Industry tournament incentives and auditors' professional judgment

Abstract

Purpose: this study examines whether CEO’s industry tournament incentives are associated with auditors’ professional judgements, particularly in determining key audit matters (KAM) and setting materiality levels (MAT).

Design/methodology/approach: we use a sample of UK firms and measure auditors’ judgment through the number of KAM and the MAT levels, where a higher number of KAM indicates a broader audit scope, and a lower MAT level suggests a more detailed audit inspection. The analysis also examines cases in which CEOs possess financial expertise and employs various alternative specifications and robustness checks to address potential endogeneity.

Findings: findings show that a larger industry tournament gap is associated with a decrease in KAM and an increase in MAT levels. However, this relationship is nuanced: when CEOs have a financial background, auditors perceive the higher in-industry pay gap as increasing business and fraud risks, prompting a deeper audit approach. Specifically, auditors lower materiality threshold and increase the depth of audit procedures to address these perceived risks. These findings underscore the importance of compensation and financial expertise dynamics in shaping audit practices.

Originality: while prior research has primarily focused on audit fees, this study offers novel insights by shifting the focus to auditors’ professional judgments. Specifically, it is the first to examine how industry tournament incentives influence auditors’ judgment, thereby providing new evidence on new channels, namely, the number of Key Audit Matters and Materiality levels, through which auditors respond to CEO industry tournament pressures. These channels are arguably less prone to measurement bias than audit fee-based. Furthermore, the study extends the literature by demonstrating how auditors adjust their judgments in response to CEOs’ financial backgrounds, which may serve as a signal of heightened strategic reporting risk.

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Identifiers

ORCID for Alaa Zalata: orcid.org/0000-0003-2018-4313

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