negative pcaob inspections of triennially inspected auditors and involuntary and voluntary client...

Negative PCAOB Inspections ofTriennially Inspected Auditorsand Involuntary and VoluntaryClient Lossesija_432 231..246

Brian Daugherty,1 Denise Dickins2 and Wayne A. Tervo3

1University of Wisconsin – Milwaukee2East Carolina University3Murray State University

In 2004, the Public Company Accounting Oversight Board(PCAOB) began inspecting registered accounting firmsperforming audits of US publicly-traded companies. Weexamine triennially inspected auditors’ involuntary andvoluntary client losses in the period following receipt of adeficient PCAOB report. We find deficiency reports areassociated with triennially inspected auditors beinginvoluntarily dismissed by their clients, and companiesdismissing triennially inspected auditors are more likely tohire triennially inspected auditors without deficiency reports,suggesting PCAOB inspections may be costly to trienniallyinspected auditors. We also find deficiency reports areassociated with triennially inspected auditors voluntarilyresigning from their publicly traded clients, and ceasing to beregistered with the PCAOB, suggesting triennially inspectedauditors with deficiency reports may be more likely to assessthe post-inspection cost of regulatory compliance as greaterthan the rewards associated with auditing public companies.These findings are important to regulators, marketparticipants, and academics – both in the US andinternationally – as they evaluate whether provisions of SOXeffectively address concerns about audit quality or may haveunintended negative consequences.

Key words: Public Company Accounting Oversight Board,PCAOB inspections, triennially inspected auditors, auditors,client dismissals, client resignations.

Correspondence to: Brian Daugherty, Assistant Professor, Accounting Area, University of Wisconsin – Milwaukee, Sheldon B. LubarSchool of Business, 3202 N. Maryland Avenue, Milwaukee, WI 53211, USA. Email [email protected]

International Journal of Auditing doi:10.1111/j.1099-1123.2011.00432.xInt. J. Audit. 15: 231–246 (2011)

ISSN 1090-6738© 2011 Blackwell Publishing Ltd

SUMMARY

In 2004, the Public Company Accounting OversightBoard (PCAOB) began inspecting registeredaccounting firms performing audits of US publiclytraded companies. We examine trienniallyinspected auditors’ involuntary and voluntaryclient losses in the period following receipt of adeficient PCAOB report. We find deficiency reportsare associated with triennially inspected auditorsbeing dismissed by their clients, and companiesdismissing triennially inspected auditors are morelikely to hire triennially inspected auditors withoutdeficiency reports, suggesting PCAOB inspectionsmay be costly to triennially inspected auditors. Wealso find deficiency reports are associated withtriennially inspected auditors resigning from theirpublicly traded clients, and ceasing to be registeredwith the PCAOB, suggesting triennially inspectedauditors with deficiency reports may be more likelyto assess the post-inspection cost of regulatorycompliance as greater than the rewards associatedwith auditing public companies.

Important to regulators, market participants,and academics – both in the US andinternationally – these results suggest low qualityauditing may be revealed by PCAOB inspectionswith some degree of accuracy and could beviewed as a favorable consequence of the newaudit quality oversight mechanism implementedby the PCAOB inspection process. We alsofind the existence and rate of deficiencies fortriennially inspected auditors may be significantlyless in second inspections, suggesting a potentialincrease in audit quality subsequent to theinception of the PCAOB’s inspection program.These results have implications beyond US capitalmarkets as 907 (44.9 percent) firms registered withthe PCAOB as of June 30, 2009 were foreignbased; however, the bulk of the extant PCAOBinspection research to date focuses on US auditingfirms and registrants.

In February 2010, the PCAOB issued a pressrelease on the progress of international inspectionsnoting, in part, ‘Access to information necessaryto conduct inspections was, and continues to be,denied in China, Finland, France, Germany, Greece,Ireland, the Netherlands, Norway, Portugal,Sweden, Switzerland, and the United Kingdom’(PCAOB, 2010a). As foreign jurisdictions have, orare contemplating, regulation modeled in part onthe provisions of SOX and the mission of thePCAOB, the findings of US PCAOB inspections

may play an important role in global auditingstandard-setting and oversight.

INTRODUCTION

The Public Company Accounting Oversight Board(PCAOB), created by the Sarbanes-Oxley Act of2002 (SOX) and subject to Securities and ExchangeCommission (SEC) oversight, was formed (in part)‘to oversee the audit of public companies that aresubject to the securities laws, and related matters,in order to protect the interests of investors andfurther the public interest in the preparation ofinformative, accurate, and independent auditreports’ (US House of Representatives, 2002, p. 6).Section 102 of SOX requires all firms engaged toaudit companies with publicly traded securities inthe US to register with the PCAOB. The PCAOB’swebsite (www.pcaobus.org) indicated 1,874and 2,022 auditing firms were registered as ofDecember 31, 2008 and June 30, 2009, respectively(the dates used in our research). Our analysesare limited to inspection reports through December31, 2008, as we examine post-inspection outcomessuch as auditor resignations, client dismissals,and auditors’ cessation of PCAOB registration.These outcomes typically occur in a relativelyshort time period following release of inspectionreports.

Section 104 of SOX requires that all registeredfirms be inspected by the PCAOB annually if theyaudit more than 100 public companies (annuallyinspected auditors), and be inspected at leasttriennially if they audit 100 or fewer publiccompanies (triennially inspected auditors).Inspections are designed to assess auditors’ degreeof compliance with the rules and standardsset forth by SOX and the PCAOB related toaudit quality and the public interest. Sincecommencement of the inspection program in 2004,and through December 31, 2008, the PCAOB issued811 inspection reports. Of these, 754 (93.0 percent)were performed on US-based triennially inspectedauditors, including 149 (18.4 percent) second roundinspections.1

PCAOB inspections generally target registeredaccounting firms’ audits of publicly tradedcompanies perceived to have the highest audit risk(PCAOB, 2008d). Inspection reports either identifyno deficiencies (clean reports), or report one ormore deficiencies that, in the PCAOB’s opinion,suggest the registered auditor failed to obtainsufficient competent evidence to support the audit

