1 Does the Organization and Culture of the Largest Audit Firms Influence their Audit Quality and Efficiency? Daniel Aobdia Kellogg School of Management, Northwestern University [email protected]This version: December 2016 This research paper was prepared while the author was a Senior Economic Research Fellow at the PCAOB. The PCAOB, as a matter of policy disclaims responsibility for any private publication or statement by any of its Economic Research Fellows and employees. The views expressed in this paper are the views of the author and do not necessarily reflect the views of the Board, individual Board members, or staff of the PCAOB. I would like to thank David Aboody, Preeti Choudhary, Michael Gurbutt, Robert Knechel (discussant), Patricia Ledesma, Robert Magee, Robert Pawlewicz (discussant), Luigi Zingales, PCAOB staff and seminar participants at the 2016 Duke/UNC Fall Camp, the 2016 George Mason Conference on Investor Protection, Corporate Governance, and Fraud Prevention, National Taiwan University, UCLA, the 22 nd University of Illinois Symposium on Auditing Research, and the PCAOB for helpful discussions on earlier versions of this work. I acknowledge generous financial support from the Kellogg School of Management and in particular the Lawrence Revsine Fellowship.
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1
Does the Organization and Culture of the Largest Audit Firms
Influence their Audit Quality and Efficiency?
Daniel Aobdia
Kellogg School of Management, Northwestern University
This research paper was prepared while the author was a Senior Economic Research Fellow at the PCAOB. The
PCAOB, as a matter of policy disclaims responsibility for any private publication or statement by any of its
Economic Research Fellows and employees. The views expressed in this paper are the views of the author and do
not necessarily reflect the views of the Board, individual Board members, or staff of the PCAOB. I would like to
thank David Aboody, Preeti Choudhary, Michael Gurbutt, Robert Knechel (discussant), Patricia Ledesma, Robert
Magee, Robert Pawlewicz (discussant), Luigi Zingales, PCAOB staff and seminar participants at the 2016
Duke/UNC Fall Camp, the 2016 George Mason Conference on Investor Protection, Corporate Governance, and
Fraud Prevention, National Taiwan University, UCLA, the 22nd
University of Illinois Symposium on Auditing
Research, and the PCAOB for helpful discussions on earlier versions of this work. I acknowledge generous financial
support from the Kellogg School of Management and in particular the Lawrence Revsine Fellowship.
2
Does the Organization and Culture of the Largest Audit Firms
Influence their Audit Quality and Efficiency?
Abstract
This study investigates the association between the largest audit firms’ internal organization and
audit quality and efficiency. Using a unique dataset of firm-wide deficiencies in the quality
control (QC) systems identified by the PCAOB during its inspections of audit firms, I find a
negative association between firm-level QC deficiencies and audit quality. Furthermore, audits
conducted by audit firms with more organization-level deficiencies appear less efficient, as
evidenced by more hours worked on the engagements, despite audit fees remaining unchanged
and audit quality being worse. These results appear to be partly driven by deficiencies in the tone
at the top (a proxy for culture) and the audit methodology. In contrast, audit firms with more
deficiencies of a practical nature (audit performance issues) do not appear to spend enough effort
on their audit, consistent with a “shirking” hypothesis. Overall, these results suggest that while
both practical-level and organization-level deficiencies negatively influence audit quality, their
root causes are different.
Keywords: Audit Quality, Audit Efficiency, Quality Control Systems, PCAOB Inspections,
Culture, Audit Methodology, Impact of Regulation.
JEL Classification: M42, M48, M14, L51.
3
1. Introduction
The purpose of this study is to determine empirically the role of an audit firm’s organization
and culture for its audit quality and efficiency, by specifically focusing on a firm’s quality
control (QC) systems. Even though this question is of interest to academics and regulators, little
is empirically known about the influence of these systems, mainly due to the unavailability of
public data.1 For example, Francis (2011, p138), indicates that “research on the relation between
accounting firms and audit quality is severely limited by the availability of data on
characteristics of accounting firms. To date, research on this topic has relied on variables that
can be constructed from public disclosures such as client-based measures of industry expertise
or office size. However, these measures do not go inside the “black-box” of the accounting
firm’s organizational structure and operations.” DeFond and Zhang (2014, p304) further
confirm that “we currently know little about basic characteristics of audit firms such as their
choice of ownership structure, governance systems, audit quality control systems, compensation
schemes, or audit technology.” This study uses a unique dataset of QC deficiencies identified by
the Public Company Accounting Oversight Board (PCAOB) in its annual inspections of the eight
largest audit firms to answer this question.
