CAN AUDITOR INDUSTRY EXPERTISE REDUCE INCIDENCES OF MISREPORTING?
Keywords:
Auditing, Equity Incentives, Misreporting
Abstract
The purpose of this paper is to examine the influence of auditor industry expertise on the relationship between equity incentives and financial misreporting. Previous studies report mixed findings on the relationship between financial misreporting and equity incentives; however, they fail to consider detection mechanisms such as auditor industry expertise. Auditor industry experts have been shown to have better financial reporting quality. This study evaluates the interaction of auditor industry expertise (“specialists”) on the relationship between equity incentives as proxied through vega and financial misreporting such as abnormal accruals, likelihood of just meeting or beating analysts’ earnings forecasts, and financial restatements. Vega measures the sensitivity of the CEO’s portfolio to a .01 change in stock volatility. Results indicate that there does not appear to be statistically significant evidence of a relationship between equity incentives and financial misreporting in firms that are audited by an auditor industry expert. This conclusion provides important information to those concerned with the possibility that senior executives whose compensation are largely tied to performance measures are potentially incented to misreport financial results. While this data may seem counter-intuitive, we conclude that firms do not benefit from auditor industry expertise as it relates to equity incentives and financial misreporting.
JEL Classification Codes: M12, M41, M42.
References
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Armstrong, C. S., Larcker, D. F., Ormazabal, G., & Taylor, D. J. (2013). The relation between equity incentives and misreporting: The role of risk-taking incentives. Journal of Financial Economics, 109(2), 327-350. https://doi.org/10.1016/j.jfineco.2013.02.019
Balsam, S., Krishnan, J., & Yang, J. S. (2003). Auditor industry specialization and earnings quality. Auditing: A Journal of Practice & Theory, 22(2), 71-97. https://doi.org/10.2308/aud.2003.22.2.71
Bergstresser, D., & Philippon, T. (2006). CEO incentives and earnings management. Journal of Financial Economics, 80(3), 511-529. https://doi.org/10.1016/j.jfineco.2004.10.011
Billings, B. A., Gao, X., & Jia, Y. (2014). CEO and CFO equity incentives and the pricing of audit services. Auditing: A Journal of Practice & Theory, 33(2), 1-25. https://doi.org/10.2308/ajpt50650
Brockman, P., Martin, X., & Unlu, E. (2010). Executive compensation and the maturity structure of corporate debt. The Journal of Finance, 65(3), 1123-1161. https://doi.org/10.1111/j.1540-6261.2010.01563.x
Burns, N., & Kedia, S. (2006). The impact of performance-based compensation on misreporting. Journal of Financial Economics, 79(1), 35-67. https://doi.org/10.1016/j.jfineco.2004.12.003
Chen, H., Jeter, D., & Yang, Y. W. (2015). Pay-performance sensitivity before and after SOX. Journal of Accounting and Public Policy, 34(1), 52-73. https://doi.org/10.1016/j.jaccpubpol.2014.09.003
Cheng, Q., & Farber, D. B. (2008). Earnings restatements, changes in CEO compensation, and firm performance. The Accounting Review, 83(5), 1217-1250. https://doi.org/10.2308/accr.2008.83.5.1217
Coles, J. L., Daniel, N. D., & Naveen, L. (2006). Managerial incentives and risk-taking. Journal of Financial Economics, 79(2), 431-468. https://doi.org/10.1016/j.jfineco.2004.09.004
Core, J., & Guay, W. (2002). Estimating the value of employee stock option portfolios and their sensitivities to price and volatility. Journal of Accounting Research, 40(3), 613-630. https://doi.org/10.1111/1475-679X.00064
Craswell, A. T., Francis, J. R., & Taylor, S. L. (1995). Auditor brand name reputations and industry specializations. Journal of Accounting and Economics, 20(3), 297-322. https://doi.org/10.1016/0165-4101(95)00403-3
