Do Investors Care About the Auditor's Economic Dependence on the Client?
Posted: 21 Mar 2006 Last revised: 16 Jun 2010
Date Written: June 16, 2010
In this study, we investigate whether investor perceptions of the financial reporting credibility of Big Five audits is related to the auditor's economic dependence on the client as measured by nonaudit as well as total (audit and nonaudit) fees paid to the incumbent auditor. We utilize the client-specific ex ante cost of equity capital as a proxy for investor perceptions of financial reporting credibility, and examine auditor fees both as a proportion of the revenues of the audit firm and the revenues of the audit firm's practice office through which the audit was conducted. Our findings suggest that both nonaudit as well as total fees are perceived negatively by investors, i.e., the higher the fees paid to the auditor, the greater the implied threat to auditor independence, and the lower the financial reporting credibility of a Big Five audit. Further, our findings appear to be largely unrelated to corporate governance, i.e., investors do not perceive the auditor as compensating for weak governance. Separately, recent anecdotal evidence suggests that declining revenues from nonaudit services - as a result of recent regulatory restrictions - are being offset by substantial increases in audit fees. Other things being equal, rising audit fees imply higher profit margins for audit services indicating that the audit function may no longer be a loss-leader. Thus, to the extent that investors perceive total fees negatively, recent regulatory initiatives to limit nonaudit fees may not have adequately addressed the perceived, if not the actual, threat to auditor independence posed by fees.
Keywords: Auditor fees, Financial reporting credibility, Big Five audits, Corporate governance
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