The Effect of Auditor Expertise on Executive Compensation

53 Pages Posted: 7 Nov 2011 Last revised: 11 Jan 2012

Sudarshan Jayaraman

University of Rochester - Simon Business School

Todd T. Milbourn

Washington University in Saint Louis - Olin Business School

Date Written: January 10, 2012

Abstract

We examine the effect of auditor expertise on managerial equity-based compensation. Consistent with theories that predict that firms will grant more equity-based compensation to their managers when financial statement manipulation is more likely to be detected, we find strong evidence that firms audited by an industry expert grant their CEOs more equity-based compensation. Additional tests indicate that these firms also grant their CFOs greater equity-based compensation. However, in contrast, equity-based compensation of all other executives is unaffected by whether or not their firms are audited by an industry expert. Tests that embed auditor expertise within the firm’s overall corporate governance framework indicate that auditor expertise helps mitigate the adverse consequences of poor corporate governance. Our results are robust to a rigorous treatment of endogeneity and suggest that firms consider the financial misreporting effects of equity-based incentives and trade off these costs with the benefits of higher managerial effort when designing compensation contracts. An important implication of our results is that the relation between equity-based incentives and accounting fraud is complicated and depends on the presence of detection mechanisms such as auditor expertise that allow firms to grant more equity-based compensation while simultaneously lowering the occurrence of earnings management.

Keywords: Executive compensation, auditor expertise, earnings management, accounting fraud

Suggested Citation

Jayaraman, Sudarshan and Milbourn, Todd T., The Effect of Auditor Expertise on Executive Compensation (January 10, 2012). Available at SSRN: https://ssrn.com/abstract=1955488 or http://dx.doi.org/10.2139/ssrn.1955488

Sudarshan Jayaraman

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

Todd T. Milbourn (Contact Author)

Washington University in Saint Louis - Olin Business School ( email )

1 Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-6392 (Phone)
314-935-6359 (Fax)

HOME PAGE: http://www.olin.wustl.edu/faculty/milbourn/

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