b'Canada a higher deficit and Mexico a lower one.Act, which established the Public Company Accounting I had to find a new way to disentangle the fiscal condi- Oversight Board (PCAOB), which inspects auditors of tions of the government from the overall macroeconomiccompanies registered with the U.S. Securities and Exchange conditions, he says. To get something closer to what aCommission. The Big Four accounting firms as well as scientist is doing in a lab, I needed to find situations whereaccounting firms with more than 100 public clients are the deficit is increasing for reasons that are unrelated to theinspected annually. Firms with 100 or fewer public clients business cycle.are triennially inspected. The goal of the inspection, which To do that, Silva looked at governments militaryincludes a review of the audit work papers, quality control spending, which is related to geopolitical conditions, notand tone at the top, is to assess and improve audit quality. economics, he says. If you spend more with your military,But does it? your deficits will increase because you are ramping upResearchers, audit firms, their clients and regulators government spending and not necessarily ramping up yourare interested in empirical evidence on the effectiveness tax collection as well. Analyzing data from 39 countriesof public regulation, Khurana says. We were interested with increasing deficits due to defense expenditures, Silvain knowing if the PCAOB inspection program improves found that the higher the deficit, the less fiscally stable theinspected auditors audit quality of U.S.-listed clients for government is and the less capable that government is ofboth annually and triennially inspected audit firms. safeguarding the banks if there is a recession or financialKhurana and his colleaguesincluding Nate Lundstrom, distress in the banking sector.PhD, 19 pored over financial statement data. To measure Deficits matter for the credit risks the banks face, Silvaaudit quality, the researchers looked at the likelihood of says. Its better when the government has deficits undermaterial financial misreporting as well as other more subtle sustainable levels because if banks start facing financialindicators of clients earnings management. What they distress, the government has a variety of ways to stimulatefound is that audit quality improvements resulting from the economy and to safeguard the banks, either directly byPCAOB inspections are stronger for the largest four audi-providing bailouts or indirectly by using fiscal policies totors (the Big Four) relative to smaller auditors. stimulate the economy and help borrowers, which, in turn,The Big Four have more of a reputation to protect helps reduce the risk of the bank.than a small audit firm, and they also have deep pockets, Silvas research shows when fiscal conditions worsen,which results in more litigation exposure, Khurana says. banks increase their loan-loss provisions. But the implica- As Big Four auditors have more at stake in terms of repu-tions of his research suggest that banks provisioning rulestation and litigation risk compared to smaller auditors, it should be forward-looking: When you have a sequence ofmakes sense that their audit quality response is similarly good years when everybody is doing well and the economystronger. Another potential driver of this asymmetric audit is coming closer to full employment, what happens? Banksquality response to the new inspection regime is inspection set up smaller provisions because they expect to be losingfrequency. The Big Four are inspected annually, so they less with their credit portfolios. So whenever a bad outcomehave more frequent opportunities for continuous improve-actually hits, they wont be as prepared. What you want isment. We did not find evidence that the smaller auditors that whenever you have a sequence of good years, you endimproved on par with the largest four, he says. One up over-provisioning so you reserve more for bad years.possibility is that their more infrequent interactions with That way, whenever a bad year comes, youll be betterPCAOB inspectors resulted in the inspection process having prepared to withstand credit losses.an attenuated impact on their audit quality improvements. The study, Fiscal Deficits, Bank Credit Risk, andKhuranas research offers empirical evidence on the Loan Loss Provisions, has been accepted for publicationeffectiveness of public regulation: In the context of the in the Journal of Financial and Quantitative Analysis. highly concentrated U.S. audit market and the importance Better Inspectorof the Big 4/non-Big 4 audit quality differential in affecting Do PCAOB inspections improve audit quality, or do theya companys auditor choice and information risk, our results notthat is the question Inder Khurana, the Geraldinesuggest the PCAOB inspection program affected audit Trulaske Chair of Accountancy in the Trulaske College ofquality differently among audit firms.Business, wanted to know.The study, PCAOB Inspections and the Differential Before the Enron scandal, the auditing profession wasAudit Quality Effect for Big 4 and Non-Big 4 US self-regulated. In response to Enron and several otherAuditors, is forthcoming in Contemporary Accounting accounting scandals, Congress enacted the Sarbanes-OxleyResearch.2022 Newsmagazine 19'