The analytical accounting literature highlights the importance of an audit firm’s QC systems
as a mechanism designed to align individual incentives of the partners with the overall incentives
of the firm. While the auditing literature often treats an audit firm as a single person “auditor”,
and relies on the notion of reputation and litigation to incentivize firms to conduct high quality
audits (e.g., DeAngelo 1981, Dye 1993), in practice, partners make decentralized decisions in
performing various tasks (e.g., Liu and Simunic 2005). Every partner is simultaneously an owner
1 Academic researchers have instead used experimental and survey settings to try to answer the question (e.g.,
Bedard et al. 2008, Jenkins et al. 2008).
4
and an agent of the partnership (e.g., Huddart and Liang 2003), and has incentives to shirk when
effort is unobservable (e.g., Holmstrom 1982). While the literature shows that mutual monitoring
and peer pressure can reduce this moral hazard (e.g., Balachandran and Ramakrishnan 1987,
Kandel and Lazear 1992), in practice these are likely to be effective only when the size of the
partnership is small (e.g., Huddart and Liang 2003). Under these conditions, Huddart and Liang
(2005) show that in larger partnerships the specialization of a small number of partners in
monitoring and supervision tasks, while the other ones produce the output, lessens shirking in
both monitoring and production tasks. Thus, the implementation of this specialized monitoring
and supervision in the form of a firm’s QC system is essential to increase audit effort and quality.
The economics literature also proposes a similar role for organizational culture: In the absence of
proper ex-ante incentives to regulate individual employee behavior, culture is valuable as a
safeguard to prevent employees from making decisions with a short-term benefit but that are
very detrimental in the long-run in light of the overall incentives of the firm (O’Reilly 1989,
Kreps 1990, Guiso et al. 2015b). These theories are supported by anecdotal evidence at Arthur
Andersen, whereby a culture shift in the organization combined with poor QC systems
contributed to several failed audits, including Boston Chicken, Waste Management, and Enron
(Brown and Dugan 2002, Eichenwald and Norris 2002, Richard and Thurm 2002, Toffler and
Reingold 2003, Wyatt 2004, Gendron and Spira 2009). Furthermore, survey evidence suggests a
link between culture or QC systems, and auditors engaging into low quality behavior (Otley and
Pierce 1996, Malone and Roberts 1996).
Based on this theoretical background, I ask the following questions to assess the relevance of
the audit firms’ QC systems: Are deficiencies in the audit firms’ QC systems associated with
lower audit quality? If so, how does this impact audit efficiency and profitability? Are
5
deficiencies of a more practical nature (audit performance) different from more fundamental,
organization-level deficiencies? Are clients more likely to switch auditors when an audit firm has
more deficiencies in its QC systems? And what is the specific role of an audit firm’s culture and
audit methodology vis-à-vis other types of QC deficiencies?2 The answers to these questions
provide new insights into the role of QC systems, culture and audit methodology for audit quality
and efficiency. Further, they highlight the regulatory role of the PCAOB in detecting these QC
deficiencies, which are not initially publicly reported and will remain nonpublic only if the audit
firm addresses the criticism to the Board's satisfaction no later than 12 months from the date of
the audit firm’s inspection report.
I use a unique dataset of QC deficiencies, built from the nonpublic versions of the PCAOB
inspection reports to answer these questions. The PCAOB is a non-profit organization
established by the Sarbanes-Oxley Act of 2002 (SOX) to oversee the audits of public companies
(referred to as issuers or client issuers in the remainder of this paper) and improve audit quality.
In particular, the PCAOB conducts inspections of public accounting firms that audit issuers.
These inspections are annual for firms that regularly provide audit reports for more than 100
issuers, and at least triennial otherwise (Section 104 of SOX). For annually inspected firms, the
PCAOB inspections mainly focus on two elements: A review of individual audit engagements,
and a review of the firm’s QC systems (e.g., PCAOB 2015).3 The review of the firm’s QC
systems is itself composed of two parts, which are detailed in Figure 1, and are closely aligned
with the corresponding auditing standard QC 20.
2 Audit methodology issues that I consider for this particular analysis are composed of design issues in the audit
methodology or training programs, and do not include issues with the application of the audit methodology, which
are part of the more practical-level types of deficiencies (audit performance deficiencies). 3 The review of the audit firms’ QC systems is a SOX requirement (section 104) that instructs the PCAOB to
“evaluate the sufficiency of the quality control system of the firm, and the manner of the documentation and
communication of that system by the firm.”
