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Abstract

This note reports the results of a study conducted regarding PCAOB inspections of triennial CPA firms. The purpose was to see if there was any evidence that inspections contributed to improved audit quality. It was found that small firms did not correct staffing deficiencies, which were related to previous audit deficiencies determined by the PCAOB. However, deficient firms did increase their audit fees significantly more following their first inspections than non-deficient firms. This result is consistent with applying greater audit effort after the inspection. Interestingly, this response does not persist through second inspections.
Research Report
A note on the effect of PCAOB inspections on the audit quality
of triennial CPA firms
Alan I. Blankley *, Keejae P. Hong, David Kerr,Casper E. Wiggins
Department of Accounting, Belk College of Business, University of North Carolina at Charlotte, Charlotte, NC 28223, USA
ARTICLE INFO
Article history:
Available online 26 September 2014
Keywords:
PCAOB inspections
Audit quality
Triennial firms
Audit fees
ABSTRACT
This note reports the results of a study conducted regarding PCAOB inspections of trien-
nial CPA firms. The purpose was to see if there was any evidence that inspections contributed
to improved audit quality. It was found that small firms did not correct staffing deficien-
cies, which were related to previous audit deficiencies determined by the PCAOB. However,
deficient firms did increase their audit fees significantly more following their first inspec-
tions than non-deficient firms. This result is consistent with applying greater audit effort
after the inspection.
Interestingly, this response does not persist through second inspections.
© 2014 Elsevier Ltd. All rights reserved.
Introduction
Early studies examining the results of Public Company
Accounting Oversight Board (PCAOB) inspections of small
public accounting firms indicated that a major character-
istic of firms that received an audit deficiency judgment was
that they were over-extended.1By and large, these small
firms had too many issuer clients – too much work – for
the size of their staffs. After studying inspection results
through July 2006, Hermanson, Houston, and Rice (2007)
concluded that firms that had performed audits where the
PCAOB had identified deficiencies in their engagements
tended to be smaller, had more issuer clients, and were
growing more rapidly than non-deficient firms.
If it is true that the size of the staff, the number of issuer
clients, and the likelihood of being found deficient are
related, then it seems reasonable to suppose that correc-
tive action to reduce the number of issuer clients, or increase
the number of staff, or both, would help improve the quality
of these firms’ audits by relieving a constraint on the number
of audit hours available for issuer client engagements. Such
action would be consistent with the notion that the inspec-
tion was instrumental in helping to improve the audit quality
of triennial firms. Of course, relative staff imbalances could
also be improved through redirecting effort from non-
issuer clients to issuer clients, or by increasing the total hours
worked on issuer engagements as well. This redirected effort
would likely be reflected in increased fees for issuer clients;
it would also be consistent with an improvement in audit
quality following the inspection.
To determine whether PCAOB inspections helped to
improve audit quality of small accounting firms, the in-
spection reports for 947 triennial firm-years between January
2004 and June 2012 were examined. The study first inves-
tigated whether the structural problems identified by
Hermanson et al. (2007) continued to be an issue after 2006.
The study then examined whether deficient firms im-
proved their staffing relative to the number of issuer clients
after their inspections, and finally examined audit fee
Note: The authors express their appreciation for the assistance of Dr.
Gregory Jonas, Associate Professor, Case Western Reserve University, and
assistant editor of Research in Accounting Regulation, for his assistance.
* Corresponding author. Tel.: +704 687 7707; fax: 704-687-6938.
E-mail address: aiblankl@uncc.edu (A.I. Blankley).
1For convenience, firms that received an audit engagement deficiency
judgment from the PCAOB during an inspection will be referred to as “de-
ficient” firms, and those for whom the PCAOB did not identify any audit
engagement deficiency as “non-deficient” firms. This use of the term should
not be interpreted to mean the firm is deficient (or not) in any other sense.
http://dx.doi.org/10.1016/j.racreg.2014.09.004
1052-0457/© 2014 Elsevier Ltd. All rights reserved.
Research in Accounting Regulation 26 (2014) 212–216
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Research in Accounting Regulation
journal homepage: www.elsevier.com/locate/racreg
changes for both deficient and non-deficient firms after their
first two inspections.