Dechow, P., Ge, W., & Schrand, C. (2010). Understanding earnings quality: A review of the proxies, their determinants and their consequences. Journal of Accounting and Economics, 50(2-3), 344-401. https://doi.org/10.1016/j.jacceco.2010.09.001
Duellman, S., Ahmed, A. S., & Abdel-Meguid, A. M. (2013). An empirical analysis of the effects of monitoring intensity on the relation between equity incentives and earnings management. Journal of Accounting and Public Policy, 32(6), 495-517. https://doi.org/10.1016/j.jaccpubpol.2013.08.007
Erickson, M., Hanlon, M., & Maydew, E. L. (2006). Is there a link between executive equity incentives and accounting fraud?. Journal of Accounting Research, 44(1), 113-143. https://doi.org/10.1111/j.1475-679X.2006.00194.x
Fargher, N., Jiang, A., & Yu, Y. (2014). How do auditors perceive CEO's risk‐taking incentives?. Accounting & Finance, 54(4), 1157-1181. https://doi.org/10.1111/acfi.12044
Financial Accounting Standards Board (FASB). (2004). Accounting Standards Codification (SFAS123R). Retrieved from https://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1218220124271&acceptedDisclaimer=true
Francis, J. R., Reichelt, K., & Wang, D. (2005). The pricing of national and city‐specific reputations for industry expertise in the US audit market. The Accounting Review, 80(1), 113-136. https://doi.org/10.2308/accr.2005.80.1.113
Graham, J. R., Harvey, C. R., & Rajgopal, S. (2005). The economic implications of corporate financial reporting. Journal of Accounting and Economics, 40(1-3), 3-73. https://doi.org/10.1016/j.jacceco.2005.01.002
Hribar, P., & Craig Nichols, D. (2007). The use of unsigned earnings quality measures in tests of earnings management. Journal of Accounting Research, 45(5), 1017-1053. https://doi.org/10.1111/j.1475-679X.2007.00259.x
Jayaraman, S., & Milbourn, T. (2015). CEO equity incentives and financial misreporting: The role of auditor expertise. The Accounting Review, 90(1), 321-350. https://doi.org/10.2308/accr50854
Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305-360. https://doi.org/10.1016/0304-405X(76)90026-X
Jiang, J. X., Petroni, K. R., & Wang, I. Y. (2010). CFOs and CEOs: Who have the most influence on earnings management?. Journal of Financial Economics, 96(3), 513-526. https://doi.org/10.1016/j.jfineco.2010.02.007
Jones, J. J. (1991). Earnings management during import relief investigations. Journal of Accounting Research, 29(2), 193-228. https://doi.org/10.2307/2491047
Kannan, Y. H., Skantz, T. R., & Higgs, J. L. (2014). The impact of CEO and CFO equity incentives On audit scope and perceived risks as revealed through audit fees. Auditing: A Journal of Practice & Theory, 33(2), 111-139. https://doi.org/10.2308/ajpt-50666
Kim, Y. Li, H., & Li, S. (2015). CEO equity incentives and audit fees. Contemporary Accounting Research, 32(2), 608-638. https://doi.org/10.1111/1911-3846.12096
Kothari, S. P., Leone, A. J., & Wasley, C. E. (2005). Performance matched discretionary accrual measures. Journal of Accounting and Economics, 39(1), 163-197. https://doi.org/10.1016/j.jacceco.2004.11.002
Laux, C., & Laux, V. (2009). Board committees, CEO compensation, and earnings management. The Accounting Review, 84(3), 869-891. https://doi.org/10.2308/accr.2009.84.3.869
Matsunaga, S. R., & Park, C. W. (2001). The effect of missing a quarterly earnings benchmark on the CEO's annual bonus. The Accounting Review, 76(3), 313-332. https://doi.org/10.2308/accr.2001.76.3.313
Public Company Accounting Oversight Board (PCAOB). (2016, December 31). Auditing Standards (AS 1001.02). Retrieved from https://pcaob-assets.azureedge.net/pcaob dev/docs/defaultsource/standards/archived/documents/auditing-standards-as-of-december-14 2017944330126.pdf?sfvrsn=210de147_2
Reichelt, K. J., & Wang, D. (2010). National and office‐specific measures of auditor industry expertise and effects on audit quality. Journal of Accounting Research, 48(3), 647-686. https://doi.org/10.1111/j.1475-679X.2009.00363.x
