The Revolving Door between the PCAOB and Large Audit Firms

In a recent study, we examine the flow of workers between the Public Company Accounting Oversight Board (PCAOB) and large U.S. audit firms. The PCAOB, created by the Sarbanes-Oxley Act of 2002, oversees the audits of public companies by, among other things, performing external inspections of firms that audit those companies. Recent studies have found that these inspections deliver important signals to the market for audit services.  In particular, the number of deficiencies identified in the firm’s PCAOB inspection report can harm an audit firm’s ability to retain and attract new clients (Nagy, 2014; Aobdia and Shroff, 2017).

The link between an audit firm’s inspection report and its market share for audit services provides strong motivation for firms to increase their audit quality. However, it also raises concerns that firms may use inappropriate means to reduce the number of audit deficiencies. Although such behavior can take many different forms, a particular concern raised by industry experts is the lack of independence caused by worker flows between the PCAOB and regulated audit firms (e.g., McKenna, 2011). These concerns have increased following the Department of Justice and the Security and Exchange Commission’s decision in January 2018 to bring charges against multiple former KPMG employees. Referencing this case, Lynn Turner, former SEC chief accountant, noted that “[w]e have a serious problem with the revolving door between the audit firms and the regulators who are supposed to be keeping the firms on the straight and narrow path…The people involved in [the KPMG] case are people who worked at a Big Four audit firm, went to work for the regulator, then left the regulator and went back to the firm, they illegally obtained information from the regulator that they then used inside the audit firm (Mokhiber, 2018).” Motivated by these concerns, our study seeks to provide basic facts on worker flows between the PCAOB and U.S. audit firms. We also seek to understand better the relation between these worker flows and an audit firm’s future inspection reports.

Using a large sample of publicly available curricula vitae, we document a steady increase over time in the number of PCAOB employees that accept senior-level positions in the 11 audit firms that are annually inspected by the PCAOB (“Big 11”).[1] We then examine the determinants of these hiring decisions, finding that the number of PCAOB employees hired by a Big 11 firm into senior-level positions is positively related to the number of engagement-level deficiencies identified in the firm’s most recent inspection report. The economic magnitude of our analysis suggests that moving from the mean of 9.2 deficiencies to one standard deviation above the mean number of deficiencies (i.e., 9.2 deficiencies + 7.0 deficiencies = 16.2 deficiencies) is associated with a Big 11 firm hiring 1.12 additional PCAOB employees over the subsequent 18-month period. This increase is substantial when considering that the unconditional mean number of PCAOB employees hired into senior-level positions in a Big 11 firm over a similar period is only 1.23 per firm-year.

We then highlight two potential mechanisms through which former PCAOB personnel may enable audit firms to improve results of future inspections. First, former employees could use their detailed knowledge of the PCAOB inspection process to alter the firm’s audit processes such that they align better with PCAOB standards.  We refer to this mechanism as the “human capital hypothesis.” Second, and as alleged in the case against former KPMG personnel, former employees could obtain confidential PCAOB information for the purpose of directing their new employer to focus on the specific engagements scheduled for inspection.  We refer to this mechanism as the “inside information hypothesis.” Although these two mechanisms are not mutually exclusive, the latter hypothesis is more likely to be associated with a large, immediate improvement in audit processes, because it bypasses the challenges inherent to organizational learning.

Consistent with former PCAOB employees successfully assisting audit firms in their effort to improve future inspections, we find a negative relation between the number of former PCAOB employees that a firm hires and the number of deficiencies reported in its future inspection reports. However, the reduction is not present for the year in which these employees join the firm, but rather during the subsequent period when the former employees would have been less likely to have personally accessed private information related to the firm’s upcoming inspections. Although this finding is more consistent with the human capital hypothesis, it does not preclude the possibility that the future reductions in deficiencies arise in part from the former PCAOB employees obtaining confidential information about future inspections from former colleagues at the PCAOB.  To the extent former employees use inside information, our findings suggest that the PCAOB’s recent actions to reinforce their safeguards against the improper disclosure of confidential information are warranted to ensure that investors’ reliance on these reports is merited. However, to the extent former PCAOB employees don’t use inside information, this finding provides empirical evidence that revolving doors can lead to improved regulatory compliance.

Our finding that the hiring of PCAOB personnel is associated with improvements in audit firms’ future inspection reports raises the question as to whether the hiring of PCAOB personnel also reduces other firm-wide measures of audit failure. However, we find no evidence of any association between the number of former PCAOB employees that a firm hires and the number of future restatements or SEC enforcement actions.  Our findings suggest that PCAOB personnel bring valuable knowledge about how to perform and document audits that satisfy PCAOB reviewers, but that this expertise does not necessarily have direct implications for the accuracy and reliability of clients’ financial reports.


[1] The PCAOB generally performs inspections on a triennial basis. However, audit firms with more than one hundred issuers receive an annual inspection.

This post comes to us from professors Bradley E. Hendricks and Wayne R. Landsman at the University of North Carolina at Chapel Hill’s Kenan-Flagler Business School, and from F. Dimas Peña-Romera, a PhD candidate at the school. It is based on their recent paper, “The Revolving Door between the PCAOB and Large Audit Firms,” available here.

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