Public Company Accounting Oversight Board Inspection Research Articles

The impact of auditors creating flowcharts on auditors’ understanding of the flow of transactions and internal control evaluation

Purpose Motivated by the importance of gaining an understanding of the flow of transactions when assessing the effectiveness of internal controls for Sarbanes–Oxley Act (SOX) compliance, concerns raised by the Public Company Accounting Oversight Board (PCAOB) of audit firm deficiencies in these areas and auditors’ use of both narratives and flowcharts to document the flow of transactions, this article aims to examine the impact of auditors creating flowcharts versus narratives on auditors’ transaction flow understanding and internal control evaluation performance. Design/methodology/approach This paper conducts a between-participants experiment examining auditor-created flowcharts versus narratives and different levels of documentation quality on auditors’ understanding of the flow of transactions and internal control evaluation performance. Findings This paper finds that auditors who create flowcharts gain a better understanding of the clients’ transaction flow and perform better on internal control evaluations than auditors who create narratives. Process results from a moderated-mediation model also show a moderating effect of quality and mediating effect of understanding. Practical implications These findings inform PCAOB policy decisions and inspection efforts and audit firms’ quality and process improvement efforts by providing initial support for having auditors create flowcharts to improve their understanding of the flow of transactions and internal control evaluation performance. Originality/value To the best of the authors’ knowledge, this is the first study to examine the effect of auditor-created flowcharts compared to narratives on auditors’ understanding of the flow of transactions and internal control evaluation performance.

The Regulatory Approach of James R. Doty: PCAOB Chair 2011–2018

James R. Doty was the chair of the US Public Company Accounting Oversight Board (PCAOB) from February 2011 to January 2018. Extant research investigates the outcomes of the PCAOB's regulatory approach without examining what that approach is. This article examines two approaches to regulation: merit and disclosure. For example, the PCAOB inspection process, which focuses on remediation of deficiencies, is a form of merit regulation. A disclosure approach to regulation would focus instead on more timely disclosure of inspection findings to audit committees, investors, and other users of financial statements. The article explores the impact of Doty's regulatory approach on the direction of the PCAOB during his tenure. Under Doty, the PCAOB's approach shifted towards a more disclosure based regulatory approach and away from a merit based regulatory approach. The article is based on extensive documentary evidence as well as interviews with James Doty.

Auditors’ Use of In‐House Specialists

ABSTRACTUsing Public Company Accounting Oversight Board (PCAOB) inspection data from 2006 to 2018, we examine the use of auditor‐employed specialists in audit engagements. First, we find that the use of specialists is increasingly prevalent and related to clients’ size and complex accounting estimates. Second, the use of specialists is positively associated with the incidence of audit process deficiencies (identified by PCAOB inspections) but is not associated with output‐based audit‐quality proxies (restatements or absolute discretionary accruals). Hence, although process deficiencies are more likely to occur in engagements with higher use of specialists, financial reporting quality is not negatively impacted. Third, the use of specialists is positively associated with the likelihood of goodwill impairments and negatively associated with engagement profitability. Finally, cross‐sectional tests suggest that board accounting expertise is a salient condition for more effective use of specialists. Collectively, our findings align with concerns noted by the PCAOB and prior experimental and survey studies. Although specialists assist auditors with the audit of complex estimates, engagements with comparatively high specialist use entail an incremental risk of audit process deficiencies.

The Association between PCAOB Inspection Reports and Seasoned Equity Offering Discounting

SUMMARY We examine the association between Public Company Accounting Oversight Board (PCAOB) inspection reports and a firm’s cost of equity capital, measured using seasoned equity offering (SEO) discounting. SEO discounting occurs when the offer price is lower than the prior day’s market price of the firm’s shares and represents “money left on the table” for issuing firms. We document an economically significant, positive association between SEO discounting and the use of an auditor found to be deficient by the PCAOB for clients of triennially inspected auditors. Cross-sectional evidence suggests that this relation is stronger for clients with lower analyst following and disclosed material weaknesses in financial reporting controls, and weaker if the auditor issues a going concern modification. Our evidence is consistent with PCAOB inspections providing meaningful information about audit quality to market participants, particularly for clients of smaller, triennially inspected auditors. Data Availability: All data are from publicly available sources. JEL Classifications: M42.

