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. JEL Classifications: M42; M14.

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I find that managers manage earnings upward in the quarters preceding a debt-covenant violation, but downward in the quarter a violation occurs. And they continue to manage earnings downward while the firm remains in violation. Because this scenario can play out within a year, the use of yearly data to examine the debt-covenant hypothesis can be problematic. Further analysis shows that the earnings management around the debt-covenant violation is also done to improve the manager's bargaining power in the renegotiation that follows the violation. Furthermore, I find no evidence of excessive earnings management by high-debt firms to stave off a violation, but I do find evidence that the Sarbanes-Oxley Act restrains managers from using accruals to stave off a violation. These results are based on examining 193,803 firm-quarters, 8,804 firms, and 2,035 new covenant violations spanning 1996 to 2007.

Using data on corruption convictions from the U.S. Department of Justice, we find that auditors charge higher fees when a firm is headquartered in a more corrupt district. This result is robust to a wide range of time and location fixed effects, using capital city isolation as an instrument, and propensity score matching. We also find that, relative to those in non-corrupt districts, firms in corrupt districts are more likely to have weak internal controls and to restate earnings and that their auditors exert greater effort. This evidence suggests that auditing firms in corrupt areas entails additional risk, which auditors price into fees.

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