The effect of general counsel prominence on the pricing of audit services

J. Account. Public Policy 38 (2019) 1–14

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The effect of general counsel prominence on the pricing of audit services John L. Abernathy a, Thomas R. Kubick b,⇑, Adi N.S. Masli b a b

Kennesaw State University, United States University of Kansas, United States

a r t i c l e

i n f o

Article history: Available online 11 February 2019 Keywords: Audit fees Audit engagement risk Executive compensation General counsel

a b s t r a c t We investigate the effect of corporate general counsel (GC) ascension to the senior management team on the pricing of audit services. Prior research suggests that the GC position may have a significant influence in setting the tone at the top by promoting corporate integrity, ethics, and serving as a governance and monitoring mechanism, but also recognizes that prominent GCs may face ethical dilemmas, causing them to disregard professional responsibilities to curry the favor of the CEO and other executives. Using audit fees to proxy for audit engagement risk, we find a negative association between GC ascension to top management and audit fees. We investigate the mechanisms behind this relation and find GC ascension is associated with a reduction in both default risk and financial misstatement risk, which supports auditors’ perceived reduction in client business risk and audit risk, respectively. Ó 2019 Elsevier Inc. All rights reserved.

1. Introduction We examine whether auditors’ perception of engagement risk, as proxied by audit fees, changes for client firms that ascend the corporate general counsel (GC) to the top management team.1 The auditor’s engagement risk primarily consists of three components: (i) client business risk, which is the risk associated with the client’s survival and profitability; (ii) audit risk, which is the risk that financial statements are materially misstated; and (iii) auditor business risk, which is the risk of potential litigation and loss of reputation for the auditor (Johnstone, 2000; DeFond and Zhang, 2014).2 Despite the fact that auditing standards emphasize assessing ‘‘tone at the top” as a component of engagement risk (e.g., Auditing Standard No. 5), there is relatively little empirical evidence regarding whether the managerial attributes of the client affect the auditor’s assessment of engagement risk.3 Given the debate on whether or not the GC serves as an effective governance mechanism when he or

⇑ Corresponding author. E-mail address: [email protected] (T.R. Kubick). As discussed in more detail later, consistent with prior literature (e.g., Menz, 2012), we define the top management team as the top five highest paid executives within the firm. We consider a GC to be ‘‘prominent” if he or she is a member of top management. Also consistent with prior work (Kwak et al., 2012; Abernathy et al., 2016; Hopkins et al., 2015; Ham and Koharki, 2016), we identify a GC if their title contains variations of the following keywords: general counsel, chief legal officer, chief law officer. 2 This definition is similar to the AICPA’s definition of engagement risk (AICPA, 1994). 3 Cohen and Hanno (2000) find that management control philosophy affects auditors’ judgments in audit engagements. Krishnan and Wang (2015) examine the relation between managerial ability and engagement risk, while recent papers investigate the relation between CEO equity incentives and audit pricing (e.g., Fargher et al., 2014; Billings et al., 2014). 1

https://doi.org/10.1016/j.jaccpubpol.2019.01.001 0278-4254/Ó 2019 Elsevier Inc. All rights reserved.

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she ascends to top management (Hopkins et al., 2015; Kwak et al., 2012; Nelson and Nielsen, 2000), it is important to understand how auditors perceive the GC function as it pertains to engagement risk. By investigating auditor assessments of engagement risk, we can gain useful insights about the perceived effects of prominent GCs. In performing his or her duties, the external auditor assumes a public and social responsibility (Carmichael, 2004; Broadley, 2005; Sikka, 2009). Professional auditing standards direct auditors to carry out comprehensive assessments of the client’s risks (Lyon and Maher, 2005; DeFond and Zhang, 2014). Auditors have a unique information advantage and are able to review their client’s board of director meeting minutes, access proprietary information, and make inquiries to management and other key corporate players (DeFond and Zhang, 2014; Aobdia, 2015; Dhaliwal et al., 2016). Consequently, auditors gain a deep understanding of the client’s business operations and their risk assessments may portray the client’s true underlying risk factors. Furthermore, observed audit pricing is informative as researchers find it to be a leading indicator of the client’s future operating and financial risk (Stanley, 2011; Hribar et al., 2014). In recent years, the role of the GC has expanded and in many firms, the GC is a member of the top management team (Hopkins et al., 2015; Ham and Koharki, 2016). Traditionally, the GC has been viewed as the corporate gatekeeper (Duggin, 2007; Cox, 2007) or governance monitor of the firm (Larcker and Tayan, 2011). That is, the GC is primarily responsible for protecting the company from litigation risk, acting as the ‘‘ethics police” (Winders, 2005), monitoring compliance within the organization, and representing shareholder interests by upholding professional standards of conduct (DeMott, 2005; Jagolinzer et al., 2011; Kwak et al., 2012; Hopkins et al., 2015).4 As the role of the GC has expanded, there has been concern that the GC, as a member of top management can serve as a facilitator of management interests (Hazard, 1997; Duggin, 2007). That is, as a member of top management, GCs may feel pressure to show allegiance to their top-management peers, namely the CEO and CFO (Duggin, 2007). Consistent with this view, Nelson and Nielsen (2000) suggest that GCs may discount their gatekeeping role in order to be seen as part of the company. Ham and Koharki (2016) provide evidence that bond market participants perceive that GCs may place less emphasis on gatekeeper responsibilities upon appointment to senior management. Thus, it is unclear ex ante the extent to which the GC serves the interests of top management or shareholders when there is a conflict of interest (Hazard, 1997). Concerns about conflicting incentives of the GC have been validated in many corporate failures of the early 2000s and in the options backdating scandal of the mid 2000s (Cutler, 2004; Jagolinzer et al., 2011). Further, the SEC brought 76 actions against GCs from 2002 to 2005 that ranged from failure to disclose information to executives or auditors, options backdating, and direct participation in company fraud (Cox, 2007; MacLean, 2007). Such failures led to changes in regulation with respect to the role of the GC. Specifically, SOX formally designated the GC as a corporate gatekeeper responsible for communicating issues to an appropriate level of executive management or to the SEC for issues of fraud or illegal activity (SEC, 2002). The American Bar Association followed suit by revising its professional standards to the view that the GC acts as a gatekeeper (Coffee, 2006). Further, many provisions of the Dodd-Frank Act of 2010 fall under the purview of the GC, including whistleblower provisions (Veasey and Di Guglielmo, 2012). Indeed, the significant increase in attention from regulators and policymakers has certainly raised public interest in the influence of the GC in corporate policy. The role of the GC, particularly with respect to financial reporting, has recently received considerable attention from regulators and academic researchers (Efendi et al., 2013; Kwak et al., 2012; Hopkins et al., 2015; Ham and Koharki, 2016). Research provides mixed evidence on the role that the GC, as a member of top management, plays in the firm. On one hand, consistent with the perspective that the GC plays the gatekeeper role within the firm, Kwak et al. (2012) find that companies with a GC in top management are more likely to issue management earnings forecasts that are less optimistic and more accurate, concluding that prominent GCs play an important governing and monitoring role in their company’s disclosure policies. Hopkins et al. (2015) find that the presence of a prominent GC reduces the likelihood of restatements and is associated with a lower fraud propensity, consistent with the idea that GCs are gatekeepers and help prevent violations of GAAP and SEC regulations. In addition, Jagolinzer et al. (2011) provide evidence that GCs limit the extent to which corporate insiders use their private information to extract rents from shareholders. On the other hand, a stream of literature finds evidence consistent with the facilitator role of the GC within the firm. Specifically, Hopkins et al. (2015) find that firms with GCs in top management use greater discretion in accounting choices than other firms.5 Furthermore, Ham and Koharki (2016) document an increase in firms’ credit risk subsequent to promoting the GC to top management, which suggests bond market participants are concerned that the GC, as a member of top management may act as a facilitator of management interests more so than an internal gatekeeper of the firm’s compliance function, which increases credit risk. Thus, given the auditor’s comparative advantage in looking inside the company and objectively assessing the relationship between the GC and senior management as well as the tone at the top, the extent to which GC ascension is associated with auditor’s perception of engagement risk provides potentially interesting insights on the countervailing roles of the GC that are being debated in the literature.

