit fees of CEOs with equity-based compensation below the 25th percentile (0.986*[ ] = 0.233). Overall, the results reported in Table 5 suggest that auditors perceive a higher audit risk to be associated with CEO equity-based compensation, which is consistent with the notion that equity-based compensation provides executives with opportunities 20

21 to engage in misreporting. Therefore, auditors will charge higher audit fees due to potential litigation/reputation risk or increased audit efforts. Results on the control variables are generally consistent with prior research. Audit fees are significantly higher for firms that are larger and more complex (have foreign assets or business operations), lower liquidity (in terms of a lower quick ratio), and have poorer accounting performance (a lower ROA). The audit fees and non-audit fees are also positively related. This finding is consistent with previous findings that purchasers of non-audit services from their auditors pay higher audit fees because of knowledge flowing from one service to the other (Simunic, 1984; Bell et al., 2001). [Insert Table 5] Performance-vesting equity grants and audit fees In this subsection, we estimate the audit fee regression model (Model 2) to investigate the association between the propensity to use performance hurdles (on equity-based compensation) and audit fees. The results reported in column 3 of Table 6 show that the coefficient on Use_Hurdle is positive and significant at the 10% level (coefficient= 0.205, t= 1.88), in support of our argument that it is the earnings manipulation risk that may explain the positive relation between CEO equity-based compensation and audit fees. That is, performance-vesting provisions represent an attempt by management to extract rents from shareholders to maximise their private interests (Bertrand and Mullainathan, 2001). As a result, auditors charge higher audit fees to compensate them for their increased audit risk with potential accounting problems from the use of performance-based compensation plans. Thus, hypothesis 2 is supported. 21

22 Market- and accounting-based performance hurdles and audit fees So far we have documented a positive association between the use of performance hurdle and audit fees. We proceed to examine whether the association documented above varies with different performance hurdle types (e.g. market-based performance hurdles versus accounting-based hurdles). Results show that our hypotheses 3a and 3b are both supported. As shown in Table 6, the coefficient on Hurdle_Acct is positive (coefficient= 0.156, t= 2.26) and statistically significant at the 5% level while that on Hurdle_Stock is negative (coefficient= , t= -2.07) and significant. These results are consistent with the notion that performance targets based on stock-market conditions appear to be fairer and more objective as compared to accounting-based targets, thereby reducing the possibility of earnings manipulation. Therefore, compensation contracts designed on the basis of market-based performance measures create relatively lower inherent risk for auditors, and thus lower audit fees are charged. [Insert Table 6] Accounting-based performance hurdles, vesting horizon and audit fees The vesting horizon is another essential feature of executive compensation packages. There is evidence that managers may focus on short-term financial results at the expense of long-run prosperity if the performance hurdles are based on a short-term horizon. Dikolli et al. (2009) argue that a natural way to mitigate such short-term horizon problems is through appropriate design of executive compensation contracts that offer sufficient horizon incentives. We expect that managers are more likely to manipulate current earnings to increase their short-term benefits if their compensation is based on a short-horizon performance hurdle, increasing audit risk (Vafeas and Waegelein, 2007). To test our expectation, we examine whether 22

23 the positive link between accounting-based CEO compensation and audit fees is less pronounced if the performance hurdle is long-term. We augment equation (2) with an interaction term of Hurdle_Acct with Vest_Long. As shown in Table 7, the coefficient of interest on the interaction term (Hurdle_Acct*Vest_Long) is negatively associated with audit fees (coefficient= , t= -2.71). Therefore, our hypothesis 4 is supported. This finding is consistent with our argument that the long-term equity grants, which evaluate accounting performance over several years, can reduce managers incentives to manipulate annual accounting earnings and engage in misreporting. Therefore, lower audit fees reflect the lower audit risk or reduced audit effort. [Insert Table 7] 4.3 Additional and robustness tests CEO compensation, CEO characteristics and audit fees In this section, we complement our analysis by examining the effect of CEO characteristics, such as CEO tenure 3, age and CEO power 4 on the association between CEO equity-based compensation and external audit fees. Fama (1980) and Holmstrom (1982) argue that manager s ability over tenure will be evaluated with his current and past performance. Thus, in order to build reputation with the market and avoid being labelled as low ability, short-term tenured CEOs have stronger incentives to report good performance. In other words, short-term tenured CEOs are more likely to enhance their reported performance through aggressive reporting. Consistent with this argument, Ali and Zhang (2015) find that earnings overstatements are more pronounced for firms with a short-term tenured CEO. Prior research also suggests that CEO age has an impact on risk-taking behaviour. However, the empirical evidence is mixed and inconclusive. For instance, 3 We define CEO tenure as the CEO's length of tenure (years) in the company. 4 We measure the CEO power as the pay slice of the CEO, which is the CEO total equity-based compensation scaled by the total equity-based compensation of the top five executives. 23

