Impact Code of Ethics To Ia

J. Account.
Public Policy 41 (2022) 107001
Contents lists available at ScienceDirect
J. Account. Public Policy

journal homepage: www.elsevier.com/locate/jaccpubpol
Full length article
Code of ethics quality and audit fees

Hong Kim Duong a,⇑, Giorgio Gotti b, Michael T. Stein a, Anthony Chen c
a
School of Accountancy, Old Dominion University, Norfolk, VA 23529, USA
b
School of Accountancy - Brownsville Campus, The University of Texas at Rio Grande Valley, Brownsville, TX 78520, USA
c
School of Accountancy, California State University at Fullerton, Fullerton, CA 92831, USA
a r t i c l e i n f o a b s t r a c t
Article history: Using a sample of U.S. firms from 2003 to 2018, we examine the effect of an audit client’s
Available online 20 July 2022 code of ethics quality on audit fees. We find that clients with a lower code of ethics quality
pay significantly higher audit fees, suggesting that auditors perceive such clients as riskier
JEL Classifications: and charge greater risk premiums. We also find that such clients have higher litigation risk
M14 and auditors spend greater effort when auditing such clients. Our study is among the first
M42 to demonstrate the role of a client’s code of ethics quality in audit pricing. Overall, our find-
Keywords:
ings are consistent with codes of ethics being useful to auditors in assessing managers’
Code of ethics financial representations and providing value to firms.
Audit risk Published by Elsevier Inc.
Audit fees
Audit effort
1. Introduction
The U.S. Securities and Exchange Commission (SEC) defines a code of ethics as a set of written standards to demonstrate a
company’s awareness of ethical issues and how it will deal with such issues. While a corporate code of ethics has long been
suggested as an important measure for reducing the risk of misconduct, its efficacy has been repeatedly questioned due, in
part, to the numerous scandals that have occurred over the past several decades. As a prime example, the passage of the
Sarbanes-Oxley Act (SOX) in 2002 was a response to the flurry of highly publicized financial reporting scandals related to
both ethical and auditing problems (e.g., Enron). The Act was intended to restore investors’ trust in financial reporting by
requiring greater oversight and independence of auditors and by mandating improvements in business ethics and corporate
governance (Farber, 2005; Bealing and Baker, 2006). SOX Section 406 requires publicly traded companies to adopt and dis-
close a code of ethics that governs the conduct of managers and, if not, disclose the reason why.1
The SEC (2003) suggested this requirement would provide greater understanding and insight regarding the ethical prin-
ciples that guide executives and aid in assessing a company’s corporate governance. However, critics argued that the costs of
this requirement would outweigh the benefits and that it would be sufficient for firms to merely acknowledge the existence
of a code of ethics, consistent with the common view that codes of ethics are simply window-dressing (see, e.g., Stevens,
1994; Helin and Sandstrom, 2007; Kaptein, 2015). The extant literature provides mixed and inconclusive evidence on the
role of the code of ethics in decision-making. On the one hand, previous studies find that codes of ethics have little to no
⇑ Corresponding author.
E-mail addresses: hkduong@odu.edu (H. Kim Duong), giorgio.gotti@utrgv.edu (G. Gotti), mstein@odu.edu (M.T. Stein), antchen@fullerton.edu (A. Chen).
1
The New York Stock Exchange (NYSE, 2004) and the National Association of Securities Dealers Automated Quotations (NASDAQ, 2003) mandate companies
listed on these exchanges to provide a publicly available code of ethics starting in the fiscal year 2004.
https://doi.org/10.1016/j.jaccpubpol.2022.107001
0278-4254/Published by Elsevier Inc.
H. Kim Duong, G. Gotti, M.T. Stein et al. J. Account. Public Policy 41 (2022) 107001
impact on legal violations, labor rights, and corporate socially responsible activities (Mathews, 1987; McKendall et al., 2002;
Egels-Zanden, 2007; Mijatovic and Stokic, 2010). On the other hand, other studies find that codes of ethics play an essential
role in restricting opportunistic behaviors in financial reporting such as earnings manipulations and restatements (Chen
et al., 2018; Ahluwalia et al., 2018).
Despite increased attention to ethical standards due to the events of the past few decades, the importance and efficacy of
codes of ethics remain a contentious issue. Evaluating client ethics is considered to be a critical step in the audit process but
also one of the most difficult and subjective steps (Chow et al., 1987; Love and Manisero, 2011). Given this difficulty and the
common perspective that ethics codes are window-dressing, it is unclear to what extent, if at all, auditors (appropriately)
assess the quality of the code of ethics and incorporate this information into their decisions.2 In this study, we investigate
whether auditors consider their clients’ code of ethics quality in assessing audit risk, as proxied by the pricing of audit services.
Auditors are charged with obtaining evidence relevant to the financial statements proposed by the client firm and then,
through the application of Generally Accepted Auditing Standards (GAAS), opining as to whether or not the statements are
fairly presented. The fees charged by the auditor should cover all the costs (including a competitive return to audit firm
equity holders) of providing this service. The study of factors associated with audit fees has been an ongoing subject by
auditing researchers since the late 1970s. Beyond the curiosity of researchers, the study of audit fees is often motivated
by an interest in topics such as auditor independence, the nature of audit technology, corporate governance, the existence
of audit firm specialization, the impact of regulatory changes, and the costs of implementation of GAAS, etc. Researchers
argue that each of these topics has implications that might be uniquely observable in the cross-sectional variation of audit
fees. That is, while audit fee studies often examine the impact of various factors on audit risk, and hence audit fees, they
serve various purposes distinct from examining the determinants of audit fees. Similarly, our study posits that code of ethics
quality is likely to have an observable effect on audit fees, which provides insight into the value of ethics codes to the audit
production function. It is an empirical question of whether stakeholders or auditors actually use code of ethics quality (or
other associated measures) in their assessments of information risk.
The motivating hypothesis of the study is that increases in the client firm’s assessed level of code of ethics quality are
associated with increased reliability of the client firm’s financial representations to both the auditors (specifically the unau-
dited financial statements that are the subject of the audit) and to external stakeholders. For example, Duong, Fasan, and
Gotti (2021) argue that code of ethics quality measures the ability of firms to constrain frauds and reduce other employee
misconduct, which, in turn, could lead to a decrease in the cost of capital faced by the firm. Relevant to our study is that the
same mechanism (constraining fraud and reducing misconduct) also impacts audit fees. The argument is straightforward.
Code of ethics quality influences the beliefs of financial statement users over the information risk inherent in the represen-
tations of client firm managers.
To examine the impact of code of ethics quality (CEQ) on audit fees, we exploit a novel dataset that contains information
regarding four aspects of a firm’s code of ethics, which include the comprehensiveness of the code of ethics, the system for
implementing the code of ethics, policies on bribery and corruption, and policies and systems addressing human rights for a
sample of public U.S. firms included in the S&P 500 index. Using these four components, we perform factor analysis and cre-
ate an aggregate measure of the quality of the code of ethics.
Our results show that when a client has a lower CEQ, auditors view the client as riskier and charge significantly higher
audit fees. Furthermore, in the context of heightened audit risk (e.g., when clients are involved in mergers and acquisitions,
or seasoned equity offerings), the impact of CEQ on the pricing of audit fees is magnified. Our main findings persist in a bat-
tery of robustness tests utilizing additional control variables, fixed effects, and various other methods to address endogene-
ity. We assess the economic significance of the results and find that a one-unit decrease in the measure of CEQ is associated
with an approximate nine percent increase in total audit fees.
Simunic (1980) suggests that audit fees can increase due to greater auditor effort and/or higher expected losses related to
audit risk. To further investigate which particular factors may drive audit fees, we examine the impact of a client’s CEQ on
auditor report lag, a proxy for effort, and client litigation, a proxy for the auditor’s expected losses. We find that auditors take
more time to sign off on their reports and face a higher probability of litigation when their clients have lower CEQ. Our
results indicate that a one-unit decrease in the measure of client CEQ is associated with approximately another day spent
on the audit report and a 17.82 percent increase in the probability of litigation.
Our findings are consistent with previous studies that show that auditors consider the client’s perceived business risk
(Beaulieu, 2001; Bell et al., 2001; Bell et al., 2008) and audit committee quality (Zaman et al., 2011) when deciding on audit
effort and pricing. While prior studies find that unethical actions influence audit fees (Lyon and Maher, 2005; Koh and Tong,
2013; Lawson et al., 2019; Kuang et al., 2020), our study examines the impact of the quality of the code of ethics. Whereas
the unethical actions in prior studies are salient events that clearly signal a lack of managerial integrity, a low-quality ethics
code does not necessitate unethical behavior (Erwin, 2011). Moreover, codes of ethics are commonly viewed to provide little
benefit (Stevens, 1994; Helin and Sandstrom, 2007). By showing that a client’s code of ethics quality affects audit fees, our
study helps evaluate criticisms and requirements pertaining to codes of ethics, and contributes to the debate in the business
2
While audit standards require auditors to assess their clients’ ethical values and behaviors in evaluating audit risk, they are not required to examine the
code of ethics. See Audit Standard (AS) 2110: Identifying and Assessing the Risk of Material Misstatement, and AS 2201: An Audit of Internal Control Over
Financial Reporting That is Integrated with An Audit of Financial Statements.
2
ethics literature on whether a code of ethics is merely window-dressing (Somers, 2001; Valentine and Barnett, 2003; Holder-
Webb and Cohen, 2012).
Our study also contributes to the audit literature. Our contention in this study is that testing the association of codes of
ethics quality with variation in audit fees can provide insights into both audit production and the value of ethics codes as
more generalized control mechanisms. For instance, if codes of ethics were narrowly constructed to reduce financial state-
ment fraud, then we would expect there to be a substitution effect between CEQ and audit fees (i.e., the effect would be
relatively large and uniform across clients). On the other extreme, if ethics codes were designed to reduce fraud and
misconduct unrelated to the financial statements, then we would expect CEQ to be unrelated to audit fees. If codes of ethics
fit between the polar cases, then expectations about the empirical outcomes are not so obvious and, in our opinion, espe-
cially worth exploring. Of particular interest, from an audit production perspective, what are the conditions in which code
of ethics quality is (or is not) associated with audit fees? Is it due to other in-place controls or the nature of the client, such as
size, industry, reporting aggressiveness, etc.? Our study is a start down the path of understanding these potential
relationships.
The remainder of the paper is structured as follows. Section 2 discusses the related literature and outlines the hypothesis
development. Section 3 presents the research design and data sample. In Section 4, we discuss our empirical results. Robust-
ness tests and additional analyses are presented in Section 5, respectively. In Section 6, we provide concluding remarks.
2. Related literature and hypothesis development
2.1. Literature review
Several studies have investigated the association between an audit client’s engagement in controversial activities and
audit fees. Lyon and Maher (2005) find that bribe-paying clients pay higher audit fees. They argue that bribe-paying clients
are exposed to greater business risk because paying bribes increases direct costs, the cost of shareholder litigation, and reg-
ulatory intervention. Bribe-paying clients are also more likely to have poor managerial integrity and weak internal control
infrastructure. Kuang et al. (2020) examine the impact of inherent and control risk on audit fees and find that clients subject
to whistleblowing allegations pay significantly higher audit fees, regardless of the substance of the allegations. In addition,
they find that clients with substantiated whistleblowing cases pay significantly greater audit fees than those with frivolous
cases. Koh and Tong (2013) find that clients involved in controversial corporate activities raise concerns about management
ethics and are associated with higher audit fees. Similarly, Lawson et al. (2019) show that audit fees are higher for violators
of the Foreign Corrupt Practices Act (FCPA), not only during the period in which regulatory investigations occur, but also dur-
ing the violation period.
While prior research examines the impact of unethical behaviors on audit fees, it does not examine the impact of the
quality of the code of ethics, which is the focus of this study. This is an important distinction for several reasons. First, while
a firm’s unethical actions are pronounced events that provide clear signals regarding managerial integrity and ethics, a lower
quality code of ethics does not imply unethical behavior (Mathews, 1987; McKendall et al., 2002; Erwin, 2011). Second,
assessing client ethics is considered by auditors to be one of the most difficult audit tasks (Chow et al., 1987), and the inci-
dence of conspicuous, unethical actions by clients is relatively low. For example, Kuang et al. (2020) identify 770 firm-year
observations with whistleblowing allegations out of a sample of 23,923 firm-year observations. Lawson et al. (2019) identify
a total of 278 FCPA violations from the years 1978 to 2017. In contrast, most clients have a code of ethics, which can be
assessed.
Lastly, section 406 of the Sarbanes-Oxley Act requires public U.S. companies to adopt and disclose a code of ethics that
governs managerial conduct and, if not, provide a justification. The NYSE and NASDAQ also require listed companies to adopt
and disclose a code of ethics. However, prior research examining the impact of codes of ethics is mixed and inconclusive.
Chen et al. (2018) find that a higher quality code of ethics deters managers from engaging in opportunistic financial reporting
practices. Ahluwalia et al. (2018) show that the adoption of a code of ethics is associated with a reduction in the likelihood of
financial restatements. In contrast, other studies find results suggesting that codes of ethics are unlikely to have a discernible
impact and are merely window-dressing designed to minimize potential legal exposure in the event of misconduct (Lere and
Gaumnitz, 2003; Kaptein and Schwartz, 2008; Kaptein, 2015). Using a sample of manufacturing firms in the U.S., Mathews
(1987) finds that codes of ethics do not deter violations of government regulations. Similarly, McKendall et al. (2002) conduct
a survey among 315 U.S. companies and find no evidence that firms with a set of higher ethical standards have fewer legal
violations. Egels-Zanden (2007) and Mijatovic and Stokic (2010) also find that ethical codes have little to no impact on firm
behavior. If codes of ethics do not have a discernible impact and are perceived to provide little to no value, they are unlikely
to influence auditor judgments and decisions.
We contribute to the literature by investigating the association between the quality of clients’ codes of ethics and audit
pricing. This provides greater insight into both the value of ethics codes and the audit production function. In addition, we
examine different components of the codes of ethics, including the implementation system, policies relating to bribery and
corruption, and policies relating to human rights. Thus, rather than focusing on a specific aspect of the code of ethics, our
measure allows us to examine the impact of a firm’s ethical values more broadly. Our study also provides insight into the
impact of client CEQ on audit effort and litigation risk.
3
2.2. Hypothesis development: code of ethics quality and audit fees
According to a study from KPMG (2014), codes of ethics are focused on promoting the core values of a corporation and
deterring misconduct. The most commonly cited core values in codes of ethics are integrity, respect, honesty, responsibility,
and trust. More than 75% of the codes specify, in detail, employee responsibilities regarding confidential information, the
accuracy of reporting, fraud, the protection of corporate property, and gifts and entertainment.3 By clarifying the boundaries
of acceptable behavior and provided that a code of ethics is adhered to, a code of ethics is expected to lead to a change in judg-
ments and subsequent decision-making (Ladd, 1985), which should reduce the risk of managerial misconduct.
Although empirical evidence regarding the impact of a code of ethics on restricting corporate misconduct and opportunis-
tic behavior is still inconclusive, the extant theory predicts that such a relationship exists. Bicchieri’s (2006) model of social
norm activation suggests that an individual will follow a social norm if three conditions are met, which we discuss in the
context of the code of ethics. The first is the contingency condition, which requires that an employee be aware that they
are in a setting in which the code of ethics applies. The second condition, known as the empirical expectations condition,
is the belief that many people conform to codes of ethics. And the third condition (normative expectations) suggests that
the employee believes that many other people believe the employee should conform to the code of ethics. Bicchieri’s
(2006) model also indicates that the threat of punishment for nonconformance is the strongest form of expectation to ensure
conformance. Given efforts by regulators and the financial markets to emphasize and require codes of ethics, and the degree
to which corporate scandals are publicized, it is reasonable to expect that the social norms provided by a code of ethics will
be activated.
The AICPA’s Statements on Quality Control Standards suggest that consideration of the integrity of a client’s management
is an important element in client acceptance and continuance. AS 2110 and AS 2201 require auditors to obtain an under-
standing of the control environment and fraud risks of a company by evaluating whether ethical values are developed, com-
municated, and understood by employees, especially those in top management.4 A survey of Big 4 auditors suggests that a
relatively common method of assessing managerial integrity involves evaluating the client’s code of ethics (Kassem, 2018).
As a code of ethics is perceived as an important mechanism for developing and communicating ethical values (Babri et al.
2021), a lower quality code of ethics may reflect poorly on managerial integrity and the quality of the control system, increasing
both inherent and control risk.5 Prior research provides evidence that auditors’ assessments of management integrity are related
to audit risk, audit planning, and audit outcomes (see, e.g., Kizirian et al., 2005; Allen et al., 2006).
In a seminal study, Simunic (1980) develops a model to specify the determinants of audit fees. In his model, the costs of
conducting an audit (i.e., audit fees) consist of two components: (i) the resource cost component, and (ii) the expected loss
component. The resource cost component measures auditor effort, while the expected loss component is the present value of
possible future losses that may arise from auditing the client’s financial statements. Both components are influenced by the
amount of audit risk. Audit risk refers to the likelihood of an auditor providing a clean opinion on a misstated financial state-
ment, and is a function of inherent, control, and detection risk (Knechel and Salterio, 2016). Together, inherent and control
risk determine the likelihood that a material misstatement exists in the client’s financial statements. When an auditor
assesses a client as having high inherent and/or control risk, the auditor may increase the billing rate to compensate them-
selves for the increased amount of audit effort needed to reduce detection risk (i.e., higher resource component) or for the
potential litigation and reputation costs (i.e., higher expected loss component) (Simunic and Stein, 1996; Hay et al., 2006;
Kuang et al., 2020). Consistent with these theoretical arguments, a large body of evidence shows that auditors increase
the pricing of their audit services when a client’s perceived inherent and control risks are higher (DeFond and Zhang, 2014).6
However, there are several reasons why clients with lower CEQ may not pay higher audit fees. First, we note that while
evaluating a client’s business ethics is an integral part of an audit, audit standards are ambiguous with respect to assessment
procedures. For example, AS 2201 states, ‘‘As part of evaluating the control environment, the auditor should assess – whether
sound integrity and ethical values, particularly of top management, are developed and understood.” AS 2110 contains similar
ambiguous wording in providing guidance on assessing ‘‘ethical behavior” and ‘‘ethical values”. That is, audit standards are
unclear regarding specific procedures to assess a client’s ethicality. Therefore, it is possible that the quality of the code of
ethics may not be (fully) incorporated into auditors’ judgments and decisions, especially in light of the common perspective
that codes of ethics are window-dressing (Stevens, 1994; Helin and Sandstrom, 2007). Second, clients with higher CEQ may
demand higher-quality audits (e.g., wider scope or more extensive testing) to avoid potential litigation risk and reputation
impairment. Thus, it is possible to observe no difference or even higher audit fees for clients with higher CEQ. The above
discussion leads to the following hypothesis stated in null form:
3
See more details in ‘‘The business codes of the Fortune Global 200: What the largest companies in the world say and do.” (KPMG, 2014).
4
AS 2201 can be accessed at: https://pcaobus.org/oversight/standards/auditing-standards/details/AS2201. AS 2110 can be accessed at: https://pcaobus.org/
oversight/standards/auditing-standards/details/AS2110.
5
Control risk refers to the risk of a material misstatement because of deficiencies in the internal control system. Inherent risk refers to the risk of a material
misstatement due to error or omission as a result of factors other than the failure of controls. Detection risk is the risk that the audit procedures may fail to
detect a material misstatement (AICPA, 2017).
6
Gul et al. (2003) and Bedard and Johnstone (2004), for instance, find that heightened earnings management risk increases planned audit effort and billing
rates. Previous research also documents higher audit fees for clients with internal control deficiencies (Hogan and Wilkins, 2008; Lee, 2018), lower accounting
conservatism (DeFond et al., 2016), more severe agency problems (Griffin et al., 2010), higher managerial risk-taking incentives (Fargher et al., 2014; Jia, 2017),
higher litigation risk (Venkataraman et al., 2008), and higher corporate governance risk (Bedard and Johnstone, 2004).
4
H1: The quality of a client’s code of ethics does not affect its audit fees, ceteris paribus.
2.3. Research design
2.3.1. Measures of codes of ethics quality