6
(Insert Figure 1 About Here)
The first part of the QC review corresponds to a bottom-up generalization of deficiencies
identified in individual audit engagements. QC deficiencies in this area are called audit
performance deficiencies and correspond to similar issues identified in several individual
engagements (see Appendix A for an example). The second part corresponds to top-down
analyses complemented by additional insights derived from the inspection of specific individual
audit engagements and interviews in individual audit offices. Overall, this top-down review
focuses on organization-level issues of an audit firm (see Appendix B for an example), and
focuses, among others, on tone at the top, a proxy for culture in the audit firm (e.g., POB 2000,
Jenkins et al. 2008, Berson et al. 2008, Guiso et al. 2015b), and on the design of the audit
methodology. The PCAOB discusses QC system deficiencies under Part II of the inspection
reports (hereafter I also refer to a QC system deficiency as a Part II Finding). These Part II
Findings are not released to the public if addressed satisfactorily within one year of the issuance
of an inspection report (Section 104(g)(2) of SOX, Gradison and Boster 2010). 4
I obtain the nonpublic versions of the PCAOB inspection reports for the U.S. operations of
the Big 4 and other annually inspected “second-tier” auditors, and build several measures based
4 Note that the statutorily prescribed criterion for whether a quality control criticism is made public is whether the
criticism has been “addressed by the firm, to the satisfaction of the Board” within 12 months after the Board issues
the inspection report [SOX 104(g)(2)]. The Board has explained that, in evaluating whether it is satisfied with a
firm’s remediation action in the 12 months, the Board recognizes that “with respect to some types of quality control
criticisms, a firm may not, realistically, be able to implement practices and procedures that completely achieve the
desired objectives in a 12-month period,” and that, accordingly, a favorable Board determination “does not
necessarily mean that the firm completely and permanently cured any particular quality control defect.” (PCAOB
2006a, pp6 and 7). Consequently, a QC deficiency may not be completely remediated one year following the
issuance of an inspection report, even if the PCAOB does not make public the Part II Finding. This continuous
nature of the remediation process prevents me from using it in the main tests as a quasi-exogenous shock to the
firms’ QC systems. I still use the remediation process in supplemental tests to better understand its role.
7
on these reports.5,6
Because at present no other researcher has access to this highly confidential
and proprietary dataset, I aim to remove any element of subjectivity in the construction of the
measures. First, I count the number of words in each Part II Finding report. Because Part II
sections of a PCAOB report are clearly separated between audit performance deficiencies and
top-down organization-level deficiencies, I also split this word count between these two types of
deficiencies. I further delve into the organization-level QC deficiencies, which the PCAOB has
analyzed and reported quite consistently over time, and build a firm-wide QC index of such
deficiencies. The QC index is built from eight categories, which include, among others,
deficiencies in tone at the top, audit methodology, partner management, independence policies
and management of foreign affiliates, and is higher when deficiencies are identified in more
categories.7 In additional tests, I also separate from this index deficiencies identified in the tone
at the top and audit methodology to focus on the influence of culture and tools in an organization
on its efficiency and performance in general.
In general, the descriptive statistics indicate that QC deficiencies are frequently identified by
the PCAOB. This contrasts with limited instances of their public release, indicating that most
deficiencies are addressed by the audit firms to the satisfaction of the Board within the one-year
period following the release of the inspection report.8 I also confirm, in untabulated analyses,
5 The “second tier” auditors are defined as in Hogan and Martin (2009) and include Grant Thornton, BDO, Crowe
Horwath and McGladrey. 6 According to the PCAOB (2006a, p9 and 10), “The quality control procedures at larger firms are typically far
more complex, extensive, and formal than those at smaller firms. Board inspection procedures are correspondingly
more extensive, and inspection report discussions of those quality control systems are usually set out in extensive
and specific terms… Board inspection critiques of those systems are correspondingly more detailed.” Consequently,
I only focus on larger firms in the analyses in order to derive meaningful comparisons across firms. 7 I am unable to include in the index “Audit Performance” deficiencies because these correspond to different themes
(e.g., Evans et al. 2011) that are more transient and idiosyncratic. 8 Note that, consistent with footnote 4, this does not indicate that the deficiency is completely remediated within one
year. Consistent with remediation being a continuous process, I find reasonably high autocorrelations in the index of
QC deficiencies, suggesting that it can take in practice several years to remediate a particular type of deficiency.
