This paper complements and extends the limited extant research on inspection risk by clearly defining the construct and providing empirical evidence consistent with its existence and impact on auditors’ planning decisions. The authors contend that while auditors may perceive that PARs do not influence effort or fees, both PARs likely cause auditors, perhaps unconsciously, to increase effort and fees. 

C. M. Stefaniak, R. W. Houston, and D. B. Brandon. 2017. Investigating Inspection Risk: An Analysis of PCAOB Inspections and Internal Quality Reviews. Auditing: A Journal of Practice and Theory 36 (1): 151 – 168.

The authors report the results of an experiment that examines how auditor anticipation of the two primary external and internal post-audit reviews (PAR), specifically, U.S. Public Company Accounting Oversight Board (PCAOB) inspections or public accounting firms’ internal quality reviews (IQRs), affects auditors’ perceptions of overall engagement risk, as well as effort and pricing decisions. The authors define inspection risk as “the risk that an auditor or audit firm will suffer harm as a result of a PAR.” Although the current PAR regime has been in place for over ten years, there is little empirical evidence concerning whether, and to what extent, anticipating a PAR impacts auditor behavior, and whether the effects of anticipating a PCAOB inspection or IQR differ. IQRs also remain largely uninvestigated, despite researchers beginning to investigate external PCAOB reviews. 

To investigate how PAR salience affects auditors’ judgments and decisions, the authors conduct a 1 x 3 between-subjects experiment using a number of high-level auditors as participants. They manipulate PAR salience as PCAOB inspection salient, IQR salient, or no explicit expectation of a PAR. 

• The authors find that PAR salience yields greater perceived overall engagement risk, even after controlling for traditional engagement risk-related factors, implying that auditors perceive inspection risk as incremental to these factors.
  • In addition, increased PAR salience results in greater audit effort and fees, consistent with an inspection risk component.
• The authors find that both PARS yield higher fees, with the higher fees attributable only to greater effort, rather than an “inspection risk premium.”
• PCAOB inspection results are more visible than IQRs, and partners perceive that PCAOB inspections can yield greater negative consequences for themselves and their firms; therefore, the authors find that PCAOB inspection salience involves larger increases in perceived overall engagement risk and audit effort than does IQR salience.
  • However, the authors do not find differences in audit fees between PCAOB and IQR salience. 

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This study shows that Big N auditors are more effective in reducing the cost of debt in countries with strong investor protection. In particular, the authors find that high-quality auditors are perceived by creditors as providing higher-quality audits in strong investor protection countries other than the U.S., including the U.K. and Canada. The study has implications for policy makers because it suggests that auditors (and, perhaps, auditing standards) may not be effective in weak investor regimes. High-quality auditors may be less effective in performing a governance role without the support of a strong investor protection regime. 

Gul, F. A., G. S. Zhou, and X. K. Zhu. 2013. Investor Protection, Firm Informational Problems, Big N Auditors, and Cost of Debt around the World. Auditing: A Journal of Practice & Theory 32 (3): 1-30.

In this paper, the authors first confirm that auditor quality reduces the cost of debt across countries. Next, they examine (1) the joint effect of investor protection and auditor quality on the cost of debt across countries, and (2) whether informational quality affects this relationship. The authors investigate the question of whether, in an international setting, firms with more informational problems are more likely to benefit from high-quality auditors and/or strong investor protection than firms with fewer informational problems.

The authors are motivated to examine these issues because of four factors.

• First, although prior studies using U.S. data have documented a link between the choice of Big N auditors and lower cost of debt, these findings have focused on the U.S., where auditors are exposed to high levels of litigation risks. It is unclear whether the relationship holds in jurisdictions with low litigation risks.
• Second, there are competing views of the relationship between the effectiveness of Big N auditors and countrywide governance regimes in international settings.
• Third, prior international studies on the role of auditor quality have not recognized that firms with higher levels of informational problems may benefit more from auditor quality and/or stronger investor protection than do firms with lower levels of informational problems.
• The final motivation for the study lies in the importance of debt in corporate financing for firms across countries.

The auditor and financial data are obtained from the Compustat Global Industrial and Commercial file. The data on analysts are obtained from the Institutional Brokers’ Estimate System (I/B/E/S). The investor protection data are extracted from LLSV and LLS. The other macroeconomic data are collected from the World Bank. There are 96,396 observations from 30 countries for the period from 1994 to 2006.

