Client Retention or Reputation? An Analysis of Audit Fees and Financial Statement Fraud

Abstract

Corporate fraud imposes a large social cost, estimated at 22 cents per dollar invested in the fraud firm, yet misreporting firms have a low likelihood of being detected (Dyck, Morse and Zingales, 2013). Auditors, who are expected to be at the forefront of fraud detection, lag behind other stakeholders in uncovering misstatements. We investigate auditors’ poor record in detecting fraud using a new measure of financial statement manipulation that, unlike previous measures, is an ex-ante measure of misstatement and is not commingled with a firm’s business and economic risks. We posit that auditors balance their client retention motive with reputational costs when auditing a firm. Since investors can infer audit effort from the publicly disclosed audit fee, the reputational impact of misstatements may be contingent on the perceived effort. Thus, despite having reputational incentives to prevent misstatements, the expected rents to the auditor of retaining a potentially misstating client may outweigh the reputational cost when the audit fee is low. Consistent with the retention effect, we find a negative relation between the likelihood of material misstatement and audit fees. This effect is economically significant as a one standard deviation increase in misstatement risk associates with an 8.5% fee reduction. In additional testing, we find no evidence that auditors signal investors to the reduced financial statement quality through alternate channels. Furthermore, although a strong audit committee is related to fewer misstatements, it does not mitigate the negative relation between material misstatements and audit fees.