Audit‐Planning Judgments and Client‐Employee Compensation Contracts

This paper investigates, in a laboratory setting, the impact of different types of client‐employee compensation contracts on auditors' audit‐planning judgments. Self‐interested client‐executive actions (motivated by executive incentive pay) have been claimed to be at the core of a 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 a 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.