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The effect of PCAOB inspections on corporate innovation: evidence from deficiencies about the valuation of intangibles

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Abstract

I examine the economic consequences on corporate innovation when PCAOB inspections cite auditors for insufficient procedures in auditing the valuation of intangibles. I find that the clients of deficient auditors recognize larger and timelier impairments of intangibles, suggesting that affected auditors increase scrutiny about the valuation of intangibles in subsequent audits. This effect obtains only for valuation-related deficiencies and is salient for the clients of auditors who receive such deficiencies repeatedly. I also document real effects that the clients of deficient auditors exhibit less use of external mergers and acquisitions—which yield recognizable intangibles whose valuation is subject to increased auditor scrutiny. Overall, these results suggest that the intervention by the PCAOB effectively alters the measurement of intangibles and perhaps unintentionally affects how clients invest in corporate innovation.

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Data Availability

All data used are publicly available from sources cited in the text.

Notes

  1. Bena and Li (2014) mention that U.S. public firms pursue innovation in about two-thirds of all mergers between 1984 and 2006. Given the increasing trend for innovation via mergers and acquisitions (BCG 2017; Deloitte 2017), this ratio becomes a lower bound of mergers and acquisitions related to innovation in my study.

  2. For example, when Marissa Mayer stepped down from the CEO of Yahoo!, which was acquired by Verizon in 2017, commentators said she was reluctant to admit that her major acquisitions had failed to help Yahoo! catch up with technological changes, resulting in untimely recognition of intangible impairments (Gu and Lev 2011).

  3. In this paper, I refer to intangibles in general because the audit deficiencies mostly mention goodwill and other intangibles together or do not distinguish between goodwill and other intangibles. The valuation of intangibles other than goodwill is also subject to managerial incentives to delay the recognition of intangible impairments.

  4. In contrast, audit deficiencies regarding the valuation of intangibles may have almost no effect on internal innovation strategies (e.g., in-house R&D) because most internally developed intangibles are expensed immediately under U.S. GAAP. Although U.S. GAAP allows the capitalization of internally developed software, the amount is economically insignificant in general.

  5. Prior studies suggest that goodwill impairments lead to decreases in CEO compensation and negative reactions in the stock market (Li et al. 2011; Darrough et al. 2014).

  6. Joint ventures fall between M&As and R&D expenditures in that joint venturers share corporate resources for innovation, but none of them individually control joint ventures. The accounting treatment for joint ventures reflects this economic nature—joint venturers recognize intangibles only in limited circumstances (see Section 2.2 for details).

  7. Shroff (2020) provides the real effects of non-U.S. audit clients’ investment and financing decisions. Aobdia et al. (2021) provide evidence on the operating decisions of U.S. financial institutions.

  8. I use the term “unintended” in the sense that the PCAOB is primarily concerned about the effect of its inspections on audit quality, not necessarily on real decisions of audit clients, without implying negative consequences. The findings of this paper, in fact, suggest that the consequences of audit deficiencies regarding the valuation of intangibles are positive.

  9. PwC (2014) and BCG (2017) report an increasing trend of technology-driven deals since the early 2000s.

  10. For example, in 2017, Crowe Horwath (Hong Kong) was sanctioned for refusing to cooperate with the PCAOB’s investigation.

  11. In 2001, the FASB eliminated the pooling of interest method, which does not generate any intangible assets from business combinations.

  12. The purpose of a joint venture is to share risks and rewards in develo** new products or technologies, to combine complementary technological knowledge, and to pool resources in develo** products or other facilities (ASC 323). For example, Energy Technology Venture is a joint venture involving General Electric, NRG Energy, and ConocoPhillips, focusing on the development of innovative energy technologies.

  13. “Financial Reporting Developments: A Comprehensive Guide on Joint Ventures,” E&Y, June 2015.

  14. Joshua Forgione, associate chief accountant at the SEC, a speech at the 2009 AICPA National Conference (https://www.sec.gov/news/speech/2009/spch120709jsf.htm).

  15. In an untabulated test, I find an insignificant change in auditor turnover around the release of inspection reports that contain relevant audit deficiencies. This is likely because deficient auditors carefully adjust the level of scrutiny and, although clients may benefit from less auditor scrutiny about the valuation of intangibles, auditor switches are also costly for clients, who could experience higher bank lending costs and negative reactions in the stock market (Griffin and Lont 2010; Francis et al. 2017).

  16. In this vein, Barrios et al. (2019) show that financial measurement practices by independent auditors lead to a significant variation in firm-level productivity.

  17. The effect of reduced managerial discretion on joint venture investments is nuanced because venturers can avoid the costs by using the equity method or fair value accounting for joint venture investments. Audit deficiencies regarding the valuation of intangibles are almost irrelevant to in-house R&D, where companies hardly recognize intangible assets under U.S. GAAP.

  18. The real effects arise by mitigating the moral hazard problem associated with excessive M&A or by managers’ learning about the value of external innovation strategies from auditor scrutiny (Roychowdhury et al. 2019). In this paper, the former is more plausible, given the literature documenting agency costs associated with M&A (e.g., Masulis et al. 2007).

  19. GDWLIP represents impairment losses from both goodwill (Compustat variable GDWL) and other intangibles (Compustat variable INTANO) for companies that report these items together. In case companies report them separately, GDWLIP only reflects goodwill impairments, and WDP includes other intangible impairments. However, WDP also includes impairment or write-down of assets other than goodwill (e.g., financial assets). Because other intangible impairments are only a small fraction of WDP, I use GDWLIP as the numerator of Impair.

  20. I first download the inspection reports from the PCAOB website (https://pcaobus.org/oversight/inspections/firm-inspection-reports). Next, I search for keywords (e.g., impair, intangible, and goodwill) that broadly exist in inspection reports that mention audit deficiencies related to the valuation of intangibles to minimize the false negative error that I fail to identify inspection reports that actually mention such deficiencies. Finally, if an inspection report includes any of the keywords above, I read through the inspection report to determine whether the report indeed mentions the valuation-related deficiencies of intangibles. Appendix 2 shows the examples of common phrases used to mention audit deficiencies related to the valuation of intangibles.

  21. Although suggestive by nature, the reason the clients in the healthcare sector have a lower proportion of deficient auditors could be because of the importance and the number of patents, which provide verifiable, hard evidence in the assessment of intangibles. The fluctuation of raw materials in the oil and gas market could contribute to a higher proportion of deficient auditors in the energy sector.

  22. In additional tests, I check the robustness of the results when the net purchase is based on non-goodwill intangibles and when all M&A are considered and find similar results.

  23. The recent econometric literature raises the concern that the estimated treatment effect in a staggered difference-in-differences framework may be biased where the already-treated observations still serve as a part of the control group for later-treated observations (e.g., Baker et al. 2022). To assess the effect of such a bias, in an untabulated test, I run a regression model where I remove the already-treated observations from the control group for the later-treated observations and find similar results, suggesting that the influence of such a bias is not significant.

  24. The regression model in this paper can be viewed as a special case of the first-differenced difference-