4 Brown (2003) provides survey evidence consistent with the role of gatekeeper, in that corporations hire in-house attorneys to prevent the company from being involved in litigation. Furthermore, Duggin (2007) notes that the GC has a professional obligation for oversight of all legal aspects of the corporation’s operation and governance. 5 However, Hopkins et al. (2015) find that firms with GCs among top management have lower incidence of restatements and reduced fraud propensity scores, consistent with the GC’s role as gatekeeper.

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Audit pricing is a meaningful setting to examine our research question because auditors are sensitive to the risk that individual firms bring to the audit engagement (which we broadly refer to as engagement risk), and this risk should be incorporated into audit fees (DeFond and Zhang, 2014). Simunic (1980) proposes that auditors respond to engagement risk by exerting more effort and/or by charging higher audit fees to compensate for greater risk. This positive relationship between engagement risk and audit fees is well established in the literature (see Hay et al., 2006 for a review). As such, audit pricing can provide information about changes in engagement risk when the GC ascends to top management. Specifically, if auditors believe that GC ascension reduces engagement risk, then audit fees may decrease. However, if auditors believe that GC ascension may lead to the GC discounting his or her gatekeeping responsibilities in order to serve as a facilitator of top management interests, thereby potentially exacerbating engagement risk, then we expect an increase in audit fees. To test the effect of GC ascension into the top management team on audit pricing, we employ firm fixed effects regressions and find a negative association between GC prominence and audit fees. We follow extant research (Kwak et al., 2012; Hopkins et al., 2015) and use top management compensation to identify firms that have placed extra emphasis (through compensation) on the GC role. This provides more powerful identification, as the importance of the GC becomes more salient when the GC is a member of the top management team. We also employ a ‘‘changes” (first differences) regression specification and find results confirming that the ascension of the GC to top management is associated with a reduction in audit fees. Our results support the notion that auditors perceive that the GC acts as an important governance and monitoring mechanism (i.e., the gatekeeper role of GC) that reduces the auditor’s engagement risk. In further analyses, we examine potential mechanisms behind the association between GC prominence and audit fees. We test whether GC prominence is associated with client default risk, the likelihood of accounting misstatements, and class action lawsuits. These empirical measures capture client business risk, audit risk, and auditor business risk, respectively, which are the primary mechanisms underlying audit engagement risk. We find that default risk and accounting misstatement risk are lower for years in which the GC is prominent, which suggests an improvement in client business risk and audit risk, respectively. Although we do not observe a statistically significant relationship between GC ascension and class action lawsuits, we recognize that our sample of relatively large and established (S&P 1500) firms does not have a high incidence of class action lawsuit activity thereby providing a relatively low power test. However, we interpret the improvement in client business risk and audit risk as indirectly improving auditor business risk. Collectively, these additional tests provide some insight into the mechanisms behind the association between GC ascension and audit fees. As documented in prior work, poor financial reporting (as evidenced by a restatement or poor internal controls) is associated with higher audit fees because auditors perceive higher risks. We show that audit fees increase less after a financial reporting problem when there is a prominent GC in the company. Therefore, auditors perceive that the GC can be effective in limiting the adverse effects associated with financial misreporting through more effective remediation. Finally, we perform a number of additional analyses that extend our main findings. Our study makes several contributions. First, we contribute to the stream of auditing research that examines the association between clients’ executives and the pricing of audit services (Johnstone, 2000; Krishnan and Wang, 2015). Our evidence suggests that auditors evaluate changes in top management and perceive that the ascension of the GC to top management reduces audit engagement risk. As such, the evidence presented herein also provides some insights on the recommendations of the COSO (2004) report, which calls for external auditors to assess integrity and ethical tone within top management as part of their assessment of a client’s fraud risk (Beasley et al., 2010). Furthermore, prior research examines the influence of corporate governance, including composition of corporate boards, on audit fees (Carcello et al., 2002), but extant research is sparser on the association between composition of top management and audit fees. Second, we contribute to the emerging line of research examining the consequences of having a GC as a member of top management. One stream of literature provides evidence that the GC, as a member of top management, acts as a gatekeeper (Jagolinzer et al., 2011; Kwak et al., 2012). On the other hand, a stream of literature provides evidence that the GC, as a member of top management, acts as a facilitator (Hopkins et al., 2015; Ham and Koharki, 2016). We add to this emerging body of research by documenting that auditors appear to perceive GC ascension to top management as a risk-reducing mechanism, consistent with GCs maintaining the role of gatekeeper. Finally, our study should be of interest to regulators, auditors, executives (including practicing GCs), and investors. Corporate scandals involving the GCs of Tyco International Ltd.; Comverse Technology, Inc.; McAfee, Inc.; and Enron Corporation, among others, have brought about increased scrutiny on the GC in promoting corporate ethical responsibility. Furthermore, the role and influence of the GC is highlighted in SOX provisions, PCAOB auditing standards and the DoddFrank Act of 2010. While there is much debate on how much influence and power the GC, as a governance monitor, should possess within the organization, we conclude that ascension of the GC position into top management has beneficial effects on audit pricing.