The results indicated that firms cited for having an audit
engagement deficiency during their first PCAOB inspec-
tion had significantly fewer total staff relative to issuer clients
than non-deficient firms. Moreover, deficient firms did not
improve their relative staffing issues following the inspec-
tion. What they did appear to do was to redirect effort. It
was found that deficient firms increased audit fees follow-
ing their first inspection visits significantly more than non-
deficient firms. Interestingly, the same increase was not
found in audit fees for deficient firms following the second
inspection visit. It can be concluded that these results are
consistent with PCAOB inspections helping to improve the
audit quality of small accounting firms, but that the great-
est marginal improvement in audit quality occurred during
the initial inspection, as the audit review paradigm was
changing. By the time of the second inspection, many –
perhaps most – firms had already changed their processes
to the point that any additional changes resulting from sub-
sequent inspections were not substantial enough to be
observed in empirical tests of audit fees.
The rest of this note is organized as follows: firstly, a dis-
cussion of the rationale for the study; secondly, more
information on the empirical tests and their results, and
finally a conclusion discussing how these results can be of
use to regulators or practitioners.
Rationale for the study
One of the principal objectives of the Sarbanes–Oxley Act
of 2002 was to improve audit quality. Indeed, when the law
established the PCAOB, it charged the new agency with the
task of improving the quality of audits. Since its inspec-
tion process is arguably the Board’s primary means of
achieving that objective, it is important to evaluate whether
PCAOB inspections are, in fact, helping to improve audit
quality. This is especially true for small firms. Previous re-
search into audit quality has shown, across various measures
of audit quality, that small firms are associated with lower
quality audits compared to large firms (see, for example,
DeAngelo, 1981; Francis, 2004; Francis & Krishnan, 1999;
Jackson & Liu, 2010; Palmrose, 1988; Simunic, 1980). Re-
cently, Gunny and Zhang (2013) examined PCAOB inspection
reports and found that for smaller firms, PCAOB inspec-
tions were effective in identifying lower-quality audits.2Of
course, identifying audit engagement deficiencies and pro-
viding feedback during and after the inspection would be
likely to help promote audit quality improvements, as the
PCAOB suggests (PCAOB, 2012). Intuitively, this claim is
appealing. But is there any empirical evidence that the
audit quality of small firms actually improves after the
inspection?
Audit quality is a difficult concept to measure. In this
study, two measures were used, both related to audit effort.
Hermanson et al.’s (2007) paper indicates that deficient firms
were over-extended, so measures of relative staffing per
issuer client were evaluated to see whether firms brought
their staffing more in line with the needs of their issuer client
base after an inspection. The logic here is that if the firm
did not have adequate staffing to provide the audit effort
required to perform a quality audit for its issuer client base,
then increasing the available audit effort is a necessary, but
not a sufficient, condition to improve audit quality. Thus,
improved staffing metrics following an inspection would be
consistent with a tangible effort to improve audit quality.
The second measure of audit quality used is audit fees.
Previous research supports the use of audit fees as a proxy
for audit quality. O’Keefe, Simunic, and Stein (1994) initial-
ly developed a theoretical model linking audit quality (the
level of assurance) with audit effort (the levels of labor
hours). Knechel, Rouse, and Schelleman’s (2009) audit pro-
duction model assumes that the more extensive the
evidence-gathering activities are, the higher the audit quality
will be, suggesting that as audit effort increases, the quality
of the audit increases as well. Effort and quality have also
been linked empirically. Bedard and Johnstone (2004) show
that auditors plan more hours for clients with higher per-
ceived risk of earnings management. Similarly, Lee and Son
(2009) find that auditors who lengthened their audit work
permitted less earnings management, and Caramanis and
Lennox (2008) report a negative association between audit
effort and abnormal accruals. Prior research also links audit
fees and audit effort. Whisenant, Sankaragurusuvamy, and
Raghunandan (2003), Blankley, Hurtt, and MacGregor (2012),
Lobo and Zhao (2013), and Asthana and Boone (2012) all
indicate that below-normal audit fees may be associated
with shorter, lower quality audits. Thus, if deficient firms
increase fees to a greater extent than non-deficient firms
following an inspection, then that would be evidence sug-
gesting the firm is increasing audit effort, and would be
consistent with an attempt to increase audit quality.