232 B. Daugherty et al.

Int. J. Audit. 15: 231–246 (2011)© 2011 Blackwell Publishing Ltd

opinion(s) issued (deficiency reports). Examples ofdeficiencies range from relatively minor matters(e.g., copies of relevant contracts that should beincluded in audit workpapers are missing), to moreserious matters, including the audit engagementteam failing to identify or address GenerallyAccepted Accounting Principles (GAAP)exceptions requiring restatement of a client’saudited financial statements (e.g., incorrectcomputations of an impairment charge). Inspectionreports describe deficiencies on an engagement-by-engagement basis with registrant nameswithheld to protect client confidentiality. ThroughDecember 31, 2008, all annually inspected auditors,and 44.3 percent of triennially inspected auditors,received deficiency reports on one or moreinspected audit engagements.2

PCAOB inspections also involve a review ofregistered firms’ quality control (QC) systems,encompassing a review of eight functional areas.3

PCAOB findings related to QC deficiencies areafforded confidential treatment in the publicversion of inspection reports unless the deficienciesare not remedied to the PCAOB’s satisfactionwithin one year of the date of issuance. ThroughDecember 31, 2008, no annually inspected auditorhad unremediated QC deficiencies, and 8.5 percentof triennially inspected auditors had unremediatedQC deficiencies.

Consistent with the view that PCAOB inspectionreports are a powerful signal of audit quality,Abbott et al. (2011) find public companies with highagency costs and effective audit committees aremore likely to switch auditors when their currenttriennially inspected auditor receives a deficiencyreport. Similarly, former clients of audit firmsceasing to be registered with the PCAOB are foundto receive higher quality audits with their successorfirms (DeFond & Lennox, 2011). On the other hand,examining multiple years of annually inspectedauditors’ inspection reports (and likely only oneyear of triennially inspected auditors’ inspectionreports), Lennox and Pittman (2010) find noassociation between PCAOB inspection outcomesand client losses.4 Lacking from these priorinvestigations is a determination of whether clientlosses were involuntary – due to auditors beingdismissed by clients, with such reports viewed tobe a credible source in assessing differences infirms’ audit quality (as suggested by Hilary &Lennox, 2005, and Abbott et al., 2011) – orvoluntary, due to auditors resigning from clients,suggesting regulatory compliance costs may be

perceived to outweigh the benefits associated withauditing publicly traded companies. Our researchextends the extant research on PCAOB inspections,and further complements the research stream byexamining whether client losses of trienniallyinspected firms are client or auditing firm initiated.

Calls for additional research support SOX-related investigations. Nusbaum (2007) encouragesresearch to determine whether post-SOX auditsachieve their objective of enhancing investorconfidence. Hermanson et al. (2007) support effortsto determine the effects of PCAOB inspectionson triennially inspected auditors noting smallerpublic companies (generally audited by trienniallyinspected auditors) have received increasedattention in recent years, due in part todisproportionate concentrations of financialstatement fraud.

Humphrey et al. (2006) believe the bulk of recentauditor regulation appears to focus on mattersof auditor independence instead of on thecompetence of the auditor and suggest theirfindings raise questions about the capacity ofregulatory reform to fundamentally enhance theauditing function. Consistent with this notion, in asurvey of triennially inspected auditors receivingtheir initial PCAOB inspection, Daugherty andTervo (2010, p. 195) cite a respondent who feltPCAOB inspections may help restore investorconfidence, but do not improve audit quality,noting ‘quite the opposite is occurring. We aremoving more and more towards a “form oversubstance” audit just to satisfy (PCAOB) inspectionrequirements, and in the process we are losingsight of the real audit objective.’

Using archival data of public companies usingtriennially inspected auditors, we associatenegative PCAOB inspection outcomes with clientlosses, characterized as being a client dismissal oran auditor resignation. The focus of our analysesis triennially inspected auditors, primarily due todata availability. Inspection reports for annuallyinspected auditors provide less informationthan those of triennially inspected auditors. Forexample, during the period of our analyses,annually inspected auditors’ inspection reports donot report the total number of audits subject toinspection or the total number of audits inspected,and, as of the date of our analyses, only ten auditingfirms are inspected annually.5

Further, negative inspection outcomes areprobably more damaging to triennially inspectedauditors with less reputation capital, fewer

Negative PCAOB Inspections of Triennially Inspected Auditors and Involuntary and Voluntary Client Losses 233


resources to address deficiencies, greatercompetition, and longer periods to suffer theeffects of deficient inspection reports than annuallyinspected auditors. Many large multinationalpublic companies are effectively limited to using anaudit firm with an international reach and, as allannually inspected firms have received deficientPCAOB inspections to date, such companies arelikely reluctant to change auditors due to switchingcosts. Triennially inspected firms perform nearly 80percent of public company audits with clientrevenues of less than $100 million (PCAOB, 2008a);and collectively audit approximately 34 percent ofUS-based registrants (PCAOB, 2008c).

Important to regulators, market participants,and academics – both in the US and internationally –we find deficiency reports are associated withtriennially inspected auditors being dismissed bytheir clients, and companies dismissing trienniallyinspected auditors are more likely to hire trienniallyinspected auditors without deficiency reports,suggesting negative PCAOB inspection outcomesmay be costly to triennially inspected auditors. Wealso find deficiency reports are associated withtriennially inspected auditors resigning from theirpublic company clients, and ceasing to be registeredwith the PCAOB, suggesting triennially inspectedauditors with deficiency reports may be more likelyto assess the post-inspection cost of regulatorycompliance as greater than the rewards associatedwith auditing public companies.

These findings shed further light on the impactPCAOB inspection outcomes have on smallerauditing firms domiciled in the US and, byextension, the impact that similar oversight andinspection regimes may have on the broaderinternational accounting and auditing professions.Beyond US capital markets, as of June 30, 2009, 907(44.9 percent) registered firms were foreign based;however, the bulk of extant PCAOB inspectionresearch to date focuses on US auditing firms andregistrants. We attribute this in large measure toimpediments the PCAOB has encountered inconducting inspections of foreign firms auditingUS registrants.