2. Background and hypothesis development The audit fee model proposed by Simunic (1980) expresses audit fees as the sum of the cost of audit effort and an expected liability loss component. More specifically, Simunic (1980) presents a production view of the audit process; where (i) the external audit is driven by potential legal liabilities of auditors and their clients and (ii) certain firm specific factors that would cause the auditor to perform either more or less work during the engagement. Therefore, auditors can minimize

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their exposure to audit risk by performing a comprehensive risk assessment of their clients or by escalating audit effort as client risk increases, all of which raise audit fees (Seetharaman et al., 2002; Bell et al., 2001; Johnstone and Bedard, 2003; Krishnan et al., 2012). Hay et al. (2006) evaluate and summarize the large body of audit fee research and use meta-analysis to test the combined effect of the most commonly used independent variables. Their results suggest that audit fees are associated with measures of client characteristics and risks such as client size, litigation risk, client complexity, leverage and the inherent risk of accounts that have higher risk of error and require specialized audit procedures (i.e., inventory and receivables). However, auditors identify managerial characteristics as the second-most important factor affecting their assessment of litigation risk (Pratt and Stice, 1994). These managerial characteristics, broadly labeled ‘‘tone at the top,” have received significant attention from regulators as a way of evaluating and alleviating the possibility of management fraud. For example, SOX, the PCAOB’s Auditing Standard No. 5, Statement on Auditing Standards (SAS) No. 99, and the COSO Enterprise Risk Management model all suggest that tone at the top is imperative for an effective control environment and for reducing fraud (AICPA, 2002; COSO, 2004; PCAOB, 2007). Prior empirical research examines tone at the top by investigating the relation between the characteristics of CEOs and CFOs, composition of corporate boards and audit committees, financial reporting quality, litigation risk, and corporate governance.6 However, little is known about the effects of the GC, who is often a member of top management and who bears the responsibility for shaping and monitoring corporate governance within the firm (Jagolinzer et al., 2011). As the individual with the most direct and comprehensive responsibility for the legal aspects of an entity’s operation, the GC may have significant influence on the tone at the top, especially as it relates to ethics, integrity, and accountability (Hazard, 1997; DeMott, 2005; Duggin, 2007). The GC is responsible for advising and reporting to top management and the board of directors on legal issues, litigation risks, regulatory issues, key business decisions, ethical concerns, and financial and public relations issues (Friedman and Stewart, 2000). In addition, the American Bar Association Task Force on Corporate Responsibility states that the GC is one of the four most important private sector governance mechanisms for public firms (American Bar Association, 2003). SOX underscores the importance of the GC’s role as a monitoring and governance mechanism. Specifically, Section 307 of SOX emphasizes the importance of in-house counsel as an internal governance mechanism, by requiring in-house attorneys to report evidence of their firms’ material violation of securities laws to upper management. If upper management does not respond properly, in-house counsel must report potential violations directly to the audit committee, a separate committee of independent directors, or the entire board of directors. Further, the SEC requires a corporate lawyer to withdraw from representing the firm under certain circumstances, for example, when the firm’s CEO, and even the board of directors does not properly handle the problem reported by the lawyer (Henning, 2004; Sonne, 2010; Kwak et al., 2012; SEC Part 205 of 17 CFR, www.sec.gov/news/press/2003-13.htm). As stated by Kwak et al. (2012), the GC, as the head of the in-house legal department, assumes two fundamental roles: (i) advising CEOs and boards of directors on important business decisions and contracts, regulatory compliance, legal matters, and litigation risk, and (ii) monitoring CEOs’ unusual behavior against shareholders’ interest. Consistent with this view, a survey of 1216 American Corporate Counsel Association members indicates that the respondents view the role of the GC in reducing accounting or financial fraud is as important as that of CEO, COO or CFO (see ‘‘In-House Counsel Responsibilities in the Post-Enron Environment,” ACCA Docket, May 2003). More recently, the inaugural Deloitte (2011) Global Corporate Counsel Report indicates that in recent years the status of corporate counsel has increased significantly, where corporate counsel now holds a broader, more complex range of responsibilities within their organizations. The report also reveals that the corporate counsel has become the first source of advice for senior management when there is a serious legal or regulatory issue. The above discussion points to the notion that GCs assume an important role in corporate governance. Therefore, the ascension of the GC to top management can be viewed as a self-governance mechanism adopted by top management, because top management desires expert advice and a legal or compliance check on decision-making (Jagolinzer et al., 2011; Kwak et al., 2012). Being in top management, a GC is also more likely to gain access to the CEO, CFO, and other members of a company’s senior management team, which offers the opportunity for him or her to influence significant corporate decisions, as well as detect and prevent corporate wrongdoings at the highest levels (DeMott, 2005; Duggin, 2007; Deloitte, 2010, 2011). For example, Hopkins et al. (2015) find evidence that firms with highly paid GCs are less likely to restate their financials and have lower propensity to commit accounting fraud, thus suggesting that GCs are able to prevent violations of GAAP and securities regulations. Furthermore, a GC with top management status and influence can acquire ‘‘back-channel” information about key strategic decisions, which presents opportunities for the GC to engage proactively in identifying potential legal problems and educating constituents about relevant legal obligations (Hazard, 1997; DeMott, 2005; Duggin, 2007). In sum, ascension of the GC role in top management could positively signal or affect (i) the ethical and legal tone at the top, (ii) monitoring over management actions, (iii) corporate responsibility and accountability, and (iv) litigation risk management, all of which would reduce the auditor’s engagement risk – through client business risk, audit risk, and auditor business risk – thereby lowering audit fees.

6 See Menz (2012) for a review of literature regarding top management team members, Adams et al. (2009) for a review of the literature regarding corporate boards, and Bedard and Gendron (2010) for a literature review of corporate audit committees.

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While the above discussion argues that the ascension of the GC into top management could reduce audit engagement risk, one can make the case for an opposite effect. Specifically, Bainbridge and Johnson (2004) suggest that too often, GCs act as facilitators of management impropriety and recent corporate scandals were due partly to the lack of effective oversight by inhouse counsel. According to Duggin (2007), GCs constantly face pressure to compromise their professional standards in the interest of wealth maximization for the management team. She further suggests that there is a risk that relationships between the GC and other managers become so close that they compromise the ability of the GC to give objective legal advice. In addition, the appointment of, and the compensation paid to, the GC are typically approved by senior officers of the firm, particularly the CEO and CFO (DeMott, 2005; Duggin, 2007). As a result, it is unclear whether the GC will always actively monitor and evaluate management’s decision-making process (Nelson and Nielsen, 2000).7 Even as a part of senior management, the GC often reports to the CEO. As such, GCs have incentives to be seen as part of the company, rather than as obstacles to getting things done (Nelson and Nielsen, 2000; Duggin, 2007). That is, they may be pressured to alter their legal advice to suit short-term profit objectives (Duggin, 2007). In this sense, an unintended consequence of appointing a GC to top management is that the GC may discount his or her gatekeeping function to instead be a facilitator of management interests (Hazard, 1997; Ham and Koharki, 2016). Consistent with this view, Ham and Koharki (2016) find that firms who promote their GC to top management experience an increase in credit risk, which suggests bond market participants are concerned that the GC may act as a facilitator following promotion to top management. Taken together, if auditors believe the GC will be more inclined to assume the role of facilitator subsequent to ascension into top management, then the auditor will perceive higher levels of audit engagement risk and, in turn, charge higher audit fees. However, given significant judgment and discretion inherent in many corporate decisions, it is possible that a GC’s compromised objectivity may not necessarily result in greater legal risk and thus is an interesting empirical question. To examine our research question, we investigate the association between changes in audit fees and the change of GC presence in top management.8 Given the association between the change of GC presence in top management and changes in audit fees is unclear ex ante, we formulate the following hypothesis, stated in null form: H: GC ascension to top management is not associated with a change in audit fees. Prominent GCs can positively affect client business and audit risk (and ultimately auditor business risk) because they consult on key business decisions and strategies, constrain actions that harm shareholder interests, help ensure the reliability of financial reporting, and manage litigation risk (Duggin, 2007; Jagolinzer et al., 2011; Kwak et al., 2012). However, given the countervailing roles of the GC debated in the literature, prominent GCs can adversely affect the components of auditor engagement risk if the GC is primarily serving as a facilitator of management’s interests. We investigate these channels through which the GC can affect audit fees in further tests (Section 5) described later in the paper.

