PCAOB international inspections: Updates and extensions

• Published date: 01 April 2022
• Author: Philip Keejae Hong,David S. Kerr,Casper E. Wiggins
• Date: 01 April 2022
• DOI: http://doi.org/10.1111/ijau.12277

ORIGINAL ARTICLE

PCAOB international inspections: Updates and extensions

Philip Keejae Hong

1

| David S. Kerr

2

| Casper E. Wiggins

2

1

School of Accounting, College of Business

Administration, Central Michigan University,

Mount Pleasant, Michigan, USA

2

Turner School of Accountancy, Belk College

of Business, University of North Carolina at

Charlotte, Charlotte, North Carolina, USA

Correspondence

David S. Kerr, Turner School of Accountancy,

Belk College of Business, University of North

Carolina at Charlotte, Charlotte, NC 28223,

USA.

Email: dskerr@uncc.edu

Based on data from 760 PCAOB inspection reports issued between December 2006

and April 2021 for 305 non-U.S. audit firms, this paper analyses changes and trends

in PCAOB inspection traits, inspection outcomes, audit firm characteristics and firms'

reactions to those inspections. We find significant changes have occurred in several

areas, including changes in audit quality for both principal-auditor engagements and

referred-work (i.e., other auditor) engagements, audit deficiency rates for both Big-4

affiliated firms and unaffiliated firms, firms' responses to inspections and several

other changes. We also find a significant iteraction between the firm's network affili-

ation and the firm's role in the engagement (i.e., principal auditor vs. referred work).

Further analysis of this interaction reveals that when unaffiliated firms perform

referred-work engagements, they have better PCAOB inspection outcomes than

when performing principal-auditor engagements. However, affiliation with a network

mitigates this outcome.

KEYWORDS

accountability, audit deficiency, audit quality, external audit, PCAOB, regulation

1|INTRODUCTION

The Public Company Accounting Oversight Board (PCAOB) is respon-

sible for the oversight and inspection of audit firms that audit or play

a substantial role in the audit of companies whose securities are

traded in U.S. markets. All audit firms, including those based in the

U.S. as well as non-U.S. firms, that are registered with the PCAOB

must follow PCAOB rules and requirements and are subject to annual

or triennial inspections. The PCAOB's inspection programme is con-

ducted to assess and promote high-quality auditing among registered

audit firms and is the primary vehicle through which the PCAOB

accomplishes its oversight responsibility.

In this study, we focus on the PCAOB's inspections and the audit

quality of international (non-U.S.) audit firms. It is particularly impor-

tant to examine international inspections and audit quality because

the international audit environment is quite diverse and brings signifi-

cant audit challenges for the PCAOB and regulators outside of the

U.S. that are not present in the U.S. audit environment. Many of these

challenges relate to information flow difficulties due to host country

laws on data protection, privacy and confidentiality, bank and state

secrecy and national security (Duhnke, 2018). Non-U.S. audit firms

may also be subject to different sets of audit standards and rules

imposed by host countries and regulators, in addition to those of the

PCAOB (Bishop et al., 2013). In addition, the PCAOB's ability to con-

duct inspections and to transfer audit workpapers across borders may

be severely limited or not allowed, especially in China and Hong

Kong.

1

Many PCAOB international inspections are conducted in coop-

eration with host country regulators, which the PCAOB encourages.

The PCAOB has conducted inspections in 53 non-U.S. jurisdictions

and has cooperative arrangements with non-U.S. regulators in 25 of

those jurisdictions (PCAOB, 2021c). Many of the cooperative arrange-

ments provide for joint inspections with the home country regulator.

Non-U.S. audit firms include a mix of non-U.S. independent firms and

non-U.S. firms affiliated with a Big-N global network.

Using combinations of multivariate and univariate analyses, we

examine trends and patterns of changes in key characteristics of non-

Received: 3 December 2020 Revised: 13 December 2021 Accepted: 8 February 2022

DOI: 10.1111/ijau.12277

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

provided the original work is properly cited.

