Boardroom Backscratching and Audit Fees

Abstract

SUMMARY This study investigates the impact of backscratching between the CEO and directors on a firm's future performance, financial reporting quality, and audit fees. We find that the presence and extent of boardroom backscratching are associated with weaker future performance, poorer quality financial reporting, and higher audit fees. We attribute these findings to backscratching firms' increased business and information risks inducing auditors to exert greater effort and charge risk premiums in response to heightened audit engagement risks. We observe consistent results when extending our investigation to backscratching between the CEO and audit committee and between the CEO and the CFO, given that the audit committee and the CFO influence financial reporting quality. Finally, we provide evidence that backscratching firms display greater audit report lag and a higher likelihood of receiving a going concern audit opinion. Our study offers insights to regulators concerning policy development to strengthen board effectiveness and remuneration disclosures.

Fair value hierarchy, bargaining power, and audit pricing across audit firms’ client portfolios

“…Additionally, a prediction model is not needed to test our hypotheses and, thus, further supports why we do not utilize the log of audit fees. Our control variables are based on prior audit fee research (Bills et al., 2017; Hanlon et al., 2019; Hay et al., 2006), Year FE represents year fixed effects for the company's fiscal year, Industry FE represents industry fixed effects by four‐digit SIC codes, and i and t represent company and fiscal year indicators, respectively. All variables are defined in Appendix A.…”

What is it going to cost? Empirical evidence from a systematic literature review of audit fee determinants

“…Against this background, it should come as no surprise that Ettredge et al (2018), Wang et al (2009), Wang and Zhou (2012) and Bentley et al (2013) completely dispense with an assumed effect direction. In more recent studies, the tenure of audit engagement is calculated by the total logarithm of the number of years (Huang et al 2017;Gul et al 2018;Hanlon et al 2019;Mohrmann et al 2019). We decided to use this as a new variable for calculation reasons.…”

Boardroom backscratching and stock price crash risk

“…A plausible reason for such prior findings is that a construct such as the proportion of board independence mostly captures board independence in appearance but not necessarily board independence in substance. Hanlon et al (2019) demonstrate that a director who meets the regulatory definition of independence 4 (i.e., independence in appearance) can still backscratch with the CEO, which impairs board independence in substance. As boardroom backscratching unambiguously reflects a lack of board independence in substance, using this construct can provide important empirical insights on whether board independence matters for stock price crash risk.…”

“…5 Second, it is worth investigating whether boardroom backscratching influences stock price crash risk based on two competing perspectives. Hanlon et al (2019) establish a link between boardroom backscratching and poor financial reporting quality, while Hutton et al (2009) connect poor financial reporting quality with an increased risk of stock price crashes. By drawing on these relationships highlighted by Hutton et al (2009) and Hanlon et al (2019), our study expands upon their findings and examines the potential impact of boardroom backscratching on a firm's stock price effectiveness of board monitoring and the high compensation that directors and CEOs receive, academic investigation on boardroom backscratching is still limited.…”

“…To test the hypothesis in our study, we estimate concurrent excess CEO and director compensation as proxies for boardroom backscratching. Following the methodology in Hanlon et al (2019), we separately regress (i) the total compensation of the CEO and (ii) the average total compensation of all board directors (excluding the CEO as an executive director) on firm, CEO and governance characteristics that are recognized in prior literature as compensation determinants (Armstrong et al, 2012;Conyon & Peck, 1998;Conyon et al, 2009;Core et al, 1999;Finkelstein & Hambrick, 1989, Mehran, 1995Palia, 2001). Based on each form (i.e., CEO and director compensation) of regression, we then identify firms with positive residuals for both CEO and director compensation in a given year and classify these firms as backscratching firms.…”