Do PCAOB Inspections Improve the Quality of Internal Control Audits?

• Author: MARK L. DEFOND,CLIVE S. LENNOX
• Date: 01 June 2017
• Published date: 01 June 2017
• DOI: http://doi.org/10.1111/1475-679X.12151

DOI: 10.1111/1475-679X.12151

Journal of Accounting Research

Vol. 55 No. 3 June 2017

Printed in U.S.A.

Do PCAOB Inspections Improve the

Quality of Internal Control Audits?

MARK L. DEFOND

∗AND CLIVE S. LENNOX

∗

Received 19 December 2015; accepted 28 August 2016

ABSTRACT

We investigate whether Public Company Accounting Oversight Board

(PCAOB) inspections affect the quality of internal control audits. Our re-

search design improves on prior studies by exploiting both cross-sectional

and time-series variation in the content of PCAOB inspection reports, while

also controlling for audit firm and year fixed effects, effectively achieving a

difference-in-differences research design. We find that when PCAOB inspec-

tors report higher rates of deficiencies in internal control audits, auditors

respond by increasing the issuance of adverse internal control opinions. We

also find that auditors issue more adverse internal control opinions to clients

with concurrent misstatements, who thus genuinely warrant adverse opin-

ions. We further find that higher inspection deficiency rates lead to higher

audit fees, consistent with PCAOB inspections prompting auditors to un-

dertake costly remediation efforts. Taken together, our results are consistent

with the PCAOB inspections improving the quality of internal control audits

∗University of Southern California.

Accepted by Douglas Skinner. We thank the following for their helpful comments:

Mingyi Hung, Phil Lamoreaux, Christian Leuz, Mark Maffett, Jaime Schmidt, Anne Thomp-

son, and workshop participants at Erasmus University, Frije University of Amsterdam, Hong

Kong Polytechnic University, Nanyang Technological University, Tulane University, and the

Conference on Auditing and Capital Markets, sponsored by the PCAOB’s Center for Eco-

nomic Analysis and the Journal of Accounting Research. Neither of the authors has received

funding from the PCAOB. An Online Appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

591

Copyright C, University of Chicago on behalf of the Accounting Research Center,2016

592 M.L.DEFOND AND C.S.LENNOX

by prompting auditors to remediate deficiencies in their audits of internal

controls.

JEL codes: G38; K23; M42; M48

Keywords: auditing; audit opinions; internal controls; regulation; PCAOB;

SEC; SOX

1. Introduction

The Sarbanes-Oxley Act (SOX) established the Public Company Account-

ing Oversight Board (PCAOB) to provide oversight of public company au-

dits. Audit firm inspections are the PCAOB’s core function and the primary

tool given by Congress to enable the PCAOB to perform its oversight du-

ties (PCAOB [2005]). The auditing profession, however, is harshly critical

of the inspection program, claiming that it is largely ineffective (e.g., John-

son, Keune, and Winchel [2015]). Further, the academic literature gener-

ally finds little evidence that inspections improve the quality of U.S. audits.

We investigate whether the PCAOB inspections improve the quality of in-

ternal control audits, a potential consequence of the inspection process

not previously examined. Our research design improves on prior studies by

exploiting both cross-sectional and time-series variation in the contents of

PCAOB inspection reports, while controlling for audit firm and year fixed

effects. This specification resembles a difference-in-differences estimation

with a continuous treatment (e.g., Carpenter and Dobkin [2011]).

Internal controls over financial reporting are critical in assuring high

financial reporting quality, and auditors typically rely on clients’ internal

controls when auditing their financial statements. Recognizing the funda-

mental importance of internal controls, Section 404 of SOX requires the in-

dependent audit of internal controls for all public companies with a public

float exceeding $75 million (referred to as “accelerated filers”). We study

a time period when the PCAOB increased its scrutiny of internal control

audits in response to the Securities and Exchange Commission’s (SEC)

concerns of a widespread decline in the quality of internal control audits.

Specifically, a downward trend in the frequency of adverse internal control

opinions during 2005–2009 prompted the SEC to speculate that auditors

were systematically failing to identify and report material internal control

weaknesses (SEC [2009]). These concerns were heightened by a concur-

rent upward trend in the issuance of clean internal control opinions to

companies that materially misstated their financial reports, and thus should

have received adverse opinions (Rice and Weber [2012]). The PCAOB re-

sponded in 2010 by directing its inspectors to put increased emphasis on

assessing whether audit firms were obtaining sufficient evidence to support

their internal control opinions. The purpose of our study is to test whether

the PCAOB’s increased inspection efforts were successful in improving the

quality of internal control audits.

PCAOB INSPECTIONS AND INTERNAL CONTROL AUDIT QUALITY 593

Despite the PCAOB’s increased efforts, there are several reasons why

inspections may not improve audit quality. In interviews, auditing profes-

sionals assert that inspector-identified deficiencies typically capture differ-

ences in professional judgment, rather than systematic audit failures, and

argue that PCAOB inspectors lack the incentives and technical expertise

to identify deficiencies that are likely to improve audit quality (Dowling,

Knechel, and Moroney [2015], Glover, Taylor, and Wu [2015], Johnson,

Keune, and Winchel [2015]).1Another impediment to the effectiveness

of the PCAOB inspections is that the inspected engagements are not ran-

domly chosen. If the identified deficiencies are unrepresentative, their re-

mediation is unlikely to improve the firm-wide quality of internal control

audits. In addition, audit firms may resist engaging in costly remediation

because it is likely to increase audit fees and the issuance of adverse in-

ternal control opinions, both of which increase the risk of auditor dismissal

(Ettredge et al. [2011], Johnson, Keune, and Winchel [2015], Newton et al.

[2016]).The inability of the inspections to improve audit quality is also con-

sistent with prior research finding little evidence that adverse inspection

reports trigger auditor switching among U.S. clients (Lennox and Pittman

[2010], Johnson, Keune, and Winchel [2015]).2

If the PCAOB’s increased scrutiny successfully identifies systematic defi-

ciencies in internal control audits, audit firms should have strong incentives

to remediate the deficiencies in their auditing procedures. The PCAOB

can impose tough penalties on errant audit firms, and critical inspection

reports harm auditors’ career prospects (Johnson, Keune, and Winchel

[2015]). If audit firms are successful in remediating the deficiencies iden-

tified in PCAOB inspections, it should lead to firm-wide improvements in

their ability to identify material internal control weaknesses. Since auditors

are required to issue adverse opinions to clients with material internal con-

trol weaknesses, this should lead to a firm-wide increase in the issuance of

adverse internal control opinions. Thus, if the PCAOB’s increased scrutiny

of internal control audits is successful, we hypothesize that audit firms will

respond to the audit deficiencies by increasing the issuance of adverse in-

ternal control opinions to their clients.

We begin by documenting evidence supporting the SEC’s assertion that

the frequency of adverse internal control opinions declined during the pe-

riod 2005–2009, and that this was accompanied by an upward trend in audi-

tors issuing clean internal control opinions to companies with concurrent

1The PCAOB disagrees with assertions that inspector-identified deficiencies result from

differences in professional judgment. PCAOB [2012a] states: “The PCAOB bases deficiency

findings only on failures to obtain sufficient audit evidence, not on disagreements when rea-

sonable judgments appear to have been made about such matters.”

2While there is little research that finds that the PCAOB inspections, per se, improve au-

dit quality, several studies find evidence of improved audit quality following the passage of

SOX (DeFond and Zhang [2014]). For example, DeFond and Lennox [2011] find that SOX

improved audit quality by motivating small low-quality audit firms to exit the SEC market.