Following prior research (Scholtens and Dam, 2007; Chen et al., 2018), we gather data on the codes of ethics of U.S. public
firms from Vigeo Eiris7, a global independent research organization providing environmental, social, ethical, and governance
data to investors and corporate firms. Vigeo Eiris collects data from a variety of sources.8 To quantify the quality of an organi-
zation’s code of ethics, Vigeo Eiris has a scoring table to assign grades to specific attributes in four main code of ethics compo-
nents. Each component focuses on a unique, but related aspect of ethical practice, and is evaluated based on the
comprehensiveness of the current policies and procedures to identify, report, and address ethical issues. Based on the informa-
tion collected from various sources, Vigeo Eiris analysts assign grades using the answers to questions corresponding to each
component as follows:
1. System: measures the comprehensiveness of a code of ethics based on the answer to the question, ‘‘Does the company have
a code of ethics and, if so, how comprehensive is it?” The comprehensiveness is evaluated based on the degree to which a
company engages in different activities, such as obeying laws and regulations, prohibiting giving and receiving bribes,
restricting the giving and receiving of gifts, restricting facilitation payments, prohibiting political donations, and commit-
ting to honesty, integrity and fairness. The possible answers include no (coded as 0), limited (coded as 1), basic (coded as
2), intermediate (coded as 3), and advanced (coded as 4).
2. Implementation: measures the strength of the system used to implement the code of ethics based on the answer to the
question ‘‘Does the company have a system for implementing the code of ethics and, if so, how comprehensive is it?” The
strength of the implementation system is evaluated based on several elements, such as the provision of employee train-
ing, compliance monitoring, ‘‘whistleblowing” procedures, details of breaches and enforcements in reports, and regular
implementation reviews. The possible answers include no (coded as 0), limited (coded as 1), basic (coded as 2), interme-
diate (coded as 3), and advanced (coded as 4).
3. Corruption: measures the tolerance of misconduct related to bribery and corruption practices based on the answer to the
question ‘‘Does the company have countering bribery and corruption policies and procedures, and a countering bribery and
corruption reporting system, and if so, how comprehensive is it?”. The possible answers include no or limited (coded as
0), intermediate (coded as 1), and good or advanced (coded as 2).
4. Human Right: measures the tolerance of unethical practices related to human rights based on the question ‘‘What is the
extent of policy and systems addressing human right issues?” The possible answers are no (coded as 0), limited (coded as 1),
intermediate (coded as 2), and good or advanced (coded as 3). The tolerance of unethical practices related to human rights
is evaluated based on different elements such as work environment safety, child labor, forced labor, freedom of associa-
tion, collective bargaining and non-discrimination, explicit statements supporting the Universal Declaration of Human
Rights by the United Nations in 1948, communication of policies to employees, annual employee training, monitoring
and procedures to remedy non-compliance, identifying major human rights challenges, integration into risk assessment
procedures, and supporting human rights capacity-building projects.
To create an aggregate measure of code of ethics quality, we perform factor analysis to construct a variable, Ethics, to com-
bine the information from the four components (System, Implementation, Corruption, and Human Right). The factor analysis
suggests that there is one factor with an Eigen value larger than one (Eigen value = 2.42, System, Implementation, Corruption,
and Human Right positively contribute to the common factor Ethics and explain 60.38% of the variation in the data).9
2.4. Empirical model
To test our hypothesis, we use a multivariate regression in which the dependent variable is the natural logarithm of audit
fees charged by external auditors (Fung et al., 2012; Jha and Chen, 2015; Kuang et al., 2020). The key variable of interest is
the quality of the code of ethics (Ethics):
X X X
LnAuditFeei;t ¼ b0 þ b1 Ethicsi;t þ Controls þ YearIndicatorsþ IndustryIndicators þ ei;t ð1Þ
7
https://vigeo-eiris.com/. Vigeo Eiris is a global provider of Ethical Investment Research Service to investors. Vigeo Eiris was formed from a merger in
December 2015 of two long-standing research organizations: EIRIS and Vigeo. Vigeo Eiris covers more than 4,000 issuers from 40 countries. The issuers are
large public companies included in the main stock market indices in each country. In the U.S., Vigeo Eiris covers S&P 500 firms.
8
These sources include: (1) analyzing public company documents, including annual reports, websites, specific environmental reports, corporate social
responsibility reports, codes of ethics, codes of conduct, and sustainability reports; (2) analyzing responses to annual surveys and profile mailings sent to
corporate firms in the Vigeo Eiris watch list (in the U.S., this list includes S&P 500 firms); (3) using independent and reliable information sources, such as
relevant regulatory data; (4) analyzing media coverage and press releases; and (5) interacting with company representatives, without compromising the
autonomous and independent research status.
9
For the sake of brevity, the factor analysis results are not tabulated, but are available upon request.
5
where the subscripts i and t refer to firm i and year t, and e is an error term. Following the extant literature, we include a
vector of variables that control for client, auditor, and audit engagement characteristics. The model clusters standard errors
by firm (Petersen, 2009), and controls for year and industry fixed effects. Client characteristics include firm size, business
complexity, inherent risk, litigation risk, profitability, leverage, corporate governance, and analyst following (Hay et al.,
2006; Jha and Chen, 2015). As inventory and receivables are two of the most difficult areas to audit (Simunic, 1980;
Newton and Ashton, 1989), we define inherent risk as the sum of inventory and receivables divided by total assets (see,
e.g., Hay et al., 2006). Litigation risk refers to whether the client operates in a litigious industry, which increases the client
risk that auditors face (Venkataraman et al., 2008; Jha and Chen, 2015). Auditor-related control variables include auditor
type, auditor specialization, auditor scale, auditor changes, and industry competition among audit firms (Fung et al.,
2012; Newton et al., 2013). Audit engagement variables include auditor report lag, a binary variable capturing whether
the audit is conducted during the busy season, and a binary variable capturing whether the auditor issues an unqualified
opinion (Hay et al., 2006). All the variables are measured in year t and are defined in Appendix A.
2.5. Data sample and descriptive statistics
Our sample includes publicly traded U.S firms in the S&P 500 index for the period 2003–2018. The sample is limited to
S&P 500 firms and the sample period due to the availability of code of ethics data in Vigeo Eiris. The initial data sample
obtained from Vigeo Eiris includes 6,457 firm-year observations. We then merge the code of ethics data with audit fees
and other audit-related data from Audit Analytics, and with financial accounting data from Compustat North America. After
requiring the data needed to compute the variables used in the multivariate regression analyses and removing observations
without a code of ethics (System = 0), our final sample consists of 4,092 firm-year observations. All continuous variables are
winsorized at the top and bottom first percentiles to mitigate the influence of outliers.
Panel A of Table 1 reports descriptive statistics on audit fees, as well as other client, auditor, and engagement character-
istics. The mean (median) audit fee is $7,615,179 ($5,235,868).10 We also include descriptive statistics for the measure of the
quality of the code of ethics (Ethics) and its four components (System, Implementation, Corruption, and HumanRight). Although
our sample covers a longer and more recent period, the statistics of the measure of code of ethics quality and its components
are comparable to those reported in prior research (e.g., Chen et al., 2018).
Panel B of Table 1 presents the results of tests examining differences between Low- and High-Ethics clients partitioned
based on the median value of Ethics. On average, Low-Ethics clients pay $6,990,062 in audit fees (the average of LnAuditFee
is 15.760), which is significantly higher than the average audit fees of $3,685,807 (average LnAuditFee is 15.120) paid by High-
Ethics clients (p-value < 0.01). Low- and High-Ethics clients are also significantly different from one another in regard to other
characteristics, such as size, business complexity, inherent risk, and level of debt. These differences indicate the importance
of controlling for these variables when estimating the impact of CEQ on audit fees.
Panel C of Table 1 shows the annual changes in Ethics as well as its four individual components. In general, there is an
upward trend in Ethics, including its components, with the exception of Corruption. This suggests that firms have been
improving the comprehensiveness of their code of ethics, the system for implementing the code of ethics, and policies
related to human rights. For the System component, there are large increases in quality in 2004 and 2005. Afterward, the
changes in System are relatively small. The Implementation component, however, shows a fairly greater amount of variation
from year to year, whereas the Human Right component shows very little variation over the whole sample period. This sug-
gests that firms have been largely focusing on improving their systems for implementing the code of ethics.
In Table 2, we examine the correlations between our variables of interest. The correlation of 0.410 between Ethics and
LnAuditFee is statistically significant (p-value < 0.01), consistent with our hypothesis that clients following lower ethical
standards pay higher audit fees. However, Ethics is also significantly correlated with other client characteristics, which
include firm size (LnAssets), leverage (Debt), asset structure (CurrentAssets, QuickRatio), inherent risk (InherentRisk), business
complexity (Segment, ForeignOperation), corporate governance (Governance), and analyst following (AnalystCoverage), and
these characteristics are significantly correlated with LnAuditFee. These results again suggest the importance of controlling
for these characteristics in a multivariate regression framework to draw a valid conclusion.
3. Empirical results
3.1. Regression results
The main regression results reported in Table 3 are consistent with our hypothesis. Clients with lower CEQ pay signifi-
cantly higher audit fees, ceteris paribus. Columns 1 and 2 of Table 3 report the coefficients and the p-values of the main
model specified in Equation (1). The coefficient on Ethics is 0.092 and is statistically significant (p-value < 0.01). This sug-
gests that a one-unit decrease in the measure of a client’s CEQ is associated with approximately a nine percent increase in
10
The mean (median) audit fee in our sample is higher than that in some prior studies. For example, Jha and Chen (2015) report that the mean (median) audit
fee is $1,120,000 ($464,000). We attribute the discrepancy to the fact that our sample only focuses on large, publicly traded firms included in the S&P 500 index,
whereas Jha and Chen’s (2015) sample has a larger coverage of smaller, publicly traded firms. Larger firms pay higher audit fees (Pratt and Stice, 1994; Jha and
Chen, 2015).
6
Table 1
Descriptive statistics.
Panel A: Descriptive Statistics – Total Sample

