The Quality of Audit Firms Entering the Public Company Audit Market

Abstract

Little is known about the population of audit firms that successfully enter the U.S. public company audit market with no prior public company audit experience. We find that from 2004 to 2017, 388 “New Entrant” audit firms successfully entered this market. New Entrants receive more than 15% of PCAOB inspections among triennially inspected auditors, suggesting that the PCAOB expends significant effort overseeing these firms. We find that, compared to multiple control groups, New Entrant auditors provide lower quality audits as measured by a higher likelihood of misstatements, PCAOB-identified deficiencies and disciplinary orders, and lower audit effort. New Entrants also collect lower audit fees and their clients are more likely to subsequently dismiss them. Collectively, our results indicate that clients are willing to hire an audit firm with no reputation for public company audits to obtain a low fee. However, higher dismissal rates suggest that clients are unable to infer lower quality ex ante and demand at least a minimum level of audit quality. 

Keywords: Audit market, audit competition, non-Big 4 audit firms, audit quality, PCAOB

JEL Classification: K23, M41, M49