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23.09.2023

Does audit firm hiring of former PCAOB personnel improve audit quality?

verfasst von: Jagan Krishnan, Jayanthi Krishnan, Steven A. Maex

Erschienen in: Review of Accounting Studies

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Abstract

We examine whether employees of the Public Company Accounting Oversight Board (PCAOB) that are hired by large audit firms are associated with subsequent higher audit quality at these firms. Employees at the PCAOB acquire expertise related to the industry they regulate, the audit industry. We predict that this expertise, which we label “regulatory audit quality expertise,” would improve audit quality at audit firms, particularly for clients with high misstatement risk. We find that regulatory audit quality expertise is associated with fewer client restatements, which are ex post indicators of high misstatement risk not properly addressed by the auditor (i.e., egregious audit quality issues). Further, along the continuum of audit quality, regulatory audit quality expertise is associated, for high risk clients, with audit quality improvements reflected in lower discretionary accruals and more accurate internal control audit opinions. Our results provide some evidence that regulatory audit quality expertise provided by former PCAOB employees is beneficial for audit quality.

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1
Revolving door hires are personnel that move between jobs at regulators and regulated entities. While these hires can occur in both directions, we use the term throughout this paper to refer to those that go from the PCAOB to audit firms. A partner we interviewed felt that the term “revolving door” is pejorative and that we should consider using the term “returning employees.” We use the term “revolving door” following prior work and do not intend any negative connotations.
 
2
Importantly, we are not suggesting a direct link between the hires and individual clients of the hiring firms. Rather we expect that their expertise will result in improvements in audit quality that are measurable as individual client-level audit outcomes.
 
3
These audits have been conducted in conjunction with financial statement audits for public companies (under the Sarbanes-Oxley Act Section 404) since 2004. Since the former PCAOB hires bring expertise pertaining to both kinds of audits, we analyze the quality of each and refer to the former as internal control audits.
 
4
The PCAOB’s inspection results have two parts. Part I (publicly available) lists audit deficiencies. Studies showing improvements in audit quality on client engagements following negative (Part I) inspection reports include Lamoreaux (2016); DeFond and Lennox (2017); Fung et al. (2017); Krishnan et al. (2017); Aobdia (2018); and Gipper et al. (2020). Part II identifies deficiencies in the inspected firm’s system of quality control. Part II findings are not released unless the firm fails to remediate the quality control deficiencies within 12 months. Aobdia (2020) finds that an “incremental mechanism” for audit quality improvement comes from the remediation of quality control deficiencies that are identified in Part II inspection reports.
 
5
See, for example, the remarks of two former PCAOB members (Kayla Gillan and Bill Gradison) in a recent webinar (http://​www.​sechistorical.​org/​museum/​programs/​2021/​). Furthermore, Jabotinsky (2021, p. 434) said: “Where the ability to transfer from public sector to the private sector is curtailed, the quality of regulation would decline and this would, eventually, undermine the overall public welfare that the regulation seeks to promote.”
 
6
The revolving door hires at KPMG used their connections at the PCAOB to obtain “advance peeks at the secret lists of KPMG audits the PCAOB planned to review,” thus helping KPMG to better prepare for the inspections (O’Brien et al. 2018; SEC 2019).
 
7
Other studies have focused on the impairment of audit quality when a former auditor joins the client in a senior financial position or audit committee (e.g., Geiger et al. 2008; Baber et al. 2014; Naiker et al. 2013). This practice was restricted by the Sarbanes-Oxley Act of 2002, which imposed a cooling off period of one year for auditors joining the client firm in key accounting/finance positions and three years for audit committee members. These studies, focusing on the period prior to imposition of the one-year cooling off period, provide mixed evidence of impaired audit quality when auditors moved to clients (Dechow et al. 2010) but no evidence of audit quality impairment when auditors moved to their clients’ audit committees.
 
8
KPMG (2015, p. 17) describes these centralized teams as consisting of a “comprehensive network of partners, managing directors, senior managers …” They “support the firm’s professionals in meeting their responsibilities in the areas of auditing and attestation … root cause analysis and continuous improvement in audit quality, and internal and external inspections.”
 
9
Some survey studies covering perspectives on inspections (e.g., Johnson et al. (2019; Westermann et al. 2019; Ege et al. 2020) document some audit firm resentment toward inspections. However, we believe that this does not preclude improvements in audit quality following inspections.
 
10
Our expectation is consistent with Shive and Forster (2017), which documents that financial firms’ hiring of former financial regulators into executive positions trigger positive abnormal returns (suggesting their hiring is valued by the market), particularly when these individuals bring knowledge and experience rather than an expectation that their hiring will result in preferential regulatory treatment. In a setting where the transfer of technical expertise is less relevant, Jiang et al.(2018) find that bond ratings tend to be inflated for issuers that have hired more individuals from large ratings agencies, suggesting that the revolving door is harmful in this setting. Some studies focus on outcomes at the regulator before the regulator leaves to join a regulated firm (e.g., deHaan et al. 2015).
 