3. Sample selection and research methodology 3.1. Sample description Our dataset is constructed from the intersection of the Audit Analytics, Compustat, and ExecuComp databases spanning years 2004–2013. Our sample begins in 2004, when external auditors were required to conduct more extensive audit procedures and adhere to stricter rules, guidelines and standards following the passage of the Sarbanes-Oxley Act of 2002 (SOX). For example, PCAOB Standard No.2 added a new reporting requirement for auditors, stating that additional audit work is required to audit internal controls over financial reporting. Thus, starting our sample in 2004 ensures that our sample firms are subject to the same regulatory regime during the entire sample period. Consistent with prior research that links executive compensation to influence within the organization (e.g., Finkelstein, 1992; Finkelstein and Hambrick, 1996; Carpenter and Sanders, 2002; Bertrand and Schoar, 2003; Kwak et al., 2012; Hopkins et al., 2015), we define a prominent GC when he or she becomes one of the top five highest-paid executives of the firm. The ExecuComp database covers compensation data on top executives of companies in Standard & Poor’s (S&P) 500, S&P 400 MidCap, and S&P 600 SmallCap indexes. We limit our sample to the ExecuComp database because it provides yearly data on the compensation of the top five executives. The top five executives are part of a senior management team responsible for firm direction and strategy (Currim et al., 2012; Kwak et al., 2012). Consistent with prior research (Kwak et al., 2012; Hopkins et al., 2015) that examines GC ascension to the top management team, we identify GCs if their title contains the word ‘‘counsel,” ‘‘law,” or ‘‘legal” and they are in the top five highest paid executive cohort. We refer to firms with a GC in top management as ‘‘GC firms” and firms without a GC in the top man7 For example, the GC at Enron ignored the conflict of interest posed by ‘‘special-purpose-entity” transactions in which the CFO had a vested financial interest (Batson, 2003; DeMott, 2005). Additionally, Efendi et al. (2013) find that approximately 43% of the GCs at firms that had allegations of stock option backdating have been terminated. These examples suggest that at least some GCs have been either complicit or have failed to institute appropriate internal controls. 8 As noted by Chung et al. (2015), several frictions prevent auditors from fully adjusting audit fees. However, we do expect that on average, auditors will adjust fees to reflect a perceived change in engagement risk.

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Table 1 Sample distribution. Year

(1)

(2)

(3)

GC = 0

% of Column (3)

GC = 1

% of Column (3)

Total

Panel A. Fiscal year distribution 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

1118 1122 1054 1150 1333 1219 1127 1104 1060 1014

68.97% 68.50% 68.53% 68.41% 69.61% 65.05% 61.15% 61.44% 60.47% 59.09%

503 516 484 531 582 655 716 693 693 702

31.03% 31.50% 31.47% 31.59% 30.39% 34.95% 38.85% 38.56% 39.53% 40.91%

1621 1638 1538 1681 1915 1874 1843 1797 1753 1716

Total

11,301

65.04%

6075

34.96%

Industry group

(1)

(2)

17,376 (3)

GC = 0

% of Column (3)

GC = 1

% of Column (3)

Total

Panel B. Industry distribution Agriculture, Forestry, Mining, and Construction Manufacturing Transportation, Communications, Electric, Gas, And Sanitary Wholesale and Retail Trade Finance, Insurance, and Real Estate Services Public Administration

506 4694 825 1410 2116 1705 45

53.72% 65.27% 48.59% 74.80% 69.54% 66.52% 84.91%

436 2498 873 475 927 858 8

46.28% 34.73% 51.41% 25.20% 30.46% 33.48% 15.09%

942 7192 1698 1885 3043 2563 53

Total

11,301

65.04%

6075

34.96%

17,376

This table presents the sample distribution by fiscal year and by industry.

agement team as ‘‘non-GC firms.” Based on this distinction, we create a binary variable, GC, which equals 1 for GC firms and 0 for non-GC firms. Table 1 presents the sample distribution for our study. As presented in Panel A, our sample includes 11,301 non-GC firmyears (GC = 0) and 6075 GC firm-years (GC = 1). In 2004, there are 503 firms with GC presence in the top management team during the year. The number of firms with prominent GCs steadily increased to 716 in 2010, before decreasing to 693 in 2011. Panel B presents the industry distribution for our sample. The greatest frequency of firm-year observations with a prominent GC belongs to the manufacturing industry group (n = 2498), followed by finance, insurance, and real estate (n = 927). 3.2. Estimating the effect of general counsel ascension to top management on audit fees Our multivariate models rely on firm fixed-effects regressions, which focus on firm-level deviations and allow us to examine the association between within-firm changes in GC prominence and audit fees. Our regressions control for numerous financial characteristics and audit engagement factors likely to affect audit fees. Following the audit fee model developed by Simunic (1980) and Simunic and Stein (1996), audit fees reflect the economic costs to auditors, which are determined by client size, complexity, performance, risk, financial reporting quality, and other client-specific characteristics (Hay et al., 2006). Thus, we use the following model to test our hypothesis:

AUDFEE ¼ b0 þ b1 GC þ bj CONTROLS þ FIXEDEFFECTS þ e

ð1Þ

The variable AUDFEE is the natural log of audit fees and GC is an indicator variable that equals one if a firm has a general counsel in the top five highest-paid executive cohort, and zero otherwise. CONTROLS represent a vector of control variables as defined in Appendix A. Importantly, we include firm fixed effects, to isolate the effect of our variable of interest (GC) on audit fees because latent, time-invariant firm characteristics may render pooled ordinary least squares estimates inconsistent if these unobservable characteristics are also correlated with GC or our control variables. We employ a semi-log linear framework, modeling the natural log of audit fees as a function of GC and controls. This allows us to interpret the GC coefficient as a semielasticity (i.e., a negative GC coefficient indicates a percentage reduction in audit fees when a firm ascends a GC to the top management team). In all of the regression models, we cluster standard errors by firm. To reduce the influence of outliers, we winsorize the continuous variables at the 1st and 99th percentiles. In additional analyses, we present results from regressions modeling the variables as changes and measuring the postascension effect of GC on audit fees. This specification also allows us to examine the effect on audit fees for GC firms that

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have ascended their GC. Both designs have the advantage that they can account for potentially important time-invariant, unobserved heterogeneity that may be correlated with both GC prominence and audit fees.

