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ABSTRACT: We examine the impact of social capital on audit fees. We find that firms
headquartered in U.S. counties with high social capital pay lower audit fees. Social
capital measures the level of mutual trust in a region. Our results suggest that auditors
judge the trustworthiness of their clients based on where the firm is headquartered and
charge a premium when they trust the firm less. The basis of our results is the
examination of more than 28,000 audit fees for more than 5,000 firms spanning the
period of 2000 to 2009. The results are robust to controlling for a large number of firm-
level and county-level characteristics.
Keywords: audit fees; social capital; client risk; audit effort.
I. INTRODUCTION
I
n a seminal paper, Simunic (1980) considers a firms audit fees to be dependent on the
auditors effort and the expected losses from litigation. Subsequently, researchers have
investigated the impact of numerous variables as possible determinants of audit fees
(Causholli, De Martinis, Hay, and Knechel 2010). These variables are expected to affect either the
auditors effort or litigation risk, both of which affect the audit fees. Prior research has not
investigated the possible impact of the client firms local social environment, which is the focal
point of this study. Our purpose is to use a well-understood setting to investigate the role of social
capital on economic decisions, a topic that is much less understood.
Social capital is often defined as the mutual trust in society. We propose that the social capital
in the county where a U.S. firm is headquartered can have an impact on how much the auditors trust
the managers of the firm. As we discuss below, auditors arguably have less trust when a firm is
headquartered in a county with low social capital. We argue that this lack of trust will increase the
auditors effort and his or her fear of litigation and, therefore, will increase fees.
We test this idea by exploiting the variation in social capital at the county level in the United States.
Using the zip code of the firms headquarters, we gather data for variables proxying for the county-level
We thank Michael L. Ettredge (editor), John Harry Evans III (senior editor), and two anonymous referees for their
valuable feedback. We also thank the participants at the 2013 FMA Annual Conference, 2012 AAA Annual Meeting,
and 2012 Research Seminar at Texas A&M International University for their suggestions.
Editors note: Accepted by Michael L. Ettredge.
Submitted: November 2012
Accepted: July 2014
Published Online: July 2014
611
612 Jha and Chen
social capital for each firm-year. We then conduct a regression analysis that examines the association
between audit fees and the level of social capital where the firm is headquartered. In our analysis, we
control for firm characteristics based on the audit-fee literature and also include a large set of controls at
the county level. We find that audit fees are significantly lower in high social-capital counties. Our
results are also economically significant because we find that a firm that is headquartered in a county
with social capital in the 75th percentile pays about 12 percent less in audit fees compared to a firm
headquartered in a county with social capital in the 25th percentile, ceteris paribus.
According to Simunic (1980), audit fees can increase due to more audit work and/or more expected
losses. To further investigate which particular element drives up audit fees, we examine the impact of
social capital on the auditors report lag, which is a proxy for the auditors effort, and on the firms
litigation risk, which is a proxy for the auditors expected losses. We find that auditors take more time to
sign off on their report for low social-capital clients. Furthermore, the probability of litigation involving
the auditor is also higher in low social-capital counties.
We also conduct two tests of moderating effects that examine whether the influence of social capital
is stronger under certain environments. First, we investigate whether the effect of social capital is
stronger when the audit office is located closer to the client. The idea is that the auditors might have more
confidence in their judgment of the clients trustworthiness when they reside closer. We find results
consistent with our expectation because when the auditors are either located within a 100-kilometer
(62.13 miles) radius of the client or in the same metropolitan statistical area (MSA) as the client, the
effect of social capital on audit fees is tripled compared to when they are further away. Second, we
investigate if the effect of social capital is stronger for the year 2004 and subsequent years, when
auditing became more complex due to the Sarbanes-Oxley Act (SOX). We find that, indeed, social
capitals effect is stronger post-2004.
Based on prior literature (Guiso, Sapienza, and Zingales 2004, 2008b; Grullon, Kanatas, and
Weston 2010), we argue that these two additional results give us greater confidence that our results are
causal instead of correlational. Taken together, these results provide strong evidence that auditors take
into consideration the social capital of where the firms are headquartered in assessing their audit fees.
We note here that our results do not necessarily suggest that auditors are violating professional
guidelines that require that they exercise professional skepticism in auditing their clients. Rather, the
results suggest that the extent of the skepticism can vary based on where their clients are headquartered.
Our results can be interpreted as indicating that auditors are prudent in their assessments because the
social environment affects the quality of the financial reporting (Kang, Han, Salter, and Yoo 2010;
McGuire, Omer, and Sharp 2012). Jha (2013), in particular, finds that when a firm is headquartered in a
low social-capital county, the financial reports quality is poor. Specifically, the accrual management,
real earnings management, propensity to commit financial fraud, and the fogginess of financial
reports are all high. Prudence should dictate that auditors take into account the poor quality of reporting
that can generally be expected of clients located in low social-capital counties, and that auditors be more
skeptical in those cases. Our results are also consistent with the experimental and archival studies that
show that auditors consider the integrity of the management when deciding how much effort to exert in
auditing, and how much to charge their client (Beaulieu 2001).
By showing that the social capital where the firm is headquartered affects audit fees, our study
makes an important contribution to the auditing literature. It shows that the social environment
where the firm is headquartered can affect its relation with auditors and, consequently, the audit
fees. This is a new way of looking at the auditor and clients relation. Although the audit-fee
literature is extensive, no studies we know of have investigated the possible impact of the social
environment on how much the auditors charge.
More broadly, our study contributes to an emerging strand of accounting literature that documents
the effect of the social environment on managerial decisions (Hilary and Hui 2009; McGuire et al.
2012). We show that the social environment not only affects managerial decisions, but also the relations
with other stakeholders, such as auditors. Further, this study is among the few in the accounting
literature to examine the role of social capital on the firms behavior. Although the concept of social
capital is extensively studied in sociology, economics, management, and political science, the role of
social capital in accounting settings is largely unexplored. Our study raises the possibility that other
accounting decisions might be affected by the level of social capital where the firm is headquartered.