© 2022 The Authors. International Journal of Auditing published by John Wiley & Sons Ltd.

Int J Audit. 2022;26:279–313. wileyonlinelibrary.com/journal/ijau 279

U.S. audit firms over multiple rounds of PCAOB inspections, the per-

centage of audits in which deficiencies are discovered, and character-

istics of the PCAOB's inspections themselves, including the duration

of inspections. It is important to identify such trends and patterns of

changes in order to assess the effectiveness of PCAOB inspections of

non-U.S. audit firms in improving audit quality for those firms. Other

factors examined include audit firms' responses to PCAOB inspec-

tions, the types of audit deficiencies committed by these firms,

changes and trends in audit deficiency rates and changes and trends

in the percentage of audit engagements reviewed by the PCAOB. To

this end, our study involves an investigation of the effectiveness of

PCAOB international inspections in enhancing audit quality for

760 inspections of 305 non-U.S. audit firms.

The findings reveal several thought-provoking trends and rela-

tionships. For instance, there are a number of noteworthy differences

and trends in the outcomes of principal-auditor engagements and

referred-work engagements. Referred-work engagements, which are

an underexamined area of research, refers to work performed by

other audit firms at the request of the principal-auditor responsible

for issuing the audit report (Flasher & Schenck, 2019;

PCAOB, 2021b).

We find the percentage of principle-auditor engagements with

deficiencies is higher across all rounds of inspections than for

referred-work engagements. However, for both principal-auditor and

referred-work engagements, the percentage of engagements with

deficiencies declined significantly in the fourth and fifth inspections

relative to the third round of inspections. The types of deficiencies

found most often in both principal-auditor and referred-work engage-

ments relate to a failure to perform sufficient audit procedures

(e.g., sample sizes are too small), a failure to test controls sufficiently

and a failure to evaluate or assess appropriately. The percentage of

both principal-auditor engagements and referred-work engagements

reviewed by the PCAOB has declined over five rounds of inspections.

In addition, the percentage of referred-work engagements reviewed

by the PCAOB has been considerably lower than for principal-auditor

engagements. We also note that, for principal-auditor engagements

with audit deficiencies, the percentage of firms that chose not to pro-

vide a response letter to the PCAOB has declined significantly from

the first to fifth rounds of inspections.

Another noteworthy trend is in the staffing levels in non-U.S.

audit firms, indicating these firms have, on average, increased their

human resources considerably since the inception of the PCAOB

inspection process while the number of audit clients as principal audi-

tor has decreased. We also find that the increases in staffing levels

are significantly associated with decreases in the number of audit

deficiencies and the percentage of engagements with deficiencies for

principal-auditor engagements but not for referred-work engage-

ments. In addition, the legal system followed by the jurisdiction in

which the audit firm is located is associated with the number of audit

deficiencies discovered. Specifically, firms in civil law jurisdictions tend

to have, on average, more audit deficiencies than firms in common

law jurisdictions. This is true for both principal-auditor engagements

and referred-work engagements.

