The impact of audit quality on cash incentive compensation and cost of capital
Abstract I use the agency theory framework to model the effect of audit quality on prin- cipal agent dynamics. The model shows that as audit quality increases, the weight placed on accounting earnings in determining managers compensation increases. I also show that the returns expected by the investors decline with increasing au- dit quality. Hence the cost of capital to the firm decreases with increasing audit quality. I find empirical evidence to support the two propositions. The empirical results confirm that the weight placed on accounting earnings in determining the incentive pay of both CEOs and non-CEO managers increase with audit quality. The evidence also confirms that cost of capital of firms declines as audit quality increases although this effect is only observed in small firms. I further test the impact of audit tenure and auditor opinion on cost of capital and find that cost of capital is inversely proportional to auditor tenure, and that cost of capital for the client will increase if the auditor issues any opinion other than an unqualified opinion. [...]... specialist BigX auditors compared to clients who engage non specialist BigX auditors 4 I further examine the impact of different attributes of the auditor and the audit on the cost of capital of the client firm I find that the cost of capital is inversely proportional to the length of the auditor tenure I also find that the client firms cost of capital increases if the auditor issues any opinion other than an... effectiveness of the auditor as monitor on behalf of the owners will be reflected in the risk premium demanded of the firm by the owners, and will lead to a lower cost of capital I also posit that this monitoring effect will manifest itself in the CEO compensation awarded by the firm The Information Role of Auditing and Cost of Capital As previously mentioned, one of the adverse effects of the separation of ownership... important only in determining cash compensation, earnings quality will be important to cash compensation, but not to equity compensation Audit quality will impact past accounting returns And since I am investigating the effect of audit quality on compensation, I posit that audit quality will have greater impact on the cash component of CEO compensation than on the equity component Non-CEO Executives Agency theory... managers’ compensation, it has a significant bearing on the cost of capital of a firm The first two roles of the audit indicate that higher audit quality will lead to lower cost of capital for the client firm (technical aspect of auditing) The third role of the audit indicates that the more financial resources the auditor has, the lower the cost of capital of the client firm (compensatory aspect of auditing)... compensation and the cost of capital The paper is structured as follows The remainder of Chapter 1 will contain the literature survey Chapter 2 describes the analytical model Chapter 3 consists of the empirical analysis of compensation and audit quality, including the data, empirical results, sensitivity analysis and a discussion of the results Chapter 4 contains the empirical analysis of cost of capital. .. demanded In the context of financial information, the end result is that better disclosure results in a lower cost of capital. ” Hence, since higher information levels lead to lower cost of capital, I investigate the impact of audit quality in improving the information environment, and thus lowering the cost of capital for firms 1.2.3 Audit Quality The auditor provides ”reasonable assurance” that the. .. in the degree of conflict among the stakeholders of the company In addition, Francis and Wilson (1988) show that the demand for quality differentiated audits, proxied by auditing firm size is positively related to the company’s agency costs Thus I posit that the monitoring role of the audit is effective in mitigating the agency problem arising out of the separation of ownership and control of the firm The. .. bonus) of CEO compensation was 52% in 2003 Due to this decline, there is a tendency to ignore the importance of the cash component in compensation However, it is important to note that a significant proportion of compensation is in the form of cash, and there are still some parts of the puzzle that are not totally understood The incentives for cash compensation and equity compensation are different Cash. .. the perception of BigX performing higher quality audits than non-BigX is a function of the litigation environment Their conclusion is that the threat of litigation is a stronger driver than reputation behind perceived audit quality, proxied by cost of capital This conclusion implies that the investing public primarily perceives audit quality in terms of the BigX auditor’s ”deep pockets” Thus their paper... source of compensation, namely the auditor, in the event of failure of the firm Menon and Williams (1994) argue that this insurance factor is built into the share price of the client firm They examined the impact of the bankruptcy of Laventhol & Horwath (L&H) on the stock prices of its clients They document a significant negative effect on the stock prices and attribute this to the deterioration of the insurance . attributes of the auditor and the audit on the cost of capital of the client firm. I find that the cost of capital is inversely proportional to the length of the auditor tenure. I also find that the client. opinion on cost of capital and find that cost of capital is inversely proportional to auditor tenure, and that cost of capital for the client will increase if the auditor issues any opinion other. higher quality audits than non-BigX is a function of the litigation environment. Their conclusion is that the threat of litigation is a stronger driver than reputation behind perceived audit quality,