When the PCAOB Talks, Who Listens? Evidence from Stakeholder Reaction to GAAP-Deficient PCAOB Inspection Reports of Small Auditors

Abstract

SUMMARY: Section 104 of the Sarbanes-Oxley Act (SOX) created the Public Company Accounting Oversight Board (PCAOB). The PCAOB conducts inspections of registered public accounting firms that provide audits for publicly traded companies. The results of the inspection process are summarized in publicly available reports at the PCAOB website. Using these reports, we categorize the inspection reports into three levels of increasing severity: clean, GAAS-deficient, and GAAP-deficient. We examine the potential use of GAAP-deficient PCAOB inspection reports as perceived audit quality signals for the clients of GAAP-deficient auditors that are inspected on a triennial basis by the PCAOB. Our investigation is predicated on the notion that audit quality is generally not directly observable. Thus, the clients of these auditors may seek to signal their desire for audit quality by dismissing their GAAP-deficient auditors. Our results suggest that the clients of GAAP-deficient, triennially inspected auditors are more likely to dismiss these auditors in favor of triennially inspected auditors that are not GAAP-deficient. In addition, we find that greater agency conflicts, the presence of an independent and expert audit committee, and outside blockholdings magnify this effect. Interestingly, we find no evidence that the clients use GAAP-deficient reports to procure a subsequent-year audit fee discount or more favorable going-concern auditor reporting treatment. Our evidence indicates that PCAOB inspection reports created heterogeneity in auditor brand name among a group of non-Big N/non-national auditors that did not previously exist and are universally treated by prior research as “other auditors.”

From peer review to PCAOB inspections: Regulating for audit quality in the U.S.

“…In addition, the analysis shows that companies that dismissed audit firms with deficiencies were more likely to hire an audit firm with clean reports. 7 Abbott et al (2013) came to the same result. They examined the association between GAAP-deficient reports and changes in the number of clients.…”

“…Empirical work on the former peer review system has applied alternative evaluation methods to assess whether reviewed firms provide higher audit quality than non-reviewed firms (Deis & Giroux, 1992;Krishnan & Schauer, 2000;O'Keefe et al, 1994;Rollins & Bremser, 1997). In contrast, research on the PCAOB inspections has used audit client-specific measures to evaluate the extent to which inspection contributes to audit quality (Abbott, Gunny, & Zhang, 2013;Carcello et al, 2011;Gramling, Krishnan, & Zhang, 2011;Offermanns & Peek, 2011). Other studies have researched the effect of inspections on the composition of the audit market (DeFond & Lennox, 2011), or have directly asked financial experts about the effect of peer reviews and PCAOB inspections on audit quality Felix & Prawitt, 1993;McCabe, Luzi, & Brennan, 1993;Newman & Oliverio, 2010).…”

“…Abbott et al (2013) A Relation between the PCAOB inspection reports with GAAP deficiencies and the audit firms' clients. Deficiency audit firms were associated with low audit quality indicators (abnormal accruals and propensity to restate) when PCAOB reports were seriously deficient.…”

Comments of the Standards Committee of the Auditing Section of the American Accounting Association on the SEC's Concept Release No. 33-9862; 34-75344 File No. S7-13-15, Possible Revisions to Audit Committee Disclosures

“…(9) The firm's internal review and PCAOB inspection reports. Prior research (e.g., Gunny and Zhang 2013;Abbott, Gunny, and Zhang 2013) suggest that PCAOB inspection findings are negatively associated with audit quality. The AC should acknowledge its knowledge that a PCAOB inspection occurred on its audit, and comment on its findings (Q20)…”

Economic consequences of public oversight of the auditing profession

“…In addition, Tanyi and Litt (2016) show that small and midsize audit firms inspected annually are more selective in their choice of new clients in the post-inspection period compared to the triennially inspected firms. Furthermore, it has been shown that clients with effective audit committees or with high potential reporting quality of GAAP-deficient triennially inspected auditors are more likely to switch to audit firms without GAAP related deficiencies (Abbott et al 2013). Finally, the capital market also appears to react to the PCAOB inspection reports.…”