Costs of Public Auditor Oversight: Real Earnings Management and Innovation Loss

Abstract

Prior research documents positive effects of PCAOB oversight on reporting and audit quality. However, to gain a clear understanding of the net benefits of regulation, it is important to also investigate corresponding costs. To this end, we investigate the relation between PCAOB inspection oversight and real earnings management (REM), a potentially value-destroying activity. We exploit the staggered timing of foreign governments’ allowance of PCAOB inspections in a generalized difference-in-differences design and find that companies engage in greater REM during periods of PCAOB inspection oversight. This relation is stronger for companies with a reduced ability to manage earnings via accruals. We also find that firms are more likely to meet earnings benchmarks through the use of REM subsequent to PCAOB oversight. Lastly, we find a negative association between PCAOB oversight and firm innovation. Collectively, our findings highlight a trade-off between improved audit quality and real costs of auditor regulatory oversight.

Keywords: Audit regulation, earnings management, PCAOB inspections, real earnings management, innovation

JEL Classification: G38, M41, M42, M48