Corruption in the Auditor Inspection Process: The Case of KPMG and the PCAOB

ABSTRACT This case examines the high-profile scandal concerning regulatory monitoring of U.S. public accounting firms. Specifically, KPMG partners obtained confidential information from current and former PCAOB employees about audits the PCAOB planned to inspect. The primary case objectives are to (1) expand students’ knowledge of the PCAOB inspection process; (2) highlight the relationship between the regulator and the regulated audit firms, including the concepts of “regulatory capture” and “revolving door”; and (3) increase students’ awareness of the professional and ethical issues raised by the scandal, including decision making under pressure, evaluating the appropriateness of supervisory requests, overcoming temptations to engage in unethical or illegal behavior, and incentivizing job performance related to ethical conduct. The case also explores “tone at the top” and corporate culture deficiencies at KPMG during the scandal period. This case is most applicable for implementation in undergraduate or graduate auditing or accounting ethics courses.

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

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.

Audit firm political connections and PCAOB inspection reports

We examine the effect of audit firm political connections on the harshness of Public Company Accounting Oversight Board (PCAOB) inspection reports. Relying on Regulatory Capture Theory and Motivated Reasoning Theory, we show audit firm political connections, as measured through PAC contributions, are negatively associated with the harshness of Part I reports. Our results are robust to instrumentation and are not due to movements of personnel between the PCAOB and audit firms or improvements in a firm's audit quality. In supplementary tests, we show the negative relation is stronger when we consider the directed nature of PAC contributions to members of Congress who exercise SEC oversight and robust to alternative measures. Finally, we consider the harshness of Part II inspection reports and find no association with political connections. Collectively, our results suggest audit firm political connections induce favorable influence over Part I findings of PCAOB inspection reports.

Public audit oversight and the originate-to-distribute model

The originate-to-distribute (OTD) model, in which the originators of mortgages sell or securitize the mortgages to third parties, likely contributed to the 2008 financial crisis. Auditors were blamed for permitting clients to understate the risks of the model in their financial reports, fostering undisciplined lending. We investigate whether public audit oversight influences OTD lending by promoting more vigilant audits of the financial reports of originators. Using a difference-in-differences design prior to the financial crisis, we find reduced OTD lending by banks after the Public Company Accounting Oversight Board (PCAOB) criticizes their auditors’ audits of financial reports regarding OTD transactions. The reduction is greater for banks with poorer risk controls and stronger incentives to manage earnings. We also find a reduction in gains on loan sales and securitizations. The results suggest that PCAOB inspections can help discipline OTD lending, a real effect of public audit oversight in the United States.

What Are the Trends in PCAOB Inspections and the Reported Audit Deficiencies?

Although the Public Company Accounting Oversight Board (PCAOB) inspections commenced in 2003, few studies have analyzed the recurring nature of audit deficiencies both within and across U.S. and non-U.S. firms. This study investigates longitudinal trends in PCAOB Part I audit deficiencies and compares these deficiencies between initial and subsequent inspections. We classify the audit deficiencies contained in the inspection reports into three categories relating to Generally Accepted Accounting Principles (GAAP), Generally Accepted Auditing Standards (GAAS), and Internal Controls over Financial Reporting (ICFR). Using 1,551 inspections conducted over the period 2003–2017, we find that 67% of Part I audit deficiencies in the related reports pertain to GAAP and that triennially inspected audit firms have the highest occurrence of these deficiencies. On average, 22% of audit deficiencies relate to GAAS, with the highest incidence of these deficiencies attributable to annually inspected audit firms. Although ICFR has the least audit deficiencies (11%), we find a significant increase from 2009. We find no significant differences in the mean number of GAAP, GAAS, and ICFR audit deficiencies between first- and second-round inspections. However, we find a significant increase in the mean number of ICFR audit deficiencies between the third- to fifth-round inspections. The audit areas of “revenue recognition,”“inventory,” and “fair value measurements” (i.e., those requiring significant auditor judgment) are the most frequent audit deficiencies identified by the PCAOB. This study provides insights into the frequency and nature of audit deficiencies to stakeholders such as investors, auditors, audit committees, and users of financial statements.