(Milgram, Bickman, and Berkowitz 1969; Cialdini, Kallgren, and Reno 1991). This stream of
literature argues that human beings develop a set of ideals for how they should behave based on
what they see around them. When a person deviates from these ideals, there is a sense of guilt and,
therefore, a cost. Managers might take this cost into account when making decisions (Akerlof
2007). Social norms are also self-enforcing (Hilary and Huang 2013) because there is a desire to
conform to a groups expectationspartly by nature (Akerlof 2007; Hilary and Huang 2013) and
partly because deviations are costly (Coleman 1994; Portes 1998).
The dense networks in high social-capital regions also encourage honest behavior from
managers. In the context of managerial reporting behavior, a dense network means that
stakeholders, such as institutional investors, bankers, and managers, are more likely to interact
regularly with each other. More frequent interactions among these parties lead to greater
information exchange and, therefore, more effective monitoring (Wu 2008), which subsequently
leads to more truthful and forthcoming financial reporting.
1
The idea that auditors adjust their extent of auditing according to how much they trust their clients is not new. Shaub
(1996) notes that trust is inherent in the audit process. He argues that auditors assess higher inherent risk and
control risk when they trust their client less.
lawsuits (ACAP 2008). Given the concern about the risk and the cost associated with litigation
relative to the fees charged, auditors are likely to take into consideration the trustworthiness of their
client, even if the impact of the trust is only at the margin.
The discussion above suggests that in a low-trust environment, the auditors effort and the
litigation risk are both higher. Therefore, auditors likely will exert more effort and demand higher
audit fees for firms located in low social-capital counties. Conversely, they will exert less effort and
demand lower audit fees if a firm is headquartered in a high social-capital county.2 Based on the
above discussion, we propose the following hypothesis:
H: Ceteris paribus, the firms headquartered in a high social-capital county pay lower audit
fees.
This hypothesis rests on the idea that the firms headquartered in high social-capital counties
have corporate cultures that are high in social capital. This concept is based on the recent
accounting and finance literature on social environment and corporate decisions (Hilary and Hui
2009; Grullon et al. 2010). As in these studies, we borrow from the psychology literature and argue
that firms hire and retain employees who share their own values and that employees prefer to work
for firms that share their own values (Vroom 1966; Tom 1971; Holland 1976; McGuire et al. 2012).
Over time, assuming that the key employees reside close to the firms headquarters, these shared
values mean that the culture of the headquarters also reflects the culture of its location. Therefore, if
the county where the firm is headquartered has low social capital, then the auditor is likely to have
less trust in managers employed at the firms headquarters.3
Empirical Model
To test our hypothesis, we use a multivariate regression in which the dependent variable is the
natural logarithm of the audit fees charged by the external auditor. The key variable of interest is the
social capital of the county where the firm is headquartered:
LNAUDIT FEE b0 b1 SOCIAL CAPITAL b2 LNASSETS b3 DEBT b4 ROA
b5 BIG4 b6 LOSS b7 FISCAL YEAR END b8 DAYS TO SIGN
b9 PUBLIC EXCHNG b10 UNQUALIFED OPINION
b11 GOING CONCERN b12 INHERENT RISK b13 LITIGATION
b14 AUDITOR CHANGE b15 SEGMENTS
b16 COUNTY PRESENCE b17 LARGE SCALE b18 SPECIALIST
b19 AUDITOR COMPETITION b20 COST OF LIVING
b21 RELIGIOSITY b22 DIST FROM SEC b23 RURAL
b24 INCOME b25 POPG b26 LNPOP b27 LITERACY
Industry Indicators Year Indicators e:
1
The variables are defined in detail in Appendix A. Our unit of analysis is a firm-year,
where the subscript it is suppressed for expositional ease. The firm-level control variables are
2
We acknowledge that the county in which the auditor resides might also matter. We address this issue in additional
analyses later in the paper.
3
Firms can change their headquarters over time, and this change could add noise to our method. Although this noise is
possible, firms seem to rarely change their headquarters. For example, Pirinsky and Wang (2006) find only 118
changes in headquarters in a sample of 5,000 firms spanning 15 years.
based on Hay, Knechel, and Wong (2006), who include controls for the size, complexity,
inherent risk, profitability, leverage, auditor type, auditor report lag, and the busy season for
audits. We expect audit fees to be higher for large, complex, and risky firms, when the firm is
audited by the Big 4 audit firms and when the audit is conducted in a busy season. Because
Fung, Gul, and Krishnan (2012) find that the city-level industry specialization of the auditors
and their economies of scale have an impact on audit fees, we also add a measure for the city-
level industry specialization and economies of scale. We also control for the extent of the audit
market competition in the county, as in Newton, Wang, and Wilkins (2013), and the number of
clients geographic segments. Although the key managers who influence financial reporting are
located in the firms headquarters, the employees in other geographic locations also have an
effect on the accounting information systems and the firms financial reports. We control for
this effect by including the number of geographic segments in our model. And, consistent with
Fung et al. (2012), we add industry indicator variables based on the two-digit SIC code, as well
as year indicator variables, to control for the impact from changes in the financial reporting
regulations.
Because recent finance and accounting research shows that the religiosity in a county has a
significant impact on the firms financial reporting quality (Grullon et al. 2010; McGuire et al.
2012), we control for religiosity at the county level. We control for other related county-level
characteristics, including the cost of living in the county, the distance from the nearest regional
Securities and Exchange Commission (SEC) office, the population density, the county
population, the population growth, the income per capita, and the literacy rate. We expect audit
fees to be lower for firms that are located in religious counties because misconduct is expected to
be lower in these counties. We also expect audit fees to be higher where the cost of living index is
higher. The impact of the distance from the SEC is unclear. Firms further away from the SEC are
likely to have more financial reporting irregularities, which results in higher audit fees. But firms
further away from the SEC are also less prone to scrutiny by the SEC, reducing litigation risk and
lowering audit fees.4
To control for the possibility that the error terms might be correlated, we cluster the standard
errors at the county level. Because we cluster at the county level, we automatically control for
clustering at the firm level (Bertrand, Duflo, and Mullainathan 2004; Dinc 2005; Cameron and
Miller 2011).5,6 In our main regression, we do not control for corporate governance characteristics,
such as the characteristics of the board and the relative power of management compared to the
shareholders, because doing so would severely limit our sample size. However, we do control for
them in our robustness tests, and our results continue to hold. Because our entire sample is from the
U.S., we automatically control for differences in legal origin, laws, and institutions.