4. Results 4.1. Univariate analyses Table 2 presents the descriptive statistics of our full sample, as well as partitions by GC (GC = 1) and non-GC firms (GC = 0). GC firms have higher average audit fees (AUDFEE), size (ASSETS), leverage (LEVERAGE), restructuring activity (RESTRUCTURE), special items (SPECIAL) are more likely to have a year-end in December (BUSY), and are audited more often by a Big 4 auditor (BIGN). On the other hand, GC firms have lower receivable and inventory ratios (RECINV), profitability (ROA), and sales growth (GROWTH) than non-GC firms. The far right columns report p-values for t-tests and Wilcoxon tests of differences in means and medians, respectively. Overall, our descriptive analysis highlights the importance of controlling for firm characteristics that may impact audit fees.

4.2. Multivariate analyses Table 3 reports the results of the associations between ascension of the GC to top management and audit pricing (Eq. (1)). As shown in regression (1), the coefficient on GC is negative and significant (Estimate = 0.022, p-value = 0.001), which indicates that audit fees are 2.2% lower for years in which the GC is prominent relative to years in which the GC is not prominent. This result is consistent with auditors viewing prominent GCs as a gatekeeper within top management, thereby lowering engagement risk. Consistent with expectations, we find positive associations between ASSETS, RECINV, LEVERAGE, LOSS, FOREIGN, MERGER, RESTRUCTURE, SPECIAL, BIGN, RESTATEMENT, and MATWEAK and audit pricing. Similarly, we also document a negative association for ROA, CHANGEAUDITOR and UNQUALIFIED.9

4.3. Changes analysis As an alternative specification, we compare the changes in audit fees from the year before GC ascension (t  1) to year of ascension (t) as well as through two years subsequent to ascension (t + 1 and t + 2). GCASCEND is an indicator variable taking the value of one if a firm has a prominent GC in years t, t + 1, and t + 2, but did not have a prominent GC in year t  1, and zero if a firm does not have prominent GC during any of those four consecutive years. Thus, we estimate Eq. (2) below using a changes specification:

DAUDFEE ¼ a0 þ a1 GCASCEND þ aj DCONTROLS þ FIXEDEFFECTS þ e

ð2Þ

where

DAUDITFEE is the change in a firm’s AUDFEE from year t  1 to year t, t + 1, and t + 2; GCASCEND is an indicator value taking the value of one if a firm has a prominent GC in years t, t + 1, and t + 2 but did not have a prominent GC in year t  1, and zero if a firm does not have a prominent GC during any of those four consecutive years; DCONTROLS is the change in the vector of control variables from year t  1 to year t, t + 1, and t + 2. We use year t  1 as the base year because all firms in this specification do not have a GC presence in top management during year t  1. A negative coefficient for GCASCEND would confirm that companies who ascend their GCs to top management experience a reduction in audit fees. Table 4 reports the results of the associations between ascension of GC to top management and changes in audit pricing (Eq. (2)). Regression (1) reports the results for changes in audit fees from t  1 to t. The coefficient on GCASCEND is negative and significant (Estimate = 0.038, p-value <0.01), which indicates that firms who ascend their GC to top management experience a lower change in audit fees in the year of GC ascension to top management. Regressions (2) and (3) present the results for changes in audit fees for one and two years subsequent to GC ascension, respectively. The coefficient on GCASCEND is negative and significant in both the t + 1 specification (Estimate = 0.069, p-value <0.01) and the t + 2 model specification (Estimate = 0.079, p-value <0.01). These results suggest that firms who promote their GC to top management experience a lower change in audit fees, and this result strengthens for two years subsequent to the year of ascension. 9 In untabulated tests, we examine the variance inflation factors (‘‘VIFs”) for our primary control variables and confirm that all VIFs are less than three, which are well below thresholds of concern (Kennedy, 2008).

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Table 2 Summary statistics. Variable

All Firms (N = 17,376) Mean

AUDFEE ASSETS RECINV LEVERAGE ROA GROWTH LOSS FOREIGN MERGER RESTRUCTURE SPECIAL BUSY BIGN CHANGE AUDITOR GOING CONCERN RESTATEMENT UNQUALIFIED MATWEAK

Median

14.448 7.726 0.257 0.560 0.036 1.089 0.176 0.320 0.474 0.370 0.023 0.711 0.915 0.030 0.012 0.078 0.610 0.039

14.337 7.627 0.219 0.551 0.042 1.069 0.000 0.000 0.000 0.000 0.000 1.000 1.000 0.000 0.000 0.000 1.000 0.000

GC = 0 (N = 11,301) Std. Dev. 1.024 1.721 0.193 0.247 0.103 0.217 0.381 0.467 0.499 0.483 0.151 0.453 0.279 0.169 0.110 0.268 0.488 0.195

Mean 14.398 7.668 0.272 0.545 0.037 1.093 0.175 0.318 0.477 0.363 0.022 0.683 0.905 0.031 0.012 0.077 0.607 0.040

Median 14.266 7.540 0.233 0.532 0.044 1.072 0.000 0.000 0.000 0.000 0.000 1.000 1.000 0.000 0.000 0.000 1.000 0.000

GC = 1 (N = 6075) Std. Dev. 1.057 1.787 0.199 0.249 0.104 0.217 0.380 0.466 0.500 0.481 0.146 0.465 0.293 0.172 0.107 0.266 0.489 0.197

Mean 14.541 7.834 0.230 0.587 0.034 1.082 0.178 0.324 0.467 0.383 0.026 0.762 0.933 0.028 0.013 0.080 0.616 0.038

Test of differences in

Median 14.454 7.769 0.193 0.584 0.040 1.062 0.000 0.000 0.000 0.000 0.000 1.000 1.000 0.000 0.000 0.000 1.000 0.000

Std. Dev.

Mean

Median

0.952 1.586 0.178 0.240 0.102 0.216 0.382 0.468 0.499 0.486 0.159 0.426 0.249 0.164 0.115 0.272 0.486 0.191

***

***

***

***

***

***

***

***

*

***

***

***

**

**

*

*

***

***

***

***

This table reports descriptive statistics for the variables included in the main regressions. The far right columns report results from tests of differences in means and medians, respectively. ***, **, * denote significance at the 1%, 5%, and 10% levels, respectively. To mitigate the influence of outliers, all continuous variables are winsorized at the 1% and 99% levels. See Appendix A for variable definitions.

