Client Responses to Non-Compliant Audits: An Analysis of Clients Targeted by PCAOB Inspection

PCAOB inspectors are afforded privileged insight into the quality of audits selected for inspection. Using inspection reports from 2005-2012, I create a unique sample of audits that were inspected by the PCAOB (i.e., all of an auditor’s clients were selected for inspection). By tracing inspection findings to specific engagements, I directly identify compliant and non-compliant audits. I examine the contributing factors of ‘audit quality’ and provide evidence that higher audit fees and greater human capital are positively related to compliant PCAOB inspections. When PCAOB findings can be linked to a specific engagement, I also find that, on average, the client dismissal rate for deficient auditors is nearly twice as high as the dismissal rate for non-deficient auditors. I further generalize these findings to a larger sample and find some evidence that the smallest auditors are disproportionately impacted by inspection findings. That is, results indicate that client reactions to the PCAOB inspection process are disproportionately greater for the smallest audit firms that have a large proportion of their clients selected for inspection. Finally, I find no evidence that inspection findings affect the fees charged by the auditor and no evidence that the relation between client dismissals and inspection deficiencies has diminished since the initial inspection period. Taken together, these findings have implications for how stakeholders use inspection reports and how the PCAOB conducts and reports on the inspection process.