The Effect of Auditor Expertise on Executive Compensation

We examine the effect of auditor expertise on managerial equity-based compensation. Consistent with theories that predict that firms will grant more equity-based compensation to their managers when financial statement manipulation is more likely to be detected, we find strong evidence that firms audited by an industry expert grant their CEOs more equity-based compensation. Additional tests indicate that these firms also grant their CFOs greater equity-based compensation. However, in contrast, equity-based compensation of all other executives is unaffected by whether or not their firms are audited by an industry expert. Tests that embed auditor expertise within the firm's overall corporate governance framework indicate that auditor expertise helps mitigate the adverse consequences of poor corporate governance. Our results are robust to a rigorous treatment of endogeneity and suggest that firms consider the financial misreporting effects of equity-based incentives and trade off these costs with the benefits of higher managerial effort when designing compensation contracts. An important implication of our results is that the relation between equity-based incentives and accounting fraud is complicated and depends on the presence of detection mechanisms such as auditor expertise that allow firms to grant more equity-based compensation while simultaneously lowering the occurrence of earnings management