4
Given that we have a large set of control variables, we check for multicollinearity by measuring the variance inflation
factor (VIF). Because the VIFs of the explanatory variables are well below 10, and the average VIF of the
explanatory variables is 2.42, multicollinearity does not appear to be a problem.
5
In our case, the firms are nested in the counties. Therefore, we have a nested level of clustering. In such a case,
cluster-robust standard errors are computed at the most aggregate level of clustering (Cameron and Miller 2011, 7).
6
However, our main results continue to hold if we (1) cluster at the firm level, (2) adopt two-way clustering (firm and
year or county and year) (Petersen 2009; Gow, Ormazabal, and Taylor 2010), or (3) use the Huber-White standard
error without clustering.
2009. The social-capital index for each county and the underlying data used to construct the index
are available at the Northeast Regional Center for Rural Development (NERCRD).7
As far as we know, the Rupasingha and Goetz (2008) approach to measuring social capital is
the most comprehensive measure of social capital at the county level. Putnam (2007) uses their
measure of social capital as an alternative measure for individual trust. Besides Putnam (2007),
many authors in different disciplines have used Rupasingha and Goetzs (2008) index or followed
their approach, including S. Deller and M. Deller (2010) and Hopkins (2011).
Following Rupasingha and Goetz (2008), the two measures of social norms we use are voter
turnout in presidential elections and the census response rate. Higher values for these variables
represent higher social capital. The literature has used both of these measures, either independently
or as a component of a social-capital index. For example, Guiso et al. (2004) use participation in
referenda in Italy as a measure of social capital, Alesina and La Ferrara (2000) use participation in a
presidential election as a component in the construct of a social-capital index, and Knack (2002)
uses the census response rate as a measure of social capital.
The two measures of networks are the number of social and civic associations and the number
of nongovernment organizations (NGO) in counties. Social and civic associations include physical
fitness facilities, public golf courses, religious organizations, sports clubs, managers and promoters,
political organizations, professional organizations, business associations, and labor organizations in
the county, but we exclude NGOs with an international focus. Both of these measures are
normalized by the population in the county. The literature also uses these two measures
independently as measures of social capital (Knack 2002; Hopkins 2011).
Because the measures of the norms and the network are highly correlated,8 we follow
Rupasingha and Goetz (2008) by conducting a principal component analysis to construct an index of
social capital for each county for the years 1997, 2005, and 2009. We extract the first component as a
measure of the social capital.9 We then linearly interpolate the data to fill in the years 1998 to 2004
and 2006 to 2008,10 following the same approach as Hilary and Hui (2009) and many other studies.11
Appendix A provides a more detailed description of how we construct the social-capital measures.
We present the variation in social capital at the county level in Figure 1 for the year 2000. For
brevity, we do not present the figures for 2005 and 2009 because they are similar. The correlation
between the 2000 and the 2009 social-capital index is 0.91. This is consistent with the idea that
unlike physical and human capital, social capital is sticky (Anheier and Gerhards 1995).
When constructing the social-capital index, we assume that all types of association
memberships increase the general trust in the society. We acknowledge that not all researchers
agree with this view. In the context of social capital, the common approach is to view associations
as one of two types: those that act like bridges between groups, such as religious organizations,
civic and social associations, bowling centers, physical fitness facilities, public golf courses, and
sports clubs; and those that strengthen the bonding between members within a group, such as
7
The data is available upon request from Northeast Regional Center for Rural Development (NERCRD) at: http://aese.
psu.edu/nercrd.
8
For example, the correlation between the voter turnout in the election and number of organizations in the county is
0.30 in 2005.
9
The eigenvalues of the first component for 1997, 2005, and 2009 are 2.06, 1.94, and 1.84, respectively. The
eigenvalues of the other components are less than 1 except in 2009, when the second component has an eigenvalue of
1.03. To maintain consistency between the years, we use only the first component for each year and consider it the
social-capital index.
10
The results continue to hold when we use Rupasingha and Goetzs (2008) index and test for only those years for
which their index is available.
11
The use of linear interpolation to fill in the missing values of the in-between years is a common practice in the prior
literature (Kumar, Page, and Spalt 2011; Alesina and La Ferrara 2000).
FIGURE 1
Social Capital at the County Level
This figure illustrates the variations in social capital as measured at the county level for 2000.
12
We require that the audit fees be greater than zero and the total assets of firms in Compustat be greater than zero.
13
Financial firms are those with an SIC classification between 6000 and 6999, and utility firms are those between 4000
and 4999.
variables further reduces the observations in the sample: 102 observations because DEBT is unavailable;
115 because ROA is unavailable; 248 because FISCAL YEAR END is unavailable; 374 because
INHERENT RISK is unavailable; and 2,056 because SEGMENTS is unavailable. We winsorize all of the
continuous variables in the model at the 1st and the 99th percentiles to mitigate the possible effects from
outliers. We report the summary statistics of the sample in Panel A of Table 1.
Univariate Results
The univariate results are consistent with our hypothesis that auditors charge firms with
headquarters in high social-capital counties lower fees. We present this result graphically in Figure
2, in which we divide the sample into those firms located in high or low social-capital counties
based on the median level of social capital. For both groups, we calculate the ratio of audit fees to
total assets in dollars for each year and multiply it by 100. Figure 2 presents the mean values of this
ratio. The figure shows that the audit fees per dollar of assets are higher for firms headquartered in
low social-capital counties compared to those in high social-capital counties for every year. The
mean audit fee per 100 dollars of assets for firms headquartered in low social-capital counties is
0.428. For high social-capital counties, it is 0.384, which is significantly lower (p , 0.01).
Next, we check the correlations between our variables of interest. The correlation of0.03 between
SOCIAL CAPITAL and LN(AUDIT FEE) is significant (p , 0.01), consistent with higher social capital
being associated with lower audit fees. But SOCIAL CAPITAL is also significantly correlated with other
county-level demographics, and these characteristics are significantly correlated with LN(AUDIT FEE).
