Policy Feb 1, 2018
Audit Regulations Meant to Curb Accounting Scandals Are Working, Mostly
A post-Enron oversight board is a useful example for the regulation of other industries.
In 2002, after accounting scandals erupted at corporations such as Enron and WorldCom, Congress cracked down on audit firms. One problem it wanted to address was the notion that auditors, who are hired by companies to check their financial statements, had become too cozy with their clients.
So Congress established the Public Company Accounting Oversight Board (PCAOB), an independent nonprofit that, as part of its activities, inspects auditors’ work for deficiencies in their audits.
Fifteen years later, an important question arises: Did those regulations do any good?
Daniel Aobdia, an associate professor of accounting information and management at Kellogg, sought an answer while working at the PCAOB for two years. He found that, for the most part, the regulations do work. Yet, some of the time they have unintended consequences.
Aobdia analyzed the board’s inspection data and found that when accounting firms received a critical report from the PCAOB of a specific audit, they spent more time conducting subsequent audits of that client and improved the quality of their work. But if an audit passed the inspection, the firm decreased the hours spent auditing that client, and their work quality dropped.
The study suggests that the PCAOB is catching important errors.
“When they do identify deficiencies, indeed you see some improvement,” Aobdia says. But when no mistakes are found, the board’s positive reports could “almost be giving an incentive for the firms to conduct less work.”
The PCAOB could be a useful case study for regulations of other industries. While it is not clear how universal the results are, they do suggest that policymakers should be careful about triggering unintended consequences, Aobdia says.
Trivial Accounting Errors or Big Mistakes?
The PCAOB inspects large public accounting companies that audit publicly traded corporations annually and smaller firms that do the same at least every three years. For each audit firm, the board selects audits of particular clients to review, focusing on audits with a higher risk of errors for inspection. (The audits of a particular client are known as engagements.) Inspectors with auditing experience visit the firm to study documentation and interview team members.
“It’s important to see what’s going on in practice.”
If the inspectors find a problem with a particular audit, they report the issue as a “Part I finding.” These findings are released to the public, with the auditor’s name public but the client’s name concealed. While the PCAOB does not require auditors to notify clients of such reports, the clients usually find out, often because their contracts stipulate that the auditors must inform them of inspection results.
Inspectors also conduct a company-wide review of the audit firms to identify larger issues, such as whether a firm’s culture emphasizes maximizing profits over performing high-quality work. If the board finds deficiencies, it reports them as “Part II findings.” The audit firm then has one year to fix the issues. If the company misses that deadline, the Part II findings are released to the public.
Perhaps unsurprisingly, auditors have not always been thrilled about the increased oversight. Some companies initially argued that the errors identified by the board are simply different judgment calls or minor documentation issues. But little research has been done to determine whether the auditors are right.
“It’s important to see what’s going on in practice,” Aobdia says.
Impact of New Audit Regulations
The PCAOB hired Aobdia as a senior economic research fellow to analyze its 2003–13 inspection data, giving him access to proprietary information such as the names of clients in Part I findings. For the eight largest accounting firms, he also got PCAOB data from 2008 to 2013 on the number of hours worked by the audit team, broken down by the seniority level of the staff.
The PCAOB reviewed Aobdia’s reports to ensure that nonpublic details were not published, but the organization could not prevent him from releasing results regardless of the outcome, he says.
Aobdia also obtained public data showing whether the auditors’ clients had to restate their financial statements. A decrease in restatements after an inspection would indicate that audit quality was increasing because errors were caught by the auditor before the client’s financial statements were publicly released.
Aobdia found that after a problematic audit that triggered a Part I finding, the number of hours the auditors spent on the inspected project increased the following year by 9 percent compared to projects that had not been inspected. Hours worked by partners, the most senior team members, increased by 20 percent. And two years later, the number of that client’s restatements decreased, suggesting audit quality had risen.
The biggest boosts in quality occurred when the audit firm additionally received a Part II finding, perhaps because correcting a company-wide problem improved work on all engagements.
These results counter audit-firm claims that the issues found by the PCAOB are minor or involve different judgment calls. They are “more than just documentation,” Aobdia says, since partners—not just low-level team members—are substantially boosting their hours.
Moreover, improvements seem to spill over to work that was not inspected. Auditors worked more hours on uninspected audit engagements if another engagement at their office or one managed by the same partner received a Part I finding. In other words, firms may be taking the criticisms seriously enough to apply improvements to projects that were not directly reviewed.
“What it suggests is auditors care more about the process than what they’ve publicly stated from time to time,” Aobdia says.
But the outcome of the inspections was not all positive.
When an engagement was inspected but did not receive a Part I finding, audit quality decreased the next year, and the number of hours worked dropped two years later.
“They might tend to relax a little,” Aobdia says, given that passing an inspection reduces the chances that the PCAOB will review the same engagement the following year.
In addition, auditors might wonder if they are doing more work than necessary. After all, the firm could make more money if they performed only the minimum amount required.
“If you are exactly at the standard, that’s where you want to be if you want to conduct the most profitable audit possible, assuming that the client does not care about the lack of extra work,” Aobdia says.
Clients do not distinguish much between accounting firms other than recognizing two tiers: the Big Four (Ernst & Young, Deloitte, PwC, and KPMG) and every other firm in the industry. If a company is already entrenched in one tier, it may not get much payoff for working harder.
One exception is accounting firms that specialize in a particular industry, such as finance or telecommunications, which are expected to perform better than nonspecialist peers. Aobdia found that specialist auditors did not reduce their hours or work quality even if they passed the inspection. Since clients hire those firms for their higher-quality work, the auditors may not want to lower their standards.
“Even if you’re above the bar, it’s actually fine because that’s where the expectations are,” Aobdia says.
Finally, he investigated how clients reacted to Part I findings.
For bigger accounting firms, receiving a Part I finding increased the chances that the client would drop the auditor. A client might expect premium service from these companies, so any deficiencies would warrant switching to another auditor. Interestingly, however, Aobdia also found that a Part I finding increased the chances that the large accounting firm might drop a difficult client. For instance, if the client refused to provide the information needed for a high-quality audit, the accounting firm might decide that working with that client could damage its reputation.
Aobdia did not see this trend at smaller accounting companies. He speculates that clients may not drop these auditors because they aren’t expecting top-notch service anyway. Perhaps they even want a lower-quality auditor so they can slip questionable business practices by them.
“Maybe they don’t want too many questions asked,” he says.
The Benefit of “a Bit of Unpredictability” in Audit Reviews
The results suggest that PCAOB inspections had some unintended negative consequences for engagements that passed inspection, which comprise 72 percent of all inspected audits. But overall, those negative outcomes involved a limited number of engagements, Aobdia says. The board inspects about 50 engagements out of about 1,000 annually at each of the largest audit firms.
He believes the net effect is positive. “Regulation seems to be working to a certain extent,” he says.
It is not clear how broadly the study applies to regulations of other industries. The PCAOB is unusual because it is an independent nonprofit. But many other regulatory bodies are part of the government and can be influenced by political considerations.
“I’m not sure we could extend these results to everybody,” Aobdia says.
While it may be impossible to design an audit system that functions perfectly, without any unintended consequences, regulators should “try to ensure the benefits outweigh the potential drawbacks,” he says. Measures such as random inspections could counteract the tendency to decrease effort after a successful review.
“A bit of unpredictability can help a lot,” he says.
Editor’s note: Daniel Aobdia was a Senior Economic Research Fellow at the Public Company Accounting Oversight Board (PCAOB) when conducting this research. 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 here are his own and do not necessarily represent those of the Board, individual Board members, or staff of the PCAOB.