Modified Audit Reports, Executive Compensation and CEO Turnover

Abstract

This paper shows that unfavourable audit reports cause significant falls in executive compensation. Economically, the effects are larger than accounting and market performance measures, and are particularly strong when: reports are modified for issues other than going-concern uncertainties; or, reports are newly modified. The first finding is consistent with the view that managers control the quality of financial reporting whereas going-concern uncertainties can arise due to exogenous changes in operating conditions. The second finding is consistent with prior evidence that newly modified reports signal more serious problems than repeated modified reports. Finally, there is a weak positive association between modified reports and CEO turnover. Overall, the results indicate that modified reports are costly to company executives.