Dependent variable: Mean 1st Quartile Median 3rd Quartile SD
LnAuditFee 15.440 14.856 15.471 16.035 0.843
AuditFee ($US thousand) 7,615,179 2,830,500 5,235,868 9,200,000 7,696,527
Independent variable of interest:
Ethics 4.296 3.787 4.352 4.887 1.006
System 3.514 3.000 4.000 4.000 0.666
Implementation 2.942 2.000 3.000 4.000 0.868
HumanRight 0.482 0.000 0.000 1.000 0.695
Corruption 1.121 1.000 1.000 2.000 0.656
Firm characteristics control variables:
LnAssets 9.311 8.467 9.194 10.165 1.153
Assets ($US million) 24,530.34 4,753.60 9,835.40 25,965.75 43,005.42
Segment 12.258 6.000 12.000 15.000 7.838
CurrentAssets 0.376 0.219 0.366 0.512 0.197
QuickRatio 1.488 0.854 1.192 1.779 1.041
Debt 0.264 0.151 0.248 0.358 0.168
ROA 0.065 0.031 0.063 0.102 0.070
ForeignOperation 0.155 0.000 0.000 0.000 0.362
InherentRisk 0.198 0.089 0.179 0.280 0.133
Litigation 0.224 0.000 0.000 0.000 0.417
Loss 0.102 0.000 0.000 0.000 0.303
AALawSuit 0.026 0.000 0.000 0.000 0.160
Governance 2.186 2.000 2.000 3.000 0.636
AnalystCoverage 6.707 0.000 0.000 13.000 9.343
Auditor characteristics control variables:
Specialist 0.421 0.000 0.000 1.000 0.494
Scale 0.681 0.550 0.700 0.850 0.180
AuditComp 2.086 1.000 2.000 3.000 1.437
AuditorChange 0.022 0.000 0.000 0.000 0.145
Big4 0.985 1.000 1.000 1.000 0.123
Engagement characteristics control variables:
UnqualifiedOpinion 0.701 0.000 1.000 1.000 0.458
DecemberFyr 0.787 1.000 1.000 1.000 0.410
DaysToSign 53.678 48.000 54.000 58.000 13.875
N = 4,092
Panel B: Comparing Characteristics of High- and Low-Ethics Clients

Low-Ethics High-Ethics Difference t-statistics
(1) (2) (1) vs. (2)
LnAuditFee 15.760 15.120 0.640*** 25.14
LnAssets 9.709 8.913 0.796*** 22.41
Segment 12.724 11.792 0.932*** 3.83
CurrentAssets 0.354 0.398 0.044*** 6.29
QuickRatio 1.358 1.618 0.260*** 7.81
Debt 0.286 0.242 0.044*** 8.28
ROA 0.064 0.066 0.002 0.39
ForeignOperation 0.169 0.141 0.028** 2.29
InherentRisk 0.189 0.207 0.018*** 3.11
Litigation 0.226 0.222 0.004 0.42
Loss 0.099 0.105 0.006 0.86
AALawSuit 0.022 0.030 0.008 1.14
Governance 2.268 2.104 0.164*** 6.62
AnalystCoverage 4.476 8.938 4.462*** 15.03
N 2,016 2,076
Panel C: Changes in Ethics and Ethics Components

DEthics DSystem DImplementation DHumanRight DCorruption
(1) (2) (3) (4) (5)
2004 0.622 0.427 0.550 0.010 0.350
2005 1.106 0.546 0.600 0.057 0.479
2006 0.217 0.101 0.920 0.027 0.067
2007 0.142 0.090 0.327 0.032 0.026
2008 0.148 0.071 0.218 0.077 0.012
2009 0.002 0.006 0.112 0.051 0.056
2010 0.122 0.046 0.082 0.062 0.005
(continued on next page)
7
Table 1 (continued)
Panel C: Changes in Ethics and Ethics Components

DEthics DSystem DImplementation DHumanRight DCorruption
2011 0.069 0.030 0.196 0.005 0.020
2012 0.226 0.052 0.121 0.078 0.775
2013 0.347 0.037 0.304 0.026 0.522
2014 0.056 0.014 0.172 0.034 0.500
2015 0.012 0.007 0.046 0.003 0.010
2016 0.038 0.000 0.043 0.049 0.027
2017 0.004 0.012 0.005 0.020 0.014
2018 0.012 0.005 0.046 0.021 0.013
Panel A of this table reports the descriptive statistics for the whole sample. Panel B reports descriptive statistics for the Low- and High-Ethics subsamples
partitioned based on the median value of Ethics. Panel C presents the annual changes in Ethics (DEthics) and its four components (DSystem, DImplementation,
DHumanRight, and DCorruption) over the sample period. ***, **, and * indicate statistical significance at the 0.01, 0.05, and 0.10 level, respectively. A detailed
description of the variables is provided in Appendix A.
total audit fees. For the typical client in our sample with a mean value of audit fees of $7,615,179, this premium charge is
equivalent to $700,596.11
The explanatory power of our model (R2 = 76.59%) is similar to that of prior studies (Francis et al., 2005; Fung et al., 2012;
Jha and Chen, 2015; Lawson et al., 2019). The control variables are also generally statistically significant in their expected
directions. Client size loads positively, consistent with larger firms requiring more audit effort. Similarly, the coefficients
on the control variables for business complexity, leverage, inherent risk, earnings losses, auditor type, and auditor special-
ization are positive and statistically significant (Francis et al., 2005; Hay et al., 2006; Fung et al., 2012). As expected, we find
the control variables that capture the auditors’ economies of scale, audit market competition, analyst following, the issuance
of unqualified opinions, and auditor changes load negatively (Fung et al., 2012; Numan and Willekens, 2012; Jha and Chen,
2015).
To mitigate concerns regarding cross-sectional and serial correlation, we follow the Fama-MacBeth and Newey-West pro-
cedure (Fama and MacBeth, 1973; Newey and West, 1987) to estimate the main regression model annually and find that the
mean coefficient on Ethics remains negative and statistically significant (-0.155, p-value < 0.01). Thus, the results based on
the annual regressions reported in Columns 3 and 4 of Table 3 are consistent with those based on the full sample reported in
Columns 1 and 2.
3.2. Code of ethics components and alternative measures of ethics
Table 4 presents the results of regressing audit fees on each component of Ethics and the control variables. Since the four
components of Ethics are highly correlated, we examine each component separately to avoid multicollinearity issues.12 We
find a significant negative association between audit fees (LnAuditFee) and the System, Implementation, and HumanRight compo-
nents of Ethics (p-value < 0.01). Although the coefficient on Corruption is negative, it is not statistically significant. As shown in
Table 1, Corruption has the lowest amount of variation among the components of Ethics, suggesting that most of the S&P 500
firms in our sample have more similar Corruption scores relative to the other three components of Ethics. This likely contributes
to the insignificant coefficient on Corruption (See Table 5).
We also conduct additional tests using alternative measures of Ethics. The main finding that clients with lower CEQ pay
higher audit fees is robust when the quality of the code of ethics is measured as (1) the sum of the raw scores of the four
components, (2) the sum of the standardized scores of the four components, and (3) an indicator variable for high Ethics that
takes the value of one if Ethics is greater than the mean (or median), and zero otherwise. For the sake of brevity, these results
are not tabulated.
3.3. The impact of code of ethics quality on audit effort and litigation risk
In this section, we consider the impact that code of ethics quality has on auditor effort and litigation risk, which are both
factors that influence audit fees (Simunic, 1980). To show the connection, we first discuss these factors in terms of auditors’
cost and production functions. In the empirical auditing and audit fee literature, it is often assumed that competition in the
market for audits motivates auditors to minimize the costs of audit production. An assessment of the quality of the client’s
ethics code can be incorporated into the cost minimization problem by treating the assessment, ei, as a parameter of the
assurance function. A rational auditor optimizes the audit of a client by choosing the cost that minimizes the level of audit
effort (time). To avoid clutter in the model, we assume there is a single type of labor and write the cost minimization
problem as:
11
$7,615,179 0.092 = $700,596 (rounded).
12
In our main analysis, multicollinearity concerns are mitigated by using factor analysis to combine the four components of Ethics into one variable, Ethics.
8
H. Kim Duong, G. Gotti, M.T. Stein et al.
Table 2
Correlation matrix for variables used in the main analyses.
1 2 3 4 5 6 7 8 9 10 11
1 LnAuditFee
2 Ethics 0.410***
3 LnAssets 0.716*** 0.365***
4 Segment 0.235*** 0.140*** 0.086***
5 CurrentAssets 0.076*** 0.079*** 0.365*** 0.080***
6 QuickRatio 0.295*** 0.132*** 0.305*** 0.002 0.432***
7 Debt 0.124*** 0.098*** 0.147*** 0.079*** 0.380*** 0.295***
8 ROA 0.043*** 0.004 0.094 0.045*** 0.231*** 0.126*** 0.150***
9 ForeignOperation 0.050*** 0.044*** 0.029* 0.072*** 0.078*** 0.030** 0.003 0.023
10 InherentRisk 0.104*** 0.021** 0.222*** 0.158*** 0.612*** 0.091*** 0.162*** 0.154*** 0.171***
11 Litigation 0.052*** 0.014 0.040*** 0.049*** 0.264*** 0.310*** 0.143*** 0.047*** 0.031** 0.016
12 Loss 0.062*** 0.026 0.065*** 0.028* 0.055*** 0.052*** 0.073*** 0.642*** 0.005 0.123*** 0.024
13 AALawSuit 0.022*** 0.008 0.016*** 0.021 0.032*** 0.019 0.002 0.028* 0.002 0.012 0.074***
14 Governance 0.080*** 0.015*** 0.066*** 0.029* 0.057*** 0.044*** 0.012 0.019 0.034 0.057*** 0.048***
15 AnalystCoverage 0.083*** 0.193*** 0.093*** 0.058*** 0.137*** 0.136*** 0.271*** 0.134*** 0.120*** 0.037** 0.160***
16 Specialist 0.153*** 0.065*** 0.110*** 0.001 0.029** 0.106*** 0.017 0.001 0.061*** 0.053*** 0.035**
17 Scale 0.014 0.052*** 0.008 0.049*** 0.029** 0.046*** 0.007 0.002 0.030** 0.005 0.068***
18 AuditComp 0.063** 0.012 0.105*** 0.038** 0.086*** 0.238*** 0.088*** 0.035** 0.066*** 0.139*** 0.272***
9
19 AuditorChange 0.057*** 0.001 0.019 0.004 0.002 0.011 0.015 0.012 0.011 0.005 0.019
20 Big4 0.160*** 0.074*** 0.073*** 0.043*** 0.001 0.055*** 0.046*** 0.034** 0.018 0.020 0.038***
21 UnqualifiedOpinion 0.028* 0.169*** 0.063*** 0.026 0.042*** 0.004 0.039*** 0.008 0.033** 0.050*** 0.048***
22 DecemberFyr 0.038*** 0.003 0.097*** 0.040*** 0.229*** 0.059*** 0.163*** 0.093*** 0.002 0.091*** 0.101***
23 DaysToSign 0.097*** 0.050*** 0.131*** 0.053*** 0.043*** 0.015 0.034** 0.107*** 0.065*** 0.003 0.008
12 13 14 15 16 17 18 19 20 21 22
13 0.001
14 0.006 0.038***
15 0.052*** 0.067*** 0.086***
16 0.028* 0.003 0.013 0.028**
17 0.004 0.011 0.050*** 0.007 0.294***
18 0.080*** 0.008 0.019 0.007 0.129*** 0.038***
19 0.000 0.028* 0.006 0.034** 0.014 0.028** 0.007
J. Account. Public Policy 41 (2022) 107001