11
Expecting that audit firms deploy former PCAOB personnel to help in audits of high misstatement-risk clients is reasonable since audit firms are incentivized to minimize litigation risk and reputational loss arising from audits of these high risk clients (Francis et al. 2013). Further, in recent years, the PCAOB has emphasized the importance of auditor assessment of and response to risk of material misstatement and has, in inspection reports, identified numerous deficiencies in audit firm practices in these areas (Acito et al. 2018; PCAOB 2015, 2019).
 
12
One interviewee highlighted that a former PCAOB employee hired by their firm was integral in bringing increased rigor to internal inspections particularly by increasing the emphasis on auditing internal controls. As an example, they cited the former PCAOB personnel’s focus on ensuring that controls were in place over the completeness and accuracy of reports from IT systems used in the context of management review controls, which was a key area of emphasis of the PCAOB’s Staff Audit Practice (SAPA) No. 11 published in 2013.
 
13
Like Hendricks et al. (2022), our study is subject to concerns regarding the completeness and accuracy of individually maintained LinkedIn pages. As a reasonableness check on the LinkedIn data, we compared the number of current employees at the PCAOB per LinkedIn with the reported number of staff members on the PCAOB website. As of December 31, 2020, the PCAOB reported 800 staff employees (see https://​pcaobus.​org/​about), while LinkedIn provided records for 851 PCAOB-related personnel after excluding profiles containing the word “intern” or “fellow.” Thus these numbers are generally aligned. Further, Hendricks et al. (2022, p. 263) note that “because senior-level members of large audit firms use their connections to create and maintain business for their firms, it is unlikely that the individuals of interest in our study would not use professional networking sites.” However, we cannot rule out the possibility that inaccurate or incomplete LinkedIn data introduces noise into our measures.
 
14
Our sample is smaller than Hendricks et al.’s (2022) sample of 106 former PCAOB employees possibly due to the following reasons. First, our final sample comprises people who worked at large audit firms from 2008 to 2016, whereas Hendricks et al.’s sample comprises the period from the PCAOB’s inception (in 2003) through February 2018. Second, 13 PCAOB employees joined one of the large auditors after an initial move to an organization outside of our sample. For a cleaner test, we have excluded these employees from the construction of our REGAQEXP variants since we believe the level of their REGAQEXP might attenuate over time. However, if we also include these additional 13 cases in the construction of our REGAQEXP variants, our results are consistent. Finally, there might be minor differences in the sample, due to differences in the timing of when the data was collected.
 
15
For purposes of this calculation, we consider those with the role of general counsel to be at or above the level of senior manager.
 
16
In contrast, Little r restatements reflect corrections of errors in past financial statements that were not material to those individual year’s statements and do not require a Form 8-K filing (Tan and Young 2015).
 
17
Annual audit quality reports issued by the large audit firms in our sample suggest that all firms are continuously undertaking steps to improve audit quality. For example, KPMG’s 2015 Audit Quality Report stated: “Audit quality is a dynamic process that requires constant evaluation” (KPMG 2015, p. 8). Likewise, EY’s 2017 “Our Commitment to Quality” report stated: “Through our root cause process, we continue to identify the factors that lead to best-in-class audits. … We are leveraging that information to drive further improvements in audit quality across our practice” (EY 2017, p. 11). Therefore we attempt to control for the factors that might influence the relative strength in audit quality improvement actions across firms and across time. Recognizing that there are limitations in using controls to fully capture internal firm audit quality improvement actions, we also run additional analyses (in Section 6), where we attempt to identify the point at which audit quality improvement initiatives would have been most marked for audit firms and find that the presence of former PCAOB personnel contributes to quality improvements that manifest around these times.
 
18
With the inclusion of audit firm fixed effects, the estimated coefficients on the REGAQEXP proxies should be interpreted as the extent to which the dependent variable (i.e., audit quality proxy) changes as REGAQEXP changes within the given audit firm. As we report in Table 1 Panel B, there is significant time-series variation in REGAQEXP within audit firms (except for Marcum) across our sample period, which allows for appropriate identification in our models.
 
19
Ideally, we should control for other motivating factors, besides past inspection deficiencies, for firms’ hiring of PCAOB employees. For example, the KPMG scandal suggests that access to current PCAOB employees to obtain information about inspections could be one such factor. We also acknowledge that the revolving door hires make selection decisions, which could be driven by, for example, personal reasons impelling them to stay in the same area as the PCAOB job. While we cannot control for these unobservable factors, we believe that they would militate against our finding any positive association between REGAQEXP and audit quality.
 
20
There is a seeming asymmetry between Eqs. (1) and (2) in that the latter includes the interaction of REGAQEXP with HIGHRISK, while the former does not. This is because H1 posits that restatements, which are realizations of high misstatement risk not properly addressed by the auditor (i.e., egregious audit quality issues), should be reduced across the entire portfolio of the audit firm’s clients. Technically, restatement models can be run after including the interaction of REGAQEXP with HIGHRISK (in Eq. (1)). Such a model is akin to regressing indicators of high misstatement-risk (RESTATE and RESTATE_BIGR) on interactions of REGAQEXP and a high risk variable, making interpretation challenging. Nonetheless, in untabulated analyses, we run these models and find negative coefficients for the interactions of REGAQEXP and HIGHRISK.
 
