Published Paper: The Effect of Audit Firm Internal Inspections on Auditor Effort and Financial Reporting Quality

Paper Authors: Daniel Aobdia and Reining Petacchi

Publication: The Accounting Review

Abstract: We examine the effect of large audit firms’ internal inspection programs, an important monitoring mechanism, on auditor effort and financial reporting quality. Internal inspections are often predictable, and engagement teams concentrate their effort on audits ultimately selected for inspections. The extra-effort increases the likelihood of a favorable inspection rating. We find some evidence of improvement in financial reporting quality in the inspection year, suggesting that internal inspections are effective in deterring auditor shirking. Upon receiving a favorable rating, the engagement team reverts audit effort back to the pre-inspection level. However, if the rating is unfavorable, the team increases effort on future engagements of the client. This higher effort improves the client’s financial reporting quality if the internal inspection program is not deemed deficient by the PCAOB. Collectively, the results highlight the importance of an effective internal inspection program in improving financial reporting quality.

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The economic research fellows and staff economists generate high-quality working papers that inform the oversight activities of the PCAOB and are disseminated to stimulate discussion and critical comment to the benefit of the public. Working papers are preliminary materials that have not been approved by the Board and reflect only the views of the author(s).

The research topics of economic research fellows, including a description of any nonpublic data sets required for research, are presented to the Board for approval and research papers are reviewed to confirm that the topic of the paper is consistent with the researcher's proposal. That review does not, however, encompass an evaluation of the conclusions reached by researchers.