Do PCAOB Inspection Deficiencies Signal a Firm’s Audit Quality?

Capital markets operate on the availability of high-quality, consistent, and comparable information. Boards use this information to assess management’s stewardship of stockholders’ investments, investors use this information to determine where to allocate resources for maximum value, and policymakers use this information to ensure transparency and protect the public interest. The value of information to capital market operations is significant, making it important for companies to get it right when disclosing information for stakeholders to rely on, particularly when it comes to audited financial statements.

Each year the Public Company Accounting Oversight Board (PCAOB) performs inspections of select issuer audit engagements. Some of the PCAOB’s inspections are random, though many are conducted because regulators rightly identified an audit engagement as more complex than average, heightening the potential for errors. The intent of these inspections is to evaluate public company auditors’ compliance with auditing standards, but they also serve to identify common themes to help auditors improve their practice. The inspections are an important tool for capital market stakeholders, but they have limitations.

Audit quality is complex: a quality audit may be defined as compliant with auditing standards and results in the correct opinion on the financial statements, given an assessed level of audit risk, as described by Jere R. Francis in the 2011 paper, “A Framework for Understanding and Researching Audit Quality.” This definition strips away much of the nuance of audit quality, but it does provide a useful starting point for identifying a problem with using deficiency rates, alone, as a tool for rendering a judgment on the state of audit quality. Employing this definition to assess the quality of an audit requires information about the auditor’s adherence to standards and whether the audit opinion itself was appropriate in context. Part I.A deficiencies, by definition, indicate that the auditor did not obtain sufficient and appropriate audit evidence to support their opinion. In the process of addressing deficiencies, very few restatements or changes in the auditor’s opinion result. This suggests deficiency rates should be used with other measures for a more complete perspective on audit quality.

There are several proxies for audit quality, including going concern opinions, restatements, litigation outcomes, and various measures of earnings quality, all with their own sets of pros and cons. Of the available options, restatements are one of the most readily accessible and easily understood measures of both financial reporting and audit quality. Specifically, “Big R” restatements, or those that require disclosure of the unreliability of previously issued financial statements, provide a measure of the frequency with which auditors issued an incorrect opinion. Therefore, one approach could be to consider inspection outcomes in conjunction with restatement frequency to obtain a more complete picture of audit quality.

The Center for Audit Quality’s (CAQ) Financial Restatement Trends in the United States: 2013–2022 report found a 53 percent decline in the number of restatements during the years studied, from 858 restatements announced in 2013 to 402 announcements in 2022. Additionally, the percentage of “Big R” restatements dropped to 18 percent of the annual total number of restatement events over the seven pre-pandemic years included in the report. The fact that inspection outcomes and restatement trends could lead to opposite conclusions about the state and direction of audit quality highlights the need for careful consideration of the measures used to draw inferences.

There are several reasons why aggregated inspection deficiencies, even when combined with restatement data, do not tell the full picture related to audit quality.

The engagements inspected are primarily identified using a risk-based selection process and therefore are not representative of all audit engagements. As a result, the inspected engagements are complex and require auditors to exercise significant judgment on risk, with implications for the design of audit procedures and the evaluation of audit evidence. This inspection approach to directing resources where the risks of material misstatement are highest is an appropriate solution from a constrained resources perspective; however, it means that the inspected sample is biased, and the resulting deficiency rates are not representative of the population. The PCAOB themselves say that inspection reports are not intended to serve as a balanced report card or overall rating tool.

Stakeholder perception of inspection findings varies according to the specific nature of the deficiency, which suggests that a simple count of the number of deficiencies is insufficient for assessment purposes. A CAQ-commissioned study, Perspectives on Corporate Reporting, the Audit, and Regulatory Environment: Institutional Investor Research Findings, provides evidence that, for certain investors, deficiencies are not material without a restatement. This finding has some empirical support in academic literature, as one study found that triennially inspected firms with identified deficiencies solely attributable to audit procedures were no more likely to be subject to dismissal than those with clean inspection reports. Additionally, another study found that, for annually inspected firms, inspection deficiencies related to audit procedures are associated with higher audit fees. This result suggests that stakeholders believe the findings to be related to regulatory compliance and the incremental fees an acceptable cost associated with the performance of incremental audit procedures to meet established requirements. Conversely, the same study found that inspection deficiencies related to departures from accounting principles are associated with lower audit fees. This suggests that the misapplication of accounting standards is perceived negatively, and auditors are willing to negotiate lower audit fees because of concerns about issuer retention. The combined evidence further suggests that, to obtain a better understanding of inspection deficiencies, findings related to departures from audit procedures should be classified differently than those related to departures from accounting principles.

Financial statement restatements are rarely detected through the inspection process. An inspection deficiency is not equivalent to an audit failure. In fact, based on an internal CAQ analysis of the PCAOB’s own reporting, less than 1 percent (37 out of 4,668) of the engagements of annually inspected US firms that were inspected from 2009 to 2022 resulted in a “Big R” restatement. Over this same period, approximately 31 percent (1,451 out of 4,668) of engagements inspected were deemed deficient by the PCAOB. Since 2009, the audit opinions of firms providing assurance services to more than 80 percent of the US public company market capitalization are confirmed by the inspections process 99 percent of the time.

Audit quality is too nuanced to be captured by a single metric, whether using deficiency rates, restatements, or any other measure. Case in point, the culmination of the PCAOB’s decade-long effort to develop audit quality indicators is a proposal for a set of firm and engagement metrics in 11 different reporting areas. The sheer volume of proposed metrics demonstrates the challenges with attempting to assess the quality of a single audit or an audit practice. Furthermore, the PCAOB explicitly states in its “Firm and Engagement Metrics” proposal that the intentional shift in language from audit quality indicators to firm and engagement metrics was employed because it “avoids the potential misimpression that any set of metrics can comprehensively measure audit quality.” Out of context, the proposed collection of metrics will likely be of limited use to external stakeholders. However, they could serve to enhance communication between auditors and the audit committee.

Is the aggregate rise in inspection findings notable? Yes. Should it be examined? Absolutely. Does it mean, or is there evidence to suggest, that audit quality is deteriorating to the point where investors cannot rely on public company financial reports? No.

CAQ is a NACD partner, providing directors with critical and timely information, and perspectives. CAQ is a financial supporter of the NACD.

Vanessa Teitelbaum, CPA, is senior director on the Professional Practice team at the Center for Audit Quality. She joined the CAQ in 2016 and advocates for stakeholders in the audits of public companies.