Audit quality is measured by the findings from inspection of the audit practice

A direct measurement of audit quality is to investigate how an audit is done, including examination of the qualification of the personnel who conduct the audit and the process employed in the audit examination. If an audit is done by more competent, objective, and diligent people, the audit quality should be higher. The competence of an auditor is determined by factors such as the auditor’s knowledge of relevant accounting and auditing concepts and issues, knowledge of the client’s industry, business, and accounting practices, knowledge of the auditing process, and the ability to make professional judgments. The objectivity of an auditor is represented by the auditor’s unbiased state of mind when making professional judgments and decisions. Finally, the diligence of an auditor is the extent of efforts the auditor is willing to exert in the audit examination. As discussed in Chapters 4 and 5, to ensure public accountants deliver high-quality audits, the accounting professions and regulators have established various rules and standards to govern the conduct of audits. Specific threats to auditors’ independence are identified and rules to help accountants avoid or mitigate the threats are coded for professional conducts. Similarly, particular standards regarding auditors’ competence and due care are also coded for professional conducts. From time to time, accounting firms are inspected by the professional institute and/or regulators to ensure the professional standards and rules and regulations are complied with.

As discussed in detail in Chapter 4, PCAOB inspection is one such inspection. As part of the Sarbanes-Oxley (SOX) Act, Congress established independent oversight of the accounting profession by the PCAOB for audits of issuers. The PCAOB has conducted many inspections of registered public accounting firms that audit issuers each year since its creation. Per section 104 of SOX, a PCAOB inspection focuses on two elements: a review of individual audit engagements and a review of the overall quality-control systems of an audit firm. The former focuses on the important elements such as audit planning, evidence gathering, analysis, and documentations that affect the success of an individual audit engagement, while the latter focuses on the elements, such as personnel hiring and training, maintaining independence, and recruiting clients, that affect the success of the operation of the whole accounting firm. If a firm is with more than 100 issuers, it is inspected annually. Otherwise, it is inspected at least once every three years. The PCAOB does not inspect all the engagements of a particular inspected audit firm and uses a riskbased approach to select the engagements for being inspected.

Abodia (2019) suggests there are three advantages of using PCAOB inspections for assessing audit quality. First, they derive from a standards-based view of audit quality and focus on the work of the auditor conditional on the issuer’s circumstances. PCAOB inspections focus on whether each audit appropriately responds to particular issuer circumstances. PCAOB inspectors focus on professional judgment from auditors to ensure that financial statements are fairly presented. Second, the PCAOB inspections are done by highly competent people who can properly identify poor audit practices. Inspection teams are composed of experienced and knowledgeable former auditors with significant public practice experience (PCAOB 2011; Lennox and Pittman 2010a). As full-time PCAOB employees, the inspectors are independent of the public accounting profession and build extensive inspection expertise (Lennox and Pittman 2010a; PCAOB 2011; Carcello et al. 2011). Third, since the selection of the engagement for inspection is unknown to the engagement teams prior to the completion of the audit examinations, no engagement team would be able to strategically improve quality just for the inspection.

However, there are also concerns about using the PCAOB inspection results to assess audit quality. The most important concern is about inspectors’ understanding of what constitutes a “proper audit.” Although these inspectors are experienced former auditors, their role as inspectors may affect their understanding of the appropriateness of an audit such that they may expect greater efforts from auditors than required. Johnson et al. (2014) identify that the PCAOB could call attention to the lack of some procedures, even if the procedures are not necessary in the first place. It is also possible that the inspectors may exaggerate the impacts of the deficiencies uncovered from the inspections (Houston and Stefaniak 2013). Furthermore, the power of using the findings from inspections to infer the quality of an audit firm in general may be limited. Since the number of engagements inspected is not large each year, the deficiencies uncovered from a small number of engagements may not be powerful enough to generalize the quality of the audit firm for inferring the quality of the not-inspected engagements. Even for engagements with a particular client, the engagements may not be inspected repetitively for several years, and the findings from one inspection may not be generalized for those engagements uninspected in other years.

Nevertheless, the findings from an inspection provide important information about the quality of a particular audit since the inspection is done by people with significant auditing experience. It can be easily argued that the more significant the deficiencies uncovered from an inspected engagement, the lower the quality of the engagement. However, we should be cautious of using the findings in the inspected engagements to infer the general quality of the audit firms. The inspectors may exaggerate the impacts of uncovered deficiencies on the quality of engagements and the number of engagements inspected is limited each year, the actual quality of the engagement inspected may be distorted by the findings, and the findings may not be used to effectively infer the quality of the other engagements of the audit firm. More importantly, the findings do not include an overall evaluative assessment and the quality-control deficiencies are often not disclosed (DeFond 2010; Lennox and Pittman 2010a). Furthermore, it is possible that firms could develop skills to meet the expectations of the inspection process while not necessarily improving the audit quality, which also distorts the relationship between uncovered deficiencies and audit quality.

Peer review is another example of inspection where the accounting practice of one firm is inspected by another firm. Findings from peer reviews may also be able to serve as a sign of audit quality. Under the AICPA peer review system, audit firms choose their reviewers, which may, to a certain extent, make the review less independent and less effective than the PCAOB inspection (Fogarty 1996; DeFond 2010).