Seetharaman, A., Gul, F. A., & Lynn, S. G. (2002). Litigation risk and audit fees: Evidence from UK firms cross-listed on US markets. Journal of Accounting and Economics, 33(1), 91-115. https://doi.org/10.1016/S0165-4101(01)00046-5
Skinner, D. J., & Srinivasan, S. (2012). Audit quality and auditor reputation: Evidence from Japan. The Accounting Review, 87(5), 1737-1765. https://doi.org/10.2308/accr-50198
Venkataraman, R., Weber, J. P., & Willenborg, M. (2008). Litigation risk, audit quality, and audit fees: Evidence from initial public offerings. The Accounting Review, 83(5), 1315-1345. https://doi.org/10.2308/accr.2008.83.5.1315
Armstrong, C. S., Larcker, D. F., Ormazabal, G., & Taylor, D. J. (2013). The relation between equity incentives and misreporting: The role of risk-taking incentives. Journal of Financial Economics, 109(2), 327-350. https://doi.org/10.1016/j.jfineco.2013.02.019
Balsam, S., Krishnan, J., & Yang, J. S. (2003). Auditor industry specialization and earnings quality. Auditing: A Journal of Practice & Theory, 22(2), 71-97. https://doi.org/10.2308/aud.2003.22.2.71
Bergstresser, D., & Philippon, T. (2006). CEO incentives and earnings management. Journal of Financial Economics, 80(3), 511-529. https://doi.org/10.1016/j.jfineco.2004.10.011
Billings, B. A., Gao, X., & Jia, Y. (2014). CEO and CFO equity incentives and the pricing of audit services. Auditing: A Journal of Practice & Theory, 33(2), 1-25. https://doi.org/10.2308/ajpt50650
Brockman, P., Martin, X., & Unlu, E. (2010). Executive compensation and the maturity structure of corporate debt. The Journal of Finance, 65(3), 1123-1161. https://doi.org/10.1111/j.1540-6261.2010.01563.x
Burns, N., & Kedia, S. (2006). The impact of performance-based compensation on misreporting. Journal of Financial Economics, 79(1), 35-67. https://doi.org/10.1016/j.jfineco.2004.12.003
Chen, H., Jeter, D., & Yang, Y. W. (2015). Pay-performance sensitivity before and after SOX. Journal of Accounting and Public Policy, 34(1), 52-73. https://doi.org/10.1016/j.jaccpubpol.2014.09.003
Cheng, Q., & Farber, D. B. (2008). Earnings restatements, changes in CEO compensation, and firm performance. The Accounting Review, 83(5), 1217-1250. https://doi.org/10.2308/accr.2008.83.5.1217
Coles, J. L., Daniel, N. D., & Naveen, L. (2006). Managerial incentives and risk-taking. Journal of Financial Economics, 79(2), 431-468. https://doi.org/10.1016/j.jfineco.2004.09.004
Core, J., & Guay, W. (2002). Estimating the value of employee stock option portfolios and their sensitivities to price and volatility. Journal of Accounting Research, 40(3), 613-630. https://doi.org/10.1111/1475-679X.00064
Craswell, A. T., Francis, J. R., & Taylor, S. L. (1995). Auditor brand name reputations and industry specializations. Journal of Accounting and Economics, 20(3), 297-322. https://doi.org/10.1016/0165-4101(95)00403-3
Dechow, P., Ge, W., & Schrand, C. (2010). Understanding earnings quality: A review of the proxies, their determinants and their consequences. Journal of Accounting and Economics, 50(2-3), 344-401. https://doi.org/10.1016/j.jacceco.2010.09.001
Duellman, S., Ahmed, A. S., & Abdel-Meguid, A. M. (2013). An empirical analysis of the effects of monitoring intensity on the relation between equity incentives and earnings management. Journal of Accounting and Public Policy, 32(6), 495-517. https://doi.org/10.1016/j.jaccpubpol.2013.08.007
Erickson, M., Hanlon, M., & Maydew, E. L. (2006). Is there a link between executive equity incentives and accounting fraud?. Journal of Accounting Research, 44(1), 113-143. https://doi.org/10.1111/j.1475-679X.2006.00194.x
Fargher, N., Jiang, A., & Yu, Y. (2014). How do auditors perceive CEO's risk‐taking incentives?. Accounting & Finance, 54(4), 1157-1181. https://doi.org/10.1111/acfi.12044
Financial Accounting Standards Board (FASB). (2004). Accounting Standards Codification (SFAS123R). Retrieved from https://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1218220124271&acceptedDisclaimer=true