For example, the correlations of LN(AUDIT FEE) with COST OF LIVING, INCOME, and LITERACY
are 0.05, 0.21, and 0.08, respectively. They are all significant (p , 0.01). This result suggests a need to
control for these characteristics in a regression framework to make a valid conclusion.
Multivariate Results
The result of the multivariate regression is also consistent with our hypothesis. The firms
headquartered in a high social-capital county pay lower audit fees, ceteris paribus. Panel B of Table 1
presents the results from the multivariate regression analysis. The dependent variable is the natural
logarithm of the audit fees. Columns (1) and (2), respectively, report the coefficients and the p-value of
the main model summarized in Equation (1). The coefficient of 0.102 on SOCIAL CAPITAL is
significant (p , 0.01). Based on this coefficient, we know that a firm headquartered in a county with
social capital in the 75th percentile pays 88 percent of the audit fees paid by a firm headquartered in a
county with social capital in the 25th percentile (exp (0.102 0.101)/exp (0.102 1.173) 0.88),
ceteris paribus.
To mitigate the concern that idiosyncrasies in certain time periods drive our results, we run the
regression model for each year. We report the coefficient on SOCIAL CAPITAL from these regressions
in Table 1, Panel C. SOCIAL CAPITAL is significant at the p , 0.01 level in each year, which suggests
that our results are not inappropriately driven by certain years. Consistent with the audit-fee literature,
audit fees are higher for larger firms and for firms in litigation-prone industries.14
14
The coefficient on AUDITOR COMPETITION is similar to Numan and Willekens (2012), who also use the
Herfindahl index to measure competition. Unlike most studies, the coefficient of BIG4 is not positive and significant.
This is because we control for COUNTY PRESENCE (the natural logarithm of the sum of the audit fees that the
auditor collected from the firms in the county), as in Fung et al. (2012), that is highly correlated with BIG4 (0.43). The
effect of BIG4 is subsumed by COUNTY PRESENCE. In this respect, our results are consistent with Choi, Kim, Qiu,
and Zang (2012). In untabulated results, we verify that when we remove COUNTY PRESENCE as an explanatory
variable, BIG4 becomes positively significant.
TABLE 1
The Impact of Social Capital on Audit Fees
Panel A: Summary Statistics (n 28,634)
Variable Mean SD 1st Quartile Median 3rd Quartile
LN(AUDIT FEE) 13.104 1.259 12.132 13.048 13.974
AUDIT FEE 1120000 1860000 186000 464000 1170000
SOCIAL CAPITAL 0.496 0.905 1.173 0.472 0.101
CENSUS RESPONSE 0.706 0.055 0.67 0.716 0.746
VOTE 0.56 0.087 0.493 0.558 0.62
BRIDGING TYPE 0.446 0.399 0.243 0.339 0.506
BONDING TYPE 1.238 0.437 0.864 1.194 1.445
NGO 48.886 23.423 35.44 44.095 53.838
LNASSETS 5.552 1.948 4.204 5.522 6.857
ASSETS 2023.68 14840.8 66.955 250.044 950.513
DEBT 0.508 0.338 0.268 0.462 0.656
ROA 0.007 0.306 0.012 0.094 0.155
BIG4 0.82 0.384 1 1 1
LOSS 0.265 0.441 0 0 1
FISCAL YEAR END 0.666 0.472 0 1 1
DAYS TO SIGN 62.752 26.868 47 61 74
PUBLIC EXCHNG 0.84 0.366 1 1 1
UNQUALIFIED OPINION 0.536 0.499 0 1 1
GOING CONCERN 0.053 0.224 0 0 0
INHERENT RISK 0.264 0.193 0.107 0.235 0.382
LITIGATION 0.435 0.496 0 0 1
AUDITOR CHANGE 0.079 0.269 0 0 0
SEGMENTS 2.32 0.833 1.732 1.732 3
COUNTY PRESENCE 15.542 1.915 14.156 15.745 17.009
LARGE SCALE 0.318 0.388 0.01 0.01 0.64
SPECIALIST 0.586 0.492 0 1 1
AUDITOR COMPETITION 0.388 0.197 0.266 0.311 0.431
COST OF LIVING 125.614 39.813 104.9 115.5 134.4
RELIGIOSITY 0.521 0.11 0.434 0.525 0.59
DIST FROM SEC 2.666 2.559 0.485 2.055 3.579
RURAL 0.501 0.5 0 1 1
INCOME 44.856 13.88 35.6 42.252 50.42
LNPOP 13.71 1.121 13.206 13.75 14.33
POPG 0.833 1.19 0.083 0.645 1.406
LITERACY 34.662 9.378 27.267 33.733 42.011
TABLE 1 (continued)
FIGURE 2
Audit Fees and Social Capital
This figure presents the mean percentage of audit fees charged per dollar of assets of a firm headquartered in a low social-
capital county (social capital median) versus a high social-capital county (social capital . median).
V. FURTHER ANALYSES
15
Knechel and Payne (2001) use a proprietary database and find that the incremental audit effort is positively associated
with the audit report lag.
TABLE 2
The Lower Auditors Effort in High Social-Capital Counties
The table reports the results of a regression analysis that examines the association between the auditors effort and social
capital. The p-values are based on the standard errors clustered at the county level.
A more detailed description of the variables is in Appendix A.
To test whether DAYS TO SIGN is larger for firms in low social-capital counties, we
conduct a regression analysis. Table 2 presents the results. The dependent variable in these
regressions is DAYS TO SIGN and, following Chan, K. Chen, T.-Y. Chen, and Yu (2012), the
control variables are the same as those used to examine LN(AUDIT FEE). The coefficient on
SOCIAL CAPITAL is 1.901 in Column (1) and is significant (p , 0.01). This finding suggests
that a one-standard-deviation change in SOCIAL CAPITAL is associated with about 1.7 fewer
days (1.901 0.905 1.720) spent on auditing.
Moderating Tests
We conduct two moderating tests to investigate whether the effect of social capital on audit
fees is stronger when the distance between the auditor and the firm is greater, and when the
complexity of the auditing process is greater. Following prior literature (Guiso et al. 2004, 2008b;
Grullon et al. 2010), we argue that if the social capital has a stronger effect on the audit fees in
certain environments compared to others, and if the direction of the effect is as expected given
theory, then this provides further assurance that our explanation for the association between the
social capital and the audit fees is correct.
