PCAOB Inspection Research Articles

PCAOB inspection deficiencies and future financial reporting quality: Do the types of deficiencies matter?

AbstractThis study examines whether PCAOB inspection reports are useful for signaling the risk of misstatements in future periods and the extent to which different types of audit deficiencies predict future misstatements. We find that, after the inspection report is issued, PCAOB‐identified audit deficiencies are positively associated with future misstatements for the audit firm's entire client portfolio. When we examine different types of deficiencies, we find that an auditor's failure to understand the client's accounting procedures or policies is the most detrimental type of deficiency for future reporting quality. We also examine the deficiency types for Big 4 versus non–Big 4 firms separately. The results show that an auditor's failure to understand the client's accounting procedures or policies is the only deficiency type that is positively associated with future misstatements for Big 4 firms. For non–Big 4 firms, however, future misstatements are predicted by an auditor's failure to understand the client's accounting procedures or policies, inadequate substantive testing, and inadequate going‐concern assessments. Our study has important implications given the concerns raised by auditors regarding the usefulness of PCAOB inspections.

Auditor Perceptions, Reactions, and Responses to PCAOB Inspection Feedback

ABSTRACT Guided by the performance feedback literature, we study PCAOB inspections as a nonstandard feedback event. We use an experiential questionnaire to collect and analyze perceptions, reactions, and responses to inspection feedback from 120 partners and managers subject to a recent PCAOB inspection. Despite varying perceptions, we find on average auditors perceive strong firm support but also that firms acquiesce to inspectors. Generally, the feedback source, inspectors, are perceived as professional, organized, and knowledgeable and auditors agree with the feedback message, perceiving it as consistent and well reasoned. We observe a range of auditor reactions (satisfaction with and motivated to use inspection feedback), responses at the engagement level (improvements to audit quality and inspection risk or impression management), and individual responses. Multivariate analyses show more positive feedback perceptions improve reactions, which enhance desirability of responses and are robust to considering the inspection outcome, offering insights for refining inspection interactions and processes.

The Real Effects of PCAOB Inspection Reports on the M&A Deals of Non-Big 4 Accounting Firms

ABSTRACT Mergers and acquisitions (M&As) are an important way for non-Big 4 accounting firms to grow their businesses. Non-Big 4 firms also account for the vast majority of PCAOB inspections. Consistent with negative inspection reports signaling low quality at inspected firms, we find that non-Big 4 accounting firms conduct fewer M&A deals after they receive negative inspection reports. Additional analyses support our hypothesized signaling mechanism: (1) the chilling effect of inspection reports on M&A activity is stronger when the inspected firm’s business is focused on public company audits, (2) the effect is stronger when stakeholders at the target firm know less about the acquirer because the acquirer is located in a different city, and (3) clients at the target firm switch to new firms rather than move over to the acquirer if the acquirer received a negative inspection report prior to the M&A date. JEL Classifications: D82; G34; G38; M42; M48.

Non-Big 6 audit firms’ access to external resources through inter-organisational relationships

Small audit firms try to reduce their resource constraints in serving clients by creating inter-organisational relationships (IORs) through membership in accounting networks or in agreements with individual firms. Through these relationships, firms have access to audit manuals/methodology, personnel, and may perform joint audits and joint marketing of their audit services. We identify the existence of IORs from PCAOB Form 2 filings and test whether audit quality and fees vary cross-sectionally as a function of the specific resource obtained from the IOR. We find evidence that firms with access to audit technology through IORs charge higher audit fees and provide higher quality audits, in terms of smaller clients’ performance-matched discretionary accruals, higher auditors’ likelihood of issuing going concern opinions to financially distressed clients, and fewer audit deficiencies identified in PCAOB inspection reports. The findings highlight the importance of access to audit technology through IORs in improving small audit firms’ real and perceived audit quality.