In February 2010, the PCAOB issued a pressrelease on the progress of international inspectionsnoting, in part, ‘Access to information necessary toconduct inspections was, and continues to be,denied in China, Finland, France, Germany, Greece,Ireland, the Netherlands, Norway, Portugal,Sweden, Switzerland, and the United Kingdom’(PCAOB, 2010a).

The accounting and auditing professions’ localand national associations are reported to belosing relevance given the increasing focus oninternational accounting and auditing standards(Humphrey et al., 2009). However, regulatoryoversight convergence is not complete. Alles (2007)reports Canada, the UK, Europe, and Japanconcluded the costs of auditor attestation on theeffectiveness of internal control over financialreporting (ICFR) – Section 404(b) of SOX –outweigh the benefits and these jurisdictions donot currently require such attestation. As PCAOBinspections now examine both financial statementand ICFR audits, we believe our research findingsshould be of interest to standard-setting andoversight bodies outside of the US.

The European Group of Auditors’ OversightBodies was established in 2005 to ensure effectivecoordination of new public oversight systems ofstatutory auditors within the EU (Baker, 2008). Asforeign jurisdictions have, or are contemplating,regulation modeled in part on the provisions ofSOX and the mission of the PCAOB, the findingsregarding the impacts of US PCAOB inspectionsmay play an important role in global auditingstandard-setting.

The remainder of this paper is organized asfollows. The next section develops the study’shypotheses, followed by a description of themethodologies and presentation of the results. Thefinal section presents conclusions, implications,and suggestions for future research.

HYPOTHESIS DEVELOPMENT

Involuntary client losses

Institutional theory (Scott, 2001) suggestsorganizations and individuals must conform toprevailing formal and informal environmentalrules and belief systems to survive. If companiesbelieve employing firms with deficiency reportsresults in higher costs of capital or other market-imposed penalties, they may dismiss trienniallyinspected auditors with deficiency reports.

Prior to initiation of the PCAOB’s inspectionprocess, auditors of publicly traded companieswere required to be members of the AmericanInstitute of Certified Public Accountants (AICPA)SEC Practice Section (SECPS). Member firms weresubject to a peer review every three years byother members of the SECPS. The focus of thesepeer reviews was auditing firms’ quality control



systems. Peer review results were classified asunqualified, modified, or adverse (AICPA, 2010).In spite of the fact that the peer review programwas criticized for a perceived lack of independenceof the reviewers (Ribstein, 2002), results of priorresearch suggest smaller auditing firms (those nowinspected triennially by the PCAOB) with modifiedor adverse peer review reports lost clientssubsequent to the issuance of those reports, whilesimilar firms receiving unqualified peer reviewreports gained clients (Hilary & Lennox, 2005).Similarly, triennial firms ceasing to be registeredwith the PCAOB are found to have lower auditquality (versus non-exiting firms) as measuredby avoidance of AICPA peer reviews andnon-compliance with PCAOB rules, and whenmeasured by the severity of peer review andPCAOB inspection reports (DeFond & Lennox,2011). We hypothesize:

H1a: Deficiency reports will be positivelyassociated with triennially inspected auditorsbeing dismissed by clients.

If, consistent with H1a, triennially inspectedauditors with deficiency reports are likely to sufferinvoluntary client losses, it follows those clientsdismissing these auditors will be more likely toengage auditors without deficiency reports. Wehypothesize:

H1b: Companies dismissing trienniallyinspected auditors with deficiency reports aremore likely to hire triennially inspected auditorswith clean reports.

If H1b is rejected, and companies voluntarilyswitch to other triennially inspected auditors withdeficiency reports, or switch to annually inspectedfirms (all having deficiency reports), the deficiencyreport per se may be ruled out as a cause ofinvoluntary client losses.

Voluntary client losses

Individuals and organizations seek to maximizefinancial returns by, among other things,minimizing costs, including reputational costs(Jensen & Meckling, 1976). Triennially inspectedauditors, who have less reputation capital, fewerresources to address deficiencies, greatercompetition, and longer periods to suffer fromnegative inspection outcomes than annuallyinspected auditors, may perceive the cost ofPCAOB inspections as greater than the benefit that

may be derived from performing audits of publiclytraded companies. Thus, they may choose tovoluntarily resign from audits of publicly tradedcompanies and/or cease to be registered with thePCAOB. Consistent with this supposition, Readet al. (2004) documented a post-SOX increase in thenumber of local and regional auditors ceasingaudits of publicly traded companies. Results of asurvey of triennially inspected auditors suggestthese auditors have an increased likelihood ofterminating their public audit client relationshipsas a result of PCAOB inspections, and the smallestof triennially inspected auditors have a reducedinclination to accept new publicly traded clients(Daugherty & Tervo, 2010). We hypothesize:

H2a: Deficiency reports will be positivelyassociated with triennially inspected auditorsresigning from their publicly traded clients.

H2b: Deficiency reports will be positivelyassociated with triennially inspected auditorsceasing to be registered with the PCAOB.

METHODOLOGY

Of the 754 inspections performed on trienniallyinspected auditors, 167, 197, 158, and 232 reportswere publicly released in 2005, 2006, 2007, and2008, respectively, of which 149 are second roundinspections. Our analyses cover 748 of theseinspection reports, including 147 second roundinspections. That is, 147 triennially inspectedauditors are included twice in our analyses. Fourinitial and two second round inspections are lostdue to missing data.

The inspection reports of triennially inspectedauditors detail the dates of fieldwork and reportissuance, the number of office(s), the number ofpartners, staff and total number of professionals,the total number of registrant audits, the number ofaudit engagements inspected, and the number ofdeficient audits. If the registrant was required torestate financial statements to address a matteridentified by the inspection team, it is noted in thepublic version of the inspection report. Auditorsare given the opportunity to provide a writtenresponse to be appended to the PCAOB inspectionreport. The demographic characteristics of oursample of triennially inspected auditors arepresented in Table 1.

The sampled triennial firms collectively averagethree offices, 14 partners, and 87 staff. The numberof public clients ranges from one to 96, and



collectively averages ten. The percentage of auditsinspected decreases monotonically as the numberof public company audits increases, averaging 29percent for all firms.

