Are audit fees lower when auditors trust management more?

November 8, 2015

In this article, we look at the impact of auditor trust to company management (by considering the social capital) on audit fees.

1. Impact of trust to management on audit fees

Audit fees may be a significant (and necessary) expense for companies.  For example, audit fees of Coca Cola for 2014 amounted to about $29 million.  Audit fees of course depend on the company size, whether it’s a public or private company, etc.  Numerous academic studies have been performed to understand how audit firms establish their audit fees.

We will take a look at the findings of one of such empirical studies.  The research paper concentrates on interesting concepts that most people may not be familiar with.  It will probably be safe to indicate that some audit firms may not be familiar with such concepts as well, even though they likely apply the concepts as part of their audit proposals and audit pricing.

The research paper we are referring to in this article is called “Audit Fees and Social Capital” published in The Accounting Review in 2015.

First, let’s take a look at the definition of social capital.  The authors of this research paper define social capital as “norms and networks that facilitate collective action.”  This definition is rather vague.  What may provide a better idea is the empirical measure of social capital used in the research article.  The authors use a social capital index which takes into account such variables: voter turnout in presidential elections, census response rate, the number of social or civic associations, and the number of nongovernmental organizations.  For all of these variables, the greater they are, the higher the social capital index is.  The data was analyzed by the U.S. counties.

Second, the authors looked at the audit fees charged by the audit firms and the social capital index of the county where their audit clients’ headquarters are located.  The results were quite interesting.

  • Two primary drivers of audit fees are (a) audit effort and (b) risk of litigation.  Audit effort is how much work auditors need to perform before they can issue an audit opinion.  The risk of litigation is self-explanatory.
  • Clients that have their headquarters in counties with high social capital have audit fees which are 12% lower than comparable clients in low social capital counties.  The explanation of this finding is as follows: companies headquartered in high social-capital counties have a higher rate of fulfilling obligations, follow the established laws, etc.  As such, auditors trust more the managers of these companies, and as the result, the auditors tend to decrease their substantive audit procedures.  The same will hold true for the auditor’s perceived risk of litigation.  Managers of companies in high social capital counties are expected to be more honest, and thus, the risk of litigation for these companies is expected to be lower.

These findings are useful as they explain how social capital relates to the audit service pricing.  It also may be worth noting to companies that are planning to establish their headquarters (i.e., it might be beneficial to choose a county with higher social capital); however, the social capital factor will likely be relatively less significant in comparison to other numerous factors that a company considers when selecting the location of its headquarters.

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