Does the PCAOB international inspection program improve audit quality for non-US-listed foreign clients?
Introduction
All auditors (US and foreign) who audit US-listed companies are required to register with the Public Company Accounting Oversight Board (PCAOB) and be subject to PCAOB inspections. In this study, we focus on foreign auditors and consider whether audit quality for non-US-listed foreign public clients (non-US-listed clients) is higher following the initial PCAOB inspection.1 Our study addresses the issue of positive externality, i.e., whether the PCAOB international inspection program improves audit quality for foreign auditors’ non-US-listed foreign clients even though investors in these particular foreign companies are not the intended beneficiaries of the foreign auditor inspection program.2
The impact of the PCAOB international inspection program on audit quality abroad is ambiguous. Given the PCAOB's reputation for actively looking for auditor misconduct and taking follow-up disciplinary actions against deficient auditors (DeFond, 2010, Farrell and Shabad, 2005), the very act of registering with the PCAOB may exacerbate foreign auditors’ exposure to reputation loss and provide them with an ex ante incentive to strengthen their firm-level quality controls and increase audit quality. To the extent that audit deficiencies are discovered during the initial inspection, the auditor may have an additional incentive to take appropriate remedial action and strengthen firm-level quality controls to avoid further embarrassment on subsequent inspections. The improvements in the foreign auditor's firm-level quality controls could increase audit quality for all of the firm's foreign clients US-listed or otherwise. Moreover, because the starting point for audit quality is potentially lower abroad than in the US (Choi et al., 2008, Francis and Wang, 2008), the PCAOB inspection program could have a greater impact abroad than in the US.
However, reasons exist to doubt the efficacy of PCAOB inspections in improving audit quality. Prior research (DeFond, 2010, Lennox and Pittman, 2010) indicates that PCAOB inspection reports are not useful for assessing audit quality because they merely list audit deficiencies and do not provide a summary opinion about the auditor's quality. Moreover, the effectiveness of the PCAOB's international inspections may be limited by geographic distance from the US, potential language differences, or cultural barriers. Finally, foreign auditors may follow an asymmetric approach to their US-listed and non-US-listed clients. Given that the PCAOB is primarily interested in protecting investors in US-listed companies (selecting only US-listed client engagements for inspection) and the fact that auditor litigation exposure is lower for non-US-listed clients than for US-listed clients, foreign auditors may be less incentivized to improve audit quality for their non-US-listed clients. Foreign auditors may override their firm-level quality controls and utilize less effective audit programs or assemble less qualified audit teams for their non-US-listed clients (which may be less costly). To the extent that foreign auditors follow an asymmetric approach in servicing their US-listed and non-US-listed clients, any PCAOB inspection-related improvements in firm-level quality controls may not necessarily benefit their non-US-listed audit clients. For all these reasons, the overall effectiveness of the PCAOB international inspection program in improving audit quality for foreign auditors’ non-US-listed clients is far from obvious and remains an open empirical question.
Because the quality of financial reporting is a joint outcome of manager and auditor decision making, audit quality is best viewed as a continuum with higher audit quality providing greater assurance of financial reporting quality (DeFond and Zhang, 2014). Still, beyond the notion that better audit quality leads to better financial reporting quality, little or no consensus emerges in the extant literature as to how best to measure audit quality. Hence, given that all audit quality proxies have their limitations, we use multiple financial reporting quality measures (such as discretionary accruals, the propensity to just meet or beat earnings expectations, and accruals quality) that capture different dimensions of the audit quality construct. In addition, we employ a measure of auditor independence: the likelihood of the auditor issuing a modified opinion for non-US-listed clients as a proxy for audit quality. For non-US-listed clients, this metric is similar to the propensity to issue a going-concern opinion for US-listed clients, and it is generally viewed as a measure of the auditor's ability to withstand client pressure to issue a clean audit opinion (DeFond et al., 2002, Chen et al., 2010, Fung et al., 2016).
Our study covers a 13-year period (2002–2014) and includes a total of 61,612 non-US-listed client-year observations with PCAOB-registered foreign auditors from 55 non-US countries. Our sample includes observations from countries that allow as well as those that prohibit PCAOB inspections. In our difference-in-differences (DID) research design, we control for the threat of PCAOB inspections based not only on whether the observation is from a country that allows (or prohibits) PCAOB inspections (consistent with Lamoreaux (2016)) but also on a model that captures the likelihood of the client-year observation being audited by a PCAOB-inspected foreign auditor.3 Our findings suggest that initial inspections have an incremental effect on the audit quality of the foreign auditor over and above the effect of the threat of such inspections. These findings are of particular interest because some countries (such as China) continue to disallow PCAOB inspections. Our findings are consistent with those of Aobdia and Shroff (2017) who suggest that PCAOB oversight of non-U.S. auditors with US-listed clients increases the perceived assurance value of their audits and is reflected in an increase in their market share in their home countries.
All of our results continue to hold when we re-estimate our tests using a matched sample based on the propensity score of a non-US-listed foreign client having a PCAOB-inspected foreign auditor. Further, we examine whether the strength of the positive relation between PCAOB inspections and audit quality metrics for foreign auditors’ non-US-listed clients (the externality effect) varies cross-sectionally over a number of factors. The findings from our cross-sectional analyses suggest that, controlling for the threat of inspections, the impact of the initial inspection is stronger when the likelihood of a foreign auditor being inspected by the PCAOB is lower, in countries without a substantive increase in financial reporting enforcement, in countries with lower liability standards for accountants, for earlier (versus later) initial inspections, and for foreign auditors affiliated with one of the six global audit firm networks (GNs). Consistent with the notion that PCAOB inspectors share their findings and suggestions for improvement with the auditor at the time of the inspection itself without having the auditor wait for the formal inspection report (Aobdia, 2016), in additional analyses we find that the improvement in audit quality for foreign auditors’ non-US-listed clients is observable in the year the initial inspection report is issued and that the improvement has persistence beyond the first year.
