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Erschienen in: Journal of Business Ethics 2/2020

06.10.2018 | Original Paper

How the Design of CEO Equity-Based Compensation can Lead to Lower Audit Fees: Evidence from Australia

verfasst von: Xin Qu, Daifei Yao, Majella Percy

Erschienen in: Journal of Business Ethics | Ausgabe 2/2020

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Abstract

This paper investigates how the features of CEO equity-based compensation are associated with the agency costs of monitoring (measured by external audit fees) in an Australia setting. We find that audit fees significantly increase when firms award large equity grants to CEOs, which is consistent with the notion that auditors perceive higher risk associated with large equity incentives. However, by empirically testing auditors’ responses to the adoption of performance-vesting provisions, we document evidence that it is the use of accounting-based hurdles that potentially encourages unethical reporting issues. We report that audit fees are negatively associated with the use of market-based hurdles, while accounting-based hurdles lead to significantly higher audit fees but combination hurdles lower audit fees. To reduce the possible undesirable properties of accounting-based hurdles, firms adopt longer vesting periods to provide more balanced future-oriented incentives. Practical implications include the remuneration committee being aware of the hidden costs of poorly designed CEO compensation packages and avoiding undesirable ethical implications, particularly, where the CEO has significant power over the corporation.

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Fußnoten
1
‘…a high-transparency restatement involves filing an 8-K with the Securities and Exchange Commission to formally correct previously reported results. So-called low-transparency restatements correct errors as the company reports results, and the company does not tell investors to stop relying on the prior erroneous financial information…as the equity component of executive pay gets bigger, CEOs and CFOs are less likely to make high-transparency disclosures of accounting errors and misstatements to investors…’ (Cahill 2015).
 
2
These two studies are based on a sample of the U.S. firms where it is argued that little variation exists in the use of executive stock options (Hall and Liebman 1998). Also, these studies cover a sample period between 2000 and 2009 (pre-GFC period). Many regulatory requirements (e.g. say-on-pay in U.S. and two-strike rules in Australia) have come into place after the global financial crisis to improve the transparency and quality of CEO compensation. Our study can provide more insights on CEO compensation issues as it is based on a more recent sample.
 
3
‘Reform of the Taxation of Employee Share Schemes’ is published by The Treasury, Australian Government in June 2009.
 
4
The accounting scandals at Enron, WorldCom, Global Crossing, HIH, One.Tel and other companies, both in Australia and internationally, have raised great concern on the measurement and recognition of executive equity pay (Barrier 2002; Cassidy 2002).
 
5
Australia enacted its first non-binding shareholder vote on remuneration reports (‘Say on Pay’ reform) through the Corporate Law Economic Reform (Audit Reform and Corporate Disclosure) Act 2004 (CLERP9), which became effective from 1 July 2004. The major difference between the current ‘two-strikes’ rule and the previously enacted CLERP 9 on non-binding shareholder votes is that listed companies that receive the ‘first strike’ must respond to shareholder concerns. (Section 249L (2), the Remuneration Amendment Act.)
 
6
The ‘two strikes rule’: if 25% or more of shareholders at a company’s annual general meeting vote against the company’s remuneration report the first time, directors are put on notice to review their compensation policies. The second and final strike is delivered if, at the following year’s AGM, the remuneration report receives again 25% or more dissenting votes from shareholders which gives shareholders the right to spill the board while not requiring a binding vote on pay (The Amendment Act 2011).
 
7
IAS (International Auditing Standard) 240, the auditor’s responsibilities relating to fraud in an audit of financial statements specifies that ‘Information available indicates that the personal financial situation of management or those charged with governance is threatened by the entity’s financial performance arising from the following: (i) Significant financial interests in the entity. (ii) Significant portions of their compensation (for example, bonuses, stock options, and earn-out arrangements) being contingent upon achieving aggressive targets for stock price, operating results, financial position, or cash flow. (iii) Personal guarantees of debts of the entity’ (IAS 240, p. 187).
 
8
Time-vested equity grants refer to the equity grants that vest contingent upon the passage of time.
 
9
Non-financial hurdles are not analysed in this paper due to short of usage in our sample, with only 7% of the firm observations used such hurdles.
 
10
If earnings are so low in the current year that no matter which accounting procedures are selected, target earnings will not be met, managers have incentives to further reduce current earnings by deferring revenues or accelerating write-offs, a strategy known as ‘taking a bath’ (Healy 1985).
 
11
The sample companies were chosen based on the S&P/ASX 200 index as at 2013. 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 and Poor’s. The index incorporates all of the companies in the top 200. The companies in the index are reviewed quarterly by Standard and Poor’s.
 
12
Companies that did not adopt equity-based compensation (e.g. Equity% = 0) are excluded from our sample.
 
13
Our measurement of equity grants captures audit risk. The vested equity component may be perceived as risky by auditors because CEOs may have incentives to manipulate earnings to increase the value of vested equity grants before selling them (or converting to shares). Research also suggests that unvested equity awards are associated with income-increasing earnings management and future insider sells (Cheng and Warfield 2005; Margaret 2006), which can be interpreted as a means of meeting performance targets and accelerating the vesting process for personal gains. Thus, both vested and unvested equity components can increase audit risk and thus audit fees.
 
14
We did not include CEO duality in this study as a control variable because only around 3% of sample observations (firm-year) had CEO who was also the chairperson. This may be a result of ASX Corporate Governance Principles and Recommendations (2014) so CEO duality does not seem to be an issue for large listed companies in Australia. For most large companies, the remuneration committee plays an important role in setting executive pay mechanisms that are in the best interest of the shareholders. Conyon and Peck (1998) show a stronger pay-for-performance link when the remuneration committee is dominated by outsiders. Newman and Mozes (1999) further report that CEOs receive preferential treatment when directors are members of the remuneration committee. Therefore, we argue that when the CEO is a member of the remuneration committee, the committee is likely to design compensation packages that favour CEOs. We include a dummy variable that measures CEO independence. This dummy variable equals to 1 if CEO sits on the remuneration committee.
 
15
Vesting period is the time it takes for an equity grant to vest.
 
16
Industry classification is based on the two-digit Global Industry Classification Standard (GICS) code.
 
17
The base model (Model 1 without control variables) reported in Table 5 suggests a positive relationship between equity grants and audit fees.
 
18
The coefficient on Big 4 is not statistically significant. This could be due to no significant variation in this variable across our sample companies.
 
19
The results reported in Table 9 are based on a sample of 288 firm-year observations due to the missing variables for calculating discretionary accruals.
 
20
Results reported in column (2) of Tables 5, 6 and 7 are based on a sample of 288 firm-year observations due to the missing variables for calculating discretionary accruals.
 
21
Prior research (for example, Albrecht et al. 2015) provides similar results that in serious cases executives often use their power to recruit employees to participate in unethical fraudulent acts.
 
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Metadaten
Titel
How the Design of CEO Equity-Based Compensation can Lead to Lower Audit Fees: Evidence from Australia
verfasst von
Xin Qu
Daifei Yao
Majella Percy
Publikationsdatum
06.10.2018
Verlag
Springer Netherlands
Erschienen in
Journal of Business Ethics / Ausgabe 2/2020
Print ISSN: 0167-4544
Elektronische ISSN: 1573-0697
DOI
https://doi.org/10.1007/s10551-018-4031-y

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