To address the study’s hypotheses, we use adichotomous variable equal to one if the trienniallyinspected auditor received a deficiency report,otherwise equal to zero (DEF), as our primaryproxy for a negative PCAOB inspection outcome.We also use three additional proxies. The first, anindicator variable equal to one if the trienniallyinspected auditor had a deficiency related to adeparture from GAAP, otherwise equal to zero(GAAP_DEF), consistent with Gramling et al.(2011) and intended as a measure of severity of thedeficiency report. The second, an indicator variableequal to one if the triennially inspected auditorreceived a quality control deficiency, otherwiseequal to one (QC); and the third, an indicatorvariable equal to one if the triennially inspectedauditor received an unremediated QC deficiency,otherwise equal to zero (QC_UNREMED). Anunremediated QC deficiency is signaled by thePCAOB’s public release of a previouslyconfidential QC deficiency as the firm did notadequately address the PCAOB’s concerns withinone year of the release of the firm’s initialinspection report. QC_UNREMED is appropriatelyrepresentative of a negative inspection outcome,but since its existence is only known publicly oneyear after the initial inspection, its associationwith involuntary client losses (dismissals) isquestionable. However, QC may be associated withvoluntary client losses (resignations or ceasing to

be registered) as the inspected auditor is aware ofthe QC deficiency. Analyses presented later inTable 3 suggest the four measures of negativeinspection outcomes are highly correlated(p < 0.001). Accordingly, to reduce the possibility ofmulticollinearity effects, each proxy is consideredseparately in our tests of H1a, H2a, and H2b.

Our outcome measures of interest are: (1) acontinuous variable equal to the number ofpublicly traded companies dismissing thetriennially inspected auditor within six months ofreceiving DEF, divided by the total number ofpublicly traded clients of the triennially inspectedauditor as of the date of inspection (DISMISS), (2)a continuous variable equal to the number ofpublicly traded clients from which the trienniallyinspected auditor resigned within six months ofreceiving DEF, divided by the total number ofpublicly traded clients of the triennially inspectedauditor as of the date of inspection (RESIGN),6

and (3) a dichotomous variable equal to one if,as of June 30, 2009, the auditor is no longerregistered with the PCAOB, otherwise equal tozero (NOT REG).7 A substantial time periodgenerally elapses between completion of thePCAOB’s inspection fieldwork and release of thepublic report (Hermanson et al., 2007; Hermanson& Houston, 2009; Roybark, 2009), but mostauditors become aware of the report’s content atclosing meetings occurring on or near the date ofthe PCAOB’s final fieldwork, or when they aregiven a draft of the report.8

To address H1a, we associate the receipt of anegative inspection outcome with dismissals of

Table 1: Demographic characteristics of sampled triennially inspected auditors

Number of public company audits

1(n = 195)

2 to 9(n = 358)

10 to 19(n = 102)

20 to 96(n = 93)

All auditors(n = 748)

Means

No. of offices 1.51 2.33 3.07 3.80 2.59No. of partners 5.64 10.15 14.59 27.42 13.79No. of staff 19.71 53.49 67.15 137.58 86.64Partner/staff ratio 0.29 0.19 0.22 0.20 0.16No. of registrants 1.00 4.02 14.19 43.11 9.61No. of registrants inspected 1.00 2.54 4.24 6.21 2.80% inspected 100% 63.18% 29.88% 14.41% 29.14%LAG (days) 197 207 314 366 239

LAG is the average number of days from the end of PCAOB fieldwork until the date of release of the inspectionreport.



triennial inspected auditors using the followingequation:

DISMISS Intercept DEF or GAAP_DEF or

QC or QC_UNREMED Ind

= ++ 2 NNSPECTION

SIZE DEF*SIZE or GAAP_DEF*SIZE or QC*SIZE or QC

++

__UNREMED_DEF*SIZE + e

Two control variables are included in the aboveregressions, 2nd INSPECTION and SIZE. Thecontrol variable 2nd INSPECTION is a dichotomousvariable equal to one if the inspection is the secondfor the triennially inspected auditor, otherwiseequal to zero. Hermanson and Houston (2009) findsecond inspections are less likely than firstinspections to have reported deficiencies; however,there is no clear indication about the associationbetween auditor changes (dismissals orresignations) and second inspections. Accordingly,we make no prediction regarding the direction orsignificance of the coefficient on 2nd INSPECTION.9

The variable SIZE is a categorical variable intendedto reflect the size of the auditor based on thenumber of public company audits performed bythe auditor, where one equals one audit, two equalstwo to nine audits, three equals ten to 19 audits, andfour equals 20 to 96 audits. We use categories of sizeto consider the possibility of structural differences(e.g., industry depth, ability to rotate engagementpartners, ability to respond to PCAOB deficiencyissues) among auditors with only one publiccompany audit, compared to those with ten to 19,or those with more than 20.

To investigate whether the negative effects ofdeficiency reports vary dependent on auditor size,we include interaction variables intended tocapture the incremental effect of negativeinspection outcomes and auditor size. Finding asignificant, negative coefficient would suggest thesmallest auditors are most significantly impactedby negative inspection outcomes.

To test H1b, we compare the frequency ofcompanies dismissing triennially inspectedauditors with deficiency reports and subsequentlyengaging other triennially inspected auditors withdeficiency reports, to companies dismissingtriennially inspected auditors with deficiencyreports and subsequently engaging othertriennially inspected auditors with clean reports. Toaddress H2a and H2b, we associate the study’s fourinspection measures, DEF, GAAP_DEF, QC, andQC_UNREMED with the variables, RESIGN andNOT REG using the following regressions:

RESIGN Intercept DEF or QC

INSPECTION SIZE

DEF*SIZE or

nd

= + ++ +2

QC*SIZE + e10

NOT REG Intercept DEF or GAAP_DEF or

QC or QC_UNREMED Ind

= ++ 2 NNSPECTION

SIZE DEF*SIZE GAAP_DEF*SIZE QC*SIZEQC_UNREMD*S

++ + + +

IIZE + e

RESULTS

Table 2 provides descriptive statistics of ourvariables of interest grouped by auditor size. Thenumber of public company audits performed bytriennially inspected auditors (not tabulated) rangefrom one to 96, and average (median) ten (four).The average rate of deficiency reports for alltriennially inspected auditors is 44 percent.11 Onaverage, the smallest triennially inspected auditorshave a smaller frequency of deficiency reports – 39percent of the smallest auditors’ inspection reports,compared to 62 percent of the largest trienniallyinspected auditors. However, these differences arenot statistically significant (not tabulated). Onaverage, 13 percent of all deficiency reports includeGAAP departure deficiencies and the difference infrequency among auditors based on size is notstatistically significant.