20 0.056*** 0.008 0.015 0.003 0.086*** 0.158*** 0.088*** 0.173***
21 0.019 0.037** 0.101*** 0.270*** 0.050*** 0.027* 0.018 0.020 0.017
22 0.050*** 0.012 0.050*** 0.053*** 0.072*** 0.003 0.007 0.011 0.085*** 0.022
23 0.067*** 0.043*** 0.013** 0.022 0.002 0.057*** 0.007 0.082 0.090*** 0.049*** 0.042***
This table reports Pearson correlations of the variables used in the main analysis. ***, **, and * indicate statistical significance at the 0.01, 0.05, and 0.10 level, respectively. A detailed description of the variables is
provided in Appendix A.
Table 3
The impact of code of ethics quality on audit fees.
Dependent Variable = LnAuditFee

Full sample regression Fama-MacBeth annual regressions
Coefficient p-value Coefficient p-value
(1) (2) (3) (4)
Ethics 0.092*** (<0.001) 0.155*** (<0.001)
LnAssets 0.578*** (<0.001) 0.556*** (<0.001)
Segment 0.009*** (<0.001) 0.013*** (<0.001)
CurrentAssets 0.001 (0.984) 0.737*** (<0.001)
QuickRatio 0.060*** (<0.001) 0.068*** (<0.001)
Debt 0.362*** (<0.001) 0.303*** (<0.001)
ROA 0.258* (0.082) 0.369*** (0.011)
ForeignOperation 0.063*** (0.005) 0.011 (0.848)
InherentRisk 1.304*** (<0.001) 0.771*** (<0.001)
Litigation 0.022 (0.350) 0.080*** (<0.001)
Loss 0.082*** (0.011) 0.024 (0.547)
AALawSuit 0.038 (0.379) 0.099* (0.055)
Governance 0.030** (0.022) 0.020 (0.145)
AnalystCoverage 0.004*** (<0.001) 0.008** (0.037)
Specialist 0.119*** (<0.001) 0.090*** (<0.001)
Scale 0.371*** (<0.001) 0.223** (0.049)
AuditComp 0.037** (0.045) 0.055*** (0.004)
AuditorChange 0.180*** (0.021) 0.154** (0.012)
Big4 0.575*** (<0.001) 0.609*** (<0.001)
UnqualifiedOpinion 0.056*** (0.001) 0.107*** (<0.001)
DecemberFyr 0.033* (0.065) 0.013 (0.749)
DaysToSign 0.000 (0.961) 0.001 (0.812)
Industry Indicators Yes Yes
Year Indicators Yes
Observations 4,092
R2 76.59%
This table reports the results of regressing audit fees on client code of ethics quality and other control variables using the full sample (reported in Columns 1
and 2) and using Fama-MacBeth annual regressions (reported in Columns 3 and 4). The p-values are based on standard errors clustered by firm (in Columns
1 and 2) and Newey-West robust standard errors (in Columns 3 and 4). ***, **, and * indicate statistical significance at the 0.01, 0.05, and 0.10 level,
respectively. A detailed description of the variables is provided in Appendix A.
hmincðh; eÞ ¼ w h þ Lð1 qðh; eÞÞand write the cost minimization problem subject to qðh; L; eÞ ¼ qp ð2Þ
where cðÞ is the total cost function, h is the quantity of audit, w is the factor cost (wage rate) of audit effort per unit, L is the
potential loss an auditor may incur through her association with a client’s financial statements and in general represents an
index of client-specific characteristics, qðÞ is the auditor’s production function in which audit effort is transformed into
assurance, qp is a planned level of assurance chosen by the auditor, and e is the assessed level of ethics code quality for a
client.
In this model, assurance is the outcome of the audit and represents the auditor-assessed probability that the post-audit
financial statements are free of material misstatements. Assurance, q, ranges between 0 q < 1 and as q approaches 1, the
probability of a post-audit loss approaches 0. If we impose the necessary mathematical structure to assure an interior solu-
tion to this problem, the optimal choice of audit effort would be characterized by equality between the marginal rate of
assurance implicit in the q() function and the factor cost (i.e., at the margin, the wage rate equals the incremental reduction
in the expected loss of additional effort). To clearly expose our intuition about the connection between code of ethics quality
and audit fees, we posit the following assurance production function:
eh
q¼ ð3Þ
h þ L:5
We add the (reasonable) assumptions h > 0, L > 0, and 0 < e < 1 to assure compliance with the earlier restriction, 0 q < 1.
We also assume e1 > e2, which implies e1 is assessed as a higher quality ethics system than e2 to fix the ordering. In words, the
level of assurance increases in audit effort, h, and ethics assessment, e, but decreases in assessed potential loss, L.
Building on the stated cost and assurance functions, we provide a numerical-based demonstration of how e affects audit
costs for various levels of assurance. The goal is to provide a mechanism connecting changes in the assessed levels of e and
audit costs. The graph shown in Fig. 1 sets L = 500 and generates three assurance contours {q = 0.65, q = 0.75, and q = 0.85} by
varying h and e.
We focus our attention on the contour where q = 0.75 and compare the points labeled A and B. At point A, the assessed
level of code of ethics quality is assessed as 0.85 and this requires 168 units of labor to achieve the planned level of assur-
ance. If we set the cost of labor equal to $1 per unit, the expected cost of the audit is $293. We can compare this with point B
10
Table 4
The impact of code of ethics quality components on audit fees.

(1) (2) (3) (4) (5) (6) (7) (8)
Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value
System 0.376*** (0.002)
Implementation 0.058*** (<0.001)
HumanRight 0.105*** (<0.001)
Corruption 0.002 (0.884)
LnAssets 0.596*** (<0.001) 0.586*** (<0.001) 0.574*** (<0.001) 0.599*** (<0.001)
Segment 0.010*** (<0.001) 0.009*** (<0.001) 0.008*** (<0.001) 0.010*** (<0.001)
CurrentAssets 0.016 (0.831) 0.017 (0.820) 0.012 (0.870) 0.021 (0.777)
QuickRatio 0.066*** (<0.001) 0.063*** (<0.001) 0.061*** (<0.001) 0.068*** (<0.001)
Debt 0.357*** (<0.001) 0.362*** (<0.001) 0.367*** (<0.001) 0.361*** (<0.001)
ROA 0.221 (0.141) 0.233 (0.118) 0.334** (0.023) 0.222 (0.140)
ForeignOperation 0.059*** (0.008) 0.064*** (0.004) 0.058*** (0.008) 0.058*** (0.010)
InherentRisk 1.354*** (<0.001) 1.319*** (<0.001) 1.315*** (<0.001) 1.349*** (<0.001)
Litigation 0.016 (0.489) 0.026 (0.278) 0.017 (0.479) 0.017 (0.460)
Loss 0.090*** (0.006) 0.083*** (0.011) 0.079*** (0.014) 0.088*** (0.007)
AALawSuit 0.041 (0.336) 0.039 (0.357) 0.048 (0.263) 0.041 (0.337)
Governance 0.031** (0.019) 0.029** (0.030) 0.035*** (0.008) 0.032** (0.015)
AnalystCoverage 0.004*** (0.002) 0.004*** (0.002) 0.004*** (0.002) 0.004*** (0.002)
Specialist 0.122*** (<0.001) 0.121*** (<0.001) 0.117*** (<0.001) 0.124*** (<0.001)
Scale 0.364*** (<0.001) 0.377*** (<0.001) 0.356*** (<0.001) 0.365*** (<0.001)
AuditComp 0.033* (0.078) 0.037** (0.043) 0.030*** (<0.001) 0.033* (0.078)
AuditorChange 0.173** (0.026) 0.174** (0.026) 0.177** (0.023) 0.168** (0.031)
Big4 0.577*** (<0.001) 0.605*** (<0.001) 0.599*** (<0.001) 0.604*** (<0.001)
UnqualifiedOpinion 0.053*** (0.003) 0.053*** (0.003) 0.055*** (0.002) 0.054*** (0.002)
DecemberFyr 0.042** (0.020) 0.043** (0.017) 0.033* (0.065) 0.045** (0.012)
DaysToSign 0.000 (0.8297) 0.000 (0.911) 0.000 (0.986) 0.000 (0.819)
Industry Indicators Yes Yes Yes Yes
Year Indicators Yes Yes Yes Yes
Observations 4,092 4,092 4,092 4,092
R2 76.22% 76.38% 76.61% 76.16%
This table reports the results of regressing audit fees on each of the four components of the code of ethics quality and other control variables. The p-values
are based on standard errors clustered by firm. ***, **, and * indicate statistical significance at the 0.01, 0.05, and 0.10 level, respectively. A detailed
Table 5
Example of distribution of material errors in unaudited financial statements.
Distribution of Materials Errors in Unaudited Financial Statements

