An International Meeting of the American Accounting Association American Accounting Association 2006 Annual Meeting August 6–9, 2006 Washington, D.C.

Atasi Basu
Utica College

Randal J. Elder
Syracuse University

Mohamed Onsi
Syracuse University

Abstract: This paper studies the effect of auditor's independence and opinion on executive compensation and executive effort allocation. Using the principal agent theory, we examine a compensation contract involving two signals, one for incentive and one for control. The incentive signal is the earnings reported by the executive (agent) 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 framework. The weights show that the owner (principal) rewards the agent for higher earnings and penalize for audit qualification. The pay-performance sensitivity (the weight on earnings) increases monotonically as the auditor becomes more independent. Interestingly, the pay-opinion sensitivity (the weight on audit opinion) first increases and then decreases as the auditor becomes more independent. Some of these results are tested empirically with publicly available data.

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