No news is bad news: Do PCAOB part II reports have an effect on annually inspected firms’ audit fees and audit quality?

Abstract

We investigate the effect of the PCAOB’s Part II report on annually inspected firms’ audit fees and audit quality. The PCAOB replaced the peer review auditor program with an independent inspection of audit firms. Upon completion of each inspection, the PCAOB issued inspection reports that include a public portion (Part I) of identified audit deficiencies, and (in most cases) a nonpublic portion (Part II) of identified quality control weaknesses. The Part II report is only made public when the PCAOB deems that remediation was insufficient after at least 12 months have passed. Starting around the time of the 2007 Deloitte censure (Boone et al., 2015), the PCAOB shifted from a soft synergistic approach to an antagonistic approach, such that Part II reports were imminent, despite delays that ultimately led to their release one to four years later than expected. Our study spans the period from 2007 to 2015, and examines the effect on audit fees and audit quality at the earliest date that the Part II report could have been released – 12 months after the Part I report was issued. We find that following the 12 month period, that annually inspected audit firms eventually lost reputation by lower audit fees, while they concurrently made remedial efforts to increase the quality of their client’s financial reporting quality (abnormal accruals magnitude and restatements). However, three years after the Part II report was actually released, audit fees increased.