Effect of Client Reputation on Audit Fees at the Office Level: An Examination of S&P 500 Index Membership

Abstract

SUMMARY Prior studies have examined the effect of a decline in the auditor's or client's reputation on auditor switching, market shares, and stock prices. We extend these studies by examining the effect of an unexpected increase in a client's reputation on audit fees at the office level. We argue that association with a reputed client will enhance the auditor's reputation and establish a brand name, thus enabling the auditor to charge higher fees from other clients. Using a client's inclusion into the prestigious S&P 500 index as a proxy for the client's change in reputation, we find that the audit fees are discounted for this S&P client when it enters the index. The audit fee for this client increases following its exit from the index. We posit that changes in the audit fees for the S&P 500 clients are attributable to the changes in the reporting quality of these firms following their entry to and exit from the index. We also find increases in the audit fees of non-S&P clients of the audit office around such events. We argue that the presence of S&P clients helps auditors differentiate themselves from other auditors and allows them to extract rents from non-S&P clients. Last, we find no evidence of improvement in the reporting quality of other non-S&P clients, supporting our rent-extraction story.