Approximately 64 percent of deficiency reportsinclude quality control issues and 10 percent oftriennially inspected auditors have unremediatedQC deficiencies. Again, the difference in frequencyof QC issues or unremediated deficiencies amongauditors based on size is not statistically significant.Consistent with prior research, we also find thatsecond inspections are less likely to be associatedwith deficiency reports and QC deficiencies(p < 0.001). On average, 54 percent (73 percent) offirst round inspections have deficiencies (QCdeficiencies), and 5 percent (27 percent) of secondround inspections have deficiencies (QCdeficiencies), not tabulated. These differences aresignificant (p < 0.001).

As reported in Table 1, the lag time betweenPCAOB inspectors’ end of fieldwork and reportissuance (LAG) averages 239 days, and increasesmonotonically with the size of the auditor. LAG ishighly correlated with all four measures of negativeinspection outcomes (all p-values < 0.001) – nottabulated. On average, within six months of



receiving a deficiency report, triennially inspectedauditors lost 6 percent of their publicly tradedclients. One-third are attributed to dismissals andtwo-thirds are attributed to resignations. Inaddition, 15 percent of triennially inspectedauditors are no longer registered with the PCAOB.Compared to the largest triennially inspectedauditors, on average, the smallest auditors are morelikely to no longer be registered with the PCAOB –22 percent versus 10 percent – a significant(p = 0.003) difference. The variable, DISMISS,includes 164 individual companies dismissing theirtriennially inspected auditor within the six-monthperiod following the date of the auditor’sdeficiency report.

Correlation analyses of the study’s dependentand independent variables are presented in Table 3.Significant positive correlations suggest negativeinspection outcomes are associated with voluntaryor involuntary client losses.

As expected, given that public company auditsmust cease if triennially inspected auditors ceaseto be registered with the PCAOB, DISMISS andRESIGN are highly correlated with NOT REG(p < 0.05 and p < 0.001, respectively). DISMISS is

highly correlated with DEF and GAAP_DEF(p < 0.05 and p = 0.05, respectively), but not withQC or QC_UNREMED (both p-values > 0.10). Thisrelationship suggests clients may be concernedwhen financial statements are misstated, but notwhen auditors’ internal quality control systems fail.

RESIGN is highly correlated with DEF and QC(p = 0.001 and p < 0.01, respectively), but not withGAAP_DEF or QC_UNREMED (both p > 0.10).NOT REG is highly correlated with DEF, QC, andQC_UNREMED (p < 0.001, p < 0.001, and p < 0.05,respectively) and is moderately correlated withGAAP_DEF (p < 0.10). These relationships suggestquality control deficiencies may contribute totriennially inspected auditors choosing to exit thebusiness of auditing publicly traded companies.

Results of the test of H1a are presented inTable 4. Given the lack of correlation of DISMISSwith QC and QC_UNREMED identified in Table 3,results of regression analyses are only presentedincluding the independent variables of interest,DEF and GAAP_DEF.12

Consistent with expectations, using both DEFand GAAP_DEF as measures of negativeinspection outcomes, results suggest triennially

Table 2: Descriptive statistics of sampled auditors by size

Number of public company audits

1(n = 195)

2 to 9(n = 358)

10 to 19(n = 102)

20 to 96(n = 93)

All auditors(n = 748)

Means

DEF 0.39 0.38 0.60 0.62 0.44GAAP_DEF 0.08 0.09 0.18 0.12 0.13QC 0.67 0.56 0.75 0.78 0.64QC_UNREMED 0.11 0.08 0.18 0.09 0.10DISMISS 0.02 0.01 0.02 0.03 0.02RESIGN 0.03 0.04 0.06 0.03 0.04NOT REG 0.22 0.13 0.21 0.10 0.15

DEF, an indicator variable equal to one if the triennially inspected auditor received a deficiency report, otherwiseequal to zero.GAAP_DEF, an indicator variable equal to one if the deficiency report included a departure from generallyaccepted accounting principles, otherwise equal to zero.QC, an indicator variable equal to one if the deficiency report included an unremediated quality controldeficiency report, otherwise equal to zero.QC_UNREMED, an indicator variable equal to one if the triennially inspected auditor received an unremediatedquality control deficiency report, otherwise equal to zero.DISMISS, dismissals within six months of receiving a deficiency report as a percentage of total publicly-tradedclients as of the date of inspection.RESIGN, resignations within six months of receiving a deficiency report as a percentage of total publicly-tradedclients as of the date of inspection.NOT REG, a dichotomous variable equal to one if, as of June 30, 2009, the auditor is no longer registered,otherwise equal to zero.



Tab

le3:

Cor

rela

tion

anal

ysis

(n=

748)

DIS

MIS

SR

ESI

GN

NO

TR

EG

DE

FG

AA

PD

EF

QC

QC

UN

RE

ME

D

DIS

MIS

SPe

arso

nC

orre

lati

on1.

000

-0.0

010.

083

0.08

10.

070

0.05

30.

024

Sig.

0.97

80.

023

0.02

60.

054

0.14

80.

518

RE

SIG

NPe

arso

nC

orre

lati

on1.

000

0.15

60.

122

0.04

10.

102

0.00

1Si

g.<0

.001

0.00

10.

264

0.00

50.

987

NO

TR

EG

Pear

son

Cor

rela

tion

1.00

00.

182

0.06

10.

146

0.07

9Si

g.<0

.001

0.08

2<0

.001

0.02

9D

EF

Pear

son

Cor

rela

tion

1.00

00.

