The Unintended Consequences of the Frequency of PCAOB Inspection

• Author: Barri Litt,Paul Tanyi
• Date: 01 January 2017
• DOI: http://doi.org/10.1111/jbfa.12230
• Published date: 01 January 2017

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 44(1) & (2), 116–153, January/February 2017, 0306-686X

doi: 10.1111/jbfa.12230

The Unintended Consequences of the

Frequency of PCAOB Inspection

Paul Tanyi and Barri Litt∗

Abstract: After more than 50 years of self-regulation of the US auditing profession, the

Sarbanes-Oxley Act of 2002 (SOX) created the Public Company Accounting Oversight Board

(PCAOB) as a quasi-governmental entity with statutory authority to inspect accounting firms

that audit public clients. The frequency of this inspection is annual or triennial, based upon the

number of public clients the firm audits. We examine the effects of these two levels of inspection

frequency on financial reporting quality and audit fees for clients of small and midsize public

accounting firms. Our findings provide evidence of significantly higher audit quality and audit

fees for clients of annually inspected firms relative to clients of triennially inspected firms. These

findings are robust to auditor-client alignment analyses, propensity score matching, time-series

analyses, examination of firms that have changed from triennial to annual inspection, and

particular examination of firms with inspection deficiencies. Overall, our study suggests that

the two-tier frequency system of PCAOB inspection may have also resulted in two-tier audit

quality and audit fee systems for small and midsize public accounting firms, with more frequent

inspection leading to more rigorous and informed auditor decisions. We discuss the implications

of our results for the Board and the profession at large.

Keywords: PCAOB inspections, inspection frequency, audit quality, audit fees, restatements,

meet or beat, going-concern, small and midsize public accounting firms

1. INTRODUCTION

Amongst efforts to more stringently regulate the US auditing profession, the Sarbanes-

Oxley Act of 2002 (SOX) created the Public Company Accounting Oversight Board

(PCAOB) as a quasi-governmental entity to oversee the external audit market. Prior

to this point, the audit profession had been self-regulated by the American Institute of

Certified Public Accountants (AICPA) for over 50 years. In its new mandate to improve

audit quality, the PCAOB has statutory authority over registration, standard-setting,

inspection and reinforcement of public accounting firms that audit public clients. One

of its most powerful tools to restore public confidence in audited financial statements

∗The first author is with the Accounting Department, Belk College of Business, University of North Carolina

– Charlotte, Charlotte, North Carolina, USA. The second author is with Accounting Department, Huizenga

College of Business and Entrepreneurship, Nova Southeastern University, Fort Lauderdale, Florida, USA.

(Paper received October 2015, revised revision accepted October 2016).

Address for correspondence: Barri Litt, Carl DeSantis Building, 3301 College Avenue, Fort Lauderdale, FL

33314.

e-mail: BL381@nova.edu; BarriLitt@gmail.com

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is its performance of periodic audit firm inspections (PCAOB, 2005). The frequency of

these inspections varies based upon the number of public clients the public accounting

firm audits. If a public accounting firm issues an audit report for more than 100 public

clients in a calendar year, it will be inspected annually by the PCAOB. If the public

accounting firm issues an audit report for less than or equal to 100 public clients, it

will be inspected triennially (once every 3 years) by the PCAOB.

In this study,we present evidence that indicates this difference in PCAOB inspection

frequency creates an environment in which audit clients of annually inspected public

accounting firms may receive higher quality audits, but may also pay significantly

higher audit fees compared to audit clients of triennially inspected public accounting

firms. In our tests, we focus only on non-Big 4 public accounting firms over the period

from 2000 to 2011. This selection is made intentionally to eliminate any Big 4 effect.

We then divide this group of public accounting firms into two categories: (1) firms

with less than or equal to 100 public clients, and (2) firms with more than 100 public

clients. In the years following the beginning of PCAOB inspections, the former are

inspected triennially, and the latter are inspected annually. We separately examine the

financial reporting quality and total audit fees charged to these audit clients based on

this distinction in the pre- and post-PCAOB inspections periods in order to isolate the

effects of the frequency of PCAOB inspections.