Costs and benefits of a risk-based PCAOB inspection regime

We investigate the costs and benefits of the PCAOB's risk-based inspection regime by studying how auditors respond to engagement-level inspection risk. Using an established inspection selection model, we find evidence that auditors behave consistent with accountability theory when auditing clients with elevated ex-ante inspection risk. Specifically, we observe an increased propensity to report material weaknesses, a decreased propensity to assert that previous material weaknesses have been remediated, increased audit effort, and a decreased likelihood of subsequent financial statement restatement. In general, these outcomes reflect auditors' attempts to minimize negative inspection outcomes in a way that could be beneficial to investors. However, auditors' apparent focus on relative inspection risk also creates potential costs for investors as evidenced by an increased likelihood of resignation from the client and inattention to clients with relatively lower inspection risk when auditor resources are most constrained. Importantly, several tests provide evidence that auditors' response to inspection risk is distinct from and incremental to their response to misstatement risk. Overall, our findings suggest that there are potential benefits and potential costs associated with auditors' responses to a selection approach that is primarily risk-based.

PCAOB Inspections and Auditor Liability

SUMMARY The PCAOB has been inspecting firms for almost 20 years, yet there is little evidence regarding the effect of PCAOB inspections on auditor liability. We examine conditions under which a clean PCAOB inspection finding (at the engagement level) provides auditor liability protection for an audit subsequently called into question. Using source credibility theory, we predict and find that the defense introducing a clean PCAOB inspection finding for the litigated engagement reduces jurors’ negligence assessments by increasing the perceived credibility of the firm’s defense. We also find that, if the plaintiff introduces a PCAOB-issued control criticism (firm-wide level), jurors’ negligence assessments increase, regardless of whether a clean PCAOB inspection finding for the engagement is present. Collectively, results suggest that PCAOB inspection findings influence jurors’ negligence assessments. These findings have implications for audit firms, the PCAOB, and other public policy makers, as well as attorneys and triers of fact in audit litigation. Data Availability: Please contact the authors.

The Effect of Recurrent Deficiencies in PCAOB Inspections on Audit Quality within the Big Four Audit Firms in South Africa

The research aims to examine PCAOB inspection deficiencies' impact on audit quality in South Africa's Big Four, highlighting challenges in maintaining high standards across Financial Statements (FS), Internal Control Over Financial Reporting audits (ICFR), Auditor Ethics, Professional Conduct, and Due Professional Care. The study analyzes South African Big Four firms' audit work and its impact on audit quality, focusing on four PCAOB inspection deficiencies: FS and (ICFR) audits, Auditor Ethics/Independence, Professional Conduct, and Due Professional Care and Scepticism. The study used a mixed-method (qualitative and quantitative) case study approach. A self-administered questionnaire was used to collect primary data. Secondary data was collected from existing literature and inspection reports. The test results indicate that the identified deficiencies significantly influence audit quality, establishing a strong connection between these deficiencies and the audit quality of Big Four firms. The findings suggest that recurrent deficiencies in PCAOB inspections have a negative effect on audit quality within the Big Four Audit Firms in South Africa, concluding that deficiencies in these variables (Integrated Audits of FS and ICFR, Auditor Ethics and Independence, Professional Misconduct, and Due Professional Care and Professional Scepticism) can adversely affect the overall audit quality of the Big Four firms.

Shifting Barriers to PCAOB Inspections: Evidence from Chinese Companies’ Listing Decisions and Audit Quality

Shifting Barriers to PCAOB Inspections: Evidence from Chinese Companies’ Listing Decisions and Audit Quality

PCAOB inspection deficiencies and future financial reporting quality: Do the types of deficiencies matter? *

PCAOB inspection deficiencies and future financial reporting quality: Do the types of deficiencies matter? *

PCAOB inspection deficiencies and audit fees

AbstractThis study aims to extend research on the effect of PCAOB inspections on audit firm behavior by examining generally accepted auditing standards (GAAS) and generally accepted accounting principles (GAAP) type PCAOB inspection deficiencies, separately, to reveal the differential effects on audit fees in subsequent years. We empirically examine the audit fees of 98,393 client firm‐year observations for auditors who received a PCAOB inspection report during 2004–2021 via multivariate regression analyses. We find that GAAS (GAAP) deficiencies are associated with higher (lower) audit fees in the years following the reported deficiency. Our results suggest that the PCAOB inspection process modifies audit firm behavior when GAAS deficiencies are reported leading to the firm charging higher audit fees to defray the costs of addressing the deficiencies, but due to the severity of GAAP deficiencies that are identified, audit firms are willing to negotiate lower fees to retain the client. Our results are primarily driven by annually inspected audit firms. These results suggest that auditors respond to GAAS and GAAP PCAOB inspection deficiencies differently. The results of our study are useful to regulators and policymakers, such as the SEC and the PCAOB, in understanding how auditors respond to PCAOB inspection deficiencies and their due diligence to correct those deficiencies. PCAOB inspections are intended to evaluate compliance with accounting and auditing standards to improve audit quality and our study helps to extend the research to date which has not yet clearly demonstrated whether or not this has been accomplished.