379

0.66

70.

228

Sig.

<0.0

01<0

.001

<0.0

01G

AA

PD

EF

Pear

son

Cor

rela

tion

1.00

00.

291

0.14

0Si

g.<0

.001

<0.0

01Q

CPe

arso

nC

orre

lati

on1.

000

0.25

4Si

g.<0

.001

QC

UN

RE

ME

DPe

arso

nC

orre

lati

on1.

000

Sig.

DIS

MIS

S,d

ism

issa

lsw

ithi

nsi

xm

onth

sof

rece

ivin

ga

def

icie

ncy

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rcen

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talp

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ly-t

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eda

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N,r

esig

nati

ons

wit

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six

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inspected auditors with negative inspectionoutcomes are more likely to have involuntary clientlosses (p < 0.05), and these losses do not varyby auditor size, measured categorically orcontinuously (not tabulated). In addressing H1b,we find 15 (9 percent) of the companies dismissingtheir triennially inspected auditor subsequentlyengaged annually inspected auditors, 117 (71percent) engaged other triennially inspectedauditors with clean reports, and 32 (20 percent)engaged other triennially inspected auditors thatalso have deficiency reports. Since the frequency ofdeficiencies for all triennially inspected auditors is44 percent, if receipt of a deficiency report wasnot associated with companies dismissing theirtriennially inspected auditors in favor of trienniallyinspected auditors without deficiency reports, wewould expect that 44 percent of newly engagedtriennially inspected auditors of these companieswould also have deficiency reports. Instead, ourresults suggest that of the subsequently engagedtriennially inspected auditors (n = 149), only 32 (21percent) have deficiency reports, a significantdifference (p < 0.001).

Results of the test of H2a and H2b are presentedin Table 5. Given the lack of correlation of RESIGNwith GAAP_DEF and QC_UNREMED identified

in Table 3, results of regression analyses testingH2a are only presented including the independentvariables of interest, DEF and QC.13

Consistent with expectations, we find RESIGNand DEF are positively related (p = 0.004). Resultssuggest QC is not a significant indicator of auditorsresigning from their clients (p > 0.10). Further,second inspections have no impact on clientresignations (p > 0.10). Importantly, the size of thetriennially inspected auditor per se generally doesnot influence RESIGN, but when considered in thepresence of deficiency reports (DEF), size acts tomoderately decrease the likelihood of resigningfrom a significant portion of audits of publiclytraded companies (p = 0.078).

Also consistent with expectations, we find NOTREG is positively related to DEF, GAAP_DEF,and QC (p < 0.001, p = 0.022, and p = 0.017,respectively). NOT REG and QC_UNREMEDare unrelated (p > 0.10). Second inspectionssignificantly reduce the likelihood that trienniallyinspected auditors will no longer be registered(p < 0.001, using all measures of negativeinspection outcomes). Similarly, size reduces thelikelihood of NOT REG, without regard toGAAP_DEF, QC, or QC_UNREMED (all p > 0.10),but significantly decreases the likelihood of no

Table 4: Estimation of the impact of negative inspection outcomes on involuntary client losses (n = 748)DISMISS = Intercept + DEF or GAAP_DEF + 2nd INSPECTION + SIZE + DEF*SIZE or GAAP_DEF*SIZE + e

Dependent variable: DISMISS

B Sig. B Sig.

Intercept -0.001 0.935 0.008 0.354DEF 0.032 0.043a

GAAP_DEF 0.054 0.044a

2nd INSPECTION 0.005 0.601 0.001 0.977SIZE 0.005 0.313 0.003 0.345DEF*SIZE -0.008 0.239GAAP_DEF*SIZE -0.015 0.159Adj R2 0.004 0.003

aSignificant at p < 0.05.DISMISS, dismissals within six months of receiving a deficiency report as a percentage of total publicly-tradedclients as of the date of inspection.DEF, a dichotomous variable equal to one if the triennially inspected auditor received a deficiency report,otherwise equal to zero.GAAP_DEF, an indicator variable equal to one if the deficiency report included a departure from generallyaccepted accounting principles, otherwise equal to zero.2ndInspection, a dichotomous variable equal to one if the inspection is the auditing auditor’s second inspection,and is otherwise equal to zero.SIZE, a categorical variable representing the size of the auditor.DEF*SIZE, intended to capture the interaction of the variables DEF and SIZE.GAAP_DEF*SIZE, intended to capture the interaction of the variables GAAP_DEF and SIZE.Interaction terms are denoted by ‘*’.



Tab

le5:

Est

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spec

tion

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’.



longer being registered with the PCAOB in thepresence of DEF (p = 0.008).

Using a continuous measure of SIZE, the effect ofthe interaction of DEF and SIZE on DISMISS andRESIGN are insignificant (p > 0.10, not tabulated).Confirming our expectations, further analysissuggests the impacts of deficiency reports aregreatest on the smallest auditors – those with fewerthan 10 clients. Collectively, these results suggestthe smallest of triennially inspected auditors maybe particularly impacted by negative PCAOBinspection outcomes.

Instead of reactions to negative inspectionoutcomes, client losses (dismissals or resignations)may be the result of PCAOB disciplinary actions. Totest for this possibility, we gathered data aboutPCAOB disciplinary orders issued to trienniallyinspected auditors in our sample during the periodof our analyses (2005 to 2008). We found 11 firmsincluded in our sample were issued PCAOBdisciplinary orders, but none of those orders waswithin six months (before or after) of receiving adeficient PCAOB inspection report. Accordingly,we do not believe the issuance of disciplinaryorders impacts the study’s results.