8
that there is sufficient variation in the QC deficiencies dataset to conduct meaningful empirical
analyses.9
In the first set of analyses, I find a negative association between an audit firm’s QC
deficiencies and audit quality, measured using the propensity to restate financial statements, the
propensity to meet/beat the zero earnings threshold, and deficiencies identified by the PCAOB in
the inspection of individual engagements (Part I Findings).10,11
I find some evidence that both
audit performance and organization-level deficiencies are negatively associated with audit
quality. Because audit performance deficiencies are generally derived from the inspections of
individual engagements, and the selection of these engagements is risk-based (e.g., Hanson
2012), the result on audit performance deficiencies suggests that to a certain extent individual
engagement-level deficiencies identified by the PCAOB can be generalized to other
engagements of the firm. Within organization-level deficiencies, deficiencies in the audit
methodology also matters in terms of audit quality, highlighting the importance of this area. This
study is the first to empirically document results consistent with the theories mentioned above.
Furthermore, these results suggest that the PCAOB identifies relevant QC deficiencies that
ultimately influence audit quality.
Consistent with audit fees being determined by a competitive process in the audit market and
not by internal differences in the organization of the audit firms (Doogar and Easley 1998,
9 I am unable to provide detailed descriptive statistics on the QC deficiencies because of the very clear SOX
requirements that preclude these deficiencies from being publicly disclosed if remediated within one year of
issuance of the PCAOB inspection report. 10
Aobdia (2015a) finds that these measures are appropriate to measure audit quality. I also use a measure of accruals
based on Leuz et al. (2003) that represents a valid proxy for audit quality (Aobdia 2015a). However, the results are
weaker using this measure, perhaps because this measure is a relatively weak predictor of audit quality (Aobdia
2015a). 11
I caveat against putting too much weight in the Part I Findings as a measure of audit quality for this particular
study, because both Part I Findings and Part II Findings are determined by the PCAOB inspectors. Thus, a
mechanical relation could exist between these two types of deficiencies, even though I choose a different timing of
measurement to reduce this concern.
9
Donovan et al. 2014), I find no evidence that QC deficiencies are associated with audit fees.
However, I find that firms with more QC deficiencies tend to provide more non-audit services to
their audit clients, even though the economic effect is reasonably limited.12
The relation between QC deficiencies and engagement hours is unclear and is likely to
depend on the type of QC deficiencies identified. On the one hand an audit firm with more
deficiencies could “shirk” and not spend enough effort on its audits in general. On the other
hand, such a firm may 1) improperly scope and price its audits at the time of client acceptance or
continuation by selecting the “wrong clients”, or 2) conduct inefficient audits because of lack of
expertise, training, or inefficient methodologies (both possibilities indicate inefficiencies in the
way an audit firm conducts its day to day operations). Consistent with the first “shirking”
alternative, I find negative associations between audit performance deficiencies with both audit
hours (including total partner hours and engagement quality review - EQR - partner hours), and
audit quality. Collectively, these results suggest that the auditor did not spend enough time on the
engagements to bring audit quality to a satisfactory level. Given that audit fees are not associated
with audit performance deficiencies, these inferences also result in a positive association
between such deficiencies and average hourly fees. In contrast with the “shirking” results, I find
1) a positive association between organization-level deficiencies and audit hours (this association
is mainly driven by tone at the top and methodology issues), 2) a negative association with audit
quality, and 3) no association with audit fees (and thus a negative association with audit fees per
hour). Collectively, these results are consistent with inefficiencies existing at audit firms with
12
The limited economic significance of these results is consistent with SOX Section 201 that prohibits audit firms
from providing many types of non-audit services, and subjects any non-audit service to pre-approval by the issuer’s
audit committee.
10
poor organization-level QC systems because of audit firms selecting the “wrong clients” or being
inefficient in their day to day operations, as mentioned above.
I also test whether remediation of these QC deficiencies has any influence on audit quality
and efficiency. I find some evidence of a positive association between the proportions of
deficiencies remediated and audit quality, and a negative association with audit hours and a
positive association with fees per hour. These results suggest that both audit quality and
efficiency improve following remediation of the Part II Findings, consistent with QC issues
negatively influencing audit quality and efficiency and their remediation improving it.
In a final set of tests, I assess whether clients are more likely to switch auditors that have
more QC deficiencies. On the one hand, audit firms are very unlikely to communicate the
nonpublic part of the inspections to their clients (e.g., PCAOB 2012). Anecdotal evidence
suggests that audit firms routinely refuse to share them with audit clients and that they even
restrict their distribution internally (e.g., Evans et al. 2011).13
On the other hand, deficiencies in
the firms’ QC systems could have some consequences visible by the client, such as more difficult
interactions with the audit team during the engagement in case hours are wasted and some of
them involve client time. Consistent with the second alternative, I find that clients of audit firms
with more QC deficiencies are more likely to switch auditors the following year. This result
suggests more client dissatisfaction when the auditor has more QC deficiencies, even if the
deficiencies are not directly communicated to the issuer.
