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

• Published date: 01 May 2020
• DOI: http://doi.org/10.1111/jbfa.12426
• Author: Jeong‐Bon Kim,Wenxia Ge
• Date: 01 May 2020

DOI: 10.1111/jbfa.12426

How does the executive pay gap influence audit

fees? The roles of R&D investment and

institutional ownership

Wenxia Ge1Jeong-Bon Kim2

1Asper School of Business, University of

Manitoba, Winnipeg, Canada

2Department of Accountancy, City University of

Hong Kong,Kowloon, Hong Kong

Correspondence

WenxiaGe, Asper School of Business, University

ofManitoba, 181 Freedman Crescent, Winnipeg,

MB,R3T 5V4, Canada.

Email:wenxia.ge@umanitoba.ca

Fundinginformation

CPACanada and Canadian Academic Accounting

Association

Thedata that support the findings of this study

areavailable from the sources identified in the

paper.

Abstract

Using a sample of US firms from 2003–2014, this study examines

how the executive pay gap affects audit fees for firms with differ-

entlevels of R&D investment and institutional ownership. Consistent

with managerial power theory, we find that the executive pay gap

is positively associated with audit fees, and that the positive asso-

ciation is attenuated by intense R&D investment and higher insti-

tutional ownership. We also find that the executive pay gap more

strongly affects audit fees after the passage of the 2010 Dodd–Frank

Act and the PCAOB’s 2012 call to identify the audit risk related to

executiveincentive compensation. Additional analyses show that the

moderating effects of R&D investment and institutional ownership

on the pay gap–audit fees association are not conditional on audi-

tor tenure, but the moderating effect of institutional ownership is

stronger for firms hiring specialist auditors. Collectively,our findings

suggest that auditors consider the business context, such as inno-

vation initiative and external monitoring, when assessing audit risk

related to the executivepay gap.

KEYWORDS

auditfees, auditor tenure, executive pay gap, institutional ownership,

managerial power, R&D investment, specialist auditor, tournament

incentives

JEL CLASSIFICATION

G30, M12, M42, M52

1INTRODUCTION

Since the 2008–2009 global financial crisis, the relative pay gap between the chief executiveofficer (CEO) and other

employees has attractedconsiderable attention from regulators, the media, and academic researchers. Section 953 of

the Dodd–FrankWall Street Reform and Consumer Protection Act 2010 (hereafter “the Dodd–Frank Act”) directs the

J Bus Fin Acc. 2020;47:677–707. wileyonlinelibrary.com/journal/jbfa c

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Securities and Exchange Commission (SEC) to implement a rule requiring all public companies to disclose the annual

total compensation of their CEO, the median annual total compensation of all other employees,and the ratio between

the two. Subsequently,the SEC issued the pay ratio disclosure rule in August 2015 (US SEC, 2015), and adopted inter-

pretive guidance on the rule on September 21, 2017. Consequently, with effect from early 2018, all publicly traded

companies have been required to disclose the payratio information (US SEC, 2017).

Against this background, this study examineswhether and, if so, how the pay gap between the CEO and other execu-

tives in the top management team (hereafter “the executivepay gap”) affects audit fees charged to firms with different

R&D investment intensity and to firms with different institutional ownership levels.Previous studies have shown that

relative pay levels are more consequential to managerial behavior than absolute pay levels (e.g., Pfeffer & Langton,

1993). As the pay differential between the CEO and other senior executives has been trending upward over time

(Bebchuk & Grinstein, 2005; Frydman & Saks, 2010; Shi, Connelly,& Sanders, 2016), there is growing interest in and

debate about the distribution of executive paywithin an organization. Tournament theory suggests that the executive

pay gap motivates the CEO to work harder and incentivizes other executivesto endeavor to win promotion to the apex

of the managerial hierarchy (i.e., the CEO position), leading to better firm performance (Kale, Reis, & Venkateswaran,

2009; Kini & Williams, 2012; Lazear & Rosen, 1981). By contrast, managerial power theory suggests that the pay

disparity within top management teams reflects an entrenched CEO and incentivizes other executives to engage in

managerial opportunism that may destroy firm value but increase their promotion chances (Harbring & Irlenbusch,

2011).

The increasing executive pay gap has implications for audit risk, via its impact on clients’ agency risk and business

risk, as well as the risk of failing to detect material financial misstatements. However, there is limited empirical evi-

dence on whether and how auditors perceive the executivepay gap and incorporate the potential audit risk associated

therewith into audit pricing. Two concurrent studies report that the executivepay gap is positively associated with

audit fees (Bryan & Mason, 2017; Jia, 2017), 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, 2000; Duru, Iyengar, & Thevaranjan, 2002; Gibbons & Murphy, 1992; Tsao, Lin, & Chen, 2015). A

higher executivepay gap may thus be warranted for firms that engage in intense R&D activities. Accordingly, our first

research question is: Does a firm’s innovation intensity affect the auditor’s assessment of the audit risk associated with a

higher executivepay gap?

Moreover, numerous studies show that strong external monitoring by outside stakeholders, particularly insti-

tutional investors, improves financial reporting quality by constraining managerial reporting opportunism, thereby

alleviating the information asymmetry between inside managers and outside stakeholders (e.g., Aggarwal, Erel,

Ferreira, & Matos, 2011; Ajinkya, Bhojraj, & Sengupta, 2005; Boone & White, 2015; Bushee & Noe, 2000; Kim & Yi,

2015; Ramalingegowda & Yu, 2012). Given the well-established link between high reporting quality (and thus low

audit risk) and low audit fees (Choi, Kim, Liu, & Simunic, 2008, 2009; Kim, Liu, & Zheng, 2012), our second research

question is: Does a firm’s level of institutional ownership (i.e., external monitoring) affect the auditor’s assessment of the audit

risk associated with the executive pay gap? This study aims to provide large-sample, systematic evidence on the two

research questions. Tothe best of our knowledge, neither question has previously been explored.

Using a large sample of US public firms and a study period of 2003–2014, we first test the relation between the

executive pay gap and audit fees. We use two variables to measure the pay gap among a firm’s fiveexecutives with

the highest total pay (i.e., top-five executives).The first variable, lnPayGap1, is the natural logarithm of the difference

between the CEO’s total pay and the median value of the other four executives’ total pay. The second variable,

lnPayGap2, is the natural logarithm of the difference between the CEO’s total pay and the mean value of the other

four executives’ total pay.The dependent variable is the natural logarithm of audit fees (lnAuditFee). We find that the

executivepay gap is positively associated with audit fees, consistent with results reported by Bryan and Mason (2017)

and Jia (2017). These results are in line with managerial power theory, suggesting that auditors perceive audit risk to

be higher for firms with a higher executivepay gap, for which reason they charge higher audit fees.