Table 3 Firm fixed effects regressions of the association between GC prominence and audit fees. AUDFEE (1) Variables

coef

p-value

GC ASSETS RECINV LEVERAGE ROA GROWTH LOSS FOREIGN MERGER RESTRUCTURE SPECIAL BUSY BIGN CHANGE AUDITOR GOING CONCERN RESTATEMENT UNQUALIFIED MATWEAK Intercept Year Fixed Effects Number of observations R-squared

0.022*** 0.381*** 0.280*** 0.109** 0.260*** 0.013 0.036*** 0.025** 0.010* 0.016** 0.067*** 0.053 0.177*** 0.047*** 0.009 0.079*** 0.035*** 0.260*** 11.227*** Yes 17,376 0.5791

0.001 0.000 0.000 0.011 0.000 0.371 0.000 0.048 0.095 0.019 0.000 0.455 0.000 0.003 0.856 0.000 0.000 0.000 0.000

This table reports firm fixed effects regression results testing the association between GC prominence and audit fees. The dependent variable is the natural log of audit fees (AUDFEE). GC is an indicator variable that equals one if a firm has a general counsel in the top five highest-paid executive cohort, and zero otherwise. For brevity fiscal year fixed effects are included but not tabulated. Standard errors are clustered by firm. *, **, and *** denote significance at the 10%, 5%, and 1% levels, respectively. To mitigate the influence of outliers, all continuous variables are winsorized at the 1% and 99% percentiles. See Appendix A for variable definitions.

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J.L. Abernathy et al. / J. Account. Public Policy 38 (2019) 1–14 Table 4 GC ascension and changes in audit fees.

DAUDFEE Variables

t  1 to t (1)

t  1 to t + 1 (2)

t  1 to t + 2 (3)

coef

p-value

coef

p-value

coef

p-value

GCASCEND DASSETS DRECINV DLEVERAGE DROA DGROWTH DLOSS DFOREIGN DMERGER DRESTRUCTURE DSPECIAL DBUSY DBIGN DCHANGE AUDITOR DGOING CONCERN DRESTATEMENT DUNQUALIFIED DMATWEAK Intercept Industry Fixed Effects Year Fixed Effects Number of observations R-squared

0.038*** 0.349*** 0.051 0.166*** 0.234*** 0.020 0.023** 0.016 0.017** 0.003 0.064*** 0.133* 0.100* 0.070** 0.031 0.048*** 0.009 0.175*** 0.072 Yes Yes 6192 0.451

0.000 0.000 0.602 0.003 0.000 0.229 0.042 0.347 0.035 0.777 0.003 0.062 0.052 0.021 0.526 0.000 0.220 0.000 0.743

0.069*** 0.347*** 0.202** 0.193*** 0.291*** 0.005 0.009 0.041** 0.018** 0.020** 0.020 0.113* 0.114** 0.035 0.019 0.093*** 0.026*** 0.164*** 0.183 Yes Yes 6097 0.535

0.000 0.000 0.022 0.000 0.000 0.790 0.457 0.011 0.025 0.028 0.364 0.089 0.018 0.166 0.698 0.000 0.000 0.000 0.549

0.079*** 0.363*** 0.321*** 0.196*** 0.267*** 0.006 0.019 0.037** 0.018** 0.027*** 0.048* 0.094 0.140*** 0.040* 0.007 0.105*** 0.033*** 0.218*** 0.099 Yes Yes 6067 0.545

0.000 0.000 0.001 0.000 0.000 0.779 0.154 0.023 0.039 0.003 0.059 0.238 0.001 0.100 0.910 0.000 0.000 0.000 0.743

This table reports regression results testing the association between GC ascension and changes in audit fees. DAUDITFEE is the change in a firm’s AUDFEE from t  1 to t, t + 1, and t + 2. GCASCEND equals one if a firm has a prominent GC in years t, t + 1, and t + 2 but did not have a prominent GC in year t  1, and zero if a firm does not have a prominent GC during any of those four consecutive years. For brevity, industry and year fixed effects are included but not tabulated. Standard errors are clustered by firm. *, **, and *** denote significance at the 10%, 5%, and 1% levels, respectively. To mitigate the influence of outliers, all continuous variables are winsorized at the 1% and 99% percentiles. See Appendix A for variable definitions.

Table 5 Mechanisms underlying the association between GC prominence and audit fees. DEFAULT DISTANCE (1)

MISTATE (2)

CLASS SUIT (3)

Variables

coef

p-value

coef

p-value

coef

p-value

GC ASSETS RECINV LEVERAGE ROA GROWTH LOSS FOREIGN MERGER RESTRUCTURE SPECIAL BIGN GOING CONCERN UNQUALIFIED MATWEAK Intercept Year Fixed Effects Number of observations R-squared

0.216*** 0.138 2.655*** 8.118*** 2.959*** 0.867*** 0.495*** 0.041 0.412*** 0.555*** 0.812*** 0.279 0.945** 0.017 0.260* 12.888*** Yes 14,640 0.469

0.009 0.331 0.001 0.000 0.000 0.000 0.000 0.789 0.000 0.000 0.000 0.447 0.021 0.801 0.087 0.000

0.016* 0.051*** 0.022 0.005 0.041 0.011 0.019 0.009 0.001 0.005 0.031* 0.040 0.053 0.003 0.089*** 0.344*** Yes 17,376 0.012

0.050 0.000 0.753 0.891 0.364 0.447 0.115 0.468 0.863 0.519 0.099 0.209 0.164 0.722 0.000 0.001

0.004 0.042*** 0.131*** 0.005 0.033 0.004 0.022*** 0.009 0.005 0.008 0.016* 0.039** 0.047* 0.002 0.055*** 0.361*** Yes 17,376 0.012

0.424 0.000 0.002 0.810 0.289 0.685 0.002 0.352 0.278 0.120 0.075 0.040 0.069 0.651 0.000 0.000

This table reports firm fixed effects regression results testing the association between GC prominence and distance to default, accounting misstatements, and class action lawsuits. The dependent variable for Column (1), (2), and (3) is DEFAULT DISTANCE, MISTATE, and CLASS SUIT, respectively. GC equals one if a firm has a general counsel in the top five highest-paid executive cohort, and zero otherwise. For brevity, fiscal year fixed effects are included but not tabulated. Standard errors are clustered by firm. *, **, and *** denote significance at the 10%, 5%, and 1% levels, respectively. To mitigate the influence of outliers, all continuous variables are winsorized at the 1% and 99% percentiles. See Appendix A for variable definitions.