This study makes several contributions. First, this study contributes to the audit literature and
responds to the observation by Francis (2011) and DeFond and Zhang (2014) that more research
13
One potential reason audit firms may do so is because clients do not have access to the other audit firms’
proprietary parts of the reports, and therefore no benchmark is available to determine whether a report indicates
good, bad or average performance for a specific audit firm.
11
is needed to explore the role of audit firms’ characteristics for audit quality. I find, in support of
prior theoretical literature, evidence that the audit firms’ QC systems matter for audit quality. My
results also highlight the importance of the roles of a firm’s culture and audit methodology for
audit quality. They contribute to an emerging literature in economics and finance that focuses on
culture, responding to the call by Guiso et al. (2015a) for more research on the role of culture in
corporations. Notably, I find a positive association between firm’s culture and performance,
consistent with Guiso et al. (2015b) who find such results for publicly traded corporations.
My study also contributes to the literature on PCAOB inspections. Several recent studies find
that PCAOB inspections improve both perceived and actual audit quality (e.g., DeFond and
Lennox 2015, Fung et al. 2015, Gipper et al. 2016, Shroff 2015). However, the mechanism by
which they do so is not understood very well. Aobdia (2015b) suggests that the mere possibility
of inspection of an individual engagement provide a deterrence effect. This study provides
evidence that QC deficiencies negatively influence firm-wide audit quality and their remediation
has the potential to improve it. My study also suggests that audit firms with worse organization-
level QC systems are less efficient for similarly priced audits, or, in other words, less profitable.
This result is more surprising than the negative association identified between audit performance
deficiencies and audit hours, which is more suggestive of audit firms with more practical-
oriented deficiencies “shirking” on their engagements. Because the PCAOB is focused on
inspecting the firms’ QC systems and making sure that the firms remediate the deficiencies
identified during the inspection process, these results suggest that, excluding audit-performance
deficiencies, firms that remediate organization-level types of deficiencies have the potential to
12
become more profitable over the long run.14,15
This highlights an unusual impact of regulation in
the form of potential efficiency improvements leading to higher profitability for the regulated
entities. In this particular context, this goes against the conventional wisdom that regulation is
costly for the regulated entities (e.g, Franks et al. 1998, Iliev 2010, Anderson and Sallee, 2011).16
The remainder of this paper is structured as follows. Section 2 provides some background on
the relevant elements of a QC system, the PCAOB inspections and a review of the prior
literature; Section 3, the hypothesis development; Section 4, the data and sample construction;
and Section 5, the main empirical tests. Section 6 provides additional empirical analyses and
Section 7 concludes.
2. Background on the relevant elements of a QC system, PCAOB inspections and prior
literature
Audit practitioners and regulators have emphasized over the years the need for an audit firm
to have a proper QC system. For example, the PCAOB adopted in 2003 as an interim standard
the AICPA standard QC 20, which indicates that “a CPA firm shall have a system of quality
control of its accounting and auditing practice.” This standard indicates that an audit firm QC
system needs to encompass the five following elements: Independence, integrity and objectivity;
Personnel management; Acceptance and continuance of clients and engagements; Engagement
performance; and Monitoring.
14
The initial remediation is likely to be costly, and consequently, it is unclear whether audit firms that successfully
remediate the QC deficiencies identified by the PCAOB can become more profitable over the short-run.
Furthermore, remediating QC deficiencies is likely to be a necessary, but not sufficient condition for a firm to
become more profitable. Last, I am unable to include for this analysis the costs of the PCAOB inspections for the
audit firms, which could be quite substantial. 15
An increase in profits in the form of a reduction of hours also assumes that the mix of hours between the different
types of personnel composing the audit team does not change too much. This assumption is reasonable given that the
analysis shows that most types of hours are higher when more QC deficiencies are identified at the auditor. 16
This result applies to the specific context of auditing, a highly concentrated oligopoly (e.g., Aobdia et al. 2015),
where the initial incentives to improve efficiency may not be as high as in other industries.
13
Similarly, the AICPA indicates in its standard QC 10 that “The firm must establish and
maintain a system of quality control.” Furthermore, this standard indicates that a firm’s QC
system needs to address each of the following elements: Leadership responsibilities for quality
within the firm (the tone at the top); Relevant ethical requirements; Acceptance and continuance
of client relationships and specific engagements; Human resources; Engagement performance;
and Monitoring. Overall, these requirements indicate that an audit firm must be organized such
that they are addressed. PCAOB inspections aim to ensure that an audit firm does so.
