The Unintended Consequences of the Frequency of PCAOB Inspection

Abstract

After more than 50 years of self-regulation of the US auditing profession, the Sarbanes-Oxley Act of 2002 (SOX) created the Public Company Accounting Oversight Board (PCAOB) as a quasi-governmental entity with statutory authority to inspect accounting firms that audit public clients. The frequency of this inspection is annual or triennial, based upon the number of public clients the firm audits. We examine the effects of these two levels of inspection frequency on financial reporting quality and audit fees for clients of small and midsize public accounting firms. Our findings provide evidence of significantly higher audit quality and audit fees for clients of annually inspected firms relative to clients of triennially inspected firms. These findings are robust to auditor-client alignment analyses, propensity score matching, time-series analyses, examination of firms that have changed from triennial to annual inspection, and particular examination of firms with inspection deficiencies. Overall, our study suggests that the two-tier frequency system of PCAOB inspection may have also resulted in two-tier audit quality and audit fee systems for small and midsize public accounting firms, with more frequent inspection leading to more rigorous and informed auditor decisions. We discuss the implications of our results for the Board and the profession at large.

Audit quality and properties of analysts’ information environment

“…Passed in 2002, SOX created several restrictions on auditor‐client relations such as banning the incumbent auditor from supplying many non‐audit services to audit clients. It also created the Public Company Accounting Oversight Board (PCAOB), and an entirely new oversight and review process focusing on audit quality (Tanyi & Litt, ). Proponents have argued that such regulation has the effect of improving audit quality via reduced threats to auditor independence, although research generally fails to find evidence in support of these claims (Ruddock, Taylor, & Taylor, ).…”

Audit Quality in New Zealand – Early Evidence from the Regulator

“…; Lamoreaux ). Tanyi and Litt () found that the financial reporting quality of clients of small to medium‐sized audit firms inspected annually by the PCAOB is significantly higher than that of clients of audit firms inspected triennially.…”

“…After first-time PCAOB inspections, lower abnormal accruals were also identified for foreign companies cross-listed in the United States and audited by foreign accounting firms (Krishnan et al 2017;Lamoreaux 2016). Tanyi and Litt (2017) found that the financial reporting quality of clients of small to medium-sized audit firms inspected annually by the PCAOB is significantly higher than that of clients of audit firms inspected triennially. Audit firms that receive deficiencies in their inspection reports experience negative impacts.…”

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

“…On the other hand, it has been documented that small audit firms do not perceive that the inspection process improved audit quality or public confidence in the audit profession (Daugherty & Tervo, 2010). Tanyi and Litt (2017) show that annually inspected non-Big 4 audit firms are more selective in their choice of new clients in the post-inspection period, compared with triennially inspected non-Big 4 audit firms. This would suggest that the impact of the PCAOB may not be equivalent between large and small audit firms.…”