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

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.