Executive tournament incentives and audit fees

How does the executive pay gap influence audit fees? The roles of R&D investment and institutional ownership

“…As reported in columns (1) and (3), the coefficients of lnPayGap1 and lnPayGap2 are 0.053 and 0.049, respectively, with both significant at the 1% level. The results indicate that a larger executive pay gap is associated with higher audit fees, which is consistent with prior studies (Bryan & Mason, ; Jia, ) and in line with managerial power theory. The results are also economically significant.…”

“…The dependent variable is the natural logarithm of audit fees ( lnAuditFee ). We find that the executive pay gap is positively associated with audit fees, consistent with results reported by Bryan and Mason () and Jia (). These results are in line with managerial power theory, suggesting that auditors perceive audit risk to be higher for firms with a higher executive pay gap, for which reason they charge higher audit fees.…”

“…However, there is limited empirical evidence on whether and how auditors perceive the executive pay gap and incorporate the potential audit risk associated therewith into audit pricing. Two concurrent studies report that the executive pay gap is positively associated with audit fees (Bryan & Mason, ; Jia, ), consistent with managerial power theory. However, CEOs may be highly paid for undertaking risky innovation activities, particularly by firms with high R&D investment (e.g., Balkin, Markman, & Gomez‐Mejia, ; Duru, Iyengar, & Thevaranjan, ; Gibbons & Murphy, ; Tsao, Lin, & Chen, ).…”

“…According to managerial power theory, auditors are likely to be concerned with agency problems associated with the executive pay gap, and charge a fee premium to clients with a high executive pay gap to mitigate the associated cost of potential litigation or reputation loss. Bryan and Mason () and Jia () provide empirical evidence that tournament incentives are positively associated with audit fees, and that this association is attenuated by CEO succession, CEO tenure, CEO age, and abnormal accruals. Their results suggest that auditors view tournament incentives as an audit risk‐increasing factor, which is consistent with managerial power theory.…”

“…Second, our study provides new insights into the link between tournament incentives and audit fees. Bryan and Mason () and Jia () find that the pay gap among top executives is associated with higher audit fees, suggesting that auditors are concerned that tournament incentives encourage managerial risk‐taking and misreporting. Our study complements them by showing that auditors tend to perceive high CEO pay in client firms with high R&D investment as a reward for undertaking risky innovative activities; as such, auditors tend to assess the audit risk associated with the executive pay gap to be lower for R&D‐intensive firms than for firms with less R&D investment.…”