Standard-setting in auditing: Insights from PCAOB inspections

We explore whether the Public Company Accounting Oversight Board (PCAOB) consistently follows its own standard-setting policies. We do this using a methodology that combines the reports of audit partners, the timing of enacted auditing standards, and the issuance of PCAOB inspection findings. Rules governing standard-setting are critical to ensure that auditing standards are appropriate, efficient, and are therefore likely to be generally accepted. Our results suggest that in some instances auditors were penalized for omitting evidence from their working papers which is not specified in the standards, in effect, changing or removing auditor judgment in the amount and nature of audit evidence to be gathered in corroboration of management’s assertions and creating new auditing standards outside of the formal standard-setting process. Beyond the societal benefits of standard-setters adhering to their own policy-making rules, changes in auditing procedures impact the behavior of both auditors’ and managers and is costly. Although subject to limitations, we believe our results are informative to policy makers and other participants in PCAOB standard-setting.

Do PCAOB Inspections Improve Working Capital Accrual Reliability? Evidence from the PCAOB Annual versus Triennial Inspection Exposure

SYNOPSISIn this study, we examine whether the ability of working capital (WC) accruals to predict future earnings and cash flows differs between registrants whose auditors are subject to annual Public Company Accounting Oversight Board (PCAOB) inspections and those whose auditors are subject to triennial PCAOB inspections. We find that WC accruals of clients audited by auditors subject to annual PCAOB inspections enhance earnings persistence more and map into future cash flow realizations better than those audited by auditors subject to triennial PCAOB inspections. These findings are stronger for operating asset accruals than for operating liability accruals. Furthermore, after PCAOB inspection reports are released, improvements in WC accrual reliability are more evident for clients audited by annually inspected auditors than for clients audited by triennially inspected auditors. Overall, our findings suggest that more frequent PCAOB inspections help to improve WC accrual reliability.JEL Classifications: M41; M42; M48.Data Availability: The data are publicly available from the sources identified in the paper.

Exploring PCAOB inspection results for audit firms headquartered outside of the US

This study examines the audit quality, measured using Public Company Accounting Oversight Board (PCAOB) reports, for audit firms headquartered outside of the United States (US). We hypothesize and test if differences in firm audit quality as measured by PCAOB inspection deficiencies exist depending upon the size and nature of arrangements with other audit firms. More specifically, we examine five different categories of auditing firm arrangement: Big Four network affiliates; BDO and Grant Thornton network affiliates; firms with other network affiliations; firms with associations and alliances; and other (unknown or no stated affiliation). In this underexplored area of research, we find that non-US firms without formal connections to other firms have lower audit quality in comparison to the other four arrangement types. Our analysis also suggests that those with more formal connections (i.e., networks and larger associations/alliances arrangements) have similar levels of audit quality. Moreover, our results suggest that network firms that primarily do work referred to them by US audit firms have better results on PCAOB inspections; however, we do not find this relationship for associations and alliances. As the PCAOB explores group audit work standards, it is imperative that a more nuanced understanding of global audit quality progresses.

Real Effects of PCAOB International Inspections

ABSTRACT This paper examines the effect of the Public Company Accounting Oversight Board (PCAOB) international inspection program on companies' financing and investing decisions. Difference-in-differences regression estimates suggest that companies respond to their auditor receiving a “deficiency-free” inspection report by issuing additional external capital amounting to 1.4 percent of assets and increasing investment by 0.5 percent of assets. These effects are larger for (1) financially constrained companies and (2) companies located in countries where there is no regulator or the regulator does not conduct inspections. Further, the effect on financing decisions is stronger in countries with (1) low corruption, (2) strong rule of law, and (3) high regulatory quality. Descriptive evidence suggests that inspections increase the use of financial covenants in debt contracts, which is likely one of the mechanisms through which inspections generate real effects. This paper documents the value of PCAOB inspections in mitigating financing frictions for non-U.S. companies. JEL Classifications: D8; D25; G15; G31; G38; M4; M41; M42. Data Availability: Data are available from the public sources cited in the text.