Ethics Codes No Material Error Material Error Total
High-Quality 25 5 30
Low-Quality 40 30 70
Total 65 35 100
This table presents a numerical example of the distribution of material errors in unaudited financial statements of client firms within a hypothesized
population.
where the assessed level of code of ethics quality is assessed as 0.90 and 112 units of labor are needed. The expected cost of
the audit is now $237. In both cases, the expected loss is $500 (1 – 0.75) = $125.
In one of our empirical tests, we consider the impact of code of ethics quality on audit lag. We argue that audit lag is pos-
itively correlated with audit effort and thereby with audit fees (see e.g., Ettredge et al., 2006; Jha and Chen, 2015). We then
test the association between code of ethics quality and audit lag. If an increase in code of ethics quality results in a decrease
in audit lag, then by the conjectured positive association between audit lag and audit effort, we conclude there is a negative
association between code of ethics quality and audit effort. The economic argument is consistent with the analysis given in
Fig. 1. For a fixed level of assurance, a client with a lower level of code of ethics quality (Point A) will require more audit effort
than a client with a higher level of code of ethics quality (Point B).
Another plausible relationship between code of ethics quality and audit fees we look at in our empirical tests operates
through a negative correlation between code of ethics quality and litigation risk.13 To explore this possibility, recall that in
Equation (2), expected post-audit losses (litigation risk) is the product of the potential loss and the probability the financial
13
Following prior research (see, e.g., Jha and Chen, 2015), we obtain litigation data from the Audit Analytics database and code AALawSuit as 1 if a lawsuit
initiated in any given year belongs to one of the following categories: Accounting and Auditing Enforcement Release (category 54), Accounting Malpractice
(category 2), or Financial Reporting (category 2), and 0 otherwise.
11
Fig. 1. Assurance as a Function of Audit Effort and Code of Ethics Quality. This Figure provides numerical examples of assurance as a function of audit effort
and code of ethics quality. The vertical axis represents audit effort and the horizonal axis represents code of ethics quality.
statements are misstated. While, in theory, one could argue that code of ethics quality could influence either the multiplicand or
the multiplier of the expected loss, we find it more straightforward to focus on the probability of loss and, in particular, the level
of assurance term. As an example of the mechanism where code of ethics quality interacts with the assurance, consider the
following simplified audit process. To start, the auditor posits a prior belief about the probability that the client’s
unaudited financial statements are materially in error. Next, the auditor obtains evidence about the client’s ethics code and
its quality. The auditor then proceeds to use these results to update her belief with respect to the probability of material error
in the unaudited statements. Finally, the auditor uses her updated (posterior) belief to determine the extent of substantive test-
ing required to attain the planned level of assurance for the audit. We view this process as broadly consistent with a ‘‘risk-
based” approach to auditing and it would equally apply to any case where auditors consider relying upon controls to reduce
tests of details.
For concreteness, we provide the following numerical example starting with a prior distribution of the material errors in
the unaudited financial statements of client firms within a hypothesized population.
Initially, the auditor has the prior belief that 65% (65/100) of unaudited financial statements are free of material error.
After an initial investigation, the auditor learns of the quality of the client’s ethics code. Using Bayes rule, the auditor updates
her beliefs about the client’s financial statements. That is, conditional on the client having a high-quality ethics code, the
probability that the unaudited financial statements are free of material error is 83% (25/30), implying that the risk of material
misstatement is 17%. Conditional on the client having a low-quality ethics code, the probability that the unaudited financial
statements are free of material errors is 57%, implying that the risk of material misstatement is 43%. Given that the potential
loss and planned level of assurance are fixed, the auditor adjusts the substantive testing component of the audit program
accordingly. Comparing the outcomes, we see there is a lower assessed risk of a material misstatement when a high-
quality ethics code is in place. In turn, less additional evidence (auditor effort) should be required for the auditor to reach
the target assurance through substantive tests.
12
Table 6
Client’s code of ethics quality and auditor effort.
Dependent
Variable = DaysToSign
(1) (2)
Coefficient p-value
Ethics 0.902*** (0.005)
LnAssets 2.180*** (<0.001)
Segment 0.082*** (0.002)
CurrentAssets 5.573*** (0.003)
QuickRatio 0.319 (0.216)
Debt 3.250** (0.020)
ROA 25.061*** (<0.001)
ForeignOperation 2.286*** (0.004)
InherentRisk 1.298 (0.699)
Litigation 1.009 (0.224)
Loss 1.704* (0.104)
Governance 0.590 (0.145)
AnalystCoverage 0.045 (0.317)
Specialist 0.792 (0.105)
Scale 4.358*** (0.002)
AuditComp 10.474 (0.458)
AuditorChange 6.110*** (<0.001)
Big4 7.116*** (<0.001)
UnqualifiedOpinion 0.732 (0.165)
DecemberFyr 1.838*** (0.012)
Industry Indicators Yes
Year Indicators Yes
Observations 4,092
R2 15.84%
This table reports the results of a regression analysis that examines the asso-
ciation between auditor effort and client code of ethics quality. The p-values are
based on standard errors clustered by firm. ***, **, and * indicate statistical
significance at the 0.01, 0.05, and 0.10 level, respectively. A detailed description
of the variables is provided in Appendix A.
To summarize, we hypothesize that clients with low litigation risk will choose to implement high-quality codes of ethics
as controls. These controls (or lack thereof) then serve as a signal correlated with the probability that the unaudited financial
statements are free of material error. Once auditors observe this signal, the information is incorporated into the audit pro-
gram and reflected in the amount of effort (substantive testing) required to attain the targeted level of assurance.
Table 6 presents the results of our analysis examining the impact of code of ethics quality on audit lag (DaysToSign). The
coefficient on Ethics is 0.902 in Column (1) and is statistically significant (p-value < 0.01). This result suggests that a one-
unit decrease in the measure of CEQ is associated with roughly one additional day spent on an audit engagement. The
explanatory power of our model (R2 = 15.84%) is in line with the models reported in Jha and Chen (2015) and Ettredge
et al. (2006).14
Table 7 presents the results of our analysis examining the impact of code of ethics quality on litigation risk. The results
presented in Table 7 suggest that clients with lower ethical standards have significantly higher litigation risk. The coefficient
on Ethics is 0.196 and is statistically significant with a p-value of 0.036. The odds ratio based on this coefficient is 82.18 (exp
(-0.196)), suggesting that a one-unit decrease in the measure of client CEQ is associated with a 17.82 percent increase in the
probability of litigation. The explanatory power of our model is roughly in line with that reported in prior studies (see, e.g.,
Jha and Chen, 2015).
4. Robustness tests and additional analyses
Endogeneity may bias the association between client CEQ and audit fees. This coefficient bias may result from correlated
omitted variables. This issue arises from potential latent factors that influence both client CEQ and audit fees, but cannot be
measured or controlled for. To address endogeneity concerns, we employ multiple conventional approaches such as: (1)
including additional control variables, (2) using an instrumental variable approach, (3) using the generalized method of
moments (GMM) estimation technique for dynamic panels developed in Blundell and Bond (1998), (4) using entropy-
balancing, and (5) using the Blinder-Oaxaca decomposition analysis. Finally, we conduct an additional analysis to examine
the impact of CEQ on audit fees in heightened audit risk contexts where clients are involved in complex transactions such as
mergers and acquisitions (M&A) and seasoned equity offerings (SEO).
14
Jha and Chen’s (2015) model explaining audit delay has an R2 = 21.8% and Ettredge et al. (2006) report an R2 = 14.4% in the post-SOX 404 period.
13
Table 7
Client’s code of ethics quality and litigation risk.
Dependent Variable = AALawSuit

(1) (2)
Coefficient p-value
Ethics 0.196** (0.036)
LnAssets 0.026 (0.870)
Segment 0.042* (0.072)
CurrentAssets 0.685 (0.150)
QuickRatio 0.204 (0.146)
Debt 0.590 (0.557)
ROA 3.737 (0.220)
ForeignOperation 0.831** (0.039)
InherentRisk 1.564 (0.343)
Litigation 0.803** (0.016)
Loss 1.386* (0.085)
Specialist 0.351 (0.252)
Scale 0.215 (0.792)
AuditComp 0.353*** (0.001)
AuditorChange 1.672*** (0.011)
Big4 1.458 (0.987)
UnqualifiedOpinion 0.060 (0.832)
DecemberFyr 0.381 (0.235)
Year Indicators Yes
Observations 4,092
McFadden Pseudo R2 11.18%
This table reports the results of a logistic regression model examining the
association between a client’s code of ethics quality and accounting and
auditing litigation risk. The dependent variable, AALawSuit, is set equal to 1 for a
firm-year if the firm is the defendant in a lawsuit related to accounting and/or
auditing issues, and 0 otherwise. The p-values are based on standard errors
clustered by firm. ***, **, and * indicate statistical significance at the 0.01, 0.05,
and 0.10 level, respectively. A detailed description of the variables is provided in
Appendix A.
4.1. Additional control variables
Prior research suggests that earnings quality is associated with both audit fees and the quality of a code of ethics. Gul et al.
(2003) and Lawson and Wang (2016) find that auditors charge lower audit fees when their clients have higher earnings qual-
ity (i.e., lower abnormal accruals). Chen et al. (2018) find that firms with a higher quality code of ethics have higher earnings
quality (i.e., lower abnormal accruals). To ensure the robustness of our findings, we add earnings quality, measured as the
rank of the absolute value of discretionary accruals, calculated using the modified Jones model (Dechow et al., 1995), as an
additional control variable in Equation (1). In addition, Gotti et al. (2012) find a relation between audit fees and managerial
ownership. They argue that since managerial equity ownership is likely to influence managers’ financial reporting incentives,
it is also likely to influence auditor effort and audit fees. To ensure the robustness of our findings, we also add managerial
ownership as an additional control variable in Equation (1). We obtain managerial ownership data from Execucomp. The
variable, Manager Ownership, is measured as the sum of managerial stock and option values, divided by firm market value.
The results after adding both earnings quality and managerial ownership as control variables are presented in columns 1 and
2 of Table 8. Contrary to expectations, the coefficient on our earnings quality measure is negative, and the coefficient on our
managerial ownership measure is positive, however, they are not statistically significant. More importantly, the coefficient
on Ethics continues to be negative and statistically significant (p-value < 0.01). Thus, our main findings are robust to the
inclusion of the aforementioned control variables.
In addition, involvement in controversial corporate social activities can be indicative of increased client business risk and
raise concerns about management integrity and ethics. Koh and Tong (2013) show that auditors charge higher audit fees to
clients engaged in such activities. A set of high ethical standards may provide concrete guidance and deter managers from
engaging in controversial activities. To ensure that our results are not driven by corporate social activities, we additionally
control for corporate social responsibility (CSR), in addition to earnings quality and managerial ownership. We obtain CSR
data from the Vigeo Eiris database. The CSR measures from the Vigeo Eiris database are comparable to the CSR measures
of MSCI KLD database used in Koh and Tong (2013). The Vigeo Eiris CSR measure is evaluated based on three dimensions:
community, environmental, and employee performance. We merge the CSR data into our main sample and obtain a sample
of 1,597 firm-year observations. The regression results are reported in columns (3) and (4) of Table 8. We find a negative
14
Table 8
Robustness check – additional control variables.
Dependent variable: LnAuditFee

(1) (2) (3) (4)
Coefficient p-value Coefficient p-value
Ethics 0.078*** (<0.001) 0.057* (0.068)
LnAssets 0.604*** (<0.001) 0.647*** (<0.001)
Segment 0.008*** (<0.001) 0.007* (0.083)
CurrentAssets 0.091 (0.203) 0.139 (0.552)
QuickRatio 0.043*** (<0.001) 0.033 (0.227)
Debt 0.170*** (0.009) 0.060 (0.802)
ROA 0.438*** (0.004) 0.318 (0.364)
ForeignOperation 0.008 (0.730) 0.095 (0.240)
InherentRisk 1.293*** (<0.001) 1.166*** (0.006)
Litigation 0.054** (0.022) 0.078 (0.288)
Loss 0.064* (0.063) 0.044 (0.541)
AALawSuit 0.012 (0.771) 0.008 (0.901)
Governance 0.012 (0.363) 0.004 (0.918)
AnalystCoverage 0.006*** (<0.001) 0.013** (0.038)
Specialist 0.118*** (<0.001) 0.063* (0.105)
Scale 0.376*** (<0.001) 0.363*** (0.009)
AuditComp 0.043** (0.018) 0.015 (0.512)
AuditorChange 0.130 (0.146) 0.252** (0.046)
Big4 0.501*** (<0.001) 0.423*** (0.006)
UnqualifiedOpinion 0.041** (0.023) 0.061** (0.023)
DecemberFyr 0.038** (0.041) 0.042 (0.483)
DaysToSign 0.005*** (<0.001) 0.005*** (<0.001)
ManagerOwnership 0.006 (0.283) 0.008 (0.676)
AbAccruals 0.010 (0.508) 0.009 (0.736)
CSR 0.002 (0.986)
Year Indicators Yes Yes
Observations 3,368 1,597
R2 79.34% 81.86%
This table reports the coefficients of the main regression model when adding managerial ownership (ManagerOwnership), earnings quality (AbAccruals) and
CSR (CSR) to the control variables in Table 3. The p-values are based on standard errors clustered by firm. ***, **, and * indicate statistical significance at the
0.01, 0.05, and 0.10 level, respectively. A detailed description of the variables is provided in Appendix A.
coefficient on CSR, although it is not statistically significant. However, we continue to find a negative and statistically signif-
icant coefficient on Ethics, indicating that our prior findings are robust to the inclusion of CSR.
4.2. Instrumental variable approach
In our second approach to addressing endogeneity, we use the average score of the quality of codes of ethics of other firms
in the same 2-digit SIC industry (Ethics_IV) as the instrument for business ethics. We use Ethics_IV as an instrumental vari-
able because firms often follow industry-wide practices when designing and enforcing ethical standards (Duong et al., 2021),
but the average quality of firms’ codes of ethics in an industry should not directly affect the focal firm’s audit fees.15
We conduct the Durbin-Wu-Hausman test (Durbin, 1954; Wu, 1973; Hausman, 1978) to test for the presence of endo-
geneity in our regression model by comparing the OLS estimate of the structure parameters in the instrumental variable
regression to that of the two-stage least squares (2SLS). The p-value from the Durbin-Wu-Hausman test is 0.18, suggesting
that there is not a significant presence of endogeneity in our regression model, and that 2SLS is not preferred over OLS. Nev-
ertheless, we report the results using the instrumental variable approach in Columns 1 to 4 of Table 9 as a reference.
In the first-stage regression, we apply the Sanderson-Windmeijer (2016) test to check whether the instrumental variable
is significant. The test results reported in Columns 1 and 2 of Table 9 indicate that Ethics_IV is significantly related to the
endogenous regressor Ethics. The results from the second-stage regression (Columns 3 and 4) show that clients with lower
quality ethics codes pay significantly higher audit fees.
15
Lawson et al. (2019) provide evidence that when one firm violates the Foreign Corrupt Practices Act (FCPA), there is a contagion effect on audit fees among
non-violating peer firms. If this evidence violates the validity requirement that Ethics_IV does not directly affect audit fees, then the coefficient estimate we
provide on Ethics will be biased and inconsistent. However, we find it unlikely that such is the case. Lawson et al.’s results suggest that if one firm is caught
violating the FCPA, then it increases the risk that a peer firm also violated the FCPA, but was not caught. Importantly, the actions of the non-violating peer firms
in their study are not observable. In contrast, in our study, auditors can directly observe each client’s code of ethics, removing the need to infer information from
peer firms’ codes of ethics. That is, the average quality of industry firms’ codes of ethics should impact audit fees indirectly through its impact on the quality of
the focal client’s code of ethics. In addition, our IV focuses on all industry firms, and, intuitively, a firm’s peers do not include all firms in the same 2-digit SIC
industry. Lawson et al. identify peers by matching on five characteristics, which include year, industry, auditor, geographic location of the FCPA violation, and
size.
15
Table 9
Robustness check – 2SLS and Blundell and Bond (1998) GMM estimation.
2SLS Estimation Blundell and Bond (1998)

