CEO Financial Background and Audit Pricing

Abstract

SYNOPSIS Accounting scholars theorize that audit price is a function of a client's audit and business risk. Existing research finds that the functional expertise of Chief Executive Officers (CEOs) in finance improves financial reporting quality (Matsunaga, Wang, and Yeung 2013), increases profitability, and reduces the likelihood of firm failure (Custodio and Metzger 2014). These factors suggest that auditors' engagement risk decreases when incumbent CEOs possess financial expertise, raising the likelihood that auditors will charge these firms lower fees. In this study, we examine whether CEOs' work experience in accounting- and finance-related jobs affects audit fees. Using a panel of U.S. firms between 2004 and 2013, we find that firms that have a financial expert CEO pay lower audit fees. Our results are robust to various specifications, including firm-fixed effect model and specifications that control for other CEO- and Chief Financial Officer (CFO)-specific and audit committee characteristics. Our findings thus add to the literature on the advantages and disadvantages of a functional background of top managers and how this background can create value for a firm through savings in audit fees.

CEO financial background and internal control weaknesses

“…The main purpose of this study is to examine the association between CEOs' financial background and ICWs in the Iranian setting. We posit that CEO financial background could improve the corporate performance through reducing ICWs, because prior research suggests that hiring a financial expert CEO enhances financial reporting quality (Gounopoulos & Pham, ; Jiang et al, ) and firm profitability (Custodio & Metzger, ) and also reduces the audit risk (Baatwah et al, ; Kalelkar & Khan, ). Our results demonstrate that ICWs are considerably less frequent in companies hiring financial expert CEOs.…”

“…The dependent variable ICW is a dummy variable that equals 1 when the firm's auditor reports a material weakness and zero otherwise (e.g., Ashbaugh-Skaife et al, 2007;Cheng et al, 2013). The variable of interest CEOFEXP is a dummy variable that equals one if a CEO has financial work experience and zero otherwise (Custodio & Metzger, 2014;Gounopoulos & Pham, 2018;Kalelkar & Khan, 2016). risk (LITIGATION; Chen, Eshleman, et al, 2017).…”

“…Furthermore, previous studies find that CEOs with financial expertise are negatively associated with earnings management (Gounopoulos & Pham, 2018;Jiang et al, 2013), financial reporting delay (Baatwah et al, 2015), and audit fees (Kalelkar & Khan, 2016), suggesting that there is a relation between CEO financial expertise, financial reporting quality, and audit risk. In addition to CEO financial expertise, effective internal control is another significant factor associated with financial reporting quality (e.g., Ji, Lu, & Qu, 2017;Lu, Richardson, & Salterio, 2011) and audit risk (e.g., Ji, Lu, & Qu, 2018;Munsif, Raghunandan, Dasaratha, & Singhvi, 2011).…”

“…Given prior research (e.g., Ashbaugh‐Skaife, Collins, & Kinney, ; Cheng et al, ), we use auditors' opinion on the effectiveness of internal control in disclosing ICWs. In the same vein, drawing upon previous studies (e.g., Baatwah et al, ; Kalelkar & Khan, ), we define financial expert CEOs as those who hold an accounting qualification, or have work experience as an auditor, CFO, and/or other accounting‐related positions. We find a significant negative association between CEOs with financial expertise and ICWs.…”

“…Prior literature suggests that CEO financial expertise reduces the risk of poor performance and firm failure (Custodio & Metzger, 2014), as well as material misstatements (Kalelkar & Khan, 2016). Salehi, Lari, and Naemi (2018) argue that the impact of CEOs, specifically their role in financial reporting and internal control, can be enhanced when they are financial experts.…”