Abstract
Since executive stock options may give rent-seeking incentives to CEOs, CEOs with stock options are likely to misallocate corporate resources to seek personal gains, which in turn may lead to a decrease in firm value. High-quality audit services can reduce the negative impacts of executive stock options on firm value and help firms to ensure sustainable growth. However, while most of the existing accounting literature related to executive stock options (ESO) is mainly focused on earnings management, there are relatively few studies that investigate the relation between ESO and audit fees. At the same time, while previous studies on ESO have been conducted in advanced countries, few studies have identified the relationship between ESO and audit fees in emerging markets. Therefore, it is necessary to examine the effect of ESO under circumstances different from those of developed countries. To fill this gap, we investigated the association between executive stock options and audit fees and examine the moderating effects of agency problems and monitoring systems on the relationship. Using 462 observations from 110 nonfinancial Korean listed companies, for the period of 2000 to 2005, we found that executive stock options are positively related to audit fees. In addition, we found that the effects of executive stock options on audit fees are even higher in firms with high agency problems, effective internal monitoring systems, and major accounting firms. This study can help regulatory agencies to validate audit fee regulations, such as the International Standard on Auditing, that consider ESO a significant risk factor. In addition, these results can help external auditors to set up the specific guidelines for pricing audit fees. Furthermore, the results of this study will contribute to the construction of more desirable corporate governance structure in Korean companies, which in turn would not only enhance firm value but also strengthen the sustainability of companies belonging to the emerging markets.
Highlights
Executive stock options can align the interests of managers with the interests of shareholders [1] and induce managers to take more risks [2]
In order to justify our measurement of the portion of executive stock options (ESO) to total executive compensation (PESO) as an independent variable, we ran an additional analysis, replacing the ratio of the number of unvested ESO with the number of granted ESO (NESO) and the ratio of the number of unvested ESO with the number of granted ESO and shares (NESOS)
We tested a model with the ESO incentive distinguished as price incentive (DELTA) and risk incentive (VEGA) as additional control variables to determine the independent impact of the portion of ESO to total executive compensation on the audit fees (Whereas VEGA represents the change in the manager’s wealth to stock price volatility in dollar amounts, DELTA shows the change in the manager’s wealth to stock price itself in dollar amounts.)
Summary
Executive stock options (hereafter referred to as ESO) can align the interests of managers with the interests of shareholders [1] and induce managers to take more risks [2]. Managers with ESO might override the internal control system to manage the reported earnings, leading to an increase in control risk, a type of audit risk. Since ESO can influence the degree of audit risk, external auditors will take this effect into consideration in negotiating audit fees. According to the International Standard on Auditing (ISA) No 240, The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements, external auditors take ESO into consideration as a significant risk factor relating to misstatements arising from fraudulent financial reporting. (In addition, the International Standard on Auditing (ISA) No 315, Understanding the Entity and Its Environment and Assessing the Risk of Material Misstatements, presents guidance on matters which external auditors may consider to assess risk. ISA No 240 and No 315 consider ESO a significant risk factor.)
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