The Efficacy of PCAOB Operational Decision Making

The operating budget of the Public Company Accounting Oversight Board (PCAOB) has grown significantly since the regulator’s inception, with the total annual resources consumed by the PCAOB almost doubling—from $127 million to $252 million—between 2006 and 2018 (PCAOB 2007, 2019). However, because all auditors of U.S. public companies have been subject to PCAOB oversight since the initiation of the regulator’s inspection program in 2003-2004, academic research has thus far offered little insight into whether the PCAOB’s budget growth and its related post-implementation operating decisions have improved the reliability of U.S. audits.

In a new study (available here), we attempt to provide that insight by examining the opening of new PCAOB inspection offices in Boston, Charlotte, Detroit, Houston, and Tampa in 2009. These openings coincided with a substantial increase in the PCAOB’s total staff and operational costs (PCAOB 2010) and provide a source of unanticipated variation in U.S. auditor oversight. Together, these characteristics suggest the office openings are an ideal setting for assessing the causes and consequences of the PCAOB’s operational decision making.[1]

A notable feature of the office expansion is that specific locations were chosen by the PCAOB, thereby providing the regulator the opportunity to increase oversight access to certain audit firms.[2] Consistent with this, the PCAOB has acknowledged that it chooses office locations to facilitate inspections of “widely dispersed smaller firms” (PCAOB 2005, p. 10) and to “allow for certain savings in travel” (PCAOB 2013, p. 32). Additionally, a Deputy Director of the PCAOB recently noted that the regulator typically conducts inspections “at the audit firm’s office” and makes inspection assignments based on “geographic location” (Dwyer 2020), further suggesting that the new offices were opened in areas that were close to auditors (and thus audit engagements) for whom the PCAOB intended to increase monitoring.

Although this evidence suggests that the office expansion and greater oversight could have affected audit outcomes where new offices were opened, there are reasons why there may be no such effect. Survey evidence suggests that practitioners doubt the PCAOB’s effectiveness and usefulness in inspecting audit firms (Johnson et al. 2019; Westermann et al. 2019), and empirical evidence in other settings suggests that some of the PCAOB’s post-initiation actions have not improved audit quality (e.g., Lennox 2016). More generally, the PCAOB is charged with overseeing audit firms broadly and not specific audit offices, and thus it is unclear whether proximity to the PCAOB would affect audit outcomes across markets.

We first explore factors associated with the new office markets chosen by the PCAOB. Consistent with the notion that the chosen markets needed more oversight, we find that these markets had relatively lower preexisting audit quality. In addition, the results reveal that the PCAOB opened offices in larger markets and in markets with higher concentrations of audit clients within the same industry, suggesting that the PCAOB selected markets with more potential audit engagements to inspect and markets where inspectors’ specialized industry knowledge could be effectively leveraged. Finally, we find that the PCAOB was less likely to choose markets near an existing PCAOB regional office and markets that housed an existing SEC regional office. These results suggest that the PCAOB wanted to expand its geographical presence and provide some evidence that the PCAOB and SEC can be substitutes for each other in regulating public company auditors. Together, these findings suggest that the PCAOB selected markets to maximize the operational value realized from the resources committed to the expansion.

We then examine whether the PCAOB’s office expansion influenced audit outcomes. We first focus on the quality of audits provided, as the primary mission of the PCAOB is to “protect investors and further the public interest in the preparation of informative, accurate, and independent audit reports” (PCAOB 2019, p. 2). Our results indicate that financial statement misstatements significantly declined following the PCAOB’s expansion in the affected markets relative to audits in the unaffected markets. This suggests that the PCAOB intensified its oversight of auditors in the markets affected by the expansion and thus pressured those auditors to increase audit effort and reduce the likelihood of audit failures. However, we fail to find any evidence of changes in audit pricing following the office openings, suggesting that any costs imposed on auditors affected by the PCAOB’s expansion did not appear to be  directly passed on to companies (and thus shareholders) through increased audit fees. Although we find no evidence of  changes in audit pricing, we do document a significantly greater increase in auditor turnover following the office openings in the affected markets relative to the unaffected markets, suggesting that some clients in the affected markets preferred to avoid the additional scrutiny from the PCAOB’s expansion.

