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 findings of this study should be of interest to boards of directors, audit committees, and senior management who are accountable to investors and other parties for the timely and unbiased examination of whistle-blowing allegations. Prior research has shown that audit committee members can be biased in their evaluations of whistle-blower allegations and in the allocation of resources to investigate those allegations. However, the results of this study show that CAEs do not exhibit the same bias as audit committee members for allocating resources to investigate whistle-blower allegations. The audit committee often relies on the CAE to investigate whistle-blowing reports, and this study suggests that CAEs may be a better choice for managing the evaluation of whistle-blowing allegations relative to members of the audit committee. CAEs’ decisions are not shrouded in secrecy, and CAEs report to both management and the audit committee, creating multiple levels of accountability. They are less able to ignore allegations that pose personal threats than are directors.

Guthrie, C. P., C. S. Norman, and J. M. Rose. 2012. Chief Audit Executives’ Evaluations of Whistle-Blowing Allegations. Behavioral Research in Accounting 24(2): 87-99.

Section 301(4) of the Sarbanes-Oxley Act of 2002 (SOX) requires that public companies establish procedures for receiving and reviewing complaints regarding accounting and controls, and SOX requires firms to establish a confidential and anonymous channel for reporting such complaints. Prior research has shown that audit committee members evaluate anonymous whistle-blower allegations as less credible than non-anonymous allegations. Additionally, prior research has shown that when whistle-blowing allegations threaten the reputations of corporate directors, the directors justify decisions to limit the investigation of allegations by ascribing low levels of credibility to the allegation. Therefore, the purpose of this study was to evaluate how Chief Audit Executives (CAE) evaluate whistle-blowing allegations and whether CAEs are subject to the same judgment biases that audit committee members exhibit. The authors studied CAE credibility assessments of:

• Anonymous vs. non-anonymous whistle-blower allegations.
• Whistle-blower allegations that threaten the reputations of the CAE.

The authors also evaluated the amount of resources that CAEs planned to allocate to investigate these whistle-blower allegation reports.
 

The authors conducted an experiment that took place sometime before March 2012 with CAEs and deputy CAEs from both public and private companies. The participants had an average of 12.76 years of internal audit experience. About 60 percent of the participants were CPAs and about 50 percent of the participants were CIAs. The participants read a case in which they were informed of a whistle-blower allegation that management of the organization had committed fraud, and the participants then assessed the credibility of the allegation and allocated resources to investigate the claim. 

• The CAEs ascribed a lower level of credibility to anonymous whistle-blowing reports relative to non-anonymous reports.
• When the allegations threatened their reputations (meaning that the whistle-blowing reports suggested the wrongdoing was perpetrated by the exploitation of weaknesses in previously evaluated internal controls rather than by the circumvention of internal controls) CAEs further lowered their assessed credibility of the allegations.
• CAE perceptions of lower credibility for allegations that threatened their reputations did not lead the CAEs to make smaller allocations of resources to investigating these allegations. In fact, the CAEs allocated more resources to allegations for which they would be held more responsible.
   

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