International PCAOB Inspections and Earnings Management Transmission within Multinational Business Groups

Does the impact of international Public Company Accounting Oversight Board (PCAOB) inspections extend beyond country borders of inspected auditors? We investigate this question by examining multinational business groups. Following initial PCAOB inspections of accounting firms auditing foreign U.S.-listed global ultimate owners, our findings indicate that their international subsidiaries decrease earnings management. Research design choices such as the comparison of treated observations with same country-industry-year control observations and a fixed effects structure that controls for country, industry, year, and group characteristics mitigate concerns of omitted variables. Our paper provides evidence for benefits of international PCAOB inspections over and above the previously documented effects for firms located in the countries of the inspected auditors.

Does Part II of the PCAOB inspection report provide new information to the market?

PurposePart II of the Public Company Accounting Oversight Board (PCAOB) inspection report is released only when firms fail to remediate quality control criticisms and is intended to be a public signal of audit quality. The purpose of this paper is to reexamine whether audit clients react to the release of Part II of the PCAOB inspection report as a signal of audit quality.Design/methodology/approachThis study uses a difference-in-difference regression model to examine the association between the release of Part II of the PCAOB inspection report and an audit firm’s change in market share. A sensitivity analysis is also performed to determine whether the main findings are robust to the timing of the release of the report and type of quality control criticism included in Part II of the inspection report.FindingsAfter controlling for the prior year’s changes in market share, the authors find no evidence that clients react to the public release of Part II of the report. In the second part of the study, they examine when clients become aware of the contents of the Part II report prior to its release. Firms with audit performance criticisms experience a decrease in market share following the release of Part I. Firms with firm management criticisms experience a significant decrease in market share following the remediation period and before the public release of Part II.Practical implicationsThe results suggest that Part II of the PCAOB inspection report does not provide new information to the market. Clients appear to be aware of the information contained in Part II of the PCAOB inspection report prior to its release. The authors believe that the delay in releasing the Part II report may create an information imbalance, and the PCAOB may want to consider ways to improve the timeliness of the information.Originality/valueThis study questions the generalizability of prior research which finds that Part II of the inspection report provides new information that is valued by the public company audit market as a signal of audit quality. The findings provide new evidence that the contents of Part II and the firm’s ability to remediate the quality control concerns are known to audit clients prior to the public release.

PCAOB inspections: An analysis of entity-level and application-level control audit deficiencies

The Public Company Accounting Oversight Board (PCAOB) inspection process identifies deficiencies related to how firms conduct audits. Our work extends prior research by examining the type of internal control audit deficiencies (entity-level or application-level). Internal control audit deficiencies of both types may increase the risk of material misstatement, so the PCAOB is concerned with whether audit firms are performing appropriate procedures to identify entity-level and application-level internal control audit deficiencies, including those involving information technology general controls (ITGCs). Using text analysis to examine audit deficiencies by internal control type and firm size, we find that PCAOB inspection reports identify significantly more application-level than entity-level control audit deficiencies. Application-level control deficiencies generally involve revenue, inventory, and accounts receivable accounts whereas entity-level deficiencies often involve lack of centralized controls or controls over period end financial reporting. The number of application-level deficiencies identified for both Big 4 and second-tier firms varied between inspection years 2010 and 2015. However, the number of entity-level deficiencies, including ITGCs for both Big 4 and second-tier firms, held nearly steady during the period. Our findings should be of interest to practicing accountants, regulators, and other users of PCAOB inspection reports.

