Public Audit Oversight and Reporting Credibility

As the accounting scandals in the early 2000s illustrated, reliable financial reporting is a cornerstone of trust in the stock market, which in turn plays a key role for investor participation (Guiso et al., 2008). In an effort to restore trust in financial reporting after the scandals, the U.S. Congress passed the Sarbanes-Oxley Act (hereafter, “SOX”). One of its core provisions was the creation of the Public Company Accounting Oversight Board (hereafter, the “PCAOB”) and the requirement that the PCAOB inspect all audit firms (hereafter, “auditors”) of SEC-registered public companies (hereafter, “firms” or “issuers”). The introduction of the PCAOB represents a major regime shift, replacing self-regulation with public oversight.

In June 2003, the PCAOB began limited inspections of the U.S. Big Four audit firms. In 2004, the PCAOB conducted full inspections of large auditors and the first round of triennial inspections of small U.S. auditors. The inspections provide an assessment of an auditor’s compliance with SOX, the rules and standards of the PCAOB, SEC rules, and professional audit standards (PCAOB, 2004a). However, even after years of experience with the new regime, widespread skepticism remains that the PCAOB and its inspection regime have changed the credibility of financial reporting and reassured investors. In response to this skepticism, there has been a call for more economic analysis of the PCAOB’s activities and of SOX in general (e.g., House Oversight Committee, 2012; Coates and Srinivasan, 2014). At the heart of the debate is the broader economic question of whether audit oversight by a public-sector regulator enhances reporting credibility. Our study, Public Audit Oversight and Reporting Credibility: Evidence from the PCAOB Inspection Regime, which was recently made publicly available on SSRN, examines this question.

The objective of an external audit is to provide outside investors with assurance about corporate reporting in light of numerous agency problems between managers and outside investors. As there are also agency problems between managers and auditors, the credibility of an audit depends crucially on the independence of the auditor as well as the thoroughness with which the audit is conducted. When auditor independence is questionable, an audit is not likely to provide much assurance to investors. Public oversight could mitigate agency problems in auditing and thereby ensure a certain level of audit quality, which in turn should increase the credibility of financial reporting.

However, prior work in regulatory economics suggests it is not obvious that public audit oversight is an improvement over the prior regime—especially considering the potential problems with public-sector regulators, including resource constraints, inefficient bureaucracies, regulatory capture, and political pressures (e.g., Demsetz, 1968; Stigler, 1971). Consistent with these concerns about public regulators, Hilzenrath (2010) states that “the [PCAOB] looks a lot like the system it was designed to replace: slow to act, veiled in secrecy and weak—or weak willed.” Similarly, Glover et al. (2009) characterize the PCAOB’s inspection model as “inefficient and dysfunctional.”

The PCAOB introduced its inspections in three distinct phases: (i) one-time limited-scope inspections for the U.S. Big-Four audit firms in 2003 (i.e., Deloitte & Touche, Ernst & Young, KPMG, and PricewaterhouseCoopers); (ii) annual full inspections for audit firms with more than 100 issuers beginning in 2004; (iii) triennial full inspections for audit firms headquartered in the U.S. that issued a report for at least one, but no more than 100, issuers, beginning in 2004. We exploit the staggered introduction and analyze all three phases using a difference-in-differences design comparing ERCs before and after the introduction of the new PCAOB inspection regime.

In our primary analysis, we assess changes in reporting credibility based on changes in short-window stock market reactions to earnings announcements (i.e., earnings response coefficients or ERCs). Conceptually, the ERC is a function of the extent to which investors believe that a surprise in reported earnings reflects economic performance (e.g., Holthausen and Verrecchia, 1988). It can also be linked to a firm’s cost of capital.

We find that the ERCs of firms whose auditors were subject to the new PCAOB inspection regime increase significantly compared to the ERCs of our control samples. That is, investors react more strongly to earnings news after a firm’s auditor has been treated by the new regime, which is consistent with public audit oversight increasing investors’ perceptions of financial reporting credibility. The effects are present for firms with Big Four, other annually-inspected auditors as well as smaller, triennially-inspected auditors. The findings do not appear to be driven by other SOX provisions unrelated to audit oversight. Corroborating these results, we find that abnormal trading volume reactions to 10-K filings increase after the introduction of the inspection regime.

Overall, our study provides large-sample evidence on the capital-market benefits of the PCAOB inspection regime, which was an integral part of SOX. While our study does not attempt to provide a full-fledged cost-benefit analysis, the evidence shows that public audit oversight not only has compliance costs but also generates significant capital-market benefits by enhancing the credibility of financial reporting. Our study also provides further support for the notion that financial reporting credibility and trust in the numbers are priced in capital markets.

The full paper is available for download here.