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CEO tenure and audit pricing

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Abstract

We examine the relationship between CEO tenure and audit fees. After controlling for client and auditor attributes in the analyses, we find that audit fees are higher in the initial 3 years of CEOs’ service, suggesting that CEOs in their early career are more likely to show high risk-taking behavior and manage earnings that increases the probability of financial misreporting. Auditors incorporate this risk in their audit pricing decisions resulting in higher audit fees. We also find that audit fees are higher in the final year of CEOs’ service, supporting the argument for departing CEOs’ horizon problem that CEOs in their final year are more likely to manage earnings, and auditors perceive this action as increasing reporting risk in their audit pricing decisions, resulting in higher audit fees. However, the firms with more effective audit committees pay relatively lower audit fees in initial years of CEOs’ service indicating that effective audit committees reduce auditors’ assessed risk during this time-period resulting in lower audit fees. We do not find any evidence on the effect of firms’ CFO power and corporate social responsibility performance on audit fees in these two time-periods of CEOs’ service. The main results hold in a battery of supplemental tests that include the effect of several CEO characteristics, client bargaining power and the effect of SOX. Our study extends CEO characteristics and audit fee literature, and have implications for auditors in their client acceptance and audit pricing decisions, and for regulators to identify the filers with higher financial reporting and audit engagement risk.

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Data availability

Data are obtained from public sources as described in the paper.

Notes

  1. Each CEO brings a unique management style that has repercussions on financial reporting decisions (Bills et al. 2017). Prior research provides evidence on executive-level influence over financial reporting quality (Bertrand and Schoar 2003; Ge et al. 2011) and that earnings quality is directly impacted by managerial ability (Demerjian et al. 2013) and managerial incentives (Beneish 1999; Burns and Kedia 2006; Erickson et al. 2006).

  2. Simunic and Stein (1996) suggest that total audit costs include a “resource cost and an expected liability loss component.” Resource cost increases with an increase in audit effort, and the proportion of liability loss component (ex-ante risk premium) increases with an increase in probable ex-post litigation loss liability that may arise due to undetected material misstatements. In the audit planning stage, auditors assess the probability of misstatements contained in a client’s financial statements and the effectiveness of internal control in the financial accounting process to prevent or detect such misstatements and then adjust the audit procedures to minimize the overall audit risk. Audit risk is a function of inherent risk of material misstatements, control risk that a client’s internal control system may not prevent or detect such misstatements on a timely basis, and detection risk that auditors will fail to detect the misstatements with their audit procedures. The greater the inherent risk, ceteris paribus, the more resources the auditor will have to engage in an audit to reduce the detection risk and, therefore, the audit risk to an acceptable level (Gul and Tsui 1998). Auditors respond to higher audit risk by investing more in audit process and assign more experienced professional staff to a particular engagement, leading to greater audit investment and higher audit fees. In addition, in the face of high audit risk, auditors may also include a risk premium in the quoted fees to cover future litigation loss liability that may arise from undetected financial misstatements during audits.

  3. Our study is different from Bills, Lisic and Seidel (2017) who examine the effect of CEO succession and succession planning on financial reporting risk and audit fees. They show that though new CEOs increase the perception of risk and uncertainty in financial reporting resulting in higher audit fees, careful CEO succession planning (heir apparent) attenuates risk perception as evident from the lack of audit pricing adjustment. In contrast, we investigate the impact of a career cycle of CEO on audit fees in two separate regimes of current CEOs, i.e., their early service period of 3 years and final service year, and also examine how this relationship is impacted by CFO power, CSR and audit committee effectiveness. Furthermore, from audit pricing perspective, our study provides additional insight into the observations of Ali and Zhang (2015) for these two time-periods that are associated with higher probability of financial misstatements and thus, higher reporting risk.

  4. Gul et al. (2003) document that discretionary accruals are positively associated with audit fees. Choi et al. (2018) shows that real earnings management is positively associated with audit fees.

  5. Some prior studies find little/no evidence on the association between managers’ horizon problems and accrual and real earnings management. For instance, Wells (2002) finds little evidence of income-increasing earnings management before CEO turnover and Cheng (2004) finds no association between CEO turnover and R&D expenditures. However, we argue that auditors are more likely to pay attention to potential income-increasing incentive of CEOs in their last year and exert more efforts to identify accounting misstatements of those firms.

  6. The industry dummies are for the following two-digit SIC codes: 01–14, 15–19, 20–21, 22–23, 24–27, 28–32, 33–34, 35–39, 40–48, 49, 50–52, 53–59, and 70–79.

  7. We find that all Spearman correlations among the independent variables are below 0.5 (not tabulated). Moreover, the variance inflation factors in the regressions are less than 3. Thus, multicollinearity has no consequential effect on our primary results.