GMM estimation
First-stage estimation Second-stage estimation Dependent variable:
Dependent variable: Ethics Dependent variable: LnAuditFee
LnAuditFee
(1) (2) (3) (4) (5) (6)
Coefficient p-value Coefficient p-value Coefficient p-value
Ethics 0.415*** (<0.001) 0.048*** (<0.001)
Ethics_IV 0.722*** (<0.001)
LagLnAuditFee 0.426*** (<0.001)
LnAssets 0.227*** (<0.001) 0.450*** (<0.001) 0.368*** (<0.001)
Segment 0.010*** (<0.001) 0.010*** (<0.001) 0.006*** (<0.001)
CurrentAssets 0.305*** (0.002) 0.606*** (<0.001) 0.001 (0.986)
QuickRatio 0.035*** (0.015) 0.061*** (<0.001) 0.045*** (<0.001)
Debt 0.186*** (0.012) 0.314*** (<0.001) 0.241*** (<0.001)
ROA 0.510** (0.018) 0.399*** (0.018) 0.209* (0.086)
ForeignOperation 0.010 (0.746) 0.035 (0.133) 0.039** (0.031)
InherentRisk 0.198 (0.119) 0.954*** (<0.001) 0.762*** (<0.001)
Litigation 0.037 (0.209) 0.090*** (<0.001) 0.003 (0.874)
Loss 0.094** (0.053) 0.010 (0.769) 0.022 (0.384)
AALawSuit 0.013 (0.846) 0.100** (0.020) 0.027 (0.457)
Governance 0.140*** (<0.001) 0.011 (0.460) 0.015 (0.170)
AnalystCoverage 0.010*** (<0.001) 0.003*** (0.008) 0.002 (0.126)
Specialist 0.017 (0.484) 0.098*** (<0.001) 0.081*** (<0.001)
Scale 0.190*** (0.004) 0.202*** (<0.001) 0.235*** (<0.001)
AuditComp 0.047*** (<0.001) 0.039*** (<0.001) 0.024 (0.126)
AuditorChange 0.044 (0.564) 0.198*** (0.013) 0.123* (0.071)
Big4 0.283*** (0.002) 0.490*** (<0.001) 0.393*** (<0.001)
UnqualifiedOpinion 0.207*** (<0.001) 0.199*** (<0.001) 0.058*** (<0.001)
DecemberFyr 0.084*** (0.002) 0.017 (0.415) 0.036** (0.020)
DaysToSign 0.000 (0.708) 0.000 (0.946) 0.001 (0.981)
Industry Indicators Yes Yes Yes
Year Indicators Yes Yes Yes
Observations 4,092 4,092 3,468
R2 25.27% 65.09% 84.37%
This table reports the results using the GMM estimation method as specified in Blundell and Bond (1998) and 2SLS estimation. The p-values are based on
standard errors clustered by firm. ***, **, and * indicate statistical significance at the 0.01, 0.05, and 0.10 level, respectively. A detailed description of the
variables is provided in Appendix A.
4.3. Blundell and Bond (1998) generalized method of moments
In the third approach to address endogeneity, we employ a dynamic panel model estimation using the system of gener-
alized method of moments (GMM) technique developed by Blundell and Bond (1998), which jointly estimates the cross-
sectional effects and a lagged dependent variable. This approach has been used widely in prior literature to address reverse
causality (Klein, 1998; Chen et al., 2011; Wu et al., 2021). The results reported in Table 9 (Columns 5 and 6) are consistent
with our prior findings.
4.4. Entropy balancing
In our fourth approach to address endogeneity, we use entropy balancing. The purpose of entropy balancing is to elim-
inate differences in observable covariates across a treatment and control group. This requires us to divide our sample into
two groups. We use the median value of Ethics and segregate clients into a High-Ethics or Low-Ethics group. We balance
our sample across all control variables, and we equalize the first (mean), second (variance), and third (skewness) moments
of each covariate distribution using a tolerance level of 0.015 for convergence. Descriptive statistics on the covariates for the
High-Ethics and Low-Ethics groups both prior to and after entropy balancing are provided in Panel A of Table 10.
As can be seen from Panel A, the three moments of the covariate distributions after entropy balancing are nearly identical
for the High-Ethics and Low-Ethics groups. This increases the likelihood that any differences in audit fees we document
between the two groups are driven by code of ethics quality rather than correlated differences in the control variables.
The regression results of estimating Equation (1) using our entropy balanced sample are provided in Table 10, Panel B.
The coefficient on HighEthics is negative and statistically significant (p-value < 0.01). Thus, the results in Table 10 remain
consistent with our previous findings.
16
Table 10
Robustness check – entropy balanced sample.
Panel A: Descriptive statistics before and after entropy balancing

Before entropy balancing
High Ethics Low Ethics
Variable N Mean Variance Skewness N Mean Variance Skewness
LnAssets 2,076 8.913 1.084 0.392 2,016 9.709 1.281 0.052
Segment 2,076 11.792 57.980 1.092 2,016 12.724 64.130 1.156
CurrentAssets 2,076 0.398 0.043 0.170 2,016 0.354 0.045 0.336
QuickRatio 2,076 1.618 1.462 2.233 2,016 1.358 0.692 2.012
Debt 2,076 0.242 0.029 0.714 2,016 0.286 0.027 0.745
ROA 2,076 0.066 0.005 0.786 2,016 0.064 0.008 0.611
ForeignOperation 2,076 0.141 0.121 2.067 2,016 0.169 0.112 1.769
InherentRisk 2,076 0.207 0.020 0.868 2,016 0.189 0.011 1.007
Litigation 2,076 0.222 0.173 1.341 2,016 0.226 0.166 1.306
Loss 2,076 0.105 0.094 2.577 2,016 0.099 0.088 2.701
AALawSuit 2,076 0.030 0.029 5.524 2,016 0.022 0.025 6.313
Governance 2,076 2.104 0.524 0.975 2,016 2.268 0.308 0.135
AnalystCoverage 2,076 8.938 95.790 0.874 2,016 4.476 69.101 1.734
Specialist 2,076 0.378 0.235 0.505 2,016 0.459 0.254 0.150
Scale 2,076 0.671 0.035 0.455 2,016 0.689 0.030 0.544
AuditComp 2,076 2.071 1.852 0.124 2,016 2.102 2.252 0.1123
AuditorChange 2,076 0.025 0.024 6.079 2,016 0.017 0.028 7.154
Big4 2,076 0.976 0.024 6.208 2,016 0.965 0.005 12.465
UnqualifiedOpinion 2,076 0.635 0.232 0.560 2,016 0.744 0.169 1.252
DecemberFyr 2,076 0.781 0.171 1.361 2,016 0.782 0.166 1.861
DaysToSign 2,076 54.480 233.600 4.568 2,016 52.605 152.205 2.709
After entropy balancing
High Ethics Low Ethics
Variable N Mean Variance Skewness N Mean Variance Skewness
LnAssets 2,076 8.928 1.087 0.392 2,016 8.928 1.087 0.393
Segment 2,076 11.790 58.300 1.096 2,016 11.790 51.700 1.301
CurrentAssets 2,076 0.396 0.042 0.170 2,016 0.396 0.042 0.170
QuickRatio 2,076 1.614 1.466 2.213 2,016 1.614 1.466 2.212
Debt 2,076 0.242 0.029 0.699 2,016 0.242 0.028 0.727
ROA 2,076 0.066 0.005 0.783 2,016 0.066 0.005 0.936
ForeignOperation 2,076 0.142 0.122 2.055 2,016 0.142 0.122 2.055
InherentRisk 2,076 0.205 0.020 0.859 2,016 0.205 0.020 0.859
Litigation 2,076 0.221 0.172 1.342 2,016 0.221 0.172 1.342
Loss 2,076 0.106 0.095 2.556 2,016 0.106 0.095 2.556
AALawSuit 2,076 0.029 0.029 5.524 2,016 0.029 0.029 5.525
Governance 2,076 2.121 0.493 0.931 2,016 2.121 0.435 0.931
AnalystCoverage 2,076 8.858 96.530 0.888 2,016 8.858 96.530 0.885
Specialist 2,076 0.381 0.236 0.491 2,016 0.381 0.236 0.491
Scale 2,076 0.673 0.034 0.451 2,016 0.673 0.035 0.451
AuditComp 2,076 2.073 1.854 0.126 2,016 2.073 1.854 0.126
AuditorChange 2,076 0.025 0.024 6.139 2,016 0.025 0.024 6.139
Big4 2,076 0.975 0.024 6.139 2,016 0.975 0.024 6.139
UnqualifiedOpinion 2,076 0.636 0.232 0.565 2,016 0.636 0.232 0.565
DecemberFyr 2,076 0.782 0.171 1.363 2,016 0.782 0.171 1.363
DaysToSign 2,076 54.660 231.500 4.736 2,016 54.660 231.500 4.736
Panel B: Code of Ethics Quality and Audit Fees – Entropy Balanced Regression Results
Coefficient p-value
(1) (2)
HighEthics 0.138*** (<0.001)
LnAssets 0.593*** (<0.001)
Segment 0.011*** (<0.001)
CurrentAssets 0.103 (0.222)
QuickRatio 0.056*** (<0.001)
Debt 0.416*** (<0.001)
ROA 0.277* (0.089
ForeignOperation 0.008 (0.764)
InherentRisk 1.324*** (<0.001)
Litigation 0.060** (0.030)
Loss 0.077** (0.035)
AALawSuit 0.046 (0.379)
17
Table 10 (continued)
Panel B: Code of Ethics Quality and Audit Fees – Entropy Balanced Regression Results
Coefficient p-value
Specialist 0.128*** (<0.001)
Scale 0.459*** (<0.001)
AuditComp 0.043** (0.049)
AuditorChange 0.126 (0.133)
Big4 0.543*** (<0.001)
UnqualifiedOpinion 0.068*** (0.001)
DecemberFyr 0.046** (0.022)
DaysToSign 0.000 (0.661)
Industry Indicators Yes

Year Indicators Yes
Observations 4,092
R2 76.32%
Panel A of this table presents descriptive statistics of the main variables for the High- and Low-Ethics samples partitioned based on the median value of
Ethics before and after entropy balancing. Panel B of this table reports the regression results using the entropy balanced sample. The p-values are based on
standard errors clustered by firm. ***, **, and * indicate statistical significance at the 0.01, 0.05, and 0.10 level, respectively. A detailed description of the
variables is provided in Appendix A.
4.5. Blinder-Oaxaca decomposition analysis
In our empirical tests, we find that clients with lower CEQ pay higher audit fees. To further explore this result, we utilize a
standard version of the Blinder-Oaxaca decomposition (BOD) technique, a method that has commonly been applied in labor
economics but not within the archival auditing literature. Our discussion of the BOD relies heavily upon the commentary
provided in Fortin et al. (2011). The aim of the BOD is to explain how much of the difference in mean outcomes between
two groups is due to group differences in the distributions of predictor variables (often referred to as the explained or com-
position effect) and how much of it is left unexplained by these differences (Blinder, 1973; Oaxaca, 1973). This unexplained
portion is often referred to as a ‘‘treatment” or structural effect. Importantly, a number of fairly stringent assumptions are
required to view these as general equilibrium results and caution should be used in ascribing a causal interpretation.
To apply the standard BOD to our problem, we need to transform our Ethics metric into an indicator variable by dividing
our sample into two groups. We use the median value of Ethics to assign clients to either the High-Ethics or Low-Ethics group.
We find that there are significant statistical differences in firm characteristics across these groups (see Table 1, Panel B). The
difference in the unconditional mean of logged audit fees is 0.640,16 with the Low-Ethics group having higher average logged
audit fees. An examination of the descriptive statistics suggests that the relationship between ethics code scores and other audit
risk measures is complex and does not monotonically align with the notion that high ethics code scores indicate low auditor
business risk.
In contrast to our main model (i.e., Equation 1), the BOD analysis relaxes the assumption that the coefficients of the inde-
pendent variables are constant across Low- and High-Ethics groups. These differences are accounted for in the structural or
unexplained portion of the mean decomposition. The separate regression results for Low- and High-Ethics groups are pre-
sented in Table 11.
The untabulated BOD results suggest that, based on the differences in the mean values of the predictor variables, about
20% of the total gap in audit fees between the two groups can be attributed to the explained or compositional portion. The
remaining 80% can be attributed to the unexplained or structural portion. This unexplained portion is, as noted above, due to
cross-sample differences in the relationships between audit fees and our set of predictor variables. We interpret this result as
suggesting that auditors evaluate client risk components differently for the two groups. For example, the risk associated with
a unit of client assets is essentially seen as less risky for clients with a high ethics code score than a unit of client assets would
be for a client with a low ethics code score. In turn, this results in a lower audit fee for the high ethics code score client. Our
results suggest that a relatively small portion of the difference in audit fees is due to cross-sample variation in client
characteristics.
This interpretation follows from the construction of the two-way BOD. To apportion the aggregate difference in logged
audit fees, it is necessary to create counter-factuals with respect to expected audit fees. For example, the compositional com-
ponent is calculated by evaluating the inner product of the mean values of the predictor variables for each sample with the
coefficients obtained by regressing logged audit fees on the set of predictor variables for the High-Ethics group. This results in
a pair of expected audit fees. The compositional component is then obtained by taking the difference in these two expected
values. This component is the consequence of the observed difference in the mean values of the predictor variables for each
16
This is equivalent to $3,304,255.
18
Table 11
Robustness check – blinder oaxaca decomposition analysis.