Regarding differences and trends in the inspections of Big-4 affili-

ates, next-4 affiliates and unaffiliated firms, we find the duration

(measured in days) of the PCAOB's inspections of Big-4 affiliates

exhibits an increasing trend over the first four rounds of inspections,

while the duration of inspections of unaffiliated firms shows the

opposite trend, with duration times decreasing steadily since the ini-

tial inspections. Also, the numbers of restatements and substantial

adjustments triggered by inspections of unaffiliated firms have been

consistently higher than for Big-4 and next-4 affiliates; however,

those numbers for affiliated firms and unaffiliated firms have been

declining. Bishop et al. (2013) reported in their study of first-time

inspections that unaffiliated firms had higher deficiency rates than

either Big-4 affiliates or next-4 affiliates. We find that Bishop et al.'s

observations persisted beyond the first round and into the second

and third rounds of inspections. However, by the fourth and fifth

rounds, unaffiliated firms had lower deficiency rates than both Big-4

affiliates and next-4 affiliates. Finally, on a related note, audit defi-

ciency rates for Big-4 affiliates were significantly lower in the first

round of inspections than in the subsequent four rounds, which, when

considered in conjunction with the concurrent increase in the inspec-

tion duration of Big-4 affiliates, suggests that the PCAOB increased

its scrutiny of Big-4 affiliated firms after the initial round of inspec-

tions and has maintained increased scrutiny levels through the subse-

quent four rounds.

This study contributes to the growing literature on the PCAOB's

effectiveness as a regulatory body and the impacts of its inspection

programme on the audit quality of non-U.S. audit firms in several

ways. First, we extend the literature on the PCAOB's inspection

programme's effects on registered non-U.S. audit firms by identifying

trends in characteristics of those firms and audit deficiencies over five

rounds of inspections. While many studies have been conducted on

inspections of U.S. audit firms, relatively few studies have focused on

inspections of audit firms domiciled outside the U.S. Research on

PCAOB inspections of non-U.S. auditors is important because results

of studies of U.S. audit firms are not likely to be generalizable to firms

outside the U.S. due to differences in factors such as the additional

knowledge foreign auditors must have regarding international auditing

standards, international financial reporting standards, local laws and

requirements of local regulators and other factors (Stewart, 2012). In

addition, while there are a few papers that examine the impact of

PCAOB inspections on audit quality and audit firms' responses, by

extending our sample period, we were able to provide more compre-

hensive view for the impact of PCAOB's repeated inspections on

audit quality. Many earlier studies are based on relatively short

periods of time, or only first or second PCAOB inspections for

U.S. audit firms only (e.g., Church & Shefchik, 2012; DeFond &

Lennox, 2017) and often find mixed results (e.g., Bishop et al., 2013;

Hermanson & Houston, 2009). With our sample period expanding

over 16 years (2006–2021), and PCAOB's up to five round of inspec-

tions, we were able to provide a more complete story about PCAOB's

inspection and audit quality.

In addition, we investigate the previously unexplored areas of

(1) trends in the number of deficiencies found in principal-auditor

280 HONG ET AL.

engagements compared to referred-work engagements over multiple

rounds of inspections, (2) the percentage of those engagements with

deficiencies and (3) the percentage of those engagements reviewed

by the PCAOB to name a few. Our study also identifies associations

between audit deficiencies and (1) audit firms' characteristics, (2) affili-

ation with a Big-N global network, (3) multiple rounds of PCAOB

inspections and (4) institutional factors related to the country in which

the audit firm is based. In addition, our results related to the relatively

uninvestigated area of principal-auditor versus referred-work engage-

ments is especially relevant to regulators and practitioners as the

PCAOB has recently indicated an increased focus of its inspection

process on multi-location audits and referred-work engagements

(PCAOB, 2020b).

Finally, this study's findings should be of interest to the PCAOB,

audit firms and their clients and academic researchers in assessing the

extent to which the PCAOB inspection process is serving to improve

international audit quality. As such, they should be informative to the

PCAOB in its continuing efforts to appraise and strengthen their inter-

national inspection model. Our results may also provide valuable

insights to other regulators and policy makers and to audit firms and

their clients regarding trends in the inspection process.

The remainder of this paper is organized as follows. First, we pro-

vide an overview of studies addressing PCAOB inspections of

U.S. and non-U.S. audit firms. Next, we formulate our research ques-

tions and hypotheses and describe the research models and method-

ology. We then report descriptive statistics and the results of our

univariate and multivariate analyses. Finally, we summarize our find-

ings and provide concluding remarks.

