Independent director reputation incentives, accruals quality and audit fees

• DOI: http://doi.org/10.1111/jbfa.12435
• Author: David B. Bryan,Terry W. Mason
• Date: 01 July 2020
• Published date: 01 July 2020

DOI: 10.1111/jbfa.12435

Independent director reputation incentives,

accruals quality and audit fees

David B. Bryan1Terry W. Mason2

1University of North Florida, Jacksonville,

Florida, United States

2Kansas State University, Manhattan,Kansas,

United States

Correspondence

DavidB. Bryan, University of North Florida,

Jacksonville,Florida, United States.

Email:david.bryan@unf.edu

Fundinginformation

Universityof North Florida

Abstract

While prior research provides abundant evidence that independent

directors are associated with favorable outcomes, researchers have

only recently started to investigate the impact of independent direc-

tor reputation incentives. This study examines whether the reputa-

tion incentives of independent directors are associated with accru-

als quality and audit fees. The results reveal a negative relationship

between the proportion of independent directors with relatively low

reputation incentives and accruals quality. Further, the proportion

of independent directors with relatively low reputation incentives is

positively associated with audit fees, suggesting that auditors view

lower reputation incentives as increasing risk. We also find that Big

4/5 auditor office size moderates the relationship between indepen-

dent director reputation incentives and audit fees. Specifically, our

results indicate that audit fees increase less in response to lower

reputation incentives as office size increases, suggesting that larger

offices respond to the risks associated with lower reputation incen-

tives more efficiently than smaller offices.

KEYWORDS

accruals quality, audit fees, auditor office size, independent director

reputation incentives

JEL CLASSIFICATION

M41, M42

1INTRODUCTION

Prior research finds that greater board independence is associated with numerous favorable effects, including, for

example, less earnings management (e.g., Klein, 2002; Peasnell, Pope,& Young, 2005; Xie, Davidson, & DaDalt, 2003),

greater conservatism (e.g., Ahmed & Duellman, 2007; Beekes, Pope, & Young,2004), a lower likelihood of fraud (e.g.,

Beasley,1996; Fich & Shivdasani, 2007), and higher quality information environments (e.g., Armstrong, Core, & Guay,

2014; Karamanou& Vafeas, 2005). However, recent studies imply that it is important to consider the reputation incen-

tives of independent directors when investigating the effects of board independence (e.g., Masulis & Mobbs, 2014,

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2020 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2020;47:982–1011.

BRYANAND MASON 983

2016, 2017; Sila, Gonzalez, & Hagendorff, 2017). In this study,we examine whether independent director reputation

incentives are associated with accruals quality and audit fees.

Masulis and Mobbs (2014) argue that when independent directors serve on more than one board, they prioritize

directorships based on firm size because directorships at larger firms are more prominent and prestigious and repre-

sent a more promising opportunity to acquire additional directorships, providing directors with higher incentives to

develop a reputation as a rigorous monitor.This suggests that when an independent director serves on more than one

board, the director has relatively higher reputation incentives at the larger firms. Consistent with this idea, existing

research provides evidence that firms with a greater proportion of independent directors with relatively high rep-

utation incentives are associated with better performance (Masulis & Mobbs, 2014, 2017), higher quality informa-

tion environments (Sila et al., 2017), less earnings management (Masulis & Mobbs, 2016), and a reduced likelihood of

an earnings restatement (Masulis & Mobbs, 2016). Based on these studies, we first investigate whether independent

director reputation incentives are associated with accruals quality,with the expectation that higher reputation incen-

tives improve the qua lity of accruals.

We also investigate the relationship between independent director reputation incentivesand audit fees. We argue

that higher reputation incentives are likely to reduce an auditor’s perception of audit risk and auditor business risk.

Since prior research provides evidencethat audit risk and auditor business risk are positively related to audit fees (e.g.,

Bell, Landsman, & Shackelford,2001; Gul, Chen, & Tsui, 2003; Krishnan, Sun, Wang, & Yang,2013; Lyon & Maher, 2005;

Simunic, 1980), this implies a negative relationship between the strength of reputation incentivesand audit fees. How-

ever, on the other hand, prior research finds that more independent boards demand higher quality audits, leading to

higher audit fees (Carcello, Hermanson, Neal, & Riley Jr,2002). Similarly, if higher reputation incentives prompt inde-

pendent directors to obtain more rigorous audits, then we would expecta positive association between the strength of

independent director reputation incentives and audit fees.

Followingprior research (Masulis & Mobbs, 2014, 2016, 2017; Sila et al., 2017), for each independent director in our

sample, during a given year, we classify directorships at firms that are at least 10% larger (smaller) than the smallest

(largest) firm that the director serves as being of high (low) importance to the director. Then, for each firm-year in

our sample, we calculate the proportion of independent directors that are designated as viewing their directorship

at the firm as being of high or low importance, yielding our reputation incentives variables, PCTHIGH and PCTLOW,

respectively (Masulis & Mobbs, 2014, 2016, 2017; Sila et al., 2017).

The results reveala negative association between the proportion of independent directors with relatively low repu-

tation incentives and accruals quality.However, we find no relationship between the proportion of independent direc-

tors with relatively high reputation incentives and the quality of accruals. The results indicate that a movement over

the range of PCTLOWis associated with a decrease in the measure of accruals quality of 0.0034; this represents a shift

in the measure of accruals quality that amounts to 10.0% of its mean value. Additionally,we provide evidence of a pos-

itive association between the proportion of independent directors with relatively low reputation incentives and audit

fees, implying that auditors perceivelower reputation incentives as increasing risk. The results indicate that a one stan-

dard deviation increase in PCTLOWis associated with a 1.76% increase in audit fees, which corresponds to an audit fee

that is approximately US$ 58,000 higher for the averagefirm-year observation in the sample. We find no relationship

between the proportion of independent directors with relatively high reputation incentives and audit fees.

Asa supplemental analysis, we also examine whether Big 4/5 auditor office size moderates the relationship between

independent director reputation incentives and audit fees. Francis and Yu (2009) suggest that larger Big 4 auditor

offices have greater experience and expertise in auditing public companies compared to smaller offices, leading to

a positive relationship between office size and audit quality. We posit that greater experience and expertise may

allow larger offices to respond more efficiently to the risks posed by lower reputation incentives, suggesting a smaller

increasein audit fees for larger offices. Alternatively, because larger offices produce higher quality audits, larger offices

may instead respond more vigorously to the risks associated with lower reputation incentives, suggesting a greater

increase in audit fees for larger offices. Our results are consistent with larger offices responding more efficiently to the

risks associated with lower reputation incentives compared to smaller offices.