Do Audit Firms’ Internal Inspection Programs Have Teeth? Evidence from the U.S. Operations of the Largest Audit Firms

We provide the first large sample evidence on audit firms’ internal inspection programs, an integral part of the quality control mechanisms within an audit firm. We find that internal inspections are predictable. Engagement partners can predict not only when they will be inspected, but also which of their engagements will be inspected. The engagement team, including the lead partner and quality review partner, takes advantage of this predictability and concentrates effort on the audit that ultimately is selected for an internal inspection. We further find that the engagement team changes audit effort in response to the inspection outcome. If the inspection outcome is favorable, the team immediately reverts audit effort back to the pre-inspection level. However, if the outcome is unfavorable, the team increases effort on the engagements of the client issuer for multiple years. The higher effort in preparation for an internal inspection and in response to an unfavorable inspection outcome improves the client’s financial reporting quality only if the internal inspection program is considered effective by the audit regulator. The results suggest that higher effort under ineffective internal inspection programs likely involves excessive documentation and merely reflects lower audit efficiency. The evidence taken together highlights the importance of an effective internal inspection program in shaping financial reporting quality.