CEO‐to‐Employee Pay Ratio and Audit Pricing

ABSTRACT Research Question/Issue This study examines how auditors incorporate CEO‐to‐employee pay ratios into their risk assessments and pricing decisions. Drawing on equity fairness theory, tournament incentives theory, and efficient contracting theory, we also investigate how specific firm characteristics influence the relationship between pay ratios and audit fees. Research Findings/Insights Using a dataset of Russell 3000 US firms from 2017 to 2022, we find that higher CEO‐to‐employee pay ratios are significantly associated with increased audit fees, even after controlling for the individual compensation components. Our cross‐sectional analyses reveal three key findings. First, reputation risk emerges as the primary channel through which pay ratios affect audit pricing, with the relationship being stronger for firms subject to greater stakeholder scrutiny. Second, stronger governance mechanisms amplify this relationship, reflecting increased audit rigor demanded by well‐monitored firms with high pay disparities. Third, firm complexity also intensifies the relationship between pay ratios and audit fees, indicating that auditors perceive heightened risks in complex firms with high pay disparities that extend beyond what is explained by efficient contracting theory. Theoretical/Academic Implications Our study advances the understanding of audit fee determinants by demonstrating how CEO‐to‐employee pay ratios signal distinct risks to auditors beyond traditional compensation measures. Additionally, we contribute to corporate governance research by highlighting internal pay equity as a critical yet often overlooked aspect that shapes a company's risk profile and audit outcomes. Practitioner/Policy Implications The findings offer valuable insights for companies on managing stakeholder perceptions and controlling audit costs through informed compensation policies. They also provide guidance for auditors in refining their risk assessment procedures. For regulators and policymakers, our results support the continued disclosure of pay ratios by demonstrating their relevance to key stakeholders' decision‐making processes.