Low-Ethics High-Ethics Test for Coefficient
Difference
of Firm Characteristics
Coefficient p-value Coefficient p-value F-stat p-value
(1) (2) (3) (4) (1) vs. (3)
Intercept 9.591*** (<0.001) 8.884*** (<0.001)
LnAssets 0.526*** (<0.001) 0.514*** (<0.001) 12.12*** (<0.001)
Segment 0.011*** (<0.001) 0.019*** (<0.001) 7.98*** (<0.001)
CurrentAssets 0.695*** (<0.001) 0.685*** (<0.001) 10.78*** (<0.001)
QuickRatio (-1) 0.105*** (<0.001) 0.037*** (0.006) 8.26*** (<0.001)
Debt 0.375*** (<0.001) 0.307*** (<0.001) 10.33*** (<0.001)
ROA (-1) 0.437** (0.026) 0.889*** (<0.001) 11.82*** (<0.001)
ForeignOperation 0.072*** (0.007) 0.026 (0.466) 6.09*** (<0.001)
InherentRisk 0.938*** (<0.001) 0.862*** (<0.001) 10.67*** (<0.001)
Litigation 0.010 (0.698) 0.115*** (<0.001) 7.90*** (<0.001)
Loss 0.042 (0.332) 0.015 (0.780) 0.42 (0.674)
AALawSuit 0.111* (0.091) 0.121* (0.091) 2.06** (0.039)
Governance 0.070** (0.071) 0.099*** (<0.001) 10.96*** (<0.001)
AnalystCoverage 0.001 (0.468) 0.002** (0.040) 8.45*** (<0.001)
Specialist 0.076*** (<0.001) 0.088*** (<0.001)
Scale (-1) 0.021 (0.720) 0.251*** (<0.001)
AuditComp (-1) 0.024*** (0.002) 0.023*** (0.010)
NoAuditorChange 0.132* (0.077) 0.251*** (0.001)
Big4 0.224* (0.079) 0.635*** (<0.001)
QualifiedOpinion 0.136*** (<0.001) 0.144*** (<0.001)
DecemberFyr 0.040 (0.121) 0.034 (0.265)
DaysToSign 0.000 (0.801) 0.001 (0.125)
Year Indicators Yes Yes
Observations 2,016 2,076
R2 66.89% 55.34%
This table reports the regression results for the two subsamples partitioned based on the median value of Ethics as part of the Blinder-Oaxaca Decom-
position (BOD) analysis. The p-values are based on standard errors clustered by firm. ***, **, and * indicate statistical significance at the 0.01, 0.05, and 0.10
level, respectively. A detailed description of the variables is provided in Appendix A.
sample. Critically, the difference relies on the counter-factual obtained when the Low-Ethics score predictor mean values are
multiplied by the estimated coefficients from the High-Ethics score regression.
In contrast, the unexplained or structural difference is due to cross-sample variation in the estimated coefficients when
applied to the means of the predictor variables of the High-Ethics group. The counter-factual is the cross of the High-Ethics
group’s mean values with the coefficients from Low-Ethics group’s regression. The fact that this component represents 74% of
the audit fee gap implies that, unlike the compositional component, auditors price client characteristics differently for the
two groups. Clients with a low ethics code score are perceived as riskier and are charged higher audit fees.
4.6. The effect of code of ethics quality in the context of heightened audit risk
Our previous results indicate that auditors perceive clients with lower CEQ as having higher audit risk, and thus, exert
greater effort and/or charge higher audit fees. In this section, we further examine the role of client CEQ when there is height-
ened audit risk. When there is heightened audit risk, auditors adjust the nature, timing, and extent of audit procedures to
mitigate the increased risk. These adjustments will be further influenced by assessments regarding client ethics. If the cli-
ent’s code of ethics quality is low, then a client’s management and employees will be deemed less credible. Thus, any infor-
mation obtained from a client will be assigned a lower weight, which will require the auditor to gather more evidence, or
gather evidence from a more credible source (Kizirian et al., 2005). That is, when there is heightened audit risk, a client with
a higher (lower) quality code of ethics will require the auditor to gather less (more) additional audit evidence. As a client’s
business risk is not directly observable, we use heightened audit risk events identified from the prior literature - mergers and
acquisitions (M&A) and seasoned equity offerings (SEO) - to investigate the impact of client CEQ.17
Following Huang et al. (2014), we create an indicator variable for M&A and another indicator variable for SEO. The M&A
indicator variable equals one if a client has a merger or acquisition in the current year, and zero otherwise. In regard to acqui-
17
A stream of literature documents that M&A and SEO activity is associated with upward accruals earnings management in the pre-event period and negative
accruals and stock returns in the post-event period. Further, this opportunistic behavior has been linked to shareholder lawsuits and increased audit risk (see,
e.g., Teoh et al., 1998; Gong et al., 2008; DuCharme et al., 2004; Lu et al., 2017).
19
Table 12
The effect of client’s code of ethics quality on audit fees in heightened audit risk contexts.

