Public Audit Oversight and Reporting Credibility: Evidence from the PCAOB Inspection Regime

Brandon Gipper

University of Chicago – Booth School of Business

Christian Leuz

University of Chicago – Booth School of Business; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Center for Financial Studies (CFS); University of Pennsylvania – Wharton Financial Institutions Center; CESifo Research Network

Mark G. Maffett

University of Chicago – Booth School of Business

August 7, 2015

European Corporate Governance Institute (ECGI) – Finance Working Paper No. 453/2015

Chicago Booth Research Paper No. 15-40

Abstract:

This paper examines how audit oversight by a public-sector regulator affects investors’ assessments of reporting credibility. We analyze whether the introduction of the Public Company Accounting Oversight Board (PCAOB) and its inspection regime have strengthened capital-market responses to unexpected earnings releases, as theory predicts when reporting credibility increases. To identify the effects, we use a difference-in-differences design that exploits the staggered introduction of the inspection regime, which affects firms at different points in time depending on their fiscal year-ends, auditors, and the timing of PCAOB inspections. We find that capital-market responses to unexpected earnings increase significantly following the introduction of the PCAOB inspection regime. Corroborating these findings, we also find an increase in abnormal volume responses to firms’ 10-K filings after the new regime. Overall, our results are consistent with public audit oversight increasing the credibility of financial reporting.

Public Audit Oversight and Reporting Credibility: Evidence from the PCAOB Inspection Regime – Introduction

As the accounting scandals in the early 2000s illustrated, reliable financial reporting is a cornerstone of trust in the stock market, which in turn plays a key role for investor participation (Guiso et al., 2008). In an effort to restore trust in financial reporting after the scandals, the U.S. Congress passed the Sarbanes-Oxley Act (hereafter, “SOX”). One of its core provisions was the creation of the Public Company Accounting Oversight Board (hereafter, the “PCAOB”) and the requirement that the PCAOB inspect all audit firms (hereafter, “auditors”) of SEC-registered public companies (hereafter, “firms” or “issuers”). The introduction of the PCAOB represents a major regime shift, replacing self-regulation with public oversight.

Even after years of experience with the new regime, widespread skepticism remains that the PCAOB and its inspection regime have changed the credibility of financial reporting and reassured investors.1 In response to this skepticism, there has been a call for more economic analysis of the PCAOB’s activities and of SOX in general (e.g., House Oversight Committee, 2012; Coates and Srinivasan, 2014). While prior studies examine specific aspects of PCAOB inspections, there is little evidence on the overall capital-market effects of the new oversight regime.2 At the heart of the debate is the broader economic question of whether audit oversight by a public-sector regulator enhances reporting credibility.3 This paper examines this question.

The objective of an external audit is to provide outside investors with assurance about corporate reporting in light of numerous agency problems between managers and outside investors. As there are also agency problems between managers and auditors, the credibility of an audit depends crucially on the independence of the auditor as well as the thoroughness with which the audit is conducted (e.g., Watts and Zimmerman, 1983). When auditor independence is questionable, an audit is not likely to provide much assurance to investors. Public oversight could mitigate agency problems in auditing and thereby ensure a certain level of audit quality, which in turn should increase the credibility of financial reporting.

Along the lines of this reasoning, SOX replaced self-regulation and peer reviews with public oversight and PCAOB inspections in an attempt to restore investors’ trust in the independence and quality of external auditing. However, prior work in regulatory economics suggests it is not obvious that public audit oversight is an improvement over the prior regime – especially considering the potential problems with public-sector regulators, including resource constraints, inefficient bureaucracies, regulatory capture, and political pressures (e.g., Demsetz, 1968; Stigler, 1971; La Porta et al., 2006). Consistent with these concerns about public regulators, Hilzenrath (2010) states that “the [PCAOB] looks a lot like the system it was designed to replace: slow to act, veiled in secrecy and weak – or weak willed.” Similarly, Glover et al. (2009) characterize the PCAOB’s inspection model as “inefficient and dysfunctional.” Another complication is that much of the audit process is unobservable to outsiders.

Because investors observe only the audit opinion, it is difficult for them to assess the effects of public oversight on external audits. However, the new oversight regime produces a number of publicly observable outcomes (e.g., inspection reports), allowing investors to form updated assessments. In addition, investors are able to observe changes in corporate reporting. For example, prior research documents a large increase in restatements after the introduction of SOX and the PCAOB (Hennes et al., 2008). Our tests presume that investors incorporate this information into their assessments of reporting credibility.

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