2.1 PCAOB inspections
Prior to SOX, audit firms were self-regulated through, among other things, the AICPA’s peer
review program, started in the 1970s (e.g., Hermanson, Houston and Rice, 2007; Lennox and
Pittman, 2010). This changed following several well-known accounting scandals at Enron,
WorldCom and elsewhere (e.g., Hanson, 2012). As part of SOX, Congress established
independent oversight of the accounting profession by the PCAOB for audits of issuers. Since its
creation, the PCAOB has conducted hundreds of inspections of registered public accounting
firms that audit issuers. These inspections are annual for firms that regularly provide audit
reports for more than 100 issuers, and at least triennial otherwise (Section 104 of SOX). The
PCAOB began its inspection program with limited inspections of the Big 4 in 2003 (e.g.,
PCAOB 2004), and conducted its first full inspections in 2004.
PCAOB inspections of annually inspected firms mainly focus on two elements: A review of
individual audit engagements, and a review of the firm’s QC systems (e.g., PCAOB 2012, Center
for Audit Quality 2012, PCAOB 2015).17
For the latter review, the assessment is based on
17
A limitation of the PCAOB inspections of individual audits is that the inspectors do not have access to the client,
but can only focus on the audit work papers and interviews of the audit firm. Thus, PCAOB inspectors may not have
14
specific analyses that focus on the firms’ QC policies and procedures, and from inferences
derived from the review of individual engagements (e.g., PCAOB 2015). Overall, the nature of
the inspection of a firm’s QC systems is consistent with the requirements in PCAOB standard
QC 20 and the AICPA standard QC 10. The review of the firm’s QC systems eventually yields
two types of deficiencies. The first type, audit performance deficiencies, is directly derived from
deficiencies identified in the inspections of individual audit engagements and corresponds to the
different themes identified in these individual inspections. While the identification of individual
audit deficiencies through the PCAOB inspections of individual engagements does not always
indicate that there are QC level deficiencies, a repeated instance of a similar type of audit issues
is likely to be considered a QC deficiency and included in the audit performance part of the Part
II section of the report (e.g., Evans et al. 2011, also see Appendix A for an example). Because
the nature of the deficiencies identified in individual engagements has changed over time, these
deficiencies also tend to be reasonably more transient in nature.
The second type of deficiencies is based on an overall assessment of the organization and
corresponds to organization-level issues. Accordingly, the assessment is conducted at the firms’
National Offices but also involves specific procedures based on individual engagements or
interviews at specific offices (e.g., PCAOB 2005). The publicly disclosed portions of the
PCAOB inspection reports discuss the different QC areas reviewed and provide a description of
the types of procedures performed. These organization-level areas have remained stable over
time. For example, for the limited inspections conducted in 2003, they included a review of
seven functional areas, including the tone at the top, partner management, independence policies,
client acceptance and retention policies, the internal inspection program, the audit policies,
access to some information available to the auditors at time of the engagement if this information was not
documented in the audit work papers.
15
procedures and methodologies, including training, and the policies related to foreign affiliates
(e.g., PCAOB 2004). Even though the description slightly changed over time, the most recent
inspection reports indicate that these areas are still part of the review of the firms’ QC systems.
The major innovation over time was the introduction of additional procedures related to practice
monitoring beyond the firms’ internal inspection programs.
(Insert Table 1 About Here)
Table 1 provides additional details and examples (all based on the public portions of the
inspection reports) of procedures that are conducted by the PCAOB inspectors for the part of the
QC inspections that focus on the audit organization (also see Appendix B for an example of
publicly released audit organization QC deficiency).18
In particular, the analysis of the tone at the
top is very detailed. PCAOB inspectors not only assess what the tone at the top stated by the
leadership is, but also how it is perceived and implemented in the different practice offices by
junior staff. Appendix C provides an excerpt about the procedures conducted by the PCAOB
with regard to tone at the top, as described in the 2004 inspection report of Deloitte (PCAOB,
2005). Prior research suggests that tone at the top represents an overall assessment of the culture
of the audit firm (e.g., Guiso et al. 2015b), which is related to the tone originating from its
leaders (e.g., POB 2000, Jenkins et al. 2008, Berson et al. 2008). Based on Table 1, “audit
policies, procedures and methodologies” represent an assessment of the tools available to the
engagement teams to conduct their day-to-day audit activities. The other six areas intuitively
relate to audit quality but some of them might be more limited in nature. For example, the
18
For example, the 2003 inspection reports are very detailed in terms of procedures performed by the inspection
team. More recent reports are less detailed but still provide a description of the analyses conducted.
