Reported earnings, auditor's opinion, and compensation: theory and evidence

We study the effect of the auditor's independence on executive compensation and executive effort allocation. Using principal-agent theory, we examine a compensation contract involving two signals, one for incentives and the other for control. The incentive signal is the earnings reported by the executive and the control signal is the auditor's opinion. The optimal weights on earnings and audit opinion in the agent's compensation contract are obtained in a LEN (linear compensation plan, exponential utility, normally distributed outcome) framework. The pay-performance sensitivity (incentive weight on earnings) increases monotonically as the auditor becomes more independent. However, the pay-opinion sensitivity (incentive weight on audit opinion) first increases and then decreases as the auditor becomes more independent. We test some of these results empirically with publicly available data and find that the executive is rewarded for higher reported earnings and penalised for audit qualification. Evidence also shows that the pay-performance sensitivity increases as the auditor becomes more independent.