The study
The study had three empirical tests. First, the audit firm
staffing characteristics were evaluated to determine whether
staffing was, in fact, associated with audit engagement de-
ficiencies over the test period (2004–2012). Second, it was
determined whether the deficient firms increased their rel-
ative staffing in an attempt to alleviate the constraints that
existed. Finally, it was determined whether deficient firms
increased audit fees following inspections more than non-
deficient firms. A discussion on the sources of the study’s
data can be found below.
Data sources
The data includes information gathered from 1399 first
and second PCAOB inspection reports on inspections con-
ducted between January 2004 and June 2012 for triennial
CPA firms. All inspection reports are publicly available from
the PCAOB website. Inspection reports for firms that do not
appear in Audit Analytics and those pertaining to third in-
spection visits were excluded. The resulting data set included
947 inspection reports of domestic small firms, of which 578
2It is interesting to note that Gunny and Zhang (2013) do not find the
same effectiveness for annually inspected firms. For that group, their results
were conflicting and they conclude that the PCAOB inspections did not dis-
tinguish audit quality during their test period.
213A.I. Blankley et al./Research in Accounting Regulation 26 (2014) 212–216
represented first inspection visits and 369 represented
second inspection visits.
Client data used in the analysis of audit fees were col-
lected from Audit Analytics and matched with the CPA firm
data from the inspection reports. Client-year observations
used in the audit fee analysis ranged from 3536 for first in-
spections to 2517 for second inspections.
Staffing characteristics
The first test considered which firm characteristics were
associated with audit engagement deficiencies. Table 1 pro-
vides the mean and median staffing and client data taken
from the inspection reports.
From Table 1, observe that deficient firms have, on
average, 42 professional staff members and 13 issuer clients,
while non-deficient firms have 67 staff members and only
8 issuer clients. When the relative relationship between total
staff (including partners) and clients is considered, defi-
cient firms have, on average, only 8 total professionals (staff
plus partners) per issuer client while non-deficient firms
have closer to 17 total professionals per issuer client. These
differences are statistically significant and indicate that over
the 2004–2012 period, deficient firms were understaffed rel-
ative to non-deficient firms, and this understaffing is
significantly associated with the audit engagement defi-
ciency. Additionally, a logistic regression model was run,
which included additional variables to control for year and
other characteristics of the inspection. Results (untabulated)
confirmed that these relative staffing differences are sig-
nificantly related to being found deficient in the firm’s initial
PCAOB inspection.
Changes in relative staffing
Considering that deficient firms have fewer staff per client
in the firm’s initial inspection, then it seems reasonable to
suppose that the relatively poorer staffing constrains the
quantity of audit hours or effort available to each issuer
client. One way this constraint could be alleviated would
be to increase the relative staffing directly by hiring addi-
tional staff or reducing the number of issuer clients. Changes
the firm might make to alleviate the constraint on audit
effort would be consistent with a tangible effort to improve
audit quality. However, when changes in relative staffing
after the first inspection were examined, it was found there
were no statistical differences between the increase in staff-
ing per client for deficient firms and non-deficient firms. In
fact, non-deficient firms appeared to increase staffing per
client slightly more than deficient firms did in the period
between the first PCAOB inspection and the second inspec-
tion. An OLS regression model was also developed and tested
where the change in partners plus staff per issuer client was
regressed against a dummy variable for an audit engage-
ment deficiency from the first inspection along with size
and year controls. Results from that test confirmed that
having a deficiency was not related to changes in relative
staffing. In other words, no evidence could be found that
deficient firms attempted to increase audit effort through
changes in relative staffing as a result of the PCAOB
inspection.
