Do PCAOB Inspections Improve the Quality of Internal Control Audits?

Abstract

We investigate whether Public Company Accounting Oversight Board (PCAOB) inspections affect the quality of internal control audits. Our research design improves on prior studies by exploiting both cross-sectional and time-series variation in the content of PCAOB inspection reports, while also controlling for audit firm and year fixed effects, effectively achieving a difference-in-differences research design. We find that when PCAOB inspectors report higher rates of deficiencies in internal control audits, auditors respond by increasing the issuance of adverse internal control opinions. We also find that auditors issue more adverse internal control opinions to clients with concurrent misstatements, who thus genuinely warrant adverse opinions. We further find that higher inspection deficiency rates lead to higher audit fees, consistent with PCAOB inspections prompting auditors to undertake costly remediation efforts. Taken together, our results are consistent with the PCAOB inspections improving the quality of internal control audits by prompting auditors to remediate deficiencies in their audits of internal controls.