PCAOB inspection deficiencies and audit fees

• Published date: 01 January 2024
• Author: Pervaiz Alam,Yang Cheng,Laura K. Rickett,Justyna Skomra
• Date: 01 January 2024
• DOI: http://doi.org/10.1002/jcaf.22662

Received:  August Revised:  August Accepted:  September 

DOI: ./jcaf.

RESEARCH ARTICLE

PCAOB inspection deficiencies and audit fees

Pervaiz Alam1Yang Cheng2Laura K. Rickett3Justyna Skomra4

Department of Accounting, Kent State

University, Kent, Ohio, USA

Department of Accounting and Finance,

University of Minnesota Duluth, Duluth,

Minnesota, USA

Department of Accounting, Cleveland

State University, Cleveland, Ohio, USA

Department of Accounting, Penn State

Erie, Erie, Pennsylvania, USA

Correspondence

Laura K. Rickett, Cleveland State

University, Cleveland, OH, USA.

Email: l.rickett@csuohio.edu

Abstract

This study aims to extend research on the effect of PCAOB inspections on audit

firm behavior by examining generally accepted auditing standards (GAAS) and

generally accepted accounting principles (GAAP) type PCAOB inspection defi-

ciencies, separately, to reveal the differential effects on audit fees in subsequent

years. We empirically examine the audit fees of , client firm-year observa-

tions for auditors who received a PCAOB inspection report during –via

multivariate regression analyses. We find that GAAS (GAAP) deficiencies are

associated with higher (lower) audit fees in the years following the reported defi-

ciency. Our results suggest that the PCAOB inspection process modifies audit

firm behavior when GAAS deficiencies are reported leading to the firm charg-

ing higher audit fees to defray the costs of addressing the deficiencies, but due

to the severity of GAAP deficiencies that are identified, audit firms are willing to

negotiate lower fees to retain the client. Our results are primarily driven by annu-

ally inspected audit firms. These results suggest that auditors respond to GAAS

and GAAP PCAOB inspection deficiencies differently. The results of our study

are useful to regulators and policymakers, such as the SEC and the PCAOB, in

understanding how auditors respond to PCAOBinspection deficiencies and their

due diligence to correct those deficiencies. PCAOB inspections are intended to

evaluate compliance with accounting and auditing standards to improve audit

quality and our study helps to extend the research to date which has not yet

clearly demonstrated whether or not this has been accomplished.

KEYWORDS

auditing, audit effort, audit fees, audit quality, PCAOB deficiencies, PCAOB inspections

1 INTRODUCTION

In response to a series of accounting scandals at the begin-

ning of the century, Congress enacted the Sarbanes-Oxley

Act (SOX) in  which created the Public Accounting

Oversight Board (PCAOB) to monitor audit firms. The

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and reproductionin any medium, provided the

original work is properly cited.

©  The Authors. Journal of CorporateAccounting & Finance published by Wiley Periodicals LLC.

establishment of the PCAOB, a congressionally chartered,

private, not-for-profit corporation (Goelzer, )inde-

pendent of the accounting industry, marked the end of

more than  years of self-regulation in the US auditing

industry.In addition to the monitoring role, the PCAOB

also develops standards on auditor independence, audit

228 wileyonlinelibrary.com/journal/jcaf JCorp Account Finance. ;:–.

ALAM  .229

quality control, ethics, and audit practice. Specifically,

SOX Section  (Inspectionof Registered Public Accounting

Firms) requires the PCAOB to regularly inspect regis-

tered public accounting firms and review selected audit

engagements of the firm as well as evaluate the ade-

quacy of the quality control system, including documenta-

tion and communication (U.S. House of Representatives,

).