Changes in audit fees
The final test examined changes in audit fees following
PCAOB inspections. Firms could redirect audit effort toward
issuer clients by working more hours, resigning from en-
gagements with non-public clients, reducing time spent on
non-public clients, or some combination of the three. In this
case, audit fees are expected to increase as the firm redi-
rected effort toward its issuer clients. To examine what the
impact of the PCAOB inspection was on subsequent audit
fees, a standard audit fee OLS regression model was used,
where the change in audit fees was measured in two ways,
from the year before the inspection to the year of the in-
spection, and alternatively, from the year before the
inspection to the year after the inspection. This depen-
dent variable was then regressed on two variables of interest
and a number of control variables. The two variables of in-
terest were audit deficiency variables for the first and second
PCAOB inspections. Each variable was codeda1ifthefirm
was found to have at least one audit engagement deficien-
cy and zero otherwise during the inspection. Other variables
in the model controlled for client size, auditor tenure, fiscal
year end, the complexity of client operations, various audit
risks, and year fixed-effects.
Results of the test indicated that firms cited for audit en-
gagement deficiencies during their first inspection increased
their fees to a significantly greater extent than non-deficient
firms. This was true whether the change in fees was cal-
culated from the year before the inspection to the inspection
year or the year after, although the result was stronger when
the change in fees was measured from the year before to
the year after the inspection. This result is consistent with
deficient firms expending additional effort in order to
remediate the noted audit deficiencies, which presumably
would improve the quality of subsequent audits.
To the extent that the additional effort reflects more thor-
ough audits, rather than simply busy work undertaken
Table 1
Descriptive statistics for initial PCAOB inspections: CPA firm characteristics by audit deficiency.
Firms with audit deficiencies
(n =342)
Firms with no audit deficiencies
(n =236)
Is there a statistically
significant difference?
CPA firm characteristics Mean (Median) Mean (Median)
Number of staff 42.23 (11.0) 67.18 (23.5) Yes
Number of issuer clients 13.09 (5.0) 8.14 (3.0) Yes
Staff per issuer client 6.31 (2.0) 13.51 (6.3) Yes
Partners and staff per issuer client 8.19 (2.7) 16.67 (8.7) Yes
214 A.I. Blankley et al./Research in Accounting Regulation 26 (2014) 212–216
merely to satisfy the regulator, then this result is consis-
tent with an increase in audit quality.
Interestingly, this result did not hold when the change
in audit fees following the second inspection visit was
examined.3The coefficient on the variable of interest (the
dummy variable representing audit deficiency during the
second inspection) was not statistically significant, sug-
gesting that CPA firms receiving an audit deficiency report
at the conclusion of their 2nd PCAOB inspection did not sub-
sequently change their audit fees (i.e., audit effort) to a
greater extent than firms whose 2nd inspection report did
not reveal an audit deficiency. The result was the same re-
gardless of whether the change was calculated from the year
before to the inspection year, or to the year after. This result
may be because subsequent increases in effort were not cap-
tured in fee increases due to pricing constraints in 2008 and
beyond, or it might indicate that audit deficiencies in the
second round of inspections were not as easily remedied
by additional audit effort, or that audit effort increased, but
that the increases were not robust enough to reach a thresh-
old of statistical significance.
Discussion
The results of this study are best described as “mixed.”
There is clear evidence that staffing/client imbalances are
associated with lower quality audits, as determined by the
PCAOB. It was also found that most CPA firms appear to
respond to deficiencies identified by PCAOB inspections by
increasing the extent of work performed by the firm’s
current professional employees but not by hiring addition-
al employees. The cost of this increase in workload is passed
on to clients in the form of higher audit fees. These actions
appear to be sufficient in remediating audit deficiencies, as
the number of CPA firms with 2nd-round deficiencies is
much less than 1st-round deficiencies. Thus, the PCAOB’s
stated objective of improving the quality of audits and the
reliability of financial information appears to be succeeding.4
Firms with deficiencies identified in their 2nd round of in-
spections appear to be able to resolve those deficiencies
more efficiently than deficiencies identified in the 1st round,
as no association was found between 2nd-round deficien-
cies and a subsequent increase in audit fees.
One limitation of the study is that staffing data for the
firms is only available in total whereas fees and number of
clients are only available for listed clients. The results could
be biased to the extent that these firms have a large portion
of their business with non-listed clients or to the extent
growth rates are substantially different between the non-
listed client business versus listed client business. However,
the study’s creators believe that any such bias would not
affect the findings. Furthermore, the findings regarding the
association between audit fees and audit engagement de-
ficiencies would not be affected.