16
policies related to the foreign affiliates are relevant only to issuers with international operations
(e.g., PCAOB 2011, pC-3).
The PCAOB issues a Part I Finding when it identifies deficiencies in individual audit
engagements. These Part I Findings are disclosed to the public, with the name of the issuer
masked. The situation is different when the PCAOB identifies QC systems deficiencies and
issues a Part II Finding. Part II Findings are not disclosed to the public if remediated within one
year of the issuance of an inspection report (Section 104(g)(2) of SOX, Gradison and Boster
2010).19
Over time, several large audit firms had some (but not necessarily all) Part II Findings
publicly disclosed. However, because the Part II Findings remediated within a year are not
publicly disclosed, academic researchers and the public in general have struggled to understand
the exact nature of a Part II Finding. In order to provide more transparency, the PCAOB has
indicated several times that Part II Findings for large firms are not unusual (e.g., PCAOB 2012),
and even provided an illustrative example of a nonpublic portion of a large-firm inspection report
(Evans et al. 2011). This illustrative example includes, besides audit performance deficiencies,
three main categories of organization-level deficiencies: Partner management, audit
methodology, and tone at the top, and suggests that these categories are not rare.
(Insert Figure 2 About Here)
The typical timeline of an inspection is provided in Figure 2. Inspection fieldwork for the
individual audit engagements with issuer fiscal years ending between April 1st of year t-1 and
March 31st of year t is typically conducted between March and November of year t, after these
engagements are completed (e.g., Aobdia 2015b). The PCAOB also analyzes the firm’s QC
19
See footnote 4 for more information about the remediation process, which is reasonably continuous in nature.
17
policies and procedures at the same time. However, these analyses may not always pertain to the
prior year’s policies and also assess “real time” concerns.20
Due to this potential for “real time”
assessment, in the remainder of the analyses, when using dependent variables measured for year t
audits, I also measure Part II Findings based on the year t inspection cycle.21
2.2 Prior empirical literature
Because of the lack of availability of data, limited empirical research exists on the relation
between audit firms’ organizational structure and audit quality and efficiency (e.g., Francis 2011,
DeFond and Zhang 2014). Limited empirical studies in the area include several in the 1980s that
explore the relation between structured and unstructured audit technology and several outcome
variables, including preferences for auditing standards and audit report timeliness (Cushing and
Loebbecke 1986, Kinney 1986, Williams and Dirsmith 1988, Morris and Nichols 1988).
However, these studies are dated and predate the PCAOB regime.22
In a similar vein, because the PCAOB is precluded by SOX (Section 104(g)(2)) from
disclosing QC system deficiencies when these are addressed by the firms within 12 months after
the issuance of the inspection report (e.g., PCAOB, 2012), very limited research exists on the
role of the PCAOB inspections of the firms’ QC systems. Most current research focuses, due to
lack of identification otherwise, on the market share impact of the PCAOB inspections when QC
criticisms are eventually made public due to lack of remediation by the audit firms (e.g., Nagy
20
For example, recent inspection reports suggest that the PCAOB reviews current documents in its review of the
tone at the top (e.g., PCAOB, 2011, pC-2). 21
I use the Part I Findings identified in Year t+1, corresponding to Year t audits, when using Part I Finding as a
measure of audit quality. 22
Given that the audit office is disclosed in the auditor report, several recent papers also use office-level
characteristics to test for audit quality and fees (e.g., Francis et al. 2005, Francis and Yu 2009, Reichelt and Wang
2010).
18
2014, and Boone, Khurana and Raman 2015).23
Aobdia (2015b) is the first to use the PCAOB
proprietary inspection data to further understand the impact of the PCAOB inspection process.
However the focus in Aobdia (2015b) is on the PCAOB’s inspections of individual engagements,
and not on the inspections of the firms’ QC systems.
3. Hypothesis development
3.1. Audit firm QC deficiencies and audit quality
While the PCAOB and the AICPA have emphasized over the years the need for an audit firm
to have proper QC systems, this need is also supported by the analytical literature. In particular,
QC systems are designed to align the individual incentives of the partners with the overall
incentives of the firm to conduct high quality audits (the incentives of the firm are driven by
reputation and litigation, as shown in prior literature). For example, in Huddart and Liang
(2005)’s analytical model, partners have incentives to shirk production tasks because effort is
unobservable. Huddart and Liang (2005) further show that symmetric mutual monitoring is
insufficient to reduce the issue, because partners also have incentives to shirk the monitoring
task. Instead, they identify that task specialization, in which some partners mainly monitor while
other ones are engaged in production, is beneficial for the organization. Thus, the
implementation of this specialization in the form of a firm’s hierarchy, tone and the top and QC
systems in general has the potential to increase both audit effort and quality.