CONCLUSIONS, IMPLICATIONS, ANDSUGGESTIONS FOR FUTURE RESEARCH

We questioned whether negative outcomes of thePCAOB’s inspection program were associated withtriennially inspected auditors no longer beingregistered with the PCAOB or losing their publiclytraded clients either voluntarily by resigningfrom audits of publicly traded companies, orinvoluntarily by being dismissed by their publiclytraded clients. Our results suggest involuntaryclient losses are positively associated withdeficiency reports, and companies dismissingtheir triennially inspected auditors with deficiencyreports are more likely to engage anothertriennially inspected auditor with a clean (or no)inspection report, suggesting deficient PCAOBinspections are costly to triennial auditors.14

We also find deficiency reports of trienniallyinspected auditors are positively associated withvoluntary client losses, measured as resigning fromaudits of their publicly traded clients or no longerbeing registered with the PCAOB. We interpretthese findings as suggesting that trienniallyinspected auditors with deficiency reports mayassess the post-inspection cost of regulatorycompliance as greater than the rewards associated

with auditing publicly traded companies. Inaddition, our results suggest the smallest of thetriennially inspected auditors (those with thefewest public company audits) with deficiencyreports are most likely to cease PCAOBregistration. While this may suggest that theinspection process is most costly to the smallestauditors, it may also be an outcome associated withthe PCAOB’s risk-based inspection process. That is,since the inspection process is risk-based, andreports cover auditors, not audit clients, it may bethat larger auditors’ inspection results may not berepresentative of the auditor’s overall audit quality.Instead, low quality auditing may be revealed byPCAOB inspections with greater accuracy forsmaller auditors than it is for larger auditors giventhe higher percentage of engagements inspectedfor triennial firms.

If this is the case, our results could be viewed asa favorable consequence of the new audit qualityoversight mechanism implemented by the PCAOBinspection process. We also find the existence ofdeficiencies for triennially inspected auditors maybe significantly less in second inspections,suggesting a potential increase in audit qualitysubsequent to the inception of the PCAOB’sinspection program. This decrease mayalternatively be attributed to lower quality auditorsceasing to be registered with the PCAOB or, lesslikely, the PCAOB inspections may have declined inrigor.

Pending proposals of the PCAOB also have thepotential to negatively impact triennially inspectedauditors; as such, these findings should also be ofinterest to legislators and regulators contemplatingpossible revisions to SOX and the PCAOB’smandates, and foreign oversight agenciesimplementing, or considering implementation of,strengthened auditor oversight. In June 2008, thePCAOB adopted rules for annual and specialreporting as provided by Section 102(d) of SOX(PCAOB, 2008b). These rules require, among othermatters, that all auditors registered with thePCAOB annually provide, ‘information about auditreports issued by the auditor during the year,certain disciplinary history information aboutpersons who have joined the auditor, andinformation about fees billed to issuer audit clients,in various categories of services, as a percentage ofthe auditor’s total fees billed.’ The new rules havebeen approved by the SEC, and the first annualreporting period began June 30, 2010, for the12-month period ending on March 31, 2010



(PCAOB, 2009). While the new rules may notappear particularly onerous, they are one more in aseries of reporting requirements that may makeit increasingly difficult for smaller auditors tocontinue their audits of publicly traded companies.

The potential negative impact of the inspectionprocess revealed in our analyses on trienniallyinspected auditors, in particular the smallest ofthese auditors, may be justified as being in theinterest of audit quality. However, the impact onsmaller publicly traded companies who now havefewer auditor options must also be considered. Ourresults also have implications for the internationalcommunity as the PCAOB has faced impedimentsin conducting inspections of foreign-basedregistered firms conducting audits of USregistrants (PCAOB, 2010a), and some foreignjurisdictions have adopted, or are consideringadoption, of regulations and oversight similar toSOX and the PCAOB.

Further, the European Commission (EC)published a study on the impact of the auditmarket, especially as it relates to a relative lack ofcompetition for smaller auditing firms. The ECstudy notes that restrictions on access to capital,auditor reputation, the need for internationalcoverage, management structures, and liabilityissues are all impediments to expandedcompetition amongst smaller auditing firms (EC,2007). Our findings shed further light on theinfluence that PCAOB inspection outcomes haveon smaller auditing firms domiciled in the US and,by extension, the impact that similar oversight andinspection regimes may have on the broaderinternational accounting and auditing professions.

Given the relative infancy of the PCAOB’sinspection process, particularly as it relates totriennially inspected auditors, its impact is ripe forfuture research. For example, future research mightexamine the influence that second-round and laterinspection reports have on triennially inspectedauditors’ public audit client base, or the impact ofthe receipt of a clean inspection report followingthe earlier receipt of a deficiency inspection report,and the relationship between deficiency severityand outcome measures.

Future research might also consider whethernegative outcomes associated with peer reviewreports concerning audits of privately held clientsare associated with losses of publicly traded clients.In this light, it might also be interesting todetermine whether the PCAOB inspection processinfluences the rate of new entrants to the publicly

traded company auditing arena, as compared to therate that existed under the former peer reviewprocess. Based on the suggestion by Abdel-khalik(2002) that auditor independence could beenhanced by empowering shareholders withauditor-related decisions, instead of corporateboards, future research might experimentallyexamine the influence that clean (deficient)inspection reports have on shareholders’ relativesupport for auditor retention or dismissal.

ACKNOWLEDGMENTS

We thank several anonymous reviewers, LarryAbbott, Audrey Gramling, Jayanthi Krishnan, andparticipants in a concurrent session of the PublicInterest section at the American AccountingAssociation’s 2009 annual meeting for theirinsightful comments, observations, andsuggestions on earlier versions of the paper. Wealso thank Tim Yang for valued research assistance.

NOTES

1. Prior to initiation of the PCAOB’s inspectionprocess, auditors of publicly traded companieswere required to be members of the AICPASEC Practice Section (SECPS). Memberauditors were subject to a peer review everythree years whereby other members of theSECPS reviewed auditors’ quality controlsystems. Such peer review reports wereunqualified, modified, or adverse (AICPA,2010). Some questioned the value ofpeer-review reports performed by otherauditors. In critiquing SOX, Ribstein (2002,p. 14) opined, ‘The current system of peerreview within the AICPA obviously has notfilled in the gaps, as indicated by the recentcorporate frauds themselves and by the factthat no major accounting firm has failed a peerreview.’ Effectively, the PCAOB inspectionprocess supplanted the former peer reviewprocess for public company audits.

2. To date, annually inspected firms have allreceived deficient PCAOB inspection reportssince the inception of the process. Given thetechnical depth and global reach of largeauditing firms, many large, complex, ormultinational registrants have no option otherthan to engage a Big ‘N’ audit firm.