Our paper contributes to the literature in several ways. First, our study, to our knowledge, is the first to examine whether the PCAOB's international inspection program (which is intended to improve audit quality for foreign auditors’ US-listed clients) has a positive externality effect, i.e., also improves audit quality for foreign auditors’ non-US-listed clients.4 Our study complements studies by Lamoreaux (2016) and Krishnan et al. (2017) who examine the direct audit quality effect of PCAOB inspections, i.e., focus on foreign auditors’ US-listed clients. We contribute by documenting a positive externality in that non-US listed audit clients benefit from their audit firms' PCAOB inspections.
Second, we contribute to the literature on auditor incentives and reputation concerns outside the US. With respect to incentives, prior research (e.g., Lennox, 1999; Khurana and Raman, 2004) suggests that litigation exposure, not reputation protection, is a driver of audit quality outside the US. Along the same lines, Francis and Wang (2008) propose that audit quality abroad is a function of investor protection. The stronger the country-level legal institutions, the higher the auditor incentive to provide a quality audit. However, Weber et al. (2008) and Skinner and Srinivasan (2012) argue that reputation loss imposes actual costs on an auditor (in the form of lost market share) in Germany and Japan, respectively, and thereby incentivizes audit quality even in countries with little or no legal exposure. Pertinent to reputation concerns, the PCAOB's international inspections have the potential for embarrassing the foreign auditor through adverse publicity by disclosing engagement-level audit deficiencies and for not remediating firm-level quality control deficiencies on a timely basis. Our findings are consistent with the notion that auditor reputation matters outside the US in that the initial PCAOB inspection has an incremental salutary effect on the foreign auditor's audit quality over and above the effect of the threat of an inspection itself.
Finally, our study contributes to the inquiry of the efficacy of the PCAOB international inspection program in improving audit quality. As noted by Carcello et al. (2010), US-listed companies audited by foreign auditors account for more than $650 billion in US market capitalization. Further, foreign auditors play a substantial role in the audit of US domestic companies by auditing foreign subsidiaries that are material to the consolidated financial statements of US multinationals. For these reasons, the PCAOB views inspections of foreign auditors as a priority and devotes substantial resources to its international inspections program. Still, the board faces a difficult challenge in this area because a number of countries (such as China) have barred PCAOB inspections within their borders (on national sovereignty grounds), thereby increasing the risk of substandard audit quality for investors in US-listed companies. We document that the PCAOB international inspection program generates a positive externality, as it not only improves audit quality for foreign auditors’ US-listed clients (as shown in concurrent studies by Lamoreaux (2016) and Krishnan et al. (2017)), but also for their non-US-listed clients, thereby improving investor protection from substandard audits for US investors and foreign investors in non-US-listed foreign public companies. These findings potentially allow foreign countries and regulators to better assess the desirability (in terms of the favorable audit quality impact for their own domestic investors in non-US-listed public companies) of allowing the PCAOB to conduct inspections in their home countries.
The remainder of this paper is organized as follows. Section 2 provides background information and develops our hypotheses. Section 3 presents the research methodology and data description. A discussion of empirical results follows in Section 4. Section 5 provides concluding remarks.
Section snippets
Background
The PCAOB was established by the Sarbanes-Oxley Act of 2002 (SOX; PL 107-204) with the objective of improving audit quality for companies listed in US public securities markets. To achieve this objective, the board is vested with broad powers to oversee and discipline auditors (US and foreign) of US-listed companies and to conduct mandatory inspections of these auditors as a new channel for improving audit quality. Inspections for US auditors began in 2004. Inspections for foreign auditors
Research design
To test our hypothesis, we employ a number of audit quality proxies used in prior literature.7
Tests of Hypothesis 1
To test Hypothesis H1, we start with our test sample (see Table 1, Panel A) of non-US-listed clients with PCAOB-registered foreign auditors. This sample consists of 61,612 client-year observations for the AB_ACC and Prob. (MEET) tests, 48,706 for the AQ test, and 12,794 client-year observations for the Prob. (OPINION) test. The sample size for the Prob. (OPINION) test is much smaller because, following DeFond et al. (2002), we include only distressed clients (clients with negative return on
Concluding remarks
The 2002 Sarbanes Oxley Act represented a fundamental shift from self-regulation of US auditors to oversight by the newly established PCAOB. Consistent with its mission of improving audit quality for companies listed on US public securities markets, the PCAOB requires all auditors (US or foreign) of US-listed public companies to register with the board and be subject to periodic inspections of selected audit engagements and of their firm-level quality controls for compliance with PCAOB rules
Acknowledgments
We thank Michelle Hanlon (editor) and Karen Nelson (the referee) for their helpful comments and suggestions. We also thank Mark DeFond, Renee Flasher, Ferdinand Gul, Yongtae Kim, Phillip Lamoreaux, Clive Lennox, Oliver Li, Linda Myers, Grace Pownall, Suresh Radhakrishnan, Katherine Schipper, Bin Srinidhi, and other workshop participants at Deakin University, Indian Institute of Management Bangalore, KAIST, Korea University, National Taiwan University, Seoul National University, The Chinese
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