Is Self-Regulated Peer Review Effective at Signaling Audit Quality?

Abstract

This paper examines whether peer review conducted under the AICPA's self-regulatory regime has been effective at signaling audit quality. In spite of the long-standing debate about self-regulated peer review in the auditing profession, there is a surprising lack of research evidence as to whether such reviews are effective at signaling or improving audit quality. Prior research has examined whether the information contained in peer-review reports is associated with perceived audit quality (Hilary and Lennox 2005). We examine whether the information contained in peer-review reports is associated with actual audit quality. Our results suggest that self-regulated peer review does appear to provide effective signals regarding audit-firm quality. Specifically, we find that the number of weaknesses identified in peer-review reports is associated with other potential indicators of weak quality control or risky practices within accounting firms such as selling tax shelters, overworking staff, and taking on risky clients—even after controlling for changes in the peer-review environment over time. We also find that the number of weaknesses identified in peer-review reports is useful in predicting audit failure (i.e., malpractice claims alleging auditor negligence), and that certain types of peer-review findings (engagement-performance weaknesses, personnel-management weaknesses) are particularly useful in this regard.