(1) (2) (3) (4) (5) (6) (7) (8)
Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value
Ethics 0.084*** (<0.001) 0.094*** (<0.001) 0.094*** (<0.001) 0.102*** (<0.001)
M&A 0.049 (0.324) 0.598*** (0.001)
Ethics M&A 0.136*** (0.002)
SEO 0.061*** (0.014) 0.408*** (<0.001)
Ethics SEO 0.082*** (0.003)
LnAssets 0.576*** (<0.001) 0.578*** (<0.001) 0.578*** (<0.001) 0.579*** (<0.001)
Segment 0.009*** (<0.001) 0.009*** (<0.001) 0.009*** (<0.001) 0.009*** (<0.001)
CurrentAssets 0.007 (0.919) 0.002 (0.993) 0.020 (0.907) 0.026 (0.884)
QuickRatio 0.065*** (<0.001) 0.061*** (0.006) 0.059*** (0.008) 0.060*** (0.008)
Debt 0.351*** (<0.001) 0.366** (0.016) 0.358*** (0.018) 0.358** (0.017)
ROA 0.138 (0.360) 0.249 (0.374) 0.249 (0.374) 0.241 (0.389)
ForeignOperation 0.055*** (0.012) 0.062** (0.227) 0.063 (0.222) 0.063 (0.221)
InherentRisk 1.342*** (<0.001) 1.312*** (<0.001) 1.300*** (<0.001) 1.296*** (<0.001)
Litigation 0.022 (0.369) 0.022 (0.676) 0.027 (0.614) 0.027 (0.612)
Loss 0.092*** (0.004) 0.084* (0.073) 0.085* (0.071) 0.086* (0.067)
AALawSuit 0.056 (0.186) 0.035 (0.532) 0.039 (0.498) 0.040 (0.480)
Governance 0.072*** (<0.001) 0.030 (0.158) 0.029 (0.165) 0.030 (0.149)
AnalystCoverage 0.003*** (0.003) 0.004** (0.030) 0.004** (0.024) 0.004** (0.021)
Specialist 0.116*** (<0.001) 0.117*** (<0.001) 0.119*** (<0.001) 0.119*** (<0.001)
Scale 0.362*** (<0.001) 0.368*** (<0.001) 0.372*** (<0.001) 0.370*** (<0.001)
AuditComp 0.012 (0.478) 0.039* (0.059) 0.037* (0.077) 0.038* (0.071)
AuditorChange 0.176** (0.023) 0.179** (0.024) 0.183** (0.021) 0.181** (0.022)
Big4 0.578*** (<0.001) 0.577*** (<0.001) 0.574*** (<0.001) 0.577*** (<0.001)
UnqualifiedOpinion 0.078*** (<0.001) 0.057*** (0.004) 0.054*** (0.006) 0.055*** (0.005)
DecemberFyr 0.035* (0.063) 0.036 (0.409) 0.031 (0.471) 0.021 (0.479)
DaysToSign 0.001 (0.306) 0.000 (0.971) 0.000 (0.971) 0.000 (0.974)
Industry Indicators Yes Yes Yes Yes
Year Indicators Yes Yes Yes Yes
Observations 4,092 4,092 4,092 4,092
R2 75.96% 76.65% 76.63% 76.70%
This table reports the results of regressing audit fees on code of ethics quality and other control variables when the client is engaged in a M&A or SEO. The p-
values are based on standard errors clustered by firm. ***, **, and * indicate statistical significance at the 0.01, 0.05, and 0.10 level, respectively. A detailed
sitions, we require that the amount of the acquisition (Compustat AQC) in the current year is greater than 10 percent of
lagged total assets for M&A to be set equal to one. The SEO indicator variable is set equal to one if the client’s total issuance
of common and preferred stock in the current year (Compustat SSTK) is greater than 10 percent of lagged total assets, and
zero otherwise.
Before we examine the moderating effects of Ethics on M&A and SEO, we first examine the impact of M&A and SEO on
audit fees. These results are presented in columns (1) and (2), as well as columns (5) and (6), of Table 12. The positive coef-
ficients on M&A (0.049 in Column 1) and SEO (0.061 in Column 5) suggest that auditors charge higher audit fees when their
clients are involved in heightened-audit-risk transactions, although the coefficient on M&A is not statistically significant. In
columns (3) to (4) and columns (7) to (8), we interact M&A and SEO, respectively, with Ethics. Consistent with our main find-
ings reported earlier, the coefficient on Ethics continues to be negative and significant (-0.094 and 0.102 in Columns 3 and 7
of Table 12, respectively). Moreover, we find statistically significant and negative coefficients on the interaction terms
between Ethics and M&A (-0.136, p-value < 0.01), and between Ethics and SEO (-0.082, p-value < 0.01). Overall, these results
suggest that the impact of clients’ CEQ on audit fees is stronger when audit risk is greater. In terms of economic significance,
a one-unit decrease in the measure of client CEQ increases the premium charged during M&A events by 22.74% (0.136/0.598)
and during SEO events by 20.10% (0.082/0.408).
5. Conclusion
Business risk plays a significant role in audit risk assessment and the pricing of audit services. When an auditor accepts a
client with high perceived audit risk (either inherent or control risk), the auditor may respond by either increasing audit
effort to reduce detection risk or raising the billing rate to compensate for potential litigation and reputation costs. In this
study, we investigate the impact of client CEQ on the pricing of audit services.
20
We focus on the impact of code of ethics quality because this facet of business ethics remains an open question in both
the business ethics and audit academic literature, despite receiving a great amount of attention from the SEC and stock
exchanges. Furthermore, while proponents of ethics codes claim that they will be useful in assessing managerial integrity
and a firm’s corporate governance, the extant literature provides mixed and inconclusive evidence on the impact of ethics
codes (Helin and Sandstrom, 2007; Kaptein, 2015). Given the increased awareness of ethical issues and regulatory scrutiny
after SOX, and following Bicchieri’s (2006) model of social norm activation, we hypothesize that auditors consider clients
with lower quality codes of ethics to be riskier and, thus, charge these clients higher audit fees.
We test our hypothesis by using a novel dataset that contains code of ethics information for a sample of U.S. firms
included in the S&P 500 index. Our findings are consistent with our hypothesis, indicating that clients with a lower CEQ
pay significantly higher audit fees. In additional analyses, we find that CEQ affects auditor effort and litigation risk. We also
find that, in the context of heightened audit risk (i.e., when clients are involved in mergers and acquisitions, or seasoned
equity offerings), the effect of code of ethics quality on audit fees is stronger in magnitude.
The findings of our study highlight the importance of the code of ethics in the context of auditing. We find a direct finan-
cial benefit of the CEQ in audit pricing, consistent with auditors considering CEQ to be meaningful and useful in assessing
managers’ financial representations. Our findings show that a higher CEQ improves perceptions of the firm and provides
value to the firm and its shareholders in the form of audit cost savings. This may be particularly important for companies
where the cost of preparing, disclosing, and/or improving their codes of ethics may seem excessive or unnecessary. We con-
sider the development and implementation of a code of ethics as one action that client firms can choose to improve the qual-
ity of financial reporting (among other managerial justifications for a code of ethics). From an economics perspective, this
choice exists within an equilibrium set of possible actions the firm’s managers could choose to implement its financial
reporting strategy. The equilibrium choice is the consequence of balancing ‘‘supply” and ‘‘demand” effects. The supply side
is characterized by the cost of designing and implementing the code of ethics, while the demand side represents the per-
ceived benefits obtained from the code of ethics relative to the financial reporting strategy. Our results are also relevant
in evaluating regulatory and market requirements to adopt and disclose codes of ethics, as well as criticisms of these require-
ments. Our findings suggest that codes of ethics are not merely ‘‘window-dressing” and are an important consideration in
determining the degree to which to rely on the representations of firm managers.
Due to the restrictions imposed in the CEQ data, our sample is limited to firms included in the U.S. S&P 500 index. Thus,
the results of our study may not generalize to smaller firms or firms outside of the U.S. For example, the strength of the reg-
ulatory and/or legal system in other countries may influence the degree to which the social norms of the code of ethics will
be activated. In addition, the CEQ is subjective and difficult to measure. To the extent that our measure of CEQ is measured
with error, the coefficient estimates we provide in this study will be biased. Future research may extend our work by exam-
ining the impact of CEQ on audit fees using data samples with larger coverage (e.g., including international or private firms)
or by using different measures of CEQ. Future research may also further examine the conditions in which CEQ is (or is not)
associated with audit fees, given the findings of this study.
Funding
This research did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors.
7. Availability of data and material
The data used in this study are publicly available from the sources indicated in the text.
We have no conflicts of interest to disclose.
Using a sample of U.S. firms from 2003 to 2018, we examine the effect of an audit client’s code of ethics quality on audit
fees. We find that clients with a lower code of ethics quality pay significantly higher audit fees, suggesting that auditors per-
ceive such clients as riskier and charge greater risk premiums. We also find that such clients have higher litigation risk and
auditors spend greater effort when auditing such clients. Our study is among the first to demonstrate the role of a client’s
code of ethics quality in audit pricing. Overall, our findings are consistent with codes of ethics being useful to auditors in
assessing managers’ financial representations and providing value to firms.
Declaration of Competing Interest
The authors declare that they have no known competing financial interests or personal relationships that could have
appeared to influence the work reported in this paper.
21
Appendix A:. Variable description
Variables Description
Main Dependent Variable:
LnAuditFee The natural logarithm of total audit fees. Source: Audit Analytics
Independent variable of interest:
Ethics A code of ethics specifies an organization’s primary values and ethical rules that are designed to
promote right behaviors and deter wrong behaviors. Ethics is an aggregate measure based on a
factor analysis of four components: System; Implementation; Corruption; and HumanRight. Source:
Vigeo Eiris
HighEthics This is an indicator variable coded as one if a firm has an Ethics value greater than the median
value, and coded as 0 otherwise.
System This variable measures the comprehensiveness of a firm’s code of ethics. The System variable is
measured based on the answer to the question: ‘‘Does the firm have a code of ethics and, if so, how
comprehensive is it?” The possible answers are: no (coded = 0); limited (coded = 1); basic
(coded = 2); intermediate (coded = 3); and advanced (coded = 4). Source: Vigeo Eiris
Implementation This variable measures the comprehensiveness of the system used to implement a firm’s code of
ethics. The Implementation variable is measured based on the answer to the question: ‘‘Does the
firm have a system for implementing a code of ethics and, if so, how comprehensive is it?” The possible
answers are: no (coded = 0); limited (coded = 1); basic (coded = 2); intermediate (coded = 3); and
advanced (coded = 4). Source: Vigeo Eiris
Corruption This variable measures a company’s tolerance of unethical practices such as corruption and
bribery. In the U.S., corruption and bribery is considered illegal under the Foreign Corrupt Practice
Act. Vigeo Eiris codes the Corruption measure differently in the data period before and after 2012.
In the pre-2012 data, the possible answers to the question are ‘‘no policy disclosed” (coded as 0), ‘‘it
has adopted a policy (coded as 1), and ‘‘it has a clear policy and procedures’’ (coded as 2). In the
post-2012 data, the question is examined in more detail, and more answers are provided to each
part of the question, i.e., ‘‘What is the extent of the countering bribery and corruption policy?”; ‘‘What
is the extent of the countering bribery and corruption systems?”; and ‘‘What is the extent of countering
bribery and corruption reporting?”; The possible answers to each question are: no evidence (coded
as 0); limited evidence (coded as 1); intermediate (coded as 2); good (coded as 3) and advanced
(coded as 4). The total possible score of the answers to the three questions is between 0 and 12. To
get a more consistent measure of Corruption in our sample, we rescale the coded answers as 0 if the
total score is 0, 1 if the total score is between 1 and 6, and 2 if the total score is between 7 and 12.
Source: Vigeo Eiris
HumanRight This variable measures a company’s policy and system of human rights issues such as child labor,
forced labor, freedom of association, collective bargaining, and non-discrimination. A company has
a good policy and system of human rights issues if it shows evidence of effectively managing any
risks of human rights abuses to employees or communities. Vigeo Eiris assigns grades to the
answer to the question of Human Rights measures differently in the data period before and after
2012. In the pre-2012 data, the possible answers are no (coded as 0), limited (coded as 1),
intermediate (coded as 2), and good or advanced (coded as 3). In the post-2012 data, the question is
examined in more detail, and more answers are provided to each part of the question, i.e., ‘‘What is
the extent of the policy addressing human right issues?”; ‘‘What is the extent of the systems addressing
human right issues?” The possible answers to each question are: no evidence (coded as 0); limited
evidence (coded as 1); intermediate (coded as 2); good (coded as 3) and advanced (coded as 4). The
total possible score of the answers to the two questions is between 0 and 8. To get a more
consistent measure of Human Rights in our sample, we rescale the coded answers as 0 if the total
score is 0, 1 if the total score is between 1 and 3, 2 if the total score is between 4 and 6, and 3 if the
total is between 7 and 8. Source: Vigeo Eiris
Firm characteristics control variables:
LnAssets The natural logarithm of total assets. Source: Compustat
Segment The number of geographic segments. Source: Compustat Legacy Segment
CurrentAssets The ratio of current assets to total assets. Source: Compustat
QuickRatio The ratio of current assets (excluding inventories) to current liabilities. Source: Compustat
Debt The ratio of current and long-term debts to total assets. Source: Compustat
ROA The ratio of net income to total assets. Source: Compustat
22
Appendix A (continued)
ForeignOperation This indicator variable equals one if a company has foreign operations, and 0 otherwise. Source:
Compustat
InherentRisk The ratio of the sum of receivables and inventory to total assets. Source: Compustat
Litigation This indicator variable equals one if the firm belongs to one of the following SIC codes: 2833–2836;
3570–3577; 3600–3674; 5200–5961; and 7370–7374. Source: Compustat
Loss This indicator variable equals one if net income is negative, and 0 otherwise. Source: Compustat
AALawSuit This indicator variable equals one if there is a lawsuit against the firm in the current year, and 0
otherwise. AALawSuit is coded as 1 if the firm is classified as the defendant in the following
categories of lawsuits: Accounting and Auditing Enforcement Release (category 54), Accounting
Malpractice (category 2), and Financial Reporting (category 48). Source: Audit Analytics
Governance This variable measures CEO duality, the percentage of independent directors in the board and audit
committee, and the transparency of executive remuneration disclosures. Governance is measured
by the answer to four questions: ‘‘Does the company: (1) separate the roles of chairman and chief
executive; (2) have a board comprising of more than 33% independent directors; (3) have an audit
committee comprising a majority of independent directors; and (4) disclose executive and director
remuneration?” The possible answers are: None (coded as 0); One (coded as 1); Some (coded as 2);
All (coded as 3). Governance score is the sum of the answers to the four questions. Source: Vigeo Eiris
AnalystCoverage The number of unique analysts issuing annual earnings forecasts for each firm, based on the I/B/E/S
Detail earnings forecast data. Source: I/B/E/S
AbAccruals Abnormal accruals, measured as the rank of the absolute value of discretionary accruals calculated
using the modified Jones model (Dechow, Sloan, and Sweeney 1995).
ManagerOwnership The total value of managerial stock and option values divided by firm market value. Source:
Execucomp
CSR In the Vigeo Eiris database, community performance is graded from 1 to 4, environmental
performance is graded from 1 to 5, and employee performance is graded based on six
subcategories, where each category is graded from 1 to 3. We follow prior studies (Brammer,
Brooks, and Pavelin 2006; Chen et al. 2018) to convert the grading of environmental performance
and employee performance into a scale from 1 to 4. Finally, we obtain an aggregate measure of CSR
by adding the scores for community performance, environmental performance, and employee
performance. The total CSR score ranges from 0 to 12. Source: Vigeo Eiris
M&A This indicator variable equals one if the firm has a merger or acquisition in the current year, and 0
otherwise. Following Huang et al. (2014), we code M&A as one if the amount of acquisition
(Compustat AQC) in the current year is greater than 10 percent of lagged total assets. Source:
Compustat
SEO This indicator variable equals one if the firm has a seasoned equity offer in the current year, and 0
otherwise. Following Huang et al. (2014), we code SEO as one if the sale of common stock and
preferred stock (Compustat SSTK) in the current year is greater than 10 percent of lagged total
assets. Source: Compustat
Auditor characteristics control variables:
Specialist This indicator variable equals one if the auditor is a specialist in an industry, and 0 otherwise.
Following Fung et al. (2012), we consider an auditor a specialist if the auditor earns the greatest
proportion of audit fees in a 2-digit SIC industry (i.e., the auditor’s fees in a 2-digit SIC industry
relative to total audit fees of the same industry). Source: Audit Analytics.
Scale This variable measures the economy of scale experienced by the auditor as specified in Fung et al.
(2012). We first compute the number of clients the auditor has in each SIC-two-digit industry year
and then rank the number of clients in percentile for each year and divide it by 100. Source:
Compustat and Audit Analytics
AuditComp This variable measures competition among audit firms in the same 2-digit SIC industry. Following
Newton et al. (2013), we use the Herfindahl index to measure industry concentration. The
P si2
Herfindahl index is computed as: N i¼1 S , where N is the number of audit firms and S is the sum
of the total audit fees collected, and si is the audit fees collected by auditor i in the same SIC-two-
digit industry. A higher Herfindahl index indicates a lower level of competition. We convert the
index into AuditComp by ranking our sample observations into quintiles based on descending
values of the Herfindahl index.
AuditorChange This indicator variable equals one if the prior-year auditor has changed, and 0 otherwise. Source:
Compustat
23
Appendix A (continued)
Big4 This indicator variable equals one if the auditor is PricewaterhouseCoopers, Ernst &Young, Deloitte
& Touche, or KPMG, and 0 otherwise. Source: Compustat.
Engagement characteristics control variables:
UnqualifiedOpinion This indicator variable equals one if the auditor issues an unqualified opinion without any
additional language, and 0 otherwise. Following Landsman, Nelson, and Rountree (2009), we code
firms with an unqualified audit opinion with additional language as 0. Source: Compustat
DecemberFyr This indicator variable equals one if the client’s fiscal year ends in December, and 0 otherwise. A
December fiscal year end implies that the audit will be conducted during the auditor’s busy season.
Source: Compustat
DaysToSign The number of days between the signature date of the audit opinion and the date of the fiscal year
end. Source: Audit Analytics
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Hong Kim Duong is an Assistant Professor of Accounting at Old Dominion University. Her research interests include financial accounting, corporate
disclosure, and corporate governance. She has served as an elected Advisory Board Member of the International Accounting Section at the American
Accounting Association (2019-2021) and co-chair of the International Accounting Section Midyear Meetings in 2021 and 2022. She currently serves on the
editorial board of the Review of Accounting and Finance.
Giorgio Gotti is a Professor of Accounting and the Director of the School of Accountancy at the University of Texas Rio Grande Valley. He is serving in the
Board of Directors of the American Accounting Association (AAA) with a 3-year term (2020-2023) as Director – Focusing on International. His research
interests include international and financial accounting. He is the co-author of the North American best seller textbook International Accounting, published
by McGraw Hill. His papers have been published in The International Journal of Accounting, Journal of Accounting, Auditing & Finance, Journal of
International Accounting Research, Journal of International Accounting, Auditing & Taxation, Management International Review, Journal of Business Ethics,
among others. He is associate editor of the Journal of International Accounting, Auditing & Taxation and a member of the editorial board of The International
Journal of Accounting, Journal of International Accounting Research, and Accounting in Europe. He received my PhD in Business Administration and Master
of Accountancy from the University of Tennessee, and a Laurea in Economics from Bocconi University, Italy. He is a Chartered Accountant and Statutory
Auditor in Milan, Italy.
Mike Stein is a Professor of Accounting at Old Dominion University. His research has contributed to the literature on audit production and the economics of
auditing markets. He has published in numerous accounting journals and served on the editorial boards of The Accounting Review, Contemporary
Accounting Research, and Auditing: A Journal of Practice & Theory.
Anthony Chen is an associate professor in the School of Accountancy at California State University, Fullerton. His research interests are in financial reporting
quality, voluntary disclosure, corporate governance, and auditing.
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J. Account.

Public Policy 41 (2022) 107001

Contents lists available at ScienceDirect

J. Account. Public Policy

Full length article

Code of ethics quality and audit fees

2. Related literature and hypothesis development

2.1. Literature review

2.2. Hypothesis development: code of ethics quality and audit fees

2.3. Research design

2.3.1. Measures of codes of ethics quality

2.4. Empirical model

2.5. Data sample and descriptive statistics

3.1. Regression results

Panel A: Descriptive Statistics – Total Sample

Panel B: Comparing Characteristics of High- and Low-Ethics Clients

Panel C: Changes in Ethics and Ethics Components

(continued on next page)

Panel C: Changes in Ethics and Ethics Components

3.2. Code of ethics components and alternative measures of ethics

J. Account. Public Policy 41 (2022) 107001

Dependent Variable = LnAuditFee

Dependent Variable = LnAuditFee

Distribution of Materials Errors in Unaudited Financial Statements

4. Robustness tests and additional analyses

Dependent Variable = AALawSuit

4.1. Additional control variables

Dependent variable: LnAuditFee

4.2. Instrumental variable approach

2SLS Estimation Blundell and Bond (1998)

4.3. Blundell and Bond (1998) generalized method of moments

4.4. Entropy balancing

Panel A: Descriptive statistics before and after entropy balancing

(continued on next page)

Industry Indicators Yes

4.5. Blinder-Oaxaca decomposition analysis

Dependent Variable = LnAuditFee

Dependent Variable = LnAuditFee

7. Availability of data and material

Declaration of Competing Interest

Appendix A:. Variable description

(continued on next page)

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