The Effect of Social Capital is Stronger when Auditors Reside Close to the Firm
If social capital affects audit fees, then it is likely to have a stronger effect when the auditors are
located closer to the firm. Choi et al. (2012) show that a shorter distance between the client and the
auditor reduces the information asymmetry and improves the audit quality. Arguably, one reason a
shorter distance improves audit quality is because the collection and processing of information is easier.
Auditors are more likely to be aware of the soft information, such as information bearing upon the
trustworthiness and reputation of the firms managers, and to have greater confidence in managers
judgments when the auditors reside closer to the firm (Liberti 2005; Mian 2006). Furthermore, local
auditors can make use of the dense networks in high social-capital counties and more easily collect other
relevant soft information about the firm from other stakeholders, such as bankers, suppliers, and
customers. Therefore, the effect of the clients social capital on assessing audit fees is likely to be
stronger.
16
We code LAWSUIT as 1 if, in any given year, a lawsuit is initiated that is coded in one of the following Audit
Analytics categories: Accounting and Auditing Enforcement Release (category 54), Accounting Malpractice
(category 2), or Financial Reporting (Category 48), and 0 otherwise. Our LAWSUIT variable captures lawsuits filed
against clients, not their auditors. We focus on the likelihood of the client being sued because it is a comprehensive
measure of the client risk that auditors face. It captures both the financial reporting risk and the client business risk
both of which increase audit fees.
TABLE 3
The Lower Litigation Risk in High Social-Capital Counties
Dependent Variable LAWSUIT
(1) (2) (3) (4) (5) (6)
Coeff. p-value Coeff. p-value Coeff. p-value
SOCIAL CAPITAL 0.215 (0.005) 0.235 (0.007) 0.174 (0.029)
LNASSETS 0.404 (,0.001) 0.434 (,0.001) 0.489 (,0.001)
DEBT 0.004 (0.979) 0.161 (0.354) 0.247 (0.104)
ROA 0.829 (,0.001) 1.009 (,0.001) 0.853 (,0.001)
BIG4 0.319 (0.041) 0.291 (0.067) 0.306 (0.051)
LOSS 0.633 (,0.001) 0.644 (,0.001) 0.664 (,0.001)
FISCAL YEAR END 0.01 (0.924)
DAYS TO SIGN 0.012 (,0.001)
PUBLIC EXCHNG 0.186 (0.135)
UNQUALIFIED OPINION 0.265 (0.018)
GOING CONCERN 0.292 (0.129)
INHERENT RISK 0.645 (0.013) 0.745 (0.027) 0.791 (0.009)
LITIGATION 0.522 (,0.001) 0.575 (,0.001) 0.637 (,0.001)
AUDITOR CHANGE 0.269 (0.061)
SEGMENTS 0.008 (0.881)
COUNTY PRESENCE 0.107 (0.012) 0.115 (0.008) 0.102 (0.015)
LARGE SCALE 0.059 (0.655) 0.014 (0.919) 0.052 (0.696)
SPECIALIST 0.211 (0.032) 0.248 (0.021) 0.218 (0.031)
AUDITOR COMPETITION 0.309 (0.401) 0.342 (0.365) 0.143 (0.690)
COST OF LIVING 0.002 (0.392) 0.003 (0.170) 0.002 (0.457)
RELIGIOSITY 0.112 (0.827) 0.072 (0.884) 0.208 (0.669)
DIST FROM SEC 0.012 (0.561) 0.004 (0.835) 0.006 (0.750)
RURAL 0.189 (0.097) 0.187 (0.094) 0.147 (0.160)
INCOME 0 (0.980) 0.002 (0.859) 0.002 (0.868)
LNPOP 0.058 (0.491) 0.071 (0.424) 0.034 (0.680)
POPG 0.019 (0.650) 0.018 (0.685) 0.008 (0.863)
LITERACY 0.004 (0.721) 0.004 (0.706) 0.004 (0.720)
Q 0.096 (0.008)
Industry Indicators Yes Yes
Year Indicators Yes Yes Yes
Pseudo R2 0.071 0.097 0.116
28,634 25,717 28,251
The table reports the coefficients from the logit tests. The p-values are based on the standard errors clustered at the county level.
A more detailed description of the variables is in Appendix A.
We find the effect of social capital is stronger when auditors are located within 100 kilometers of the
firm or in the same MSA. We obtain the auditors county based on the city of the auditors office
provided in Audit Analytics.17 We collect the data on MSAs from the Census Bureau.18 We then
calculate the spatial distance between the county where the firm has its headquarters and the county
17
The sample for this test is reduced by 313 observations because either the auditors city is unavailable in the Audit
Analytics database, or it is not possible to determine the auditors county based on the information provided.
18
See: https://www.census.gov
where the firms auditor is located. Based on Choi et al. (2012), we divide the firms into those within a
100-kilometer radius or in the same MSA, and those that are neither within a 100-kilometer radius nor in
the same MSA.19,20
We rerun our main tests for these two groups separately and test whether the coefficient on
SOCIAL CAPITAL is larger when auditors are located closer to the firm. We find that the coefficient
is 0.116 when the auditor is near versus only 0.038 when the auditor resides further away (Table
4, Panel A, Columns (1) and (3), respectively). This difference is statistically significantthe p-
value for the F-test is 0.013.
19
The results are robust when we use 75 kilometers instead of 100 kilometers as the cutoff when determining whether
the auditors are close to the client.
20
Choi et al. (2012) point out that considering firms in the same MSA as being close, but not taking into account the
distance can be problematic because such a classification might falsely classify the auditor in an adjacent MSA that
might be close to the client as being distant.
21
Accelerated filers (usually large firms) began to comply only after November 15, 2004. The non-accelerated firms
(usually small, foreign firms) started to comply even later by starting in 2006 and ending in 2010. In their Table 1,
Gao, Wu, and Zimmerman (2009) provide much detail about the chronology of the compliance schedule for Section
404 of SOX.