The Effect of an Audit Firm’s Ethics Scandal on Client Acquisition Practices

SUMMARY Auditors who engage in unethical behavior often face subsequent reputational damage, such as loss of market share to competing auditors. KPMG was recently embroiled in a high-profile scandal that involved prominent members of the firm inappropriately receiving confidential information about upcoming PCAOB inspections. This article summarizes a study by Hale and Truelson (2022) that analyzes the effect of the scandal on KPMG’s reputation within the audit marketplace. Specifically, the study examines KPMG’s ability to attract new clients, the types of clients acquired, and audit fees charged to new clients. We then conclude by discussing the implications of the scandal on audit practitioners, regulators, and academics. Data Availability: Data used in this study are available from public sources identified in the document.

Chinese auditor inspection access challenges: The market’s response to integrated US regulatory and legislative action

We examine the impact of mounting regulator interest in US-listed Chinese firms facing PCAOB inspection access challenges. Our study provides evidence of the market’s response to five events taking place from 2018 to 2020. Collectively, these events mark the first-ever integrated regulatory and legislative response from the PCAOB, SEC, and US legislature since initiation of the PCAOB’s international inspection program. First, we consider whether the PCAOB’s eighth annual update of inaccessible jurisdictions is newsworthy to investors. Next, we consider investors’ perceptions of audit quality risks and delisting risks among Chinese firms. We find that the market does respond negatively towards cross-listed Chinese firms following PCAOB, SEC, and US legislative action. Results further suggest that market reactions are motivated by investors’ perception of a delisting risk among Chinese firms. This observation is most salient among small Chinese firms having fewer listing alternatives outside of the US.

The effect of PCAOB inspections on corporate innovation: evidence from deficiencies about the valuation of intangibles

I examine the economic consequences on corporate innovation when PCAOB inspections cite auditors for insufficient procedures in auditing the valuation of intangibles. I find that the clients of deficient auditors recognize larger and timelier impairments of intangibles, suggesting that affected auditors increase scrutiny about the valuation of intangibles in subsequent audits. This effect obtains only for valuation-related deficiencies and is salient for the clients of auditors who receive such deficiencies repeatedly. I also document real effects that the clients of deficient auditors exhibit less use of external mergers and acquisitions—which yield recognizable intangibles whose valuation is subject to increased auditor scrutiny. Overall, these results suggest that the intervention by the PCAOB effectively alters the measurement of intangibles and perhaps unintentionally affects how clients invest in corporate innovation.

The Effect of Audit Market Characteristics on Auditors’ Reputational Damage Following Negative PCAOB Inspection Reports

The Effect of Audit Market Characteristics on Auditors’ Reputational Damage Following Negative PCAOB Inspection Reports

Does audit regulation improve the underlying information used by managers? Evidence from PCAOB inspection access and management forecast accuracy

Survey evidence and academic research raise the possibility that audit regulation can impact not only the information contained in external financial reports but also the internal information used by management. We investigate this possibility by examining the improvement in management forecast accuracy around initiation of the Public Company Accounting Oversight Board's (PCAOB) international inspection program. Consistent with managers having improved information, we find that managers issue more accurate forecasts following PCAOB inspection access. Multiple additional analyses support that an improved information environment is the mechanism underlying our results, and this effect is distinct from, and incremental to, any effects of PCAOB inspection on external reporting quality. Our study provides evidence that audit regulation benefits an important internal stakeholder—managers.

