How the design of CEO equity-based compensation can lead to lower audit fees: evidence from Australia

Summary

The research paper, "How the design of CEO equity-based compensation can lead to lower audit fees: evidence from Australia," by Qu, Yao, and Percy (2020), investigates the relationship between the design features of CEO equity-based compensation and the agency costs of monitoring, which are proxied by external audit fees, within an Australian context. The study empirically examines how auditors respond to various equity features, particularly the adoption of performance-vesting provisions. It highlights the importance of understanding the intricate design of CEO compensation beyond just the existence of equity grants, as different design choices have distinct implications for audit risk and, consequently, audit fees. The methodology involves empirically testing auditors' responses to the implementation of performance-vesting conditions in CEO equity compensation. The researchers analyze how variations in equity features influence audit fees, controlling for other factors known to affect audit costs. Their findings reveal several critical insights into how auditors perceive and price the risks associated with CEO equity incentives. The study specifically differentiates between various types of performance hurdles—market-based, accounting-based, and combination hurdles—to discern their individual effects on audit fees, thereby providing a nuanced understanding of compensation design. The study's findings indicate that audit fees tend to increase significantly when firms grant large equity packages to their CEOs, suggesting that auditors perceive a heightened risk associated with such substantial equity incentives. Crucially, the research documents that the use of accounting-based performance hurdles in equity compensation is linked to significantly higher audit fees, implying that these hurdles might encourage unethical reporting practices. In contrast, the paper finds a negative association between audit fees and the use of market-based hurdles, while combination hurdles also lead to lower audit fees. Furthermore, the authors observe that companies often adopt longer vesting periods to mitigate the undesirable characteristics of accounting-based hurdles and promote more balanced, future-oriented incentives. The implications suggest that remuneration committees should be cognizant of the potential hidden costs and ethical concerns associated with poorly structured CEO compensation packages, especially when CEOs wield significant corporate power.