Impact of audit quality on the components of executive cash compensation

Abstract

PurposeThis paper aims to study the impact of audit quality on the components of executive cash compensation. It is predicted that as audit quality improves, greater emphasis will be placed on the incentive components of cash compensation, and lower emphasis on the salary (fixed) component. Specifically, it is predicted that as audit quality enhances, greater emphasis will be placed on earnings and sales revenues in determining executive cash compensation. Using auditor specialization as a proxy for audit quality, empirical support is provided for all of our predictions.Design/methodology/approachThis paper provides empirical support with agency theoretic predictions.FindingsThis paper developed the following hypotheses:H1– in executive cash compensation, more weight is being placed on earnings-based measures as auditor specialization improves;H2– in executive cash compensation, more weight is also being placed on sales revenues as auditor specialization improves;H3– in executive cash compensation, salary levels decrease as auditor specialization improves; andH4– the impact of auditor specialization on the weight on earnings, sales and the salary levels is lower in the post-Sarbanes–Oxley Act (SOX) period compared to pre-SOX period.Research limitations/implicationsFirst, the article limits itself to cash compensation, while current executive compensation is largely made of equity. Second, the measure of audit quality used, ‘national level auditor specialization’, may not be as effective in the post-SOX era.Practical implicationsCompensation committees should pay attention to audit quality (in whatever way it may be proxied by) in determining executive compensation.Originality/valueThis is the first paper to show that audit quality not only improves the earnings response coefficient in firm valuation but also enhances the weight placed on earnings (and sales revenues) in executive compensation.