PCAOB Enforcement: Toothless Body of Law or a Bite That Packs a Punch? Free

The Sarbanes-Oxley Act of 2002 (SOX) established the Public Company Accounting Oversight Board (PCAOB), granting it with wide-ranging investigative and disciplinary authority for use in its oversight of audit firms that conduct public company audits (SOX Section 105). With this authority, the PCAOB can investigate potential audit quality failures and standard violations and impose “sanctions designed to deter a possible recurrence and to enhance the quality and reliability of future audits” (Public Company Accounting Oversight Board (PCAOB) 2003, 2).¹ Potential penalties include one or more of the following: censuring an individual or audit firm, imposing monetary penalties, barring an individual from being associated with a public company audit firm, suspending an individual or audit firm, and revoking an audit firm’s registration with the PCAOB.

The PCAOB posits that the publication of enforcement activities should not only discipline sanctioned audit firms and individuals but also prevent and deter audit deficiencies among other auditors, providing a spillover benefit more broadly (Modesti 2015; Doty 2015; Public Company Accounting Oversight Board (PCAOB) 2020). However, the value of PCAOB enforcement was called into question in a 2019 Project on Government Oversight (POGO) report that called it “a toothless body of law” (Hilzenrath and Trevino 2019). In making this claim, the report takes a narrow focus on the dollar value of financial penalties imposed directly on Big 4 audit firms following PCAOB enforcement actions, arguing that the amount of penalties is relatively trivial.²

Following these claims, activities of the PCAOB and statements by PCAOB Chair Williams appeared to focus mainly on addressing concerns about the severity of enforcement, including financial penalties. For example, Chair Williams highlighted that the Board has “more than doubled our average penalties against individuals [in 2022] compared to the last five years and increased our average penalties against firms by more than 65 percent” (Williams 2022a).³ Although the PCAOB is “approaching enforcement with a renewed vigilance,” as illustrated by heightened enforcement in 2022 (see Figure 1), the POGO report and the PCAOB both focus only on the direct effects of enforcement (Williams 2022b). Accordingly, they fail to consider the significant reputational effects that follow PCAOB enforcement and the corresponding spillover benefits from nonsanctioned auditors improving audit quality to avoid similar harm.

To date, academic research on PCAOB oversight has largely focused on PCAOB inspections, not enforcement (e.g., DeFond and Lennox 2017; Drake, Goldman, and Lusch 2016).⁴ In fact, similar to the POGO report, prior enforcement research has focused narrowly on the direct impact of sanctions against Big 4 firms. Although these studies find a negative impact on sanctioned firms’ audit fee growth (Boone, Khurana, and Raman 2015) and their client’s stock market performance (Dee, Lulseged, and Zhang 2011), they find no evidence of audit quality improvements following enforcement. Thus, the following lingering question remains: Does PCAOB enforcement broadly deter low audit quality?

In this paper, we summarize the key findings in Lamoreaux et al. (2023), which suggest that PCAOB enforcement offers spillover audit quality benefits as measured by a lower incidence of subsequent financial statement restatements among the clients of nonsanctioned auditors. Importantly, their study finds that spillover effects vary based on auditor size, geographic location, and similarities to sanctioned auditors. We follow this summary with a discussion of the implications of Lamoreaux et al.’s (2023) findings for practitioners.

Lamoreaux et al. (2023) analyze enforcement actions posted to the PCAOB’s website from 2005 through 2015. They identify the audit firm subject to enforcement, the penalties imposed (e.g., revoked registrations, barred individuals, suspensions, monetary penalties, or censures), and the geographic location (i.e., metropolitan statistical area) for each auditor listed in these enforcement actions.

Table 1 details the number, reason, and outcomes of PCAOB enforcement actions by year during the sample period. Panel A indicates that almost 80 percent of the 130 actions sanction small U.S. auditors or their employees. The most common driver is noncompliance with PCAOB rules and auditing or quality-control standards. Panel B illustrates that enforcement increased significantly in the later years of the sample period (2013–2015) and penalties are not mutually exclusive.⁵ Although censures are the PCAOB’s most common penalty, they are often paired with a more severe punishment. Furthermore, over 40 (50) percent of the sanctions prohibit an audit firm (individual) from auditing public companies.

Focusing on the publication date of enforcement, Lamoreaux et al. (2023) investigate whether there is a spillover benefit to audit quality following PCAOB enforcement. Because investors, regulators, and auditors view restatements as a leading indicator of low audit quality (Aobdia 2019; Rajgopal, Srinivasan, and Zheng 2021), Lamoreaux et al. (2023) utilize various measures of restatements as the dependent variables in the regression equations used to determine spillover effects. The form of the regression equations and details of the dependent and independent variables are presented in Table 2.⁶ Based on the theory of psychological distance (Trope and Liberman 2003),⁷Lamoreaux et al. (2023) examine whether the effects of enforcement actions spillover (1) to the nonsanctioned offices of the sanctioned firm (a within audit firm benefit) and (2) to nonsanctioned auditors in the same geographic area a sanctioned firm (a geographic benefit).

