The Effect of Audit Firm Internal Governance on Auditor Behavior and Financial Reporting Quality: Evidence from Internal Inspections

61 Pages Posted: 15 Jul 2019 Last revised: 29 Apr 2021

Date Written: March 31, 2021

Abstract

We examine the effect of large audit firms’ internal inspection programs, an important monitoring mechanism, on auditor behavior and financial reporting quality. Internal inspections are often predictable, and engagement teams concentrate their effort on audits ultimately selected for inspections. The extra-effort increases the likelihood of a favorable inspection rating. We find some evidence of improvement in financial reporting quality in the inspection year, suggesting that internal inspections are effective in deterring auditor shirking. Upon receiving a favorable rating, the engagement team reverts audit effort back to the pre-inspection level. However, if the rating is unfavorable, the team increases effort on future engagements of the client, and this higher effort improves the client’s financial reporting quality if the internal inspection program is considered effective by the PCAOB. The results suggest that higher effort under ineffective internal inspection programs likely involves excessive documentation and reflects lower audit efficiency.

Suggested Citation

Aobdia, Daniel and Petacchi, Reining, The Effect of Audit Firm Internal Governance on Auditor Behavior and Financial Reporting Quality: Evidence from Internal Inspections (March 31, 2021). Available at SSRN: https://ssrn.com/abstract=3419484 or http://dx.doi.org/10.2139/ssrn.3419484

Daniel Aobdia (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2211 Campus Drive
Evanston, IL 60208
United States

Reining Petacchi

Georgetown University - Department of Accounting and Business Law ( email )

McDonough School of Business
Washington, DC 20057
United States

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