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...recent large public company failure and the associated demise of the company's global auditors (Byrne et. al 2002). However, we know relatively little about how client-employee compensation contracts affect the planning choices of auditors. Our main result is that audit-planning judgments are greater (i.e., audit risk is assessed higher and the level of evidence required to perform the audit is assessed higher) if the bonuses are based on financial performance measures rather than nonfinancial performance measures. We also find that audit-planning judgments are greater (i.e., audit risk is assessed higher, internal controls are assessed weaker, and more substantive evidence is required) if client-employee compensation comprises fixed salary plus bonuses, based on either financial or nonfinancial performance measures, rather than comprises a fixed salary only; however, we find only partial support for the finding with respect to nonfinancial measures. An important implication of these findings is that audit firms may need to pay careful attention to how auditors are trained in strategic systems auditing approaches that rely more on understanding a client's nonfinancial performance measures and less on transaction-based testing.
INTRODUCTION
Incentive contracting is often a necessary component of motivating productive employees (e.g., Kaplan and Atkinson 1998). Based on agency theory, incentive contracting is used to motivate the employee (the agent) to exert effort in performing his duties (Demski 1994). However, many performance measures used in incentive or bonus contracts can be easily manipulated allowing opportunistic employee behavior that may not be consistent with the best interests of the shareholders (the principal) (Healy 1985). Based on professional auditing guidelines (e.g., Canadian Institute of Chartered Accountants [CICA] 1997), when an auditor (the independent monitor) is hired to provide an opinion about the firm's financial statements, the auditor should be concerned about the performance measures used in the incentive contract, particularly if their manipulation could affect the firm's financial statements. Historically, financial performance indicators have typically been used in incentive contracts; however, recently, nonfinancial performance measures have become more common because they can be timely indicators of future financial performance (Banker et al. 2000; Rucci et al. 1998; Ittner et al. 1997). (1)
Not surprisingly, a common characteristic of the fraud found in some recently failed companies is that the interests of executives, seeking to maximize incentive pay, are vastly different from those of other stakeholders in the firm (e.g., see Byrne et al. 2002). Such failures have an obvious impact on the auditor's professional-indemnity insurance premiums, reputation, and, in the wake of the Enron collapse, potentially on the audit firm's future existence. Arguably, without incentive pay, client-employees have relatively less motivation to manipulate information provided to the auditors.
No previous work has explicitly studied this link between the type of client-employee incentive pay (i.e., based on financial or nonfinancial performance measures), client-generated information, and the audit performed. Prior studies show that auditors plan more procedures when a client's internal auditors receive incentive compensation (DeZoort et al. 2001) and when the client has explicit incentive to misstate financial results (Glover et al. 2000) However, this work does not distinguish between incentives based on different types of performance measures. Other related work examines how different types of information, i.e., financial or nonfinancial information, affect the work that auditors do. Specifically, auditors use financial information more than nonfinancial information in audit-planning tasks where financial statement assertions are tested (Dilla and Stone 1997). In addition, auditors emphasize financial information more than nonfinancial information in determining the overall scope of an audit (Cohen et al. 2000). Prior work on the effects of different types of information on the level of required audit procedures, however, does not include a link to different types of client-employee incentive pay.
The purpose of this research is to investigate experimentally whether variations in the types of performance measures used in client-employee (2) incentive compensation contracts will lead to variations in audit planning. Using auditing guidelines (CICA 1997), the bonus-plan hypothesis (Healy 1985), and attribution theory (DeZoort et al. 2001; Petty and Wegener 1998; Chaiken and Maheswaran 1994), we predict that variations in the performance measures used to determine client-employee bonuses will be associated with variations in audit-planning judgments. Specifically, the extent and scope of audit-planning judgments are expected to be greater when manager bonuses are based on financial rather than nonfinancial performance measures, which, in turn, are expected to be greater than when managers do not receive a bonus.
In the current study, 110 Canadian auditors at the senior level or higher from one Big 4 firm took on the role of the audit manager planning the upcoming audit of a hotel client. The independent variable, client compensation scheme, was incorporated into the case. The three compensation schemes are: (1) fixed salary only, (2) fixed salary plus bonus based on financial performance measures, and (3) fixed salary plus bonus based on nonfinancial performance measures. Participants were asked to make several audit-planning judgments.
The results of this study are as follows. We find that audit-planning judgments in general differ in magnitude with differences in client-employee compensation contracts. Specific types of client-employee bonuses, i.e., based on financial and nonfinancial performance measures, are associated with relatively higher audit-planning judgments, relative to the case of no bonuses. Our main result is that more extensive audit plans are made for a client who pays employees bonuses based on financial performance measures than for a client who pays employees bonuses based on nonfinancial performance measures.
This paper makes three contributions to the accounting literature. First, the study highlights that audit-planning judgments will vary in magnitude across different types of client-employee compensation contracts, such as contracts that incorporate bonuses based on either financial or nonfinancial performance measures. Hence, the study has possible implications for audit firms that emphasize an audit approach focused on nonfinancial performance measures; audit-firm training programs, for example, may need to consider how client-manipulated nonfinancial performance measures can provide misleading operational signals in detecting material misstatement of financial information.
Second, the paper adds to a small but important literature on the effect of different performance measures in the employee incentive contracts of large organizations. The differential incentive effect studied here is in the context of the work of external auditors, which has not previously been investigated in the literature. Third, this paper provides empirical evidence of the consistency between auditor behavior and required audit standards. It shows that auditors conduct work in accordance with general prescriptions regarding the potential for manipulation of bonus contracts.
This paper proceeds as follows. In the second section, we present background to the context of the study and the study's hypotheses. In the third section, we outline the experimental design. In the fourth section, we present the data analysis. In the fifth section, we summarize the findings of the paper and present directions for future research.
BACKGROUND AND HYPOTHESES DEVELOPMENT
Incentive Contracting
Compensation schemes that incorporate bonuses based on financial performance measures are well established (Murphy 1998; Ittner et al. 1997). However, research evidence suggests that such measures can be manipulated for incentive purposes by affecting related accruals (Healy 1985; Holthausen et al. 1995; Guidry et al. 1999). Accordingly, incentives based on financial performance measures can influence managers to take opportunistic actions that conflict with the best interests of the owners of the firm.
Using predictions based on agency theory, several papers have explored the manipulation of incentives based on financial performance measures through strategic accruals management. The papers find, across firms, a correlation between earnings-based incentive structures and the level of reported earnings. (e.g., see Healy 1985; Holthausen et al. 1995; Guidry et al. 1999) An implication for auditing is that such manipulations might increase the risk of material misstatement in the financial statements and thus should affect the audit plan. Section 5135 (Appendix A 1.a.(i)) of the Canadian Institute of Chartered Accountants (CICA) handbook specifically lists the existence of bonus contracts based on financial results as a factor that might increase the risk of material misstatement. The handbook suggests that an increased risk should cause the auditor to question the internal control system, obtain more reliable evidence, and expand the extent of audit procedures performed. In the U.S., the recently issued SAS No. 99 explicitly identifies "significant portions of [management] compensation ... being contingent upon...
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