Our findings provide insights into the efficacy of the PCAOB’s operational decision making. We provide evidence suggesting that the PCAOB considered prudent factors—most notably market-level audit quality—when choosing where to focus its oversight efforts, consistent with the regulator’s exercising careful stewardship of its resources and “implementing relevant, timely, and innovative solutions to achieve [its] mission” (PCAOB 2019, p. 2). Our results also provide evidence that the PCAOB’s additional investment in audit oversight has improved audit quality without imposing an observable direct cost on companies and their shareholders.

Our study is timely given PCAOB Chairman William Duhnke III’s recent statement that “this is the right time to review [the PCAOB’s] progress and identify what we are doing well and what we can do better” (PCAOB 2018; Ryan 2018) and directly responds to the PCAOB’s recent request for feedback from auditors, financial statement users and preparers, directors, and academics (Ryan 2018). Although we cannot assess the efficacy of all PCAOB operational expenditures, the 2009 office openings required a significant and continued commitment of resources, and our findings suggest that the expansion has improved audit quality and that the increased investment has therefore been effective in helping the PCAOB carry out its mission.

ENDNOTES

[1] The PCAOB’s 2009 annual report provides evidence of the magnitude of the investment in new offices. Specifically, it shows that the total number of staff members increased by 17.9 percent year-over-year (compared with only 1 to 3 percent growth in 2007 and 2008), and that total operating costs increased by 11.3 percent year-over-year (compared with 2 to 3 percent growth in 2007 and 2008) (PCAOB 2010).

[2] Since its inception, the PCAOB has operated seven regional offices (Atlanta, Chicago, Dallas, Denver, Irvine (CA), New York City, and San Francisco) in addition to its headquarters in Washington, D.C. The 2009 office expansion was the first and largest expansion.

REFERENCES

Dwyer, E. 2020. Audit committee perspectives on audit quality and assessment: A PCAOB report. Harvard Law School Forum on Corporate Governance, January 30.

Johnson, L. M., M. B. Keune, and J. Winchel. 2019. U.S. auditors’ perceptions of the PCAOB inspection process: A behavioral examination. Contemporary Accounting Research 36 (3): 1540–1574.

Lennox, C. S. 2016. Did the PCAOB’s restrictions on auditors’ tax services improve audit quality? The Accounting Review 91 (5): 1493-1512.

Public Company Accounting Oversight Board (PCAOB). 2005. 2004 Annual Report. Washington, DC: PCAOB.

Public Company Accounting Oversight Board (PCAOB). 2007. 2006 Annual Report. Washington, DC: PCAOB.

Public Company Accounting Oversight Board (PCAOB). 2010. 2009 Annual Report. Washington, DC: PCAOB.

Public Company Accounting Oversight Board (PCAOB). 2013. 2012 Annual Report. Washington, DC: PCAOB.

Public Company Accounting Oversight Board (PCAOB). 2018. PCAOB Seeks Input into its 2018-2022 Strategic Planning Through a Public Survey (April 17). Washington, DC: PCAOB.

Public Company Accounting Oversight Board (PCAOB). 2019. 2018 Annual Report. Washington, DC: PCAOB.

Ryan, V. 2018. PCAOB questions its own relevance. CFO, April 25.

Westermann, K. D., J. Cohen, and G. Trompeter. 2019. PCAOB inspections: Public accounting firms on “trial.” Contemporary Accounting Research 36 (2): 694–731.

This post comes to us from James J. Blann, a doctoral candidate in accounting at the University of Arkansas; Tyler J. Kleppe, an assistant professor of accounting at the University of Kentucky; and Jonathan E. Shipman, an associate professor of accounting at the University of Arkansas. It is based on their recent article, “The Efficacy of PCAOB Operational Decision Making,” available here.

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