PCAOB international inspections: Updates and extensions

Based on data from 760 PCAOB inspection reports issued between December 2006 and April 2021 for 305 non‐U.S. audit firms, this paper analyses changes and trends in PCAOB inspection traits, inspection outcomes, audit firm characteristics and firms' reactions to those inspections. We find significant changes have occurred in several areas, including changes in audit quality for both principal‐auditor engagements and referred‐work (i.e., other auditor) engagements, audit deficiency rates for both Big‐4 affiliated firms and unaffiliated firms, firms' responses to inspections and several other changes. We also find a significant iteraction between the firm's network affiliation and the firm's role in the engagement (i.e., principal auditor vs. referred work). Further analysis of this interaction reveals that when unaffiliated firms perform referred‐work engagements, they have better PCAOB inspection outcomes than when performing principal‐auditor engagements. However, affiliation with a network mitigates this outcome.

The PCAOB Inspection Process: A Client-Level Analysis of a Large Firm's Experience

SUMMARY We use proprietary archival data to examine one annually inspected audit firm's experience with the PCAOB inspection process. We find that the firm's audits are primarily selected for inspection due to client characteristics, while deficiencies identified by inspectors are related to characteristics of both the client and the audit team. We also find that not all identified audit deficiencies are reported to the public. However, we find some evidence that only publicly disclosed deficiencies are associated with ex post measures of audit quality, suggesting that the PCAOB releases only the most relevant and material information to the public. Finally, we find that inspections affect the concurrent year's audit team staffing decisions and reduce the proportion of the audit that is completed during the interim period. Overall, our study provides important insights into the PCAOB inspection process while also developing and validating a model of inspection risk for future researchers.

An Examination of the Effects of PCAOB Inspection Selection Method and Disclosure of Audit Strengths on Investor Judgments

SUMMARYThe PCAOB, in its inspection process, has historically focused on reporting audit deficiencies and used a risk-weighted selection method. In two experiments (focusing on a “micro” and a “macro” investment), we take a “what if” exploratory public policy perspective of evaluating the potential effects on investors' audit quality judgments and investment decisions of two evolving PCAOB inspection practices: disclosure of audit strengths and deficiencies, and the use of a random inspection selection method. In both experiments, we manipulate: inspection reporting (only deficiencies under the historical PCAOB inspection reporting; only deficiencies under a “balanced” PCAOB reporting; or a report where strengths are present but outnumbered by deficiencies) and inspection selection method (risk-weighted or random). We find that disclosure of audit strengths is highly relevant to investment decisions, through influencing investors' audit quality assessments and confidence in financial reporting. Investors also consider inspection selection method in macro-level, but not in micro-level judgments.

An Audit Quality Inspection Scandal: Ethical Lapses in a Misguided Attempt to Alleviate Regulatory Scrutiny

ABSTRACTIn 2017, KPMG discovered that several high-ranking partners in its Department of Professional Practice (DPP) had surreptitiously obtained highly confidential information on upcoming PCAOB inspections. In obtaining this information, these KPMG partners were able to anticipate and prepare for PCAOB inspections, causing the firm's inspection deficiency rate to plummet and its executives to tout the success of their efforts to improve audit quality. Once the firm discovered the scandal, the individuals involved were terminated, and six of them were ultimately convicted of felonies. This case study introduces students to relevant auditing standards, audit quality concepts, and facilitates discussion of a number of ethical issues. Learning objectives for this case include obtaining an understanding of the PCAOB and its inspection program, understanding audit documentation standards, demonstrating the ability to evaluate ethical issues, applying the fraud triangle in a unique setting, and assessing responsibility for the various parties involved.

PCAOB international inspection access and debt contracting: Evidence from American Depositary Receipt firms

We examine whether the Public Company Accounting Oversight Board’s (PCAOB’s) international inspection access affects the usage of accounting-based debt covenants in bank loan contracts of American Depositary Receipt (ADR) borrowers. We show that there is an increase in the use of financial covenants in debt contracts after the auditor of an ADR borrower becomes subject to PCAOB inspections. We also document that lenders increase the usage of financial covenants only in loans to ADR borrowers domiciled in countries with weak home country intuitions, and the increase is more pronounced for ADR borrowers from countries without a local auditor regulatory oversight body. These findings suggest that PCAOB regulatory oversight enhances the perceived credibility of accounting numbers for debt contracting and serves as a substitute for the weak monitoring of auditors for ADR borrowers domiciled in countries with weak country institutions.