Do U.S. Investors Value Foreign Component Auditors?

• Published date: 01 June 2022
• Author: BINGYI CHEN,JENELLE K. CONAWAY
• Date: 01 June 2022
• DOI: http://doi.org/10.1111/1475-679X.12412

DOI: 10.1111/1475-679X.12412

Journal of Accounting Research

Vol. 60 No. 3 June 2022

Printed in U.S.A.

Do U.S. Investors Value Foreign

Component Auditors?

BINGYI CHEN∗AND JENELLE K. CONAWAY †

Received 19 April 2019; accepted 23 September 2021

ABSTRACT

We examine whether investors consider foreign component auditors when

assessing the value of U.S. multinational corporations (MNCs) using two sets

of Public Company Accounting Oversight Board (PCAOB) international reg-

ulatory events. We find investors react negatively when the PCAOB is denied

access to inspect foreign component auditors in jurisdictions where a U.S.

MNC has significant operations and positively when those countries later al-

low inspection. For foreign component auditors that are inspected, we find

investors react positively when they receive clean inspection reports and nega-

tively when they fail to remediate quality control deficiencies. Consistent with

PCAOB international oversight providing additional assurance about foreign

∗Suffolk University; †George Mason University

Accepted by Philip Berger. We thank the editor and the anonymous reviewer for their

many helpful suggestions. We are grateful to Krishnagopal Menon, Edward Riedl, and David

Williams for their feedback and input. We also thank the following seminar participants, re-

viewers, and discussants for their useful comments and discussion: Boston University, Suffolk

University, 2018 Virginia Area Research Conference, and 2019 AAA International Section

Midyear Meeting. We thank the PCAOB for sharing the inspection report publication data.

The PCAOB has not endorsed, approved of, or otherwise affiliated itself with this research pa-

per.An earlier version of this manuscript was circulated under the title “The Valuation Impact

of PCAOB International Inspections on U.S. Multinational Corporations.” All errors are our

own.

805

© 2021 The Chookaszian Accounting Research Center at the University of Chicago Booth School of

Business.

806 b. chen and j. k. conaway

component auditor quality, our collective results indicate investors consider

foreign component auditors when valuing U.S. MNCs.

JEL codes: M40, M41, M42, G18, L51, L84

Keywords: group audit; component auditor; valuation; PCAOB; interna-

tional inspection

1. Introduction

The purpose of this study is to determine whether Public Company Ac-

counting Oversight Board (PCAOB) oversight of foreign component au-

ditors affects the investor perception of U.S. multinational corporation

(MNC) financial statement quality. The audits of U.S. MNC consolidated

financial statements commonly involve more than one auditor. The U.S.

principal auditor, who signs the audit opinion, often engages foreign com-

ponent auditors to perform a portion of the audit when the overseas oper-

ations are significant (Doty [2011]). According to a 2016 PCAOB staff anal-

ysis report, about 80% of Fortune 500 audits involve auditors from more

than one country (PCAOB [2016a]). The work performed by these foreign

component auditors is substantial and can account for “even half of the

total audit hours” in the group audit (Doty [2011]).

The involvement of foreign component auditors in multinational group

audits has been a major concern of the PCAOB in recent years. Although

Section 106(a) of the Sarbanes–Oxley Act subjects foreign auditors to

PCAOB oversight “in the same manner and to the same extent” as U.S. au-

ditors, some countries have historically prevented the PCAOB from inspect-

ing their audit firms due to legal conflicts and sovereignty issues (PCAOB

[2010]). Furthermore, the PCAOB has identified several common deficien-

cies relating to multinational group audits through its inspection program.

These deficiencies include: (1) principal auditor over-reliance on compo-

nent auditor work without appropriate review; (2) poor communication be-

tween principal and component auditors resulting in errors and unresolved

audit issues; and (3) misrepresentation of component auditor work to the

principal auditor when the component auditor failed to appropriately au-

dit an account (Doty [2011]). The previous chairman of the PCAOB, James

Doty, noted: “In theory, when a networked firm signs the opinion, the au-

dit is supposed to be seamless and of consistently high quality. In practice,

that is often not the case” (Doty [2011]). In fact, the PCAOB has sanc-

tioned several foreign component auditors for failures in auditing foreign

subsidiaries of U.S. MNCs. Examples include the sanctions against partners

at PwC Brazil and Deloitte Mexico for their respective failures in auditing

subsidiaries of Sara Lee Corp in 2017 and EZCORP in 2018 (PCAOB [2017,

2018]). These foreign component auditor failures forced both companies

to restate their group financial statements and U.S. investors lost millions

do u.s. investors value foreign component auditors? 807

of dollars.1Motivated by the PCAOB’s concerns about foreign component

auditor quality, this study examines whether U.S. investors consider foreign

component auditor quality when assessing consolidated financial reporting

quality.

Recent evidence suggests that foreign principal auditors subject to

PCAOB international inspection provide higher audit quality (Lamoreaux

[2016]) and improve investor confidence in financial reporting (Aobdia

and Shroff [2017], He, Li, Liu, and Pittman [2021]). To the extent that

PCAOB international oversight provides additional assurance about for-

eign component auditor quality, and investors consider foreign component

auditors when assessing consolidated financial reporting quality, we expect

the investor perception of foreign component auditors to impact their valu-

ation of U.S. MNCs. In this study, we use two sets of PCAOB international in-

spection events to examine whether the valuation of U.S. MNCs is affected

by foreign component auditors: inspection access and inspection reports.

First, we explore variation in regulatory oversight created by PCAOB in-

ternational inspection access. The underlying assumption is that PCAOB

inspection access (or lack thereof) improves (worsens) the perceived audit

quality of foreign component auditors. We refer to this as the inspection ac-

cess analysis. The events related to inspection access span from 2010 to 2018,

but component auditor information is not available prior to the Form AP

requirement in 2017. Therefore, we construct two samples of U.S. MNCs

whose audits likely involve foreign component auditors due to their signif-

icant overseas operations. One sample is based on ex ante 10-K Exhibit 21

disclosures that favors inclusion, which allows for more generalizability but

is also likely to exhibit measurement error, and the other is based on ex

post Form AP disclosures that favors precision, which allows for stronger

identification but is also likely to have reduced power.

We document a significant market reaction to news about PCAOB access

to inspect foreign component auditors. U.S. MNCs observe a significant

negative reaction to disclosure that the PCAOB is denied access to inspect

foreign auditors in jurisdictions where the company has significant opera-

tions, and a significant positive reaction when those countries subsequently

allow inspection. The average returns of U.S. MNCs decrease 43 basis points

around news of denied access and increase 72 basis points upon later news

of gained access; this is equivalent to an average loss of $45 million and a

subsequent gain of $75 million.2

1Share prices of Sara Lee Corp and EZCORP declined by 7% and 5%, respectively, on the

day of restatement announcements. https://www.reuters.com/article/demasterblenders-

brazil-investors-idAFL6E8J28W420120802 (last accessed September 4, 2021); https://

seekingalpha.com/news/2636165-ezcorp-tumbles- on-restatements (last accessed September

4, 2021).

2Calculated as the mean market capitalization in the Form AP sample (table 2, panel A)

multiplied by the mean cumulative market-adjusted return (table 3, panel B, column 4).