Working Paper: The Impact of the PCAOB Individual Engagement Inspection Process - Preliminary Evidence

​​Paper Author: Daniel Aobdia
​​Publication: To be published in the July 2018 edition of The Accounting Review

Research focus: This paper investigates the behavioral a​nd economic impact of PCAOB inspections of individual audit engagements at both the auditor and issuer level. More specifically, the paper assesses what happens to audit quality the year following a PCAOB inspection and whether this impact depends on whether a Part I finding was identified by the inspection team. The study also assesses whether and how issuers react to the PCAOB inspection process.

Background note: A "Part I finding" is issued when the inspection team determines, based on applicable standards, that the work conducted by the audit engagement team was not sufficient to support the audit opinion. Part I findings are made public and are available on the PCAOB's web site. Additional reference information can be found in the Board public document "Information for Audit Committees about the PCAOB Inspection Process" (PCAOB Release No. 2012-003, August 1, 2012).

Conclusions: Aobdia finds that both auditors and client issuers strongly react to the issuance of a Part I finding on their engagement. The audit firm increases subsequent audit effort and the issuer client is more likely to switch auditors, often to firms with high perceived quality.

Aobdia finds that auditors increase total hours between five and eigth percent the year following the identification of a deficiency on their engagement. Partner hours increase even more, by approximately 11 to 19 percent. This increase in effort leads to an increase in audit fees of up to three percent, which suggests that audit firms are unable to fully recoup increased engagement costs through fees charged to clients. Results are quite different in the absence of a Part I finding. The study evidences a decline in audit effort the year following the inspection, with a reduction in partner hours of six percent and engagement quality reviewer hours of eight percent. The probability of restatement increases by 1.6 percent (driven by the more severe types of restatements, those disclosed in a form 8-K under item 4.02).

Taken together the results suggest that audit firms may not seek to differentiate the audit beyond the standards set by the PCAOB. This result may be a consequence of the current U.S. disclosure regime (plain vanilla audit reports) and may need to be revisited when, for example, rules requiring disclosure of the name of the engagement partner become effective. The evidence is also consistent with the premise that PCAOB inspections give rise to a deterrence effect, making visible the fact that an auditor will generally conduct a better audit if he or she perceives that the audit is more likely to be selected for inspection by the PCAOB in the future. ​Aobdia also provides evidence that PCAOB inspections of individual engagements generate spillover effects to other engagements of the inspected partner and office, suggesting that the information transferred by the PCAOB to audit firms is valuable and applicable to non-inspected engagements.

On the issuer side, Aobdia finds that behavior is also impacted by a Part I finding. An issuer whose audit received a Part I finding is 20 percent more likely than usual to switch audit firm and tends to switch to audit firms with high perceived quality. In the absence of a Part I Finding, issuers of inspected audits are 14 percent less likely than usual to switch audit firms. These results suggest that issuers care about the quality of their audits and are significantly more likely to take action in the event a deficiency is identified by the PCAOB.​