The Effects of Board Interlocks With an Allegedly Fraudulent Company on Audit Fees

Abstract

Drawing on prior literature on audit fees, client reputation, and corporate governance, we posit that a material adverse event at a firm, such as a financial fraud allegation, leads to an increase in the audit fees of firms connected to the former by a board interlock. We propose two possible mechanisms to explain the upward pressure on audit fees: a client-side effect, where the client demands additional audit services, and an auditor-side effect, where the auditor raises its audit fees due to a perceived increase in audit engagement risk. The results indicate an average marginal increase of 12.86% in audit fees in the year following the public revelation of financial fraud. Additional analyses suggest that an auditor-side effect is in place, while we cannot find clear evidence supporting the client-side effect. Furthermore, we document that the positive effect on audit fees persists for up to at least 2 years after public disclosure of the event when the interlocked director serves as a member of the audit committee. JEL Descriptors: G34, M40, M42