Risk Perception and Audit Fees: How Do Auditors Respond When Working with Hometown CEOs?

ABSTRACT

This study examined how auditors respond to hometown CEOs using social identity theory. We found that hometown CEOs negatively affect audit fees through the reputation concerns and information advantages mechanisms, reflected as lower financial information and litigation risks in their firms. Moreover, this negative relationship is more pronounced among firms immersed in a stronger clan culture, non-state-owned firms, and those whose CEOs enjoy longer tenures, while it is less pronounced in firms whose CEOs possess foreign residency rights. These findings have implications for firms’ executive employment, auditors’ pricing decisions, and regulators’ policy-making decisions.

KEYWORDS:

• Hometown CEOs
• audit fees
• social identity theory
• reputation concerns
• information advantages

JEL:

• M12
• M41
• M42

Disclosure Statement

No potential conflict of interest was reported by the author(s).

Notes

1. AU Section 312 and SAS No.47 require that auditors consider the audit risk model as part of their audit planning and pricing, as well as indicate that the acceptable audit risk is the function of inherent, control, and detection risks. Similarly, the Auditing Standards of China for Certified Public Accountants No.1211 also require auditors to understand their client firms and evaluate their risk of material financial misreporting based on external factors, such as industry and regulation environments, operation risk, internal control, and managers’ integrity and ethics, etc.

2. One may be concerned that the 10,251 observations of firms excluded from our sample due to missing CEO hometown information (excluding group) are fundamentally different from sample firms (retaining group). To address this concern, we compared the distribution of these two groups and conducted a Heckman two-stage approach in robustness tests to mitigate the potential sample selection bias. The results (which are untabulated but are available upon request) show that the year and industry distribution of these two groups are similar, indicating that our sample is indeed representative.

3. Because the CSMAR database provides the birthplace information of approximately 25% of all CEOs, and we alternatively identified hometown CEOs (HTCEO_alt) according to whether their birthplace is consistent with their firm’s headquarters, we adopted the data on CEOs’ birth places derived from CSMAR. However, we obtained a final sample of 5,818 firm-year observations after excluding those with missing data on CEOs’ birthplace. The results (which are untabulated but are available upon request) show that the relationship between HTCEO_alt and audit fees is insignificant. A possible reason for this is that excluding large quantities of observations with missing data on CEOs’ birthplace meant that the final sample was not representative. Therefore, in this study, we identify CEOs’ hometowns according to their native place data.

4. We alternatively extracted the province from firms’ registered addresses to identify where their headquarters are located and to define hometown CEOs (HTCEO_register) according to whether their native place is consistent with their firm’s headquarters. The mean value of HTCEO_register is close to that of HTCEO. Finally, we regressed audit fees on HTCEO_register based on the baseline specification and sample. The results (which are untabulated but are available upon request) are similar to the baseline results in column (1) of Table 4.

5. We also further controlled the audit firm-fixed effects to exclude the influence of non-time varying audit firm characteristics on audit fees. The results (which are untabulated but are available upon request) show that the relationship between hometown CEOs and audit fees is negative and significant, indicating that unobservable audit firm factors do not influence our findings.

6. We alternatively defined the hometown CEOs at the city level (HTCEO_city), according to whether their native place is consistent with the city where their firms’ headquarters are located, and regressed audit fees to HTCEO_city based on the baseline specification. The results (which are untabulated but are available upon request) show that the coefficients of HTCEO_city are negative and significant, providing additional support for our main results.

7. The p-value of the under-identification test is 0.0000, the F-value of the weak instrumental variable test is 435.352, and the over-recognition test result shows “equation exactly identified,” indicating that there were no under-identification, weak instrumental variable, or overidentification problems for the instrumental variable.

8. We replicated the regressions in Table 7 using the city level measure of hometown CEOs (HTCEO_city) as the explanatory variables. The results (which are untabulated but are available upon request) show that HTCEO_city also negatively affects firms’ financial information risk and litigation risk, providing additional support for the reputation concern and information advantage mechanisms through which hometown CEOs influence audit fees.

9. For the robustness checks, we defined a dummy variable Short_AFtenure to measure auditor tenure, which has a value of 1 for firms in the bottom 25% quantile of auditor tenure and is 0 for firms in the top 25% quantile of auditor tenure. Then, we added in the variable Short_AFtenure and its interaction term with HTCEO into our baseline model and re-ran the regression. The results (which are untabulated but are available upon request) show that the coefficient of HTCEO*Short_AFtenure is significantly negatively at the 5% level, indicating that CEO’s hometown identity has a greater influence on auditors’ risk perception and pricing decisions during the early years of their client relationship.

10. According to Interim Measures of the State Council concerning the Retirement and Resignation of Workers in China, we defined CEOs close to retirement as those whose age is near the retirement threshold value (60 years for males and 50 years for females). Specifically, we excluded observations involving CEOs whose age is one (with 2,107 observations being dropped), three (with 3,314 observations being dropped), and five years (with 5,223 observations being dropped) of proximity to retirement, respectively.

11. We replicated the regressions in Table 8 using the city level measure of hometown CEOs (HTCEO_city) as the explanatory variables. The results (which are untabulated but are available upon request) show that the moderating effects of clan culture, state ownership and CEO tenure still stand. However, the coefficient of the interaction term HTCEO_city*Residency is insignificant, which may result from some observations with missing value of CEOs’ hometown city being dropped.

12. We replicated the regressions in Table 9 using the city level measure of hometown CEOs (HTCEO_city) as the explanatory variables. The results (which are untabulated but are available upon request) show that the coefficients of HTCEO_city are negative and significant, providing additional support for hometown CEOs influencing auditors’ reporting decisions except for audit pricing.

Additional information

Funding

This article is sponsored by the Innovation Platform Open Fund of Education Department of Hunan Province [No. 19K021].