In this study,we conduct an in-depth examination of the

effect of the PCAOB inspection process on audit fees. More

specifically, we focus on the subsequent effects over time

by diffferentiating the impact of Generally Accepted Audit-

ing Standards (GAAS) and GenerallyAccepted Accounting

Principles (GAAP) deficiencies identified during PCAOB

inspections. Each inspection report consists of Part I and

Part II. Part I describes audit deficiencies in conducting

the audit engagement related to insufficient application of

GAAS or GAAP.Part I is publicly available. Part II refers to

the deficiencies in the system of quality controls and is only

publicly disclosed if not remediated within  months after

the issuance of the inspection report. Registered account-

ing firms with more than  issuers per year are inspected

annually, while all other registered audit firms (less than

 issuer audit reports per year) are inspected once every 

years. The PCAOB inspects both US and non-US registered

accounting firms to ensure compliance with accounting

and auditing regulations of the PCAOB, the Securities

and Exchange Commission (SEC), and other related reg-

ulatory bodies (PCAOB, ). While the identity of the

client engagement selected for inspection is known by the

PCAOBand the audit f irm, similar information is not avail-

able to the public (PCAOB, a), creating challenges

for research examining the consequences of the PCAOB

inspection process (DeFond, ; DeFond & Lennox,

).Thus, the lack of data on the specific audit engage-

ment inspected by the PCAOB significantly limits research

opportunities in this area. Aside from studies on interna-

tional PCAOB inspections and audit quality (Fung et al.,

; Krishnan et al., ; Lamoreaux, ; Shroff, ),

more research is needed to improve our understanding of

the effect of PCAOB inspections on audit firm behavior

(PCAOB, ; Goelzer, ). DeFond () argues that

the consequences of PCAOB inspections can potentially

affect auditors’ incentives to assure high-quality audits,

which are essential for the proper functioning of capital

markets.

Based on empirical evidence, the inspection report pro-

vides a signal on audit quality to the audit firm and the

client, which could trigger a change in behavior and affect

the auditor-client relationship (Carcello et al., ;Gram-

ling et al., ; Gunny & Zhang, ). We expect that

audit firms with PCAOB inspection deficiency reports have

the incentive to take corrective action to avoid them in

the future. In addition, the audit firm is expected to take

measures to correct the deficiency,not only on the engage-

ment for which the deficiency was identified but on all

audit engagements. Gipper et al. () contend that anec-

dotal and institutional evidence indicates that the PCAOB

identifies weaknesses in audit procedures and encourages

improvements in firm-wide audit procedures and prac-

tices. Therefore, we can expect corresponding changes in

audit fees to recoup the costs of the corrective measures

following the deficiency report.

While increased audit fees do not directly infer increased

audit quality, audit fees are commonly used in literature

as a proxy for audit effort (Bell et al., )ortimespent

on the audit, implying higher audit quality (Aobdia et al.,

). Client firms demand high-quality audits due to

the negative consequences associated with audit failures.

Therefore, clients are generally willing to pay higher audit

fees for higher-quality audits, and “auditors cannot unilat-

erally charge higher fees for additional effort unless there

is a corresponding increase in client demand for the addi-

tional effort” (DeFond & Zhang, , ). This reasoning

is supported by prior research that employs audit fees to

proxy for client demand of audit services (e.g., Abbott et al.,

; Cao et al., ; Carcello et al., ). We argue that

a PCAOB inspection deficiency report provides an incen-

tive to the client to demand higher audit quality from their

audit firm, and consequently, the client will pay higher

audit fees in exchange.

So far, literature examining the effectof PCAOB inspec-

tions on audit fees does not provide consistent evidence.

Aobdia () finds that audit firms take corrective actions

following Part I deficiencies by increasing audit hours, but

it is not reflected in changes in audit fees, which sug-

gests lower profitability of audit firms. Similarly, Acito

et al. () do not find changes in audit fees for Big 

audit firms, in response to the inspection report. How-

ever, audit fees arefound to be higher following inspection

reports with high internal control deficiency rates (DeFond

& Lennox, ). Prior empirical evidence shows that

clients of firms inspected annually pay higher audit fees

than clients of the triennially inspected audit firms. Most

recently, it was found that small audit firms with Part II

inspection reports charged clients higher audit fees only

when they remediated quality control deficiencies but not

when the deficiencies were publicly disclosed with no

remediation within  months (Vanstraelen & Zou, ).

In this study, we focus on Part I deficiencies reports,

which are publicly disclosed, and classify deficiencies into

either GAAP or GAAS-related deficiencies. To the best of

our knowledge, there is no prior study that examines the

effect of GAAP and GAAS-related inspection deficiencies

on audit fees. In the most recent study, Prasad and Web-

ster (), limit their analysis to trends in the deficiencies