Cost and Informativeness of Regulatory Reports: Evidence from the UK

Abstract

The 2006 EU Directive established an EU-wide system for public oversight of the audit profession. In the UK, since 2008 the Financial Reporting Council (FRC) has published inspection reports for major audit firms, which include overall quality ratings for the individual audit engagements of each audit firm under review. This study examines the FRC’s ratings, and measures their impact on audit fees and audit firm switching. A significant increase in audit fees is found when the audit firm has a higher proportion of engagements with deficient ratings, probably arising from the additional effort and resources needed to meet the FRC’s requirements. This impact is more concentrated among clients with Big 4 audit firms. However, there is no evidence that FRC ratings affect clients’ likelihood of switching audit firms, suggesting that inspection results may not signal audit quality, and thus do not affect clients’ audit firm appointment decisions. The results provide evidence that inspection ratings may increase audit costs, but may not be valuable in distinguishing audit quality, and thus have no effect on audit committees’ audit firm appointment decisions. This finding advances understanding of the effectiveness of the audit inspection regime, and provides auditing regulators with guidance on policy making.