TABLE 4
Moderating Tests
Panel A: The Stronger Effect of Social Capital When Auditor Resides Close to the Firm
Dependent Variable LN(AUDIT FEE)
To mitigate this concern, we construct indicator variables that capture whether the firm is
headquartered in the West (AZ, AK, CA, CO, HI, ID, MT, NM, NV, OR, UT, WA, WY), the
Northeast (CT, MA, ME, NH, NJ, NY, PA, RI, VT), the South (AL, AR, DC, DE, FL, GA, KY,
LA, MD, MS, NC, OK, SC, TN, TX, VA, WV), or the Midwest (IA, IL, IN, KS, MI, MN, MO,
ND, NE, OH, SD, WI), based on the U.S. census classifications. We add these indicator variables to
our main model. This, in essence, controls for all of the time-invariant characteristics that might be
specific to a certain region. We continue to find that firms headquartered in high social-capital
counties have lower audit fees (Table 5, Panel A, Column (1))the coefficient for SOCIAL
CAPITAL is negative and significant at the 1 percent level. This addition of regional indicators
absorbs some of the effect of the social capital because the social capital is similar within a
particular region and does not change much over time. But despite this partial absorption of the
social-capital effect, we find that local social capital affects audit fees.
Another way to ensure that our results are not driven by differences across regions is to conduct
a separate analysis for each region and verify that SOCIAL CAPITAL continues to have an effect for
each region. When we run a separate regression for each region, the coefficient for SOCIAL
CAPITAL continues to be negative and significant for all regions (Table 5, Panel A, Columns (3) to
(10)). Furthermore, the size of the coefficient also appears to be similar; except for the Southern and
Western states, there is no statistical difference in the size of the coefficients of SOCIAL CAPITAL
(Table 5, Panel B). This gives us more confidence that we are not missing variables that are region-
specific in our model.
The Results are Robust when We Use Rupasingha and Goetzs (2008) Social-Capital Index
Recall that we use the updated version of the underlying data that Rupasingha and Goetz
(2008) compiled and made available on the NERCRD website. Furthermore, we follow their steps
to construct our own index for social capital. Since their data are available only for 1997, 2005, and
2009, we construct our index for these particular years and use linear interpolation to fill in the
intervening years.
To ensure that our results are not driven by the way we construct the measure of social capital
or by linear interpolation, we rerun the main test using the Rupasingha and Goetz (2008) social-
capital index. To be conservative, when running these tests, we limit the firms to only those firms
that have data available for 2005, as well as 2009.22 Despite a drop of over 90 percent in the sample
size, the results continue to hold for both those years. They are reported in Table 6. For brevity, we
do not tabulate the control variables. They are similar to those in the main results reported in Panel
B of Table 1.
22
We do so because there are fewer firms in Compustat and Audit Analytics in 2009 than in 2005. This is because after
SOX, due to greater compliance costs, many publicly traded firms started going dark (that is, firms stopped
reporting to the SEC) or turned private (Engel, Hayes, and Wang 2007).
March 2015
Panel A: Results from Multiple Regressions
Dependent Variable LN(AUDIT FEE)
Pooled Midwest Northeast West South
Coeff. p-value Coeff. p-value Coeff. p-value Coeff. p-value Coeff. p-value
SOCIAL CAPITAL 0.078 (,0.001) 0.092 (0.006) 0.101 (0.015) 0.132 (,0.001) 0.039 (0.094)
Control Variables Yes Yes Yes Yes Yes
Industry Indicators Yes Yes Yes Yes Yes
Year Indicators Yes Yes Yes Yes Yes
Regional Fixed Effects Yes
Observations 28,634 5,440 7,309 7,907 7,978
R2 0.821 0.858 0.847 0.813 0.814
TABLE 6
Results are Robust When We Use Rupasingha and Goetzs (2008) Index of Social Capital
Dependent Variable LN(AUDIT FEE)
Year 2005 Year 2009
(1) (2) (3) (4)
Coeff. p-value Coeff. p-value
SOCIAL CAPITAL (Rupasingha and 0.092 (,0.001) 0.111 (,0.001)
Goetz 2008)
Control variables Yes Yes
Industry Indicators Yes Yes
Year Indicators Yes Yes
Observations 1,840 1,840
R2 0.790 0.832
The table reports the coefficients from regression analyses when the social-capital index constructed by Rupasingha and
Goetz (2008) is used. The sample is limited to only those firms that are common to both 2005 and 2009. The control
variables are the same as in Panel B of Table 1. The p-values are based on the standard errors clustered at the county
level.
A more detailed description of the variables is in Appendix A.
As in Bergstresser and Philippon (2006), when the G-index is not available, we replace it with that
of the previous year. Following their study, we construct four indicator variables based on this
score. The addition of these variables reduces the sample size greatly, but the results continue to
hold. In Table 7, we report the results of this robustness test. The coefficient for SOCIAL CAPITAL
continues to be negative and significant (p-value , 0.01), and the magnitude of the coefficient,
although slightly lower, is similar to those reported in the main results.
The Results are Robust When We Use a Dichotomous Measure of Social Capital
In order to mitigate concerns that our results could be driven by a measurement error in
SOCIAL CAPITAL, we construct an indicator variable that is equal to 1 if SOCIAL CAPITAL is
greater than the median, and 0 otherwise. We rerun all of the tests using this indicator variable for
SOCIAL CAPITAL instead of the continuous measure. All of the results are qualitatively similar.
For brevity, we do not report these results.
VII. DISCUSSIONS
TABLE 7
Results are Robust When We Control for the Corporate Governance Variables
Dependent Variable LN(AUDIT FEE)
(1) (2)
Coeff. p-value
SOCIAL CAPITAL 0.080 (0.002)
Control variables Yes Yes
Additional controls:
Q 0.019 (0.033)
DUALITY 0.018 (0.423)
INDP DIRECTOR 0.311 (0.001)
G1 0.155 (0.003)
G2 0.145 (,0.001)
G3 0.116 (0.001)
Industry Indicators Yes
Year Indicators Yes
Regional Indicators Yes
Observations 4,756
R2 0.822
The table reports the coefficients from the main regression using more controls in addition to the control variables in
Panel B of Table 1. The p-values are based on the standard errors clustered at the county level.