3. These areas are: (i) tone at the top, (ii) partneradmission, evaluation, compensation,



assignments, and disciplinary actions, (iii)independence considerations, (iv) clientacceptance and retention, (v) consultation onaccounting, auditing, and SEC matters, (vi)internal inspection programs, (vii) policies andprocedures for staffing audit engagements, and(viii) US engagement supervision of workperformed by foreign affiliates on foreignoperations of US registrants.

4. Data used in Lennox and Pittman (2010) isrepresentative of multiple years of annuallyinspected auditors’ inspection reports andlikely only one year of triennially inspectedauditors’ inspection reports. Annuallyinspected auditors, representing Big 4 auditorsand, at the time of their analyses, six other largefirms, may be somewhat insulated from clientlosses. All annually inspected auditors haddeficiency reports; therefore public companiesself-selecting the largest auditing firms mayhave no choice but to remain with their currentauditor, or incur the cost of switching toanother large auditor, also with a deficiencyreport. The ban on provision of most non-auditservices by companies’ auditors may furtherlimit public companies’ choice of an alternativeannually inspected auditor.

5. Data required by and reported in PCAOBinspection reports is evolving. For example,subsequent to the dates of our analyses, reportsof annually inspected firms include the numberof audits inspected.

6. Auditor change data are obtained from AuditAnalytics. These data report whether theauditor change is reported as a dismissal orresignation, but do not elaborate further as tothe reason for the dismissal or resignation.The possibility exists that these data may besomewhat confounded as companies maycharacterize auditor resignations as dismissals(with agreement by the auditor as thepredecessor auditor is required to concur ordisagree with management’s characterizationof auditor switches in 8-K filings), or maydismiss their auditors for reasons other thannegative inspection outcomes. We presumethat auditor resignations inappropriatelycharacterized as dismissals would bias againstfinding a significant association betweennegative inspection outcomes and auditorresignations. Further, as reasons for dismissalare likely to occur randomly, dismissals otherthan those due to negative inspection outcomes

are not expected to adversely impact the resultsof our analyses.

7. The list of auditors registered with the PCAOBis continuously updated and does not includeinformation regarding the date an auditorceased being registered. We recognize thestudy’s methodology may include auditorsceasing to be registered several years afterreceipt of a deficiency report. We believe thismethodology is more sound than setting aone-year, or other arbitrary period, todetermine cessation as: (1) triennially inspectedfirms have up to a three-year period afterreceipt of a deficiency report before their nextinspection, (2) the wind down of operationsmay take several years, (3) NOT REG is one ofthree outcome measures used in the study; and(4) our analyses do not purport to identify acausal relationship between deficiency reportsand ceasing to be registered with the PCAOB.We also recognize our methodology potentiallyincludes some auditors that may have ceasedall operations, not just their audits of publiclytraded companies. We expect that the numberof these types of observations is not significant,occurs randomly, and would not alter theresults of our analyses. We also recognize someauditors may cease auditing public companies,but may continue to maintain PCAOBregistration as a signal of audit quality (Readet al., 2004).

8. Because our outcome measures consider datasince the date of the public release of inspectionreports, we recognize we may understate thetrue amount of triennially inspected auditorsresigning from audits of publicly tradedcompanies.

9. Only five (three) percent of the secondinspections in our sample have deficiencies(GAAP deficiencies). Accordingly, other thancomparing frequency differences between firstand second inspections, our sample data lacksufficient power to robustly investigate anyother differences that may be present.

10. Independent variables GAAP_DEF andQC_UNREMED are excluded from theregression equation as they are not found to becorrelated with RESIGN (Table 3), to reduce theimpacts of multicollinearity.

11. Hermanson et al. (2007) report 60 percent oftriennially inspected auditors had received firstround PCAOB inspection reports that includedat least one deficiency, and Daugherty and



Tervo (2010) document a 54 percent firstround deficiency rate for triennially inspectedauditors. Comparing our results suggests thepossibility that later first round and earlysecond round inspections are associated witha smaller percentage of deficiencies. Somedifferences may also be attributable to the priorstudies’ use of the number of professionals asthe measure of the size of the auditing auditor,while we use the number of public clients todelineate auditor size. Further, as suggested bythe results of Lennox and Pittman (2010), thePCAOB’s risk-based inspection approach likelyfirst targeted higher risk auditors.

12. We supplementally confirm that neither QCnor QC_UNREMED are significant indicatorsof DISMISS. Further, regression equationsconsidering these proxies for negativeinspection are not significant (p > 0.10).

13. We supplementally confirm that neitherGAAP_DEF nor QC_UNREMED aresignificant indicators of RESIGN. Further,regression equations considering these proxiesfor negative inspection are not significant(p > 0.10).

14. Using data from 2004 to 2006, an unpublishedstudy of the PCAOB’s office of research andanalysis finds triennially inspected firms tendnot to be involuntary terminated by theirclients that are the source of negativeinspection outcomes; however, they tend tovoluntarily resign from clients that are thesource of negative inspection outcomes(PCAOB, 2010b). Different from our study, thePCAOB study uses proprietary client-specificknowledge to examine whether specific clientsthat are associated with inspection deficienciesare voluntarily terminated by their trienniallyinspected auditors – or involuntarily terminatetheir triennially inspected auditor. Our studyexamines the possibility of reputational andeffort effects of inspection deficiencies on clientlosses and covers the period 2005 to 2008. Inother words, we associate PCAOB inspectiondeficiencies with involuntary and voluntaryclient losses in general.

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AUTHOR PROFILES

Brian Daugherty, Ph.D., CPA is an assistantprofessor at the University of Wisconsin –Milwaukee where he teaches courses in graduateand undergraduate auditing.

Denise Dickins, Ph.D., CPA, CIA is an assistantprofessor at East Carolina University where sheteaches courses in auditing and corporategovernance.

Wayne Tervo, Ph.D., CPA is an assistantprofessor at Murray State University where heteaches courses in cost accounting and managerialaccounting at the undergraduate and graduatelevels.