24 Scharfstein and Stein (1990), Hirshleifer and Thakor (1992), Zwiebel (1995), and Holmstro m (1999) suggest that career concerns make younger CEOs more risk-averse, leading to conservative investment policies. In contrast, Prendergast and Stole (1996) suggest that younger CEOs invest aggressively, taking greater risks to signal their superior ability. We define CEO age (AGE) as a dummy variable equal to one for CEOs with age above sixty, and zero otherwise. We further define CEO tenure (CEOTNR) as the log of the CEO tenure years. Prior studies have also found that CEO power is associated with earnings management. For example, Chatterjee and Hambrick (2007) find that CEOs with relatively greater power have the potential to engage in more rent extraction actions. Qin (2012) argues from the managerial power perspective, suggesting that a CEO who is able to dominate the board and thus exercise considerable managerial discretion is likely to avoid restrictive vesting conditions. We measure the CEO power as the pay slice of the CEO (CEO compensation over the total compensation of the top five executives) (Bebchuk et al., 2011). We predict that a CEO whose compensation package is high relative to other senior managers will have more power to influence financial reporting results. Our untabulated findings show that the coefficient on the interaction term between Equity% and AGE is negative and significant. This finding suggests that the positive relation between CEO equity-based compensation and audit fees is stronger if the CEO is younger. We also find a significant effect for CEO tenure on the relationship between CEO equity-based compensation and audit fees. In particular, the positive association between CEO equity compensation and audit fees is more pronounced for firms with a short-term tenured CEO. Last, we find that the relationship between CEO equity compensation and audit fees is stronger if the CEO s compensation package is high relative to other senior managers. In summary, additional tests 24

25 suggest that CEO characteristics have a moderating effect on the association between CEO equity-based compensation and audit fees. Robustness tests Endogeneity issue We conduct two tests for endogeneity since the association between CEO equity-based compensation and audit fees could be driven by endogenous factors. It is possible that both audit fees and Equity% are correlated with some time-invariant firm characteristics, resulting in their apparent relation. First, firm fixed effects estimation is a commonly used approach to mitigate potential omitted variables bias. We reestimate the model (1) with firm fixed effects. The results (untabulated) from the fixed effects regression suggest that the positive association between CEO compensation and audit fees are robust to controlling for time-invariant unobservable heterogeneity. Another commonly used method in accounting research in addressing potential endogeneity problem is the 2SLS method. In the first stage, we regress dependent variable (Equity%) against a set of instrumental variables suggested by prior research (Himmelberg et al., 1999; Knopf et al., 2002; Coles et al., 2006; Ortiz-Molina, 2006; Brockman et al., 2010), as well as all the control variables in Model (1). The instrumental variables include the log CEO tenure (CEO_TNR), log CEO salary and bonus compensation (CEO_COMP), and capital expenditure (CAP). Specifically, log CEO tenure is the natural logarithm of the CEO's length of tenure (years) in the company; log CEO salary and bonus compensation is the natural logarithm of the dollar amount of the CEO s annual base salary and bonus; and capital expenditure is the ratio of capital expenses to total assets. In the second stage, we regress audit fees against the fitted values of Equity% from the first stage 25

26 regressions. The untabulated results show that the fitted value of Equity% is positively and significantly associated with audit fees, further confirming that our findings are not driven by endogenous effects. Discretionary accruals Auditors are found to price accounting accruals and charge higher audit fees (Gul et al., 2003). To investigate whether CEO compensation captures the effect of accounting accruals, we include the discretionary accruals in our regression models (Model 1-5). We measure discretionary accruals using the Jones (1991) model. Consistent with prior studies, we find that auditors price past accounting accruals. That is, in all our models, there is a positive association between discretionary accruals and audit fees. More importantly, the coefficients of interests from all our models remain unchanged after controlling for accounting accruals. Alternative measure of CEO equity compensation As a robustness test, we use a larger sample including firms that do not grant their CEOs equity-based compensation. The independent variable is a dummy variable that equals to one if the sample firm grants CEO equity-based compensation, and zero otherwise. The results of this robustness test (untabulated) are qualitatively similar to those reported earlier in Table 5 and our inferences remain unchanged. Size Prior studies suggest that firm size is a primary determinant of audit fees. We control for total assets in all of our regression models. To provide a further sensitivity check, we partition 26

27 our sample into large (i.e. firm size is larger than the sample median value of total assets) and small firms (i.e. firm size is smaller than the sample median value of total assets). We find that all of our results hold in both subsamples. Other compensation Prior studies use annual compensation to measure managerial incentives (Alali 2011; Vafeas and Waegelein 2007), while we use equity-based compensation only. To compare our results with previous results, we include other components of annual compensation in our model (Model 1) and we find that only the coefficient on CEO equity-based compensation is significant, and coefficients on other components of annual compensation (e.g. base salary and cash bonus) are insignificant. The coefficient on Equity% remains largely unchanged. 5. Conclusion This paper examines the association between CEO equity-based compensation and audit fees. Using a sample of ASX 200 companies from 2009 to 2013, we document a positive association between CEO equity-based compensation (measured as the proportion of equity-based CEO compensation to total CEO compensation) and audit fees, suggesting that auditors perceive heightened audit risk associated with CEO equity-based compensation. We further investigate whether the features of CEO compensation have a moderating effect on the association documented above. We provide several novel and interesting results. In particular, first, we find that there is a positive association between the propensity to use performance hurdles (on equity-based compensation) and audit fees. Second, while the use of accounting-based performance hurdles is significantly associated with increased audit fees, companies using 27

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