Auditing the Auditors

This post comes to us from Clive Lennox of Nanyang Technological University Singapore and Jeffrey Pittman of the Memorial University of Newfoundland.

The recent major reforms to the external monitoring of U.S. audit firms which resulted in the independent inspection of audit firms by the Public Company Accounting Oversight Board (PCAOB) motivates our paper, Auditing the auditors: Evidence on the recent reforms to the external monitoring of audit firms, which was recently accepted for publication in the Journal of Accounting and Economics.

We begin our analysis by dissecting the transition from self-regulation to impartial inspection under the PCAOB. We find that the PCAOB relied on peer review reports to target lower-quality audit firms in their initial round of inspections. In addition, our data reveal that many firms elected to leave the peer review program after the PCAOB began conducting inspections despite the fact that audit firms with public company clients can submit to both PCAOB inspections and peer reviews. Indeed, we find that the worst audit firms, which we measure with the presence of an adverse or modified opinion and the number of weaknesses in their prior peer review report, were more likely to abandon the program. Further, our tests suggest that the probability of a reviewer switch is significantly higher in the event of a modified or adverse opinion. Apart from corroborating prior research that peer review reports are informative, this evidence implies that audit firms were avoiding reviewers who previously gave unfavorable opinions against them. In contrast, the PCAOB prevents such opportunism since audit firms cannot influence the selection of their inspectors, the inspectors do not have current ties to audit firms, and the PCAOB is an independently funded organization.

Although the PCAOB is insulated from the accounting profession, several commentators cast doubt on whether the PCAOB and its inspectors have adequate technical expertise to properly regulate audit firms. In univariate tests, we document that the audit engagement weaknesses disclosed in PCAOB reports fail to predict subsequent changes in audit firms’ market shares, suggesting that the reports do not affect clients’ audit firm choices. In the multivariate analysis, we estimate a model that predicts the expected number of reported weaknesses and find that PCAOB reports identify more weaknesses if audit firms: (1) have more clients, and (2) previously received unfavorable peer review opinions. Next, we construct an unexpected opinion variable, which equals the number of weaknesses disclosed in the PCAOB report minus the number of weaknesses predicted by the model. Reinforcing our univariate evidence, we continue to find that audit firms’ market shares are insensitive to their PCAOB reports.

After the PCAOB began its inspections of public company audits, the scope of peer reviews was largely confined to the audits of private companies to avoid duplication in regulatory monitoring. Our evidence indicates that audit firm choice by public companies hinges less on the peer review reports issued in recent years, implying that the perceived information content of peer reviews falls under the restricted reporting format. Moreover, audit firms began leaving the peer review program after the introduction of PCAOB inspections, especially if their previous peer review opinions had been unfavorable. Accordingly, we conclude that peer reviews have become less relevant to public companies for gauging differential audit firm quality. We also demonstrate that the PCAOB’s failure to disclose certain information—specifically, the quality control weaknesses and overall ratings of audit firms—explains why clients do not find the inspection reports to be informative. Collectively, our findings suggest that the reporting model adopted by the PCAOB is not viewed by audit clients as being informative about audit firm quality.

The full paper is available for download here.

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