21
F-Score, constructed by Dechow et al. (2011) based on Accounting and Auditing Enforcement Releases, provides a parsimonious composite measure of misstatement risk. We provide details about its construction in Appendix 1 Table 10. Other studies that use this measure to proxy for misstatement risk include McGuire et al. (2012); Fang et al. (2016); and Amiram et al. (2015).
 
22
We report sensitivity to this cutoff as well as an alternative measure of high misstatement risk in Section 5.
 
23
We follow Cunningham et al.’s (2019) computation of this probability, which is based on model [2] in Ge et al. (2017). See Appendix 1 Table 10 for details.
 
24
This is a Type II low quality internal control audit resulting from an underassessment of control risk. In contrast, a Type I low quality internal control audit would occur if an internal control material weakness opinion is issued to a nonsuspect firm. We do not include this group in our test because, as Bhaskar et al. (2019) note, this situation is not consistent with under assessing control risk.
 
25
Nevertheless, for a few observations early in our sample (< 2% of our sample), the inspection report issued most recent to the client’s audit opinion date does not contain the number of clients inspected. For these cases, we scale the number of inspected clients with deficiencies by the number of clients inspected in the next report issued for the auditor to arrive at DEF_IC and DEF_NONIC. Our results are unchanged if we dropped these observations from our sample.
 
26
Many of the client characteristics are significant in all models. Among the auditor characteristics, OFFSIZE, NAFEERATIO, TENURE, and DEF_IC are significant in all four models.
 
27
Consistent with DeFond and Lennox (2017), nonaudit fees and client size are negatively associated with the issuance of an 404(b) internal control material weakness opinion. However, the coefficient on DEF_IC is positive but insignificant at conventional levels in columns 5 through 8. In contrast, DeFond and Lennox (2017) report positive and significant coefficients on DEF_IC for their internal control material weakness models. This difference in the findings could arise due to two differences in sample construction: (1) our sample period of 2010–2016 differs from their 2010–2013 sample and (2) our sample comprises clients of 10 annually inspected auditors, while DeFond and Lennox (2017) include eight annually inspected auditors and 94 triennially inspected auditors. Nonetheless, when we limit our sample period to 2010–2013, the coefficient on DEF_IC is positive and significant (p-value < 0.02 in all columns), consistent with their study.
 
28
We use Stata’s PERMUTE command (stratifying on auditor) with 500 randomized permutations of the dependent variables. See details at www.​stata.​com/​manuals/​rpermute.​pdf.
 
29
In all our models, we control for cross-sectional differences across industries by employing industry fixed effects. As a sensitivity test, we run models employing firm fixed effects in place of industry fixed effects. The results for our test variables are consistent with those in Tables 4 and 5 with two exceptions. In Table 4 Panel B columns (2) and (4), we find that β1 is not significant and (β1 + β3) is negative but with two-tailed p-values slightly above conventional levels (0.12 and 0.16). Additionally, in models studying incorrect 404(b) opinions (Table 5), our results are no longer statistically significant. This latter result is likely due to significant lack of time-series variation in this dependent variable within firms in our sample, resulting in a significant loss of observations used in estimation.
 
30
For example, one interviewee highlighted that, during PCAOB inspections, individuals hired from the PCAOB assist inspected teams identify areas of the audit “where they could have done better” so that they can look to improve in these areas in future years.
 
31
As controls, we use a similar set of auditor characteristics as those used in model [2] except for dropping fee-based controls (AUDFEE and NAFEERATIO). We also control for SIZE, LEV, the current ratio (CURRENT, measured as the ratio of current assets to current liabilities), ROA; LOSS, (the log of) the number of segments (SEG), the ratios of inventory and receivables to total assets (INVT and RECV, respectively), indicator variables representing the existence of foreign income (FOREIGN) and extraordinary items or discontinued operations (EXTRAORD), and ICMW (e.g., Francis et al. 2005). Finally, we include year, industry (based on the Fama-French 12 industry classification), and audit firm fixed effects.
 
32
Although weaker than the relationship for high risk clients, we also observe a positive association between REGAQEXP and audit fees for low-risk clients (β1 > 0). This finding is consistent with Aobdia et al. (2021), which finds that partner industry specialization (an alternative form of audit quality expertise) commands a fee premium even for simpler audits although the fee premium is more pronounced for more complex audits.
 
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Metadaten
Titel
Does audit firm hiring of former PCAOB personnel improve audit quality?
verfasst von
Jagan Krishnan
Jayanthi Krishnan
Steven A. Maex
Publikationsdatum
23.09.2023
Verlag
Springer US
Erschienen in
Review of Accounting Studies
Print ISSN: 1380-6653
Elektronische ISSN: 1573-7136
DOI
https://doi.org/10.1007/s11142-023-09801-9