The Unintended Consequences of the Frequency of PCAOB Inspection

After more than 50 years of self-regulation of the US auditing profession, the Sarbanes-Oxley Act of 2002 (SOX) created the Public Company Accounting Oversight Board (PCAOB) as a quasi-governmental entity with statutory authority to inspect accounting firms that audit public clients. The frequency of this inspection is annual or triennial, based upon the number of public clients the firm audits. We examine the effects of these two levels of inspection frequency on financial reporting quality and audit fees for clients of small and midsize public accounting firms. Our findings provide evidence of significantly higher audit quality and audit fees for clients of annually inspected firms relative to clients of triennially inspected firms. These findings are robust to auditor-client alignment analyses, propensity score matching, time-series analyses, examination of firms that have changed from triennial to annual inspection, and particular examination of firms with inspection deficiencies. Overall, our study suggests that the two-tier frequency system of PCAOB inspection may have also resulted in two-tier audit quality and audit fee systems for small and midsize public accounting firms, with more frequent inspection leading to more rigorous and informed auditor decisions. We discuss the implications of our results for the Board and the profession at large.