We argue that the higher inspection frequency of annually inspected accounting

firms gives them greater opportunity for continuous improvement through learning

and remediation of audit deficiencies, especially given the risk-based audit selection

approach of the PCAOB. Further, the severity associated with PCAOB enforcement

actions may compel annually inspected accounting firms to be even more diligent in

conducting their audit engagements, given their more frequent exposure. Conversely,

the lower inspection frequency of triennially inspected accounting firms affords them

fewer opportunities to improve through learning and remediation effects, and less

exposure to the stringent PCAOB enforcement mechanism. We use three different

proxies of financial reporting quality (financial statement misstatements, small meet or

beat of analyst earnings-per-share forecasts, and issuance of going-concern opinions)

to thoroughly examine whether the frequency of PCAOB inspections affects auditor

decisions and the resulting quality of their clients’ financial reporting.

With respect to audit fees, the increased diligence on the part of the annually

inspected accounting firms may require additional time and human capital resources.

These may include more hours spent addressing audit and quality control deficiencies

identified by the PCAOB, and more hours spent reviewing audit engagements to

ensure their quality for PCAOB inspection scrutiny. Accordingly, the accounting firms

may pass some of those costs to their clients in the form of higher audit fees. Therefore,

a greater annual frequency of PCAOB inspection may cause firms to charge their

clients significantly higher audit fees compared to triennially inspected firms.

First, we find that in the pre-PCAOB inspection period (fiscal years 2000–2003),

clients of public accounting firms with less than or equal to 100 public clients were

not significantly different from clients of public accounting firms with more than 100

public clients with respect to financial statement misstatements, small meet or beat of

analyst earnings-per-share forecasts, or receipt of going-concern opinions (even when

we restrict our sample to financially distressed clients). We also find no significant

difference in audit fees paid to the external auditor for these two groups during this

period.

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In the post-PCAOB inspection period (fiscal years 2004–2011), when this distinction

determines inspection frequency, we find that clients of annually inspected accounting

firms are significantly less likely to misstate their financial statements and significantly

less likely to just meet or beat analyst earnings per-share forecasts when compared

to clients of triennially inspected firms. We do not find any significant difference

in the likelihood of receiving a going-concern audit opinion for these two groups

of clients. However, when we restrict our sample to only financial distressed clients,

annually inspected audit firms are more likely to issue a going-concern opinion in

this period. Finally, we find that clients of annually inspected accounting firms pay

significantly higher audit fees compared to clients of the triennially inspected firms.

As previously described, these differences did not exist in the pre-PCAOB inspection

period, and these results are consistent even after matching our two groups of firms

using propensity scores.

Second, when we examine auditor-client realignment decisions in the pre- and

post-PCAOB inspection periods, we find that the small and midsize accounting firms

inspected annually are more selective in their choice of new clients in the post-PCAOB

inspection period compared to the triennially inspected firms. The annually inspected

accounting firms are more likely to dismiss high audit risk clients and engage low

audit risk clients in the post-PCAOB inspection period. This was not the case in the

pre-PCAOB inspection period.

Third, consistent with prior research (Gunny and Zhang, 2013), we do find

evidence suggesting the instatement of PCAOB inspections did generally improve

the financial reporting quality of small and midsize accounting firm clients, albeit

marginally for triennially inspected firms. Gunny and Zhang (2013) sample and

analyze inspection reports to determine their ability to actually distinguish audit

quality, and generally find evidence of triennial inspection reports having a greater

ability relative to annual inspection reports. We utilize a much larger sample of firms,

also controlling for any potential Big-4 effects, to compare audit quality measures in

the pre- and post-inspection periods. We find significantly higher audit quality for

clients of annually inspected firms relative to clients of triennially inspected firms.

We also find audit fees are significantly higher for both groups of clients in the

post-PCAOB inspection period relative to the pre-PCAOB inspection period. While

it is difficult to separate the SOX 404 effect from the PCAOB inspection effect in

time-series analyses, we do control for those audit clients with a material weakness in

internal control.

Fourth, we find that when a public accounting firm changes from being inspected

triennially to being inspected annually by the PCAOB, this change is associated with

improved financial reporting quality and increased audit fees for its clients. Thus,

our study’s findings of increased audit quality and audit fees associated with greater

inspection frequency are supported. And last, we find similar financial reporting

quality effects for annual and triennial firms after audit deficiencies are disclosed in

the prior-year inspection report, but significantly higher audit fees for the former in

these cases. This suggests that more frequently inspected firms may pass greater costs

of addressing deficiencies to their clients.

Our findings are important to practitioners, regulators, legislators and academi-

cians as they reveal unintended effects of the difference in inspection frequency of

public accounting firms by the PCAOB based on its current policies. Thus, we help

answer the calls of prior research to investigate and provide important insight into

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