The effect of small audit firms’ failure to remediate the PCAOB’s quality control criticisms on audit market segmentation

Abstract

This paper examines the role of the Public Company Accounting Oversight Board (PCAOB) quality control inspection program on market segmentation of small firms’ audit services. Specifically, we investigate how non-remediation of quality control criticisms (QCCs) affects the supply and demand of low-quality audits. We find that remediation of QCCs improves audit quality for small accounting firms. However, some small accounting firms do not remediate QCCs (NR firms) and continue to provide low audit quality. We investigate how NR clients react to the disclosure of non-remediation of QCCs. We find that NR clients with low agency costs are more likely to retain NR firms after the disclosure of non-remediation. This finding is consistent with our expectation that voluntary QCC remediation creates a low-quality audit market segment for NR firms. Our findings suggest that the public disclosure of QCCs is not sufficient to remove low-quality auditors. Instead, NR clients use the disclosure of non-remediation of QCCs as a signal to sort themselves into segments based on their demand for audit quality. We are the first to study and find that PCAOB inspections, and specifically the voluntary nature of remediation and public disclosure of lack of remediation, create market segmentation.