Title

Reported earnings, auditor's opinion, and compensation: Theory and evidence

Date of Award

2005

Degree Type

Dissertation/Thesis

Degree Name

Doctor of Philosophy (PhD)

Department

Business Administration

Advisor(s)

Randal Elder

Keywords

Reported earnings, Auditor, Compensation, Executive compensation

Subject Categories

Accounting | Business | Business Administration, Management, and Operations

Abstract

Delegation of responsibility and use of performance measures in compensation contracts are important issues in management accounting. Unfortunately, no performance measure or compensation contract is perfect in aligning the goals of the organization with that of the agent. It is well known that an incentive motivates an agent to exert productive effort as well as unproductive effort to inflate his performance measure. Thus, a compensation contract needs to provide incentive for productive effort, and also control for unproductive effort.

This dissertation studies the effect of auditor's independence and opinion on executive compensation and executive effort allocation. Using principal agent theory, I examine a compensation contract involving two signals, one for incentive and one for control. The incentive signal is the net income reported by the executive (agent) and the control signal is the auditor's opinion. The owner (principal) can induce higher productive effort level by including the audit opinion in the compensation contract. The impact on productive effort level is higher when the auditor is more independent.

The optimal weights on earnings and audit opinion in the agent's compensation contract are obtained in a LEN framework. The weights show that the agent is rewarded for higher earnings and penalized for audit qualification. The pay-performance sensitivity increases monotonically as the auditor becomes more independent. However, the pay-opinion sensitivity does not increase monotonically as the auditor becomes more independent.

Interestingly, the pay-opinion sensitivity first increases and then decreases as the auditor becomes more independent. Intuitively, with increasing auditor independence, the need of audit opinion in the compensation contract decreases because the presence of the independent auditor itself exerts a control on the agent.

Some of these analytical results are tested empirically. Empirical evidence shows that the executive is rewarded for higher reported earnings and penalized for departures from standard unqualified opinion. The pay-performance sensitivity increases as the auditor becomes more independent. Auditor independence is measured by audit fee/(audit fee+ nonaudit fee).

The analytical model is also modified to incorporate auditor competence along with auditor independence. The modified model gives similar results to the model that only includes auditor independence.

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