  8. We do not rule out the possibility that the results for the early years of CEOs’ service could partly be attributed to the transition period of a new executive. The new CEOs might change reporting style, structure of financial reporting, disaggregation of financials or any number of items, which would prompt incumbent auditors to increase the level of their audit testing from prior years to deal with those changes. The situation is likely to increase audit efforts and audit fees.

  9. Prior research provides evidence of earnings management in the departing CEOs’ final two years (Reitenga and Tearney 2003). Thus, we construct a dummy variable of 1 if the firm-year observations correspond to the final 2 years prior to CEOs’ service and re-estimate the regressions. Regression results with the final 2 years included as a test variable are qualitatively similar to our main findings using only the final year as the test variable. Furthermore, we rerun all primary tests using firm fixed effect model and obtained qualitatively similar results.

  10. CFOPOWER is constructed based on CFOs’ continuous years of service in a firm, and is a dummy variable of 1 for firms with CFO tenure in the top quartile, and 0 otherwise.

  11. As a robustness check, we further evaluate the effect of relative CEO–CFO power on the three measures of CEO tenure using the methods adopted by Beck and Mauldin (2014) who evaluate CFO-audit committee relative power in their study. Based on the relative quartiles of CEO and CFO tenure, our variable of interest is constructed as RELATIVE_CEO_CFO, where value ranges from − 3 to + 3. Positive values indicate higher CEO power relative to CFO and negative values indicate lower CEO power relative to CFO. The untabulated results show insignificant interactions of the relative power variable with ETENURE1 and ETENURE2, and insignificant interaction of the variable with LTENURE (though it is significant in one-tailed test). Overall, the results are consistent with those reported in Table 4.

  12. We do not exclude the possibility that lower CSR performance would elevate higher financial reporting risk and audit risk in CEOs' early and late tenure. However, we argue that auditors are more likely to consider CSR firms' genuine commitment to financial statement verification and are less likely to incorporate lower CSR performance in their risk assessments.

  13. As a robustness check, we replace CSR with Hi-Strength variable, which is a dummy variable of 1 if the CSR strength is greater than industry median, and 0 otherwise and re-estimate regressions. The results are similar to the ones with CSR variable.

  14. BoardEx dataset provides biographical information for all members of board and its sub-committees including audit committee and senior executives around the globe. The biographical information includes, but is not limited to, age, gender, nationality, role and functional expertise. Because BoardEx tracks individual members over years, we collapsed the data down to company-year level in order to understand unique characteristics not only of each audit committee member, but also of the audit committee itself.

  15. BoardEx defines functional expertise of audit committee members as prior employment experience relevant to the audit committee [e.g., a public auditor at one of the 25 audit firms listed in Compustat, as a CPA or Chartered Accountant, or in an accounting-specific position, such as Chief Financial Officer, Treasurer, Controller, or Head of Accounting, see Ege (2015)] that individual members sit on.

  16. Given that ACMONITORING by construction could be open to criticism because of underlying notion of a linearity effect by summing three measures for audit committee characteristics, we do a principal component factor analysis on the three measures to form a single "factor" and re-estimate our interaction models by replacing ACMONITORING with this factor. We find that the results remain unchanged.

  17. As the board of directors is the paramount governance mechanism, following Carcello et al. (2002), we additionally control for board characteristics such as board size (BSIZE) and the proportion of independent directors on board (BINDEPENDENCE). Consistent with prior findings (Carcello et al. 2002; Abbott et al. 2003), we find that board size (BSIZE) and the proportion of independent directors on board (BINDEPENDENCE) exhibit positive relationship with audit fees, reinforcing the fact that board quality also matters in auditor’s pricing decision.

  18. Following Cohen et al. (2014), we limit our data beginning in 2001 since the BoardEx database coverage prior to that year is very sparse.

  19. When we partition the sample into two groups based on audit committee size (AC_SIZE) and audit committee functional expertise (AC_EXPERT), the positive effects of all three measures of CEO tenure on audit fees are found only in a group where audit committee size is smaller and audit committee functional expertise is weak. When the sample is partitioned into two groups based on audit committee independence (AC_INDEP), the positive effects of two CEO measures (ETENURE1 and ETENURE2) on audit fees are found only in a group where independent audit committee members are smaller in number.

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Authors and Affiliations

  1. Wayne State University, Detroit, USA

    Santanu Mitra

  2. California State University Dominguez Hills, Carson, USA

    Hakjoon Song

  3. Pennsylvania State University Great Valley, Devault, USA

    Sang Mook Lee

  4. Hanyang University, Erica, Seoul, South Korea

    Shin Hyoung Kwon

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Mitra, S., Song, H., Lee, S.M. et al. CEO tenure and audit pricing. Rev Quant Finan Acc 55, 427–459 (2020). https://doi.org/10.1007/s11156-019-00848-x

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