A more detailed description of the variables is in Appendix A.
high social capital is associated with low accrual management, as well as real earnings
management (Jha 2013), which suggests a definitive direction in which social capital might
affect audit fees.
However, the more important reason we focus on social capital is that it is directly related to
trust, more so than religiosity, and, as we have discussed in this study, trust is likely to affect the
auditors effort, as well as the perceived litigation risk.
Nevertheless, because religiosity is associated with financial reporting irregularities, in all of
our tests, we incorporate religiosity as a possible explanatory variable. We find the coefficient for
RELIGIOSITY to be negative and significant in our main results, which suggests that the audit fee is
lower in more religious counties.
In line with our expectation, we find that the economic impact of RELIGIOSITY is about three
times lower compared to SOCIAL CAPITAL. In our main results (Column (1), Panel B of Table 1),
the coefficient for RELIGIOSITY is 0.199. In terms of economic magnitude, this coefficient means
that firms headquartered in a county with religiosity in the 75th percentile are charged 0.97 times
the audit fees of those firms in the 25th percentile (exp (0.199 0.59)/exp (0.199 0.434)
0.97). Furthermore, the coefficient for SOCIAL CAPITAL shows that a similar change in social
capital results in 0.88 times lower audit fees when headquartered in the 75th percentile compared to
those headquartered in the 25th percentile.
Arguably, we find a small impact for RELIGIOSITY because our measure of SOCIAL
CAPITAL subsumes some of the effect of RELIGIOSITY; by construction, SOCIAL CAPITAL
incorporates the number of churches in the county. To address this concern, we exclude SOCIAL
CAPITAL and rerun the main model. The magnitude of RELIGIOSITY increases, but only slightly
to 0.257 (untabulated results). The economic impact of RELIGIOSITY still appears to be
considerably less compared to the impact of SOCIAL CAPITAL. This impact shows that the
smaller coefficient for RELIGIOSITY is not because SOCIAL CAPITAL subsumes the impact of
religiosity, but because the impact of SOCIAL CAPITAL is much stronger compared to that of
RELIGIOSITY.
VIII. CONCLUSION
The two main determinants of audit fees are the auditors effort and the litigation risk
associated with auditing. Both of these determinants are likely to be higher when there is less
mutual trust between the firms managers and the external auditor. Therefore, lack of trust can
increase the fees that the auditors charge. In this study, we investigate whether a social environment
that indirectly measures mutual trust can affect audit fees.
Our research question is motivated by two independent streams of the literature. First, an
emerging strand of the literature shows that the social environment where the firm is headquartered
permeates the culture of the firm and affects its managers behavior. Second, the social-capital
literature shows that mutual trust and the propensity to cooperate can differ across regions and that
such differences can affect the transaction costs of financial exchanges.
Building on these two streams of literature, we argue that auditors trust the managers of firms
headquartered in a low social-capital county less and suggest that auditors charge these firms a fee
premium. Our testable hypothesis is that audit fees are higher for firms in a low social-capital
county.
We test this hypothesis by constructing a social-capital index for each county-year and
examining whether a firm headquartered in a low social-capital county pays higher audit fees,
holding other variables constant. Our results are consistent with our hypothesis, indicating that a
firm located in a low social-capital county pays higher audit fees. We find that the result is robust to
a wide range of controls and is economically nontrivial. A deeper analysis examining the
mechanism by which social capital affects audit fees shows that in low social-capital counties, both
the auditors effort and the litigation risk are higher.
The contribution of this study is two-fold. First, it shows that the social environment can affect
the firm-auditor relation, not just corporate decision making. Second, the study suggests that trust is
an important component of the auditor-client relation, that local social capital proxies to some
extent for auditor trust, and its impact on audit fees is meaningful. We leave it to future research to
examine the impact of other nonfinancial forces that can affect audit fees.
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APPENDIX A
Variables Description
Main Dependent Variable
LN(AUDIT FEE) This variable is the natural logarithm of the total audit fee of the primary
external auditor. Source: Audit Analytics
Dependent Variable for Supporting Tests
LAWSUIT An indicator variable that is equal to 1 if there is a lawsuit against the
firm in that year. We code LAWSUIT as 1 if, in any given year, the
firm is classified in the following categories: Accounting and Auditing
Enforcement Release (category 54), Accounting Malpractice (category
2), Financial Reporting (category 48), and 0 otherwise. Source: Audit
Analytics
DAYS TO SIGN This variable is the lag between the signature date of the audit opinion
and the date of the fiscal year-end (SIG_DATE_OF_OP_S FISCAL_
YEAR_END_OP). Source: Audit Analytics
(continued on next page)
APPENDIX A (continued)
Variables Description
Main Research Variable
SOCIAL CAPITAL This variable is the measure of the social capital at the county level. It is
constructed following Rupasingha and Goetz (2008). Specifically, the
variable is constructed by using the first component from a principal
component analysis that uses four different measures. For example, we
use the following four measures: assn97, nccs97, pvote96, and respn00
for 1997, where assn97 is the sum of the religious organizations, civic
and social associations, business associations, political organizations,
professional organizations, labor organizations, bowling centers,
physical fitness facilities, public golf courses, sport clubs, managers and
promoters, membership sports and recreation clubs, and membership
organizations not elsewhere classified in 1997. We divide the total by
12 because there are 12 different categories. Further, we also divide it
by the population of the county. We then multiply it by 10,000. The
nccs97 is the total number of nongovernment organizations, excluding
the ones with an international focus, in 1997 divided by the population
multiplied by 10,000. The pvote96 is the number of votes cast divided
by the population above 18 times 100. The respn00 is the census
response rate. Then we use a principal component analysis and
consider the first component to construct one index for each county. A
similar approach is used for 2005 and 2009. For each of these years,
the presidential elections and census response closest to 2005 and 2009
are used, respectively. We then linearly interpolate and fill the social
capital data for the in-between years. Source: Northeast Regional
Center for Rural Development (NERCRD), Rupasingha and Goetz
(2008)
Firm-Level Controls used in Model (1)
LNASSETS This variable is the natural logarithm of total assets (ln(AT)). Source:
Compustat
DEBT This variable is the ratio of total liabilities to total assets (LT/AT).
