PCAOB Inspections and Audit Fees: An Analysis of Inspection Rounds of Small Audit Firms

Abstract

This study investigates the impact on audit pricing of PCAOB inspection outcomes on the quality control systems of small audit firms. Quality control deficiencies (QCDs) provide a strong signal about audit quality, which is expected to lead to price changing. We first document that audit fees in the pre-inspection period were higher for small audit firms without QCDs, implying that quality differences were already partially known and priced in the market. Next, we find evidence that in the post-inspection period audit fees further increase for firms without QCDs, while there is limited evidence for fee increases for firms with remediated QCDs, suggesting changes in audit firm reputation. Interestingly, we do not find support for fee changes for audit firms with disclosed quality control deficiencies. Finally, the magnitude of change in audit fees decreases over time. Collectively, these findings contribute to our understanding of audit quality differences amongst small audit firms and the functioning of the small audit firm market.

Ensuring auditor independence: The case for small and medium practices in Malaysia

“…In a similar vein, the regulatory scrutiny has also increased the assurance value of the inspection; it has highlighted the importance of public regulatory oversight over the audit market. This was observed by Vanstraelen and Zou (2020), who found that audit inspections impacted the reputation of audit firms.…”

“…Although audit inspections help to enhance the audit quality of firms leading to significant changes in audit firms' behaviour (Vanstraelen & Zou, 2020), the assessment of auditor independence needs to focus more at the individual office level rather than the entire firm level (Wallman, 1996;Francis, 2004). This is because practices at the national office may differ from those at the local audit offices while audit quality also tends to vary across different engagement offices, even within an audit firm.…”

“…This study contributes to the literature in several ways. First, this study is based on an Asian context where the audit practices differ substantially from the Anglo-Saxon context (i.e., the US audit market), which had been the focus of prior studies (Bedard et al, 2008;Church & Shefchik, 2012;Vanstraelen & Zou, 2020). A study involving an emerging economy would extend the research scope by highlighting the impacts of different regulatory requirements on compliance practices.…”

The effect of audit inspections on audit fees

“…However, Aobdia and Shroff's (2017) analysis finds that audit firms with deficiencies increased their total audit hours by an average of 9% in the year following an inspection but these costs were not passed on in an increase in the audit fees charged. Research by Vanstraelen and Zou (2022) finds that audit firms inspected once every three years without audit deficiencies significantly increased audit fees but audit firms with deficiencies did not increase audit fees after the second and third inspection rounds. Tanyi and Litt (2017) found that after the introduction of audit inspections in the USA, audit fees increased for clients of non-Big 4 auditors but the frequency of inspections had a significant impact on the fee increases.…”

“…The introduction of audit inspections has increased audit fees in some settings. The amount of increase can vary depending upon the frequency of inspections (Tanyi and Litt, 2017), the existence and nature of deficiencies (Blankley et al , 2014; Acito et al , 2017; Vanstraelen and Zou, 2022), and the characteristics of the enforcement regime (Florou and Yuan, 2020).…”