• The results show that firms with Big N auditors are significantly and negatively associated with the cost of debt. 
• Big N auditors play a role in reducing a firm’s cost of debt across all countries.
• The results show that the relationship between Big N auditors and the cost of debt is stronger in stricter investor protection regimes.
• The authors find that firms with higher informational problems benefit more from high-quality auditors in terms of lower cost of debt in stronger investor protection countries.
• The results suggest that in weaker investor protection countries, creditors seem to price firms’ information asymmetry problems in the cost of debt, and Big N auditors do not seem to play an effective role in reducing debt-monitoring costs.

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The authors provide initial empirical evidence that Securities and Exchange Commission (SEC) registrants found GAAP-deficient PCAOB inspection reports to be a useful signal of audit quality for triennially inspected auditors. This evidence indicates that PCAOB inspection reports created heterogeneity in auditor brand name that did not previously exist. Also, this paper is the first to empirically link audit committee characteristics to PCAOB inspection report severity and auditor choice. The authors believe this is an increasingly relevant finding as audit committees have been granted much greater auditor dismissal and hiring authority due to SOX. This study indicates that a PCAOB inspection report may serve as an audit quality signal for auditors of broker-dealers, who were previously exempt from the inspection process. Such a finding has current relevance given the PCAOB has recently sought to expand the inspection program to foreign auditors, such as those based in China whose clients are cross-listed on U.S. security exchanges or are listed due to a reverse merger.

Abbott, L. J., K. A. Gunny, and T. C. Zhang. 2013. When the PCAOB Talks, Who Listens? Evidence from Stakeholder Reaction to GAAP-Deficient PCAOB Inspection Reports of Small Auditors. Auditing: A Journal of Practice & Theory 32 (2): 1-31.

The PCAOB is a private regulatory agency, independent of the accounting industry. Congress bestowed upon the PCAOB the ability to inspect the work of all accounting firms that audit publicly traded companies. Inspections are conducted annually for Big 4 and national auditors with greater than 100 publicly held registrants (annually inspected auditors). The inspection process is conducted every three years for auditors with fewer than 100 publicly held clients (triennially inspected auditors). The authors classify inspection reports into three categories according to severity. In a clean report, the PCAOB finds no audit deficiencies. In a GAAS-deficient report, the PCAOB notes that the financial statements audited by the auditor are free of material error, but that the audit process did not fully follow GAAS-recommended audit procedures. In a GAAP-deficient report, the PCAOB states that the auditor “failed to identify a material departure from GAAP” or that the audited company “restated certain of its financial statements to make changes relating to” matters/audit deficiencies uncovered by the PCAOB inspection.

The current study examines the PCAOB in the context of whether GAAP-deficient PCAOB inspection reports of triennially inspected auditors are enough of a deleterious audit-quality signal to prompt dismissals of these auditors. This study then identifies the successor triennially inspected auditor and uses the three-tiered categorization scheme to denote an increase in auditor quality. Specifically, the authors create a dichotomous dismissal-based dependent variable coded “1” in cases where the dismissal results in a higher-quality triennially inspected successor auditor, and “0” otherwise.

The authors obtain all inspection reports from the PCAOB website from January 21, 2005 to December 31, 2007. A total of 521 triennially inspected nonforeign accounting firm PCAOB inspection reports were filed, of which 256 (49.1 percent) were clean, and 61 (11.7 percent) were GAAP-deficient. The 54 GAAP-deficient, triennially inspected auditors are included in the sample. The 54 GAAP-deficient auditors report 525 publicly held clients per their PCAOB inspection reports.

• The authors find that GAAP-deficient, triennially inspected auditors are more likely to be dismissed by their clients and are overwhelmingly replaced by a triennially inspected successor that has not received a GAAP-deficient inspection report.
• They also document that the dismissal rate for the clean PCAOB inspection report sample is 17.9 percent, while the dismissal rate for the GAAP-deficient sample is a significantly higher 44.3 percent.
• The authors find that greater agency conflicts, the presence of an independent and expert audit committee, and blockholdings magnify the likelihood of dismissing a GAAP-deficient, triennially inspected auditor in favor of a triennially inspected auditor that is not GAAP-deficient.
• Interestingly, the authors find that opinion shopping or fee shopping does not differentially impact the likelihood of dismissing a GAAP-deficient, triennially inspected auditor in favor of a triennially inspected auditor that is not GAAP-deficient.
• The authors link the use of PCAOB inspection reports to an agency-based demand for audit quality signals.