Lamoreaux et al. (2023) find that large, annually inspected auditors exhibit a within-firm spillover effect whereby nonsanctioned offices improve audit quality following enforcement against another office within their firm. For example, if the Minneapolis office of KPMG is sanctioned, the audit quality of KPMG’s other offices experience improved audit quality postsanction. In contrast, small auditors exhibit a geographic spillover effect, whereby nonsanctioned auditors improve audit quality. In other words, if a small auditor located in Salt Lake City is sanctioned, other small auditors in Salt Lake City improve audit quality. Further examination shows that the effect for large auditors follows all three types of sanctions against large firms (i.e., barring individuals, monetary penalties, and censures), whereas the effect for small auditors is driven by more serious penalties (i.e., revoked registrations and suspensions).⁸

Lamoreaux et al. (2023) further analyze the small firm sample to investigate potential underlying mechanisms for the geographic spillover benefit. First, they find that audit quality improvements are greater when a nonsanctioned auditor’s clients are of the same industry or size. Second, they find that the spillover benefit is more pronounced when PCAOB enforcements are covered by the media or nonsanctioned auditors operate in the same city as the sanctioned firm. Lastly, Lamoreaux et al. (2023) perform various sensitivity tests to ensure their findings are due to auditors improving audit quality and not audit clients improving financial report quality or improvements due to regulatory changes.

The key takeaway from Lamoreaux et al. (2023) is that PCAOB enforcement is a bite that packs a punch. The benefits from PCAOB enforcement are not limited to the penalties imposed on sanctioned auditors but extend more broadly. Importantly, though, the practical implications extend beyond these findings, as additional avenues may exist for spillover benefits to occur. For example, although Lamoreaux et al. (2023) observe geographic spillover benefits associated with small auditors, they do not find geographic benefits associated with large auditors. We spoke with large audit firm partners to determine potential reasons for the observed differences, and they suggested that most large firms are structured with an industry- or sector-based organizational hierarchy (i.e., not a geographic-based approach). Given this organizational structure, any corresponding spillover benefit within large firms likely follows a path based on industry practices. For example, auditors who specialize in an industry may have greater awareness of PCAOB enforcement within the industry and, therefore, exert greater effort to improve audit quality.

Lamoreaux et al.’s (2023) findings are based on only the PCAOB enforcements through 2015. Given the increase in remote work during the global pandemic that continues today, spillover benefits may have an increased likelihood of materializing through individual auditors’ social connections. Although some of these connections may develop based on firms’ organizational structures, others may be established through temporal or social connections. For example, spillover may occur among individuals who began in the same starting class.

Furthermore, Lamoreaux et al.’s (2023) results suggest that nonsanctioned auditors with characteristics or clientele similar to those of sanctioned firms are more likely to respond to PCAOB enforcement. This means we would expect spillover benefits associated with the PCAOB’s heightened attention to matters like cryptocurrency risks, special purpose acquisition company accounting policies, Chinese foreign holding company access, and disclosures of other firms participating in audits, should any of these matters result in enforcement actions.

A separate public policy implication relates to the timing of PCAOB enforcement communications. The PCAOB is currently prohibited from publicly reporting proceedings until they are settled, which takes two years on average. Moreover, audit firms can further delay the public release of enforcement details by petitioning the SEC for review (Public Company Accounting Oversight Board (PCAOB) 2010; Dee, Lulseged, and Zhang 2012). Bill proposals suggest a desire to make these disclosures more timely by publicizing disciplinary investigations before settlement (e.g., the PCAOB Enforcement Transparency Act of 2017, 2019, and 2021). Lamoreaux et al.’s (2023) finding that PCAOB enforcement publication provides a spillover benefit, even after a two-year delay, implies that investors may receive greater benefit from a more timely disclosure of PCAOB investigations. However, the benefits of early communication must be weighed against the possibility of reputation and economic damage to an audit firm, such as a loss of clients, even if no wrongdoing is ultimately discovered and no penalties are imposed.

Given that the findings of Lamoreaux et al. (2023) suggest positive but varied spillover benefits to audit quality following PCAOB enforcement, new developments in enforcement and connections among audit firms and individual auditors should not be overlooked by the audit profession or capital market stakeholders. Similarities among auditors and their clientele paired with an increased emphasis on enforcement are likely to enhance auditors’ awareness of the reputational costs of PCAOB enforcement and should, in turn, generate broad audit quality improvements even among nonsanctioned firms. Thus, we encourage auditors, regulators, and investors to enhance their understanding of the potential avenues for spillover benefits following PCAOB enforcement.