2|BACKGROUND, PRIOR LITERATURE,

RESEARCH QUESTIONS AND HYPOTHESES

2.1 |Literature related to PCAOB inspections of

U.S. audit firms

Initial studies of PCAOB inspections focused on inspections of audit

firms in the United States. One such line of research investigated the

effects of PCAOB inspection results on auditor reputation. All audit

firms (U.S and non-U.S.) have incentives to provide high quality audit

services to their clients. A reputation for high-quality audits is invalu-

able in the market for audit services and can enhance a firm's ability

to attract and retain clients and charge competitive or premium fees.

In contrast, an impaired reputation (for poor audit quality) may lead to

client losses, lower audit fees and more difficulty in attracting new cli-

ents. Since Part I and possibly Part II of inspection reports are publicly

disclosed, PCAOB inspection results may have information value

regarding audit quality to the marketplace. Hence, PCAOB inspection

results may have a substantial impact on audit firm reputation

(Bergner et al., 2020, p. 292).

The extent of the reputation impact of PCAOB inspection results

has received considerable debate in the literature, mostly for

U.S. audit firms, with mixed results.

2

Lennox and Pittman (2010)

compared the previous AICPA self-regulatory peer review system

with the PCAOB inspection system and concluded that PCAOB

inspection reports are perceived by audit clients as providing very lim-

ited information value regarding audit quality and therefore have little

effect on auditor reputation. The authors assert that this is primarily

due to the lack of disclosure of quality control defects in the public

portion of PCAOB reports, the absence of an evaluative summary of

the audit firm and the lack of disclosure of the inspectors' sample

sizes.

Abbott et al. (2013) examined auditor switches following PCAOB

inspections and found that clients of triennially inspected (non-Big-N)

audit firms with GAAP deficient PCAOB inspection reports were more

likely to dismiss their auditors than those with clean or GAAS-

deficient inspection reports. This suggests that the severity of inspec-

tion report deficiencies may be an indicator of audit quality and audi-

tor reputation for triennially inspected audit firms. Daugherty

et al. (2011) similarly found that clients of triennially inspected audi-

tors with deficient inspection reports are more likely to switch and

replace their auditors with triennially inspected auditors without defi-

cient inspection reports.

Other studies have focused on the information value of quality

control weaknesses, which are included in Part II of the inspection

report and only made public for firms failing to satisfactorily remediate

their weaknesses within 12 months. Nagy (2014) investigated

changes in market share for audit firms following the public disclosure

of unremediated quality control weaknesses in Part II of their inspec-

tion report. The study found that audit firms lose significant market

share following the public disclosure of this quality control informa-

tion and provides evidence that such disclosures significantly impact

auditor reputation. Johnson et al. (2018) analysed audit fees for annu-

ally inspected audit firms whose Part II disclosures are expected but

yet to be released (i.e., are beyond the 12-month period after Part I

was released). The results indicate that annually inspected firms do

experience lower audit fees and reputation loss during this window

of time.

Another objective of the early studies was to ascertain the fre-

quency of audit deficiencies and quality-control defects identified in

PCAOB inspection reports and associations between deficiencies/

defects and characteristics of the audit firms. The first of these studies

was by Hermanson et al. (2007), who examined inspection reports

issued in 2005 and 2006 for audit firms in the U.S. with 100 or fewer

issuer clients (‘smaller’audit firms). Audit deficiencies were identified

in 189 of the 316 (60%) inspection reports examined. The study also

found that firms with audit deficiencies tend to have significantly

fewer partners and staff and more issuer clients than firms without

deficiencies, suggesting that firms with audit deficiencies might be

over-extended.

Shortly thereafter, Hermanson and Houston (2008) followed up

with a study examining quality control (QC) defects identified in

PCAOB inspection reports issued through mid-2008 for smaller audit

firms in the U.S. When PCAOB inspectors identify a QC defect, the

firm has 12 months after the inspection report's date to remediate the

defect. If the defect is adequately remediated, details about the defect

HONG ET AL.281