Practical applications of the research findings
Both practitioners and inspection teams need to be sen-
sitive to the staffing sufficiency issue reported by this study.
For practitioners, partners need to recognize that the clear-
est indicator of a substandard audit from the PCAOB’s
previous inspection is the staff-to-client sufficiency level.
It may be that the firm simply needs to hire additional staff
to improve the quality of the firm’s audits or to prepare for
an inspection visit. The firm also might redirect staff from
non-issuer clients to issuer clients. If neither alternative is
feasible, then the firm may need to think about whether they
have the resources necessary to conduct public firm audits
or to take on additional clients, and should consider whether
or not to reduce the number of its issuer clients.
Given the PCAOB’s ”risk-based” approach to conduct-
ing inspections, inspection teams should take into
consideration staff-to-client ratios as well when determin-
ing the appropriate scope of work to be performed in
conducting inspections. In addition, teams should consid-
er how those ratios have changed or improved since the
previous inspection. If the partner(s) have shown no incli-
nation to address the issue, and the quality of the audits is
consistently deficient, then the team may need to discuss
whether or not the firm has the manpower to conduct issuer
client audits. However, as the study indicates, a substan-
tial increase in fees subsequent to the previous inspection
may indicate that the firm has redirected its audit effort to
improving the quality of those audits, so it is recommend
that inspection teams review audit fee behavior after the
firm’s previous inspection and compare it with fee behav-
ior from similar firms following their inspections.
Finally, the results suggest some caution may be in order
for both regulators and practitioners, but particularly for
regulators. The fact that far fewer firms were considered de-
ficient in their second inspections than in their first
inspections suggests that audit quality improved after the
initial inspections. However, the fact that an increase in fees
following the second inspections is not observed suggests
that marginal improvements in audit quality may be more
difficult (and costly) to achieve as audit firms have already
made improvements large enough to be observable in audit
fees. It may be that the low-hanging fruit for improving audit
quality has already been realized, and subsequent regula-
tions may increase costs without corresponding benefits.
For this reason, regulators need to be careful to weigh the
benefit of new regulations carefully against the cost of
compliance.
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... Several studies provide a summary of the most prominent examples of the criticisms included in (PCAOB)'s inspection reports of a number of small-size audit firms as reported by (e.g. Blankley et al., 2014a, Blankley et al., 2014b, Newman & Oliverio, 2010 as follows. Element Quality control system Deficiency Professional competence, professional care, and professional doubt  The failure of the internal control system to perform the necessary procedures to ensure professional efficiency, due care and professional skepticism by the auditor;  Audit procedures related to obtaining certain confirmations included in the inquiries of the management that have no evidence;  Lack of essential deficiencies in the tests of revenue recognition;  The failure of audit team to conduct the necessary tests to obtain sufficient evidence of the possibility of material misstatements in the financial statements, as in accordance with the requirements of the AU 316 "Consideration of Fraud in the Financial Audit Statement audit";  ...
... Third: Since the process of inspection is conducted periodically (annually or every three years), this represents a mechanism to oversee firms and provide them incentives to improve their performance in preparation for the next inspection. Blankley et al., (2014a) tested the relationship between the compliance of small audit firms to the (PCAOB) inspection and the quality of the audit process, which was measured by audit fees and 'staffing structure', i.e. ratio of audit staff to clients. Blankley et al., (2014a) find that fees increased significantly after the first round of inspection, which supports the positive effect of the inspection process on the quality of the performance of the audit firm and that the high fees audit is directly linked to the efforts of the auditor and by turn related to the quality of the audit process. ...
... Blankley et al., (2014a) tested the relationship between the compliance of small audit firms to the (PCAOB) inspection and the quality of the audit process, which was measured by audit fees and 'staffing structure', i.e. ratio of audit staff to clients. Blankley et al., (2014a) find that fees increased significantly after the first round of inspection, which supports the positive effect of the inspection process on the quality of the performance of the audit firm and that the high fees audit is directly linked to the efforts of the auditor and by turn related to the quality of the audit process. However, staffing structure disparities are related to lower quality audits following the inspection. ...
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