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J.L. Abernathy et al. / J. Account. Public Policy 38 (2019) 1–14

5. Additional analyses 5.1. Potential mechanisms behind the association between GC ascension and audit fees We document a negative association between GC prominence and audit fees. In this section, we examine the potential channels behind this association. In regression (1) of Table 5, we examine whether GC prominence is associated with a decrease in default risk. We measure default risk as the distance to default (DEFAULT DISTANCE) for the current year, computed using the Merton (1974) model, adjusted following the Bharath and Shumway (2008) approach which does not require an iterative solution.10 Thus, DEFAULT DISTANCE is an inverse measure of default risk (i.e., larger values indicate less default risk). In regression (2) of Table 5, we examine whether prominence of the GC is associated with accounting misstatements. The dependent variable MISSTATE is equal to one if the company misstates its accounting information beginning in the current year or the subsequent year, and zero otherwise. The dependent variable CLASS SUIT is equal to one if there is a class action lawsuit filed in the current year or the subsequent year. In regression (3) of Table 5, we examine whether prominence of the GC is associated with class action lawsuits.11 In all of these firm fixed effects regression models, we control for company size, complexity, performance, risk, and audit outcomes. As shown in Table 5, we find that GC prominence is associated with lower default risk and lower incidences of accounting misstatements. However, we do not find significant associations between GC and class action lawsuits. The results suggest that a GC’s effect on auditor engagement risk appears to be through lower default risk and improving the quality of accounting information. 5.2. The influence of existing financial reporting problems The GC functions as an advocate for the company when dealing with regulators, government bodies, and other external parties (DeMott, 2005; Duggin, 2007). This role often requires the GC to advocate for and defend the company in litigation proceedings and other affairs that involve sanctions (Nelson and Nielsen, 2000; Duggin, 2007). As stated by Duggin (2007; p.1007), the GC captains ‘‘both the defensive and offensive teams for their client entities and marshal[s] the resources to respond to legal actions ranging from routine civil claims to criminal investigations.” Furthermore, a 2006 report by the Association of the Bar of the City of New York affirms that the attorney has a mandate to zealously represent his or her clients (The Association of the Bar of the City of New York, 2006). Once a wrongdoing is revealed, the GC will attempt to minimize the firm’s exposure to associated sanctions and penalties (Chayes and Chayes, 1984; DeMott, 2005). Consequently, the auditor may perceive less risk when poor financial reporting clients have a GC in top management. To test this conjecture, we estimate the audit fee firm fixed effects model by including an interaction between GC and the variable PROBLEM, which equals one if the firm reports a restatement or has an internal control material weakness in either the current year or previous year. Table 6 shows the results from estimating this model. As expected, the coefficient on PROBLEM is positive and significant (Estimate = 0.129, p-value <0.01) suggesting that poor financial reporting, captured by the existence of weak internal controls or a restatement, is associated with higher audit fees. The coefficient on the interaction GC  PROBLEM is negative and significant (Estimate = 0.035, p-value <0.05), suggesting that the GC attenuates the positive association between financial reporting problems and audit fees. This result suggests that auditors perceive that GCs will be effective in managing the adverse effects associated with financial reporting issues. 5.3. Other analyses As an untabulated robustness test, we include additional control variables to Eq. (1) capturing prior lawsuit(s), CEO equity incentives, discretionary accruals, and governance characteristics. These additional control variables help isolate the effect of our variable of interest (GC) on audit fees while controlling for potential alternative explanations. We control for whether the firm was a defendant in litigation during the past three year period. We control for CEO equity incentives by including the sensitivities of CEO option portfolios to stock price (delta) and stock volatility (vega).12 Prior research finds a positive association between compensation-based incentives for risk-taking and riskiness of investment and financial policies (e.g., Coles et al., 2006; Brockman et al., 2010; Armstrong et al., 2013). Next, we control for the absolute value of discretionary accruals, computed following the performance-matching approach of Kothari et al. (2005). Finally, we control for governance characteristics because other governance mechanisms may be influencing audit pricing. We control for the number of directors on the board, the percentage of independent directors on the board, the percentage of independent directors serving on at least two other boards and whether the CEO is also chairman of the board. Including these additional control variables reduces our sample to 13,536 firm year observations. 10

Bharath and Shumway (2008) show that their adjustment to the Merton default model has improved predictive power in forecasting corporate distress. Hopkins et al. (2015) find that companies with a GC in the top management team are associated with lower instances of restatements. Morse et al. (2016) find that companies hiring lawyers as executives are associated with reductions in lawsuits against the company. 12 We follow the ‘‘one-year approximation” approach outlined in Core and Guay (2002) to estimate delta and vega. 11

11

J.L. Abernathy et al. / J. Account. Public Policy 38 (2019) 1–14 Table 6 The effect of financial reporting problems on the association between GC prominence and audit fees. AUDFEE Variables

coef

p-value

GC PROBLEM GC  PROBLEM ASSETS RECINV LEVERAGE ROA GROWTH LOSS FOREIGN MERGER RESTRUCTURE SPECIAL BUSY BIGN CHANGE AUDITOR GOING CONCERN UNQUALIFIED Intercept Year Fixed Effects Number of observations R-squared

0.016** 0.129*** 0.035** 0.388*** 0.290*** 0.109** 0.268*** 0.018 0.040*** 0.026** 0.010 0.017** 0.072*** 0.049 0.192*** 0.041** 0.016 0.042*** 11.158*** Yes 17,376 0.576

0.019 0.000 0.030 0.000 0.000 0.013 0.000 0.253 0.000 0.044 0.109 0.013 0.000 0.493 0.000 0.013 0.766 0.000 0.000

This table reports firm fixed effects regression results testing the impact of financial reporting issues on the association between GC prominence and audit fees. GC equals one if a firm has a general counsel in the top five highest-paid executive cohort, and zero otherwise. PROBLEM equals one if the firm reports an internal control material weakness or restatement in the current or previous year, and zero otherwise. For brevity, fiscal year fixed effects are included but not tabulated. Standard errors are clustered by firm. *, **, and *** denote significance at the 10%, 5%, and 1% levels, respectively. To mitigate the influence of outliers, all continuous variables are winsorized at the 1% and 99% percentiles. See Appendix A for variable definitions.

Results from this augmented specification reveal that prior lawsuits, board size, and board independence have positive and significant associations with audit fees. In contrast, the other additional control variables do not have a material effect on audit fees. Importantly, our inferences remain unchanged as we continue to find a negative and significant coefficient on GC. We also present a within-firm fixed effects regressions for GC firms, which focuses on firm-level deviations and allows the years in which treatment firms do not have GC prominence (but had GC prominence in the past or future) to serve as control observations against the years in which those same firms have GC prominence (in other words, allowing the GC firm to control for itself). Thus, this sample includes only firms that had its GC in top management team in at least one year during the sample period. The primary advantage of this approach is that the resulting coefficient estimates more accurately reflect the impact of a treatment, in this case, GC prominence, because they are based on measures for the same firm relative to years without GC prominence. Untabulated results confirm that audit fees for GC firm-years are significantly lower than for non-GC firm-years. In addition, for the same company, GC firm-years are associated with fewer accounting misstatements and lower default risk than for non-GC firm-years. We do not find any association between GC firm-years and lawsuits. In further robustness tests, we do not find that the association between GC and audit fees is stronger for GCs with higher equity incentives relative to GCs with lower equity incentives. Finally, we do not find a significant association between GC prominence and audit fees in the pre-SOX period. Hence, the main finding of the study is limited to the post-SOX period. This finding is noteworthy because, as mentioned previously, the role of the GC came under scrutiny as a result of several accounting scandals around the passage of SOX. 6. Conclusion This paper examines whether auditors’ perceptions of audit engagement risk are affected by firms that ascend the GC to the top management team. Specifically, we examine whether firms that promote a GC to top management experience a reduction in audit engagement risk, as proxied by audit fees. An emerging stream of research shows that the role of the firm’s GC has expanded in recent years and that the GC often serves as a member of top management (Deloitte, 2011). However, as the role of the GC has expanded, there is concern that GCs may discount their role as gatekeeper in order to be seen as part of the company and take on the role of facilitator of management interests (Nelson and Nielsen, 2000). In other words, it is unclear ex ante whether the GC serves the interest of top management or shareholders when there is a conflict of interest (Hazard, 1997). Subsequently, auditors may change their assessment of audit engagement risk when GCs ascend to top management.