Evidence of the Relationship between PCAOB Inspection Outcomes and the Use of Structured Audit Technologies

SUMMARY We investigate the relationship between Public Company Accounting Oversight Board (PCAOB) inspection outcomes and auditors' use of structured audit technologies (SATs) by conducting interviews with audit partners of firms inspected annually by the PCAOB, surveying triennially-inspected auditing firms, and relating auditors' reported SAT adoptions and use with their firm-specific inspection outcomes. It has been observed that auditors are adopting SATs to improve PCAOB inspection outcomes. While our evidence is consistent with this observation and motivation, we do not find evidence that SATs are an effective strategy to improve inspection outcomes. We discuss the potential reasons for this inconsistency, the most important of which may be auditors' expressed concerns about the negative impact SATs have on auditors' critical thinking skills, professional judgment, and skepticism. Supplemental tests relating auditors' SAT adoptions to their client-specific audit fees also provide initial support for auditors' reports that SATs are efficient audit tools.

Quality control system criticism raised by the Public Company Accounting Oversight Board in non-US jurisdictions and earnings quality of non-cross-listed clients

This study investigates the association between Public Company Accounting Oversight Board (PCAOB) inspection‐related criticisms of an accounting firm's system of quality control and earnings quality of non‐cross‐listed clients in non‐US jurisdictions. We also assess whether this association is different in subsamples where a local independent inspection regime is present compared with jurisdictions without such a regime. We use a difference‐in‐difference design to assess changes in accruals quality in pre‐ and post‐inspection periods. Our sample includes 2006–2011 data on first‐time, international PCAOB inspections of Big 4 accounting firms in 19 countries. Our findings indicate that earnings quality improvement of non‐cross‐listed clients after international PCAOB inspections is higher for inspections with (versus without) PCAOB‐detected deficiencies of the system of quality control. We also find that this improvement occurs in countries with independent oversight of the audit profession.

The audit market effects of disputing a GAAP-deficient PCAOB inspection report

As part of its charter, the Public Company Accounting Oversight Board (PCAOB) has the authority to inspect and review the workpapers of all accounting firms that provide auditing services to publicly traded companies. The PCAOB summarizes their findings in publicly available inspection reports available on its website. Prior research suggests that the accessibility, variation and source creditability of the inspection reports creates a publicly available audit quality signal that is used by various auditor choice stakeholders. This is particularly true for triennially inspected auditors that receive a GAAP-deficient report (Abbott, Gunny, & Zhang, 2013). In a GAAP-deficient inspection report, the PCAOB alleges that the auditor failed to identify departures from generally accepted accounting principles (GAAP) in the clients' financial statements. In this paper, we investigate whether and to what extent the auditor's response – which is also encapsulated in the inspection report – impacts the reaction to GAAP-deficient inspection reports. We create a sample of 113 GAAP-deficient inspection reports that correspond to 100 unique auditors. For these 100 auditors and their 805 audit clients, we find auditors that dispute the PCAOB findings are less likely to be dismissed by their clients when the client has an audit committee with accounting-related financial expertise. Collectively, our results indicate that auditor choice stakeholders weigh both the PCAOB- and auditor-assessments of auditor performance.

The Valuation Impact of PCAOB International Inspections on U.S. Multinational Corporations

Although the Sarbanes-Oxley Act of 2002 mandates that all auditors of public issuers in the United States are subject to Public Company Accounting Oversight Board (PCAOB) inspection, certain foreign jurisdictions prevent the PCAOB from inspecting their audit firms. Between January 2011 and November 2017, the PCAOB issued a series of 16 disclosures announcing Cooperative Agreements with foreign regulators who previously prohibited PCAOB inspections. We exploit the staggered introduction of the PCAOB international inspection program to examine whether PCAOB cross-border audit oversight affects the valuation of U.S. Multinational Corporations (MNCs). Specifically, we examine the returns of U.S. MNCs with substantial operations in certain foreign countries to news about auditors from those countries not being, and then becoming, subject to PCAOB inspection. We document a significantly negative (positive) market reaction to news that the PCAOB does not have (subsequently gains) access to inspect certain foreign participating auditors. Consistent with cross-sectional predictions, we find the valuation impact is stronger for U.S. MNCs with weaker external monitoring, greater overseas presence, and foreign operations in countries with poorer investor protections. Overall, the results are consistent with investors valuing PCAOB regulatory oversight abroad.