CEO Equity Incentives and Financial Misreporting: The Role of Auditor Expertise

51 Pages Posted: 6 Jun 2014

See all articles by Sudarshan Jayaraman

Sudarshan Jayaraman

University of Rochester - Simon Business School; Simon Business School, University of Rochester

Todd T. Milbourn

Washington University in Saint Louis - Olin Business School

Date Written: June 4, 2014

Abstract

Prior studies find inconsistent evidence regarding the effect of CEO equity incentives on financial misreporting. We argue that this inconsistency stems from not considering detection mechanisms that mitigate the effect of equity incentives on misreporting by limiting the ability of managers to carry out such manipulative activities. Using auditor industry expertise as one such detection mechanism, we document that CEO equity incentives are positively associated with misreporting only in sub-samples where auditor expertise is low, but not where expertise is high. The implication of these results is that auditor expertise lowers the cost of granting equity-based incentives, and that firms audited by an industry expert grant their CEOs greater equity incentives. We find strong evidence in favor of this implication. Controlling for previously identified determinants of CEO equity incentives, we find that firms audited by an industry expert grant their CEOs 14 percent more equity incentives than firms audited by a non-expert. To address endogeneity concerns, we use the collapse of Arthur Andersen as a quasi-natural experiment and find analogous evidence. Overall, our study documents the critical role of detection mechanisms in the link between CEO contracting and financial misreporting.

Keywords: CEO compensation, financial misreporting, accounting fraud, auditor expertise, auditing

JEL Classification: M41

Suggested Citation

Jayaraman, Sudarshan and Jayaraman, Sudarshan and Milbourn, Todd T., CEO Equity Incentives and Financial Misreporting: The Role of Auditor Expertise (June 4, 2014). Accounting Review, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2446349

Sudarshan Jayaraman (Contact Author)

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States
585-275-3491 (Phone)

Simon Business School, University of Rochester ( email )

Rochester, NY 14627
United States
585-275-3491 (Phone)

Todd T. Milbourn

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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