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We employ firm fixed effects regressions to examine whether changes in GC prominence over time influence auditors’ perception of audit engagement risk. Our results suggest that prominence of the GC is negatively associated with audit fees. We also employ a changes analysis and find results confirming that ascension of the GC is associated with a reduction in audit fees. Furthermore, we find evidence that improved accounting quality and lower default risk reveal channels through which the negative association between GC prominence and audit fees manifests. In additional analysis, we find that GC ascension to top management attenuates the audit fee premium for firms with prior financial reporting problems, consistent with auditor perceptions that GCs can mitigate legal risks through more effective remediation. Our study provides several contributions to the literature. First, we contribute to the stream of auditing research that examines the association between the clients’ monitoring mechanisms on the pricing of audit services as well as composition of top management and audit fees. Second, we contribute to the emerging line of research examining the consequences of having the GC position as a member of top management. Finally, while the role and influence of the GC has been debated among regulators and in academic circles, we provide evidence on the auditor’s perception of clients that have prominent GCs. Data availability Data are from public sources identified in the paper. Acknowledgements We thank Larry Gordon and Marty Loeb (editors), and two anonymous reviewers for helpful feedback and guidance. We also gratefully acknowledge comments from Brooke Beyer, Marcus Caylor, Dana Hermanson, Don Herrmann, Brad Lawson, Eric Rapley, Divesh Sharma, Vineeta Sharma, Chad Simon, Chad Stefaniak and workshop participants at Middle Tennessee State University, Kennesaw State University, and Oklahoma State University. Abernathy acknowledges funding form Kennesaw State University. Kubick acknowledges funding from University of Kansas. Masli acknowledges the support provided by the Brandmeyer Center for Applied Economics. Appendix A. Variable definitions

AUDFEE GC ASSETS RECINV LEVERAGE ROA GROWTH LOSS FOREIGN MERGER RESTRUCTURE SPECIAL BUSY BIGN CHANGE AUDITOR GOING CONCERN RESTATEMENT UNQUALIFIED MATWEAK DEFAULT DISTANCE

natural logarithm of audit fees; indicator variable equal to one if a firm has a GC in the top five highest paid executive cohort and zero otherwise; natural logarithm of total assets; sum of receivables and inventory divided by total assets; total liabilities divided by total assets; net income divided by total assets; total sales divided by prior year’s total sales; indicator variable equal to one if net income is negative, and zero otherwise; indicator variable equal to one if a firm has foreign exchange income or loss, and zero otherwise; indicator variable equal to one if a firm has acquisitions and zero otherwise; indicator variable equal to one if a firm has restructuring costs, and zero otherwise; indicator variable equal to one if special items divided by total assets is >= 2%, and zero otherwise; indicator variable equal to one if a firm’s fiscal year-end month is December, and zero otherwise; indicator variable equal to one if a firm is audited by one of the ‘‘Big N” audit firms, and zero otherwise; indicator variable equal to one if a firm changed auditors, and zero otherwise; indicator variable equal to one if the firm receives a going concern opinion, and zero otherwise; indicator variable equal to one if the firm announces an accounting restatement during the year, and zero otherwise; indicator variable equal to one if the firm receives an unqualified opinion without any explanatory language, and zero otherwise; indicator variable equal to one if the firm receives an adverse internal control opinion, and zero otherwise; default risk as the distance to default, computed using the Merton (1974) model, as adjusted following Bharath and Shumway (2008);

J.L. Abernathy et al. / J. Account. Public Policy 38 (2019) 1–14

MISSTATE CLASS SUIT

13

indicator variable equal to one if the company misstates its accounting information beginning in the current year or subsequent year, and zero otherwise; indicator variable equal to one if there is a class action lawsuit against the company filed in the current year or subsequent year, and zero otherwise.

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Audit.: J. Pract. Theor. 30 (3), 157–179. The Association of the Bar of the City of New York, 2006. Report of the task force on the lawyer’s role in corporate governance. New York City Bar, New York. Veasey, E., Di Guglielmo, C., 2012. Indispensable Counsel: The Chief Legal Officer in the New Reality. Oxford University Press. Winders, P., 2005. Law firm general counsel extravagance of necessity. Prof. Lawyer 15, 3–11. John L. Abernathy is an Associate Professor of Accounting at Kennesaw State University. He earned his Ph.D in Accounting at the University of Alabama in 2010. His research interests are in the areas of financial reporting quality, auditing and audit quality, corporate governance, and taxation. He has coauthored academic research papers in various peer-reviewed academic journals, including Auditing: A Journal of Practice and Theory, Journal of Accounting, Auditing and Finance, Journal of Business Finance and Accounting, and The Journal of the American Taxation Association. Thomas R. Kubick is an Associate Professor of Accounting at the University of Kansas. He earned his Ph.D in Accounting at the University of NebraskaLincoln in 2011. His research interests are in the areas of taxation, financial accounting, incentives, and governance. He has co-authored papers in various peer-reviewed academic journals, including Journal of Accounting and Economics, The Accounting Review, Management Science, Journal of Corporate Finance, Financial Management, Accounting Horizons, Auditing: A Journal of Practice and Theory, Journal of Accounting and Public Policy, Journal of the American Taxation Association, Journal of Banking and Finance, Journal of Business Finance and Accounting, and Review of Quantitative Finance and Accounting. Adi Masli is an Associate Professor of Accounting and KOCH fellow at the University of Kansas. He earned his PhD in Accounting from the University of Arkansas in 2011. His research interests include the following topics: external auditing and assurance services, the effect of internal auditing in business organizations, the influence of information technology (IT) on business value and financial reporting, internal controls and financial reporting quality, top management teams, executive compensation and labor markets, and corporate governance. He has co-authored academic research papers in various peerreviewed academic journals, including The Accounting Review, Accounting, Organizations, and Society, Contemporary Accounting Research, Auditing: A Journal of Practice and Theory, Accounting Horizons, Journal of Accounting and Public Policy, and The Journal of the American Taxation Association.