Francis, J. R., Reichelt, K., & Wang, D. (2005). The pricing of national and city‐specific reputations for industry expertise in the US audit market. The Accounting Review, 80(1), 113-136. https://doi.org/10.2308/accr.2005.80.1.113
Graham, J. R., Harvey, C. R., & Rajgopal, S. (2005). The economic implications of corporate financial reporting. Journal of Accounting and Economics, 40(1-3), 3-73. https://doi.org/10.1016/j.jacceco.2005.01.002
Hribar, P., & Craig Nichols, D. (2007). The use of unsigned earnings quality measures in tests of earnings management. Journal of Accounting Research, 45(5), 1017-1053. https://doi.org/10.1111/j.1475-679X.2007.00259.x
Jayaraman, S., & Milbourn, T. (2015). CEO equity incentives and financial misreporting: The role of auditor expertise. The Accounting Review, 90(1), 321-350. https://doi.org/10.2308/accr50854
Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305-360. https://doi.org/10.1016/0304-405X(76)90026-X
Jiang, J. X., Petroni, K. R., & Wang, I. Y. (2010). CFOs and CEOs: Who have the most influence on earnings management?. Journal of Financial Economics, 96(3), 513-526. https://doi.org/10.1016/j.jfineco.2010.02.007
Jones, J. J. (1991). Earnings management during import relief investigations. Journal of Accounting Research, 29(2), 193-228. https://doi.org/10.2307/2491047
Kannan, Y. H., Skantz, T. R., & Higgs, J. L. (2014). The impact of CEO and CFO equity incentives On audit scope and perceived risks as revealed through audit fees. Auditing: A Journal of Practice & Theory, 33(2), 111-139. https://doi.org/10.2308/ajpt-50666
Kim, Y. Li, H., & Li, S. (2015). CEO equity incentives and audit fees. Contemporary Accounting Research, 32(2), 608-638. https://doi.org/10.1111/1911-3846.12096
Kothari, S. P., Leone, A. J., & Wasley, C. E. (2005). Performance matched discretionary accrual measures. Journal of Accounting and Economics, 39(1), 163-197. https://doi.org/10.1016/j.jacceco.2004.11.002
Laux, C., & Laux, V. (2009). Board committees, CEO compensation, and earnings management. The Accounting Review, 84(3), 869-891. https://doi.org/10.2308/accr.2009.84.3.869
Matsunaga, S. R., & Park, C. W. (2001). The effect of missing a quarterly earnings benchmark on the CEO's annual bonus. The Accounting Review, 76(3), 313-332. https://doi.org/10.2308/accr.2001.76.3.313
Public Company Accounting Oversight Board (PCAOB). (2016, December 31). Auditing Standards (AS 1001.02). Retrieved from https://pcaob-assets.azureedge.net/pcaob dev/docs/defaultsource/standards/archived/documents/auditing-standards-as-of-december-14 2017944330126.pdf?sfvrsn=210de147_2
Reichelt, K. J., & Wang, D. (2010). National and office‐specific measures of auditor industry expertise and effects on audit quality. Journal of Accounting Research, 48(3), 647-686. https://doi.org/10.1111/j.1475-679X.2009.00363.x
Seetharaman, A., Gul, F. A., & Lynn, S. G. (2002). Litigation risk and audit fees: Evidence from UK firms cross-listed on US markets. Journal of Accounting and Economics, 33(1), 91-115. https://doi.org/10.1016/S0165-4101(01)00046-5
Skinner, D. J., & Srinivasan, S. (2012). Audit quality and auditor reputation: Evidence from Japan. The Accounting Review, 87(5), 1737-1765. https://doi.org/10.2308/accr-50198
Venkataraman, R., Weber, J. P., & Willenborg, M. (2008). Litigation risk, audit quality, and audit fees: Evidence from initial public offerings. The Accounting Review, 83(5), 1315-1345. https://doi.org/10.2308/accr.2008.83.5.1315
Published
2022-03-29
How to Cite
Patin, J. C., & Jens, W. G. (2022). CAN AUDITOR INDUSTRY EXPERTISE REDUCE INCIDENCES OF MISREPORTING?. International Journal of Accounting & Finance Review, 10(1), 83-92. https://doi.org/10.46281/ijafr.v10i1.1670
Section
Regular Research Article/ Short Communication Article
Copyright (c) 2022 Jeanne Claire Patin, William G. Jens
This work is licensed under a Creative Commons Attribution 4.0 International License.