Anecdotally, QC systems appear to matter. For example, Arthur Andersen auditors were able
to overrule the authority of their national specialists on the Enron engagement (e.g., Eichenwald
and Norris 2002), thereby leading to the failed audit of Enron, and eventually the demise of the
entire firm. Survey evidence also suggests that QC systems perceived as strong are associated
23
An exception is Drake et al. (2015) who focus on income tax accounts following the publicly disclosed QC
deficiencies of Deloitte for the 2007 inspection.
19
with a lower propensity of auditors to engage in low quality behaviors (e.g., Otley and Pierce
1996, Malone and Roberts 1996).24
Consequently, I test the following hypothesis:
H1a: An audit firm’s QC deficiencies are negatively associated with audit quality
The management literature defines culture as “a set of norms and values that are widely
shared and strongly held throughout the organization” (O’Reilly and Chatman 1996, Guiso et
al. 2015b), a definition applicable to public accounting firms. Anecdotal evidence, especially
based on the demise of Arthur Andersen, suggests that culture in an audit firm has an impact on
audit quality. For example, Wyatt (2004) suggests that the rise of consulting in public accounting
firms led to a culture change that focused on revenue to the detriment of audit quality, an
observation confirmed by former partners of Arthur Andersen (e.g., Gendron and Spira 2009,
Toffler and Reingold 2003).25
This anecdotal evidence is consistent with theories that consider
company culture to be relevant because employees will face choices that cannot be properly
regulated ex-ante (O’Reilly 1989, Kreps 1989), leading culture to act as a safeguard for
employees from making short-term based decisions that may have detrimental consequences on
the long-run to the entire organization (Guiso et al. 2015b). I test the following hypothesis using
tone at the top deficiencies to operationalize for culture (see Subsection 2.1):
H1b: Culture is an important factor of the association between QC issues and audit quality
24
In particular, according to Bedard et al. (2008, p188-189), “Extant research examines the frequency of such QTB
[quality threatening behavior] as collection of insufficient audit evidence, inadequate workpaper (i.e., audit
documentation) review, other violations of generally accepted auditing standards (GAAS), violations of generally
accepted accounting principles (GAAP), failure to book material adjustments, truncating sample sizes, accepting
doubtful evidence, relying on internal audit work of questionable quality, insufficient risk adjustment in audit
procedure planning, false or premature sign-off, failure to do thorough research, and under-reporting of time.
Across these studies, a surprisingly large proportion of auditors admit to engaging in QTB.” 25
This focus on revenue was new for Arthur Andersen, a company whose founder, Arthur Andersen, put reputation
over profit and refused to approve questionable transactions even if this meant the loss of the business (e.g., Brown
and Dugan 2002).
20
An audit methodology represents the backbone of the day-to-day execution of an audit.
Anecdotal evidence suggests that, at least in the past, large accounting firms’ auditors were likely
to be more knowledgeable about their audit firm methodology than about current auditing
standards. This highlights the potential reliance of engagement team personnel on the firm’s
methodology. Prior research also suggests that an audit methodology has an important impact on
auditor actions (see the discussion in Subsection 2.2). Audit firms also recognize the importance
of their audit methodologies on audit quality.26
For example, in Grant Thornton’s public
response to its 2004 PCAOB inspection (PCAOB 2006b), the letter indicates that “As the result
of the inspection of the eight largest accounting firms, the PCAOB inspection staff is in a unique
position. These inspections give them an unprecedented, in-depth understanding of each of the
firms’ audit methodologies, policies and procedures. In 2002 […] we recommended that the
AICPA coordinate a review of the major accounting firm’s audit methodologies so that best
practices could be determined and shared.” Consequently, I test the following hypothesis:
H1c: Audit methodology issues are an important factor of the association between QC
deficiencies and audit quality
3.2. Audit firm QC deficiencies, audit pricing, and the provision of non-audit services
On the one hand, several studies suggest that the audit market is characterized by price
competition (e.g., Johnson and Lys 1990, Pearson and Trompeter 1994), and some even suggest
that audit differentiation does not matter (Doogar and Easley 1998, Donovan et al. 2014). This
suggests that audit fees, determined by a competitive market pricing, are not associated with QC
deficiencies internal to individual audit firms. On the other hand, if auditors clients care about
the quality of the audit services they receive, and auditors are able to credibly convey their
26
Audit firms often advertise their methodologies on their websites. See for example