Auditing the Auditors: Evidence on the Recent Reforms to the External Monitoring of Audit Firms

Lay Summary 

Recent major reforms to the external monitoring of US audit firms are the focus of this research on the economic implications of the shift in regulatory practice. For nearly 25 years, audit firms were subject only to self-regulation under peer review. The surge of prominent financial reporting failures near the turn of the century renewed concerns about the effectiveness of self-regulation and whether monitoring separate from the profession is essential for high-quality auditing. The Sarbanes-Oxley Act of 2002 created the Public Company Accounting Oversight Board (PCAOB) charged with the responsibility of periodic independent inspections of the firms that audit public companies. The AICPA has narrowed the scope of its peer review program to public companies that wish to participate, and private companies.

Since evidence on the operating characteristics of the new regulatory regime remains scarce, we start by dissecting the transition from self-regulation to impartial inspection under the PCAOB. First, we show that the PCAOB relied on peer review reports to target lower-quality audit firms in their initial round of inspections. Second, our data reveal that many firms elected to leave the peer review program after the PCAOB began conducting inspections despite the fact that audit firms with public company clients can submit to both PCAOB inspections and peer reviews. Indeed, we find that the worst audit firms, which we measure with the presence of an adverse or modified opinion and the number of weaknesses in their prior peer review report, were more likely to abandon the program.

Our study contributes to the literature in four ways. First, we provide initial evidence on whether public companies perceive that PCAOB reports are informative about audit firm quality. Second, we isolate which specific disclosures in peer review reports affect audit firm choice. This evidence is constructive for identifying ways to improve the information content of PCAOB reports to ensure that clients learn more about differential audit firm quality. Third, we analyze how the transition to independent PCAOB inspections has affected external monitoring under the AICPA and the PCAOB. Finally, we provide evidence that the PCAOB perceives peer review reports to be informative about audit firm quality.

One of the most important provisions of the Sarbanes–Oxley Act of 2002 created the PCAOB, which now handles the periodic inspections of the firms that audit public companies, reversing almost 25 years of professional self-regulation. However, empirical evidence on whether the PCAOB is effectively discharging its regulatory responsibilities remains elusive. We analyze from an information perspective the implications of these major changes in the regulations governing audit firms. We find that audit firms’ market shares are insensitive to the content of PCAOB reports, implying that public companies discount their information value. To identify an underlying explanation for this evidence, we examine whether the PCAOB’s failure to disclose certain information is behind clients ignoring the inspection reports. We document that clients interpret the disclosure of quality control defects in peer review reports as highly informative, which is important because the public portion of PCAOB reports excludes these findings. Peer review reports also include an evaluative summary since the reviewers are required to render either an unmodified, modified, or adverse opinion about audit firm quality. A quality rating is absent from PCAOB reports, although our evidence suggests that the ratings in peer review opinions are perceived by clients to be informative.

Published in: Journal of Accounting and Economics, v.49, Is. 1-2, p. 84-103, February 2010

Departments 
Faculty of Business Administration
Funding 
SSHRC, CMA Professorship
Communities 
St. John's
Locations 
Newfoundland and Labrador
United States
Canada
Themes 
Audits
International Collaboration
Business
Industry Sectors 
Scientific Research and Development Services
Other Services (except Public Administration)
Start date 
1 Jan 2010