Source: Compustat
ROA This variable is the ratio of net income to total assets (EBITDA/AT).
Source: Compustat
BIG4 This indicator variable equals 1 if the primary auditor is one of the
following: PricewaterhouseCoopers, Ernst & Young, Deloitte & Touche,
or KPMG, and 0 otherwise. Source: Compustat and Audit Analytics
LOSS An indicator variable that is equal to 1 if the ROA is negative, and 0
otherwise. Source: Compustat
FISCAL YEAR END This is an indicator variable that is equal to 1 if the fiscal year ends in
December, and 0 otherwise. Source: Audit Analytics
DAYS TO SIGN This variable is the lag between the signature date of the audit opinion
and the date of fiscal year-end (SIG_DATE_OF_OP_S FISCAL_
YEAR_END_OP). Source: Audit Analytics
PUBLIC EXCHNG This indicator variable equals 1 if the firm is a public company trading in
a major exchange (Compustat data item STKO 0), and 0 otherwise.
Firms that are coded as 0 are either subsidiaries of the public firms or
are not traded on one of the major exchanges. Source: Compustat
(continued on next page)
APPENDIX A (continued)
Variables Description
UNQUALIFIED OPINION This indicator variable equals 1 if the auditor issues an unqualified
opinion without any additional language (Compustat data item AUOP
1), and 0 otherwise. We code the firms that have an unqualified
audit opinion with additional language as 0. This approach is in line
with Landsman, Nelson, and Rountree (2009). Source: Compustat
GOING CONCERN This indicator variable equals 1 if the auditor issues a going concern
modified report, and 0 otherwise. Source: Audit Analytics
INHERENT RISK This is the sum of receivables and inventory and scaled by assets ((RECT
INVT)/AT). Source: Compustat
LITIGATION This indicator variable equals 1 if the SIC code of the firm is one of the
following: 8332836, 35703577, 36003674, 52005961, 73707374,
or 87318734. Source: Compustat
AUDITOR CHANGE This indicator variable equals 1 if the auditor had changed in the fiscal
year, and 0 otherwise. Source: Compustat
SEGMENTS This is the square root of the number of geographic segments. Source:
Compustat Legacy Segment
COUNTY PRESENCE This variable measures the presence of the auditor in the county and is
constructed as in Fung et al. (2012). It is the natural logarithm of the
sum of the audit fees that the auditor collected from the firms in the
county. Source: Compustat and Audit Analytics
LARGE SCALE This variable measures the scale of the auditor as in Fung et al. (2012).
To construct this measure, we first construct NCLIENT, which is the
number of clients the auditor has in each two-digit SIC industry by
county-year. We then rank NCLIENT in percentile for each year and
divide it by 100. Therefore, this measure captures how large-scale the
auditor is from an industry and location perspective. Source: Compustat
and Audit Analytics
SPECIALIST This variable measures whether the auditor is a specialist and is
constructed as in Fung et al. (2012). It is an indicator variable that is
equal to 1 if the ratio of the total fees collected by the auditor for the
industry to the total fees collected is the highest, and 0 otherwise.
Source: Compustat and Audit Analytics
AUDITOR COMPETITION This variable measures the auditors competition in the county. It is
calculated as in Newton et al. (2013). Specifically, it is calculated as
follows: RNi1 sSi ; where N is the number of audit firms in a county; S is
the sum of the audit fees collected by the auditors in the county; and si
is the audit fees collected by auditor i in the county. Source:
Compustat and Audit Analytics
Firm-Level Controls used in Robustness Tests
Q This variable is the Tobins Q. It is calculated as follows: (PRCC_C
CSHO AT CEQ TXDB)/AT, where PRCC_C is the closing
price of the stock in the calendar year; CSHO is the common shares
outstanding; CEQ is the common equity; and TXDB is the deferred
tax. Source: Compustat
DUALITY This indicator variable equals 1 if the CEO is also the chairman of the
board of directors. Source: ExecuComp
(continued on next page)
APPENDIX A (continued)
Variables Description
INDP DIRECTOR The percentage of independent directors on the board. Source: Investor
Responsibility Research Center (IRRC)
G1G4 We construct four indicator variables based on the governance index
constructed by Gompers et al. (2003). Their index was constructed in
the 1990s for S&P 1500 firms by using 24 different governance
characteristics. A smaller value means that the shareholders have
greater rights. The G1 equals 1 if the governance index is less than or
equal to 6, and 0 otherwise. The G2 equals 1 if the index is more than
6 and less than or equal to 9, and 0 otherwise. The G3 equals 1 if the
index is more than 9 and less than or equal to 12, and 0 otherwise. The
G4 equals 1 if the index is more than 13, and 0 otherwise. As in
Bergstresser and Philippon (2006), when the G-index is not available,
it is replaced with the previous years. Source: Investor Responsibility
Research Center (IRRC)
County-Level Controls
COST OF LIVING This variable measures the cost of living index of a county for 2013.
Source: http://www.coli.org/
RELIGIOSITY This variable is the percentage of religious adherents in the county,
measured as in Hilary and Hui (2009). Source: Association of Religion
Data Archive (ARDA)
DIST FROM SEC This variable is the distance to the closest SEC regional office. As in
Kedia and Rajgopal (2011), the SEC headquarters considered is in
Washington, DC, and the regional offices are located in New York
City, NY; Miami, FL; Chicago, IL; Denver, CO; and Los Angeles, CA.
As in their study, we use a formula that uses the longitude and latitude
of the two points to calculate the geographic distance. Source: U.S.
Department of Commerce , Bureau of Economic Analysis (BEA)
RURAL This variable is an indicator variable that is equal to 1 if the countys
population density is less than the median and 0 otherwise. The
population density is the ratio of the population to the land area.
Source: BEA
INCOME This variable is the income per capita in a county deflated by the
Consumer Price Index. Source: Census Bureau
LNPOP This variable is the natural log of the countys population. Source: BEA
POPG This variable is the percentage of the population growth of the county
since the previous year. Source: BEA
LITERACY This variable is the percentage of persons 25 years and over with a
bachelors degree or higher in the U.S. county population. Source:
Census Bureau