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The objective of this study is to determine whether PCAOB inspection reports of triennially inspected auditors are used as audit quality signals. The study was based upon the premise that the reports may serve as a publicly-available proxy of perceived audit quality. Clients were found to react differently to the PCAOB inspection reports contingent upon their severity with GAAP-deficient reports are more likely to trigger an auditor dismissal than a clean or GAAS-deficient report. The results suggest that clients of non-Big 4/non-national auditors are using certain PCAOB inspection reports as a publicly-available signal of audit quality and not as a means of procuring more favorable audit reporting or audit fees. 

Abbott, L., K. A. Gunny, and T. C. Zhang. 2013. When the PCAOB Talks, Who Listens? Evidence from Stakeholder Reaction to GAAP-Deficient PCAOB Inspection Reports of Small Auditors. Auditing 32 (2).

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, this study categorizes the inspection reports into three levels of increasing severity: clean, GAAS-deficient, and GAAP-deficient. GAAP-deficient PCAOB inspection reports are examined for potential use as perceived audit quality signals for the clients of GAAP-deficient auditors that are inspected on a triennial basis by the PCAOB. The 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.

The authors obtained all inspection reports from the PCAOB from January 21, 2005, to December 31, 2007. The sample chosen included 54 GAAP-deficient, triennially inspected auditors with complete data for 379 of the auditors’ reported clients. This sample was used to test the following hypotheses:

• H1: There is a positive relation between the receipt of a GAAP-deficient PCAOB inspection report and the likelihood of dismissing a triennially inspected auditor in favor of a non-GAAP-deficient auditor.
• H2: Greater agency conflict values magnify the positive relation between the receipt of GAAP-deficient PCAOB inspection reports and the likelihood of dismissing a triennially inspected auditor in favor of a non-GAAP-deficient, triennially inspected auditor.  
• H3: Independent and expert audit committees magnify the positive relation between the receipt of a GAAP-deficient PCAOB inspection report and the likelihood of dismissing a triennially inspected auditor in favor of a non-GAAP-deficient, triennially inspected auditor. 
• H4: Outside blockholdings magnify the positive relation between the receipt of a GAAP-deficient PCAOB inspection report and the likelihood of dismissing a triennially inspected auditor in favor of a non-GAAP-deficient, triennially inspected auditor.
• H5: Securities issuance magnify the positive relation between the receipt of GAAP-deficient PCAOB inspection report and the likelihood of dismissing a triennially inspected auditor in favor of a non-GAAP-deficient, triennially inspected auditor.

• Dismissal rate is high for GAAP-deficient auditors
• A majority of the clients also received a going-concern modification
• The subsequent auditor is virtually always a triennially inspected auditor that is not GAAP-deficient
• Agency conflict and audit committee effectiveness are helpful in predicting which GAAP-deficient auditors are more likely to be dismissed.

Auditors should be interested in the results of this paper because the trends provide information both on emerging issues in accounting, as well as areas that are likely to be flagged by the PCAOB for inspection. For example, issues related to fair value measurement are growing as a percentage of overall issues. This may cause audit firms to examine their fair value accounting practices and training.

For more information on this study, please contact Bryan K. Church.
 

Church, B. K., and Shefchik, L. B. 2012. PCAOB Inspections and Large Accounting Firms. Accounting Horizons 26 (1): 43-63.

This article gathers data from PCAOB inspection results and analyzes that data to determine trends in the auditing field. It presents these trends in a way that should be of interest to regulators, academics, practicing accountants, and users of the PCAOB's inspection reports.

Using PCAOB inspection reports from 2005 through 2010, the results of each inspection report is manually coded into different categories. Then, using linear regression, the article determines trends of interest in the audit engagements of the big four accounting firms as well as the four other annually inspected accounting firms.

The article finds a number of trends, but some of the more important ones are:

• Issues related to fair value measurement are growing as a percentage of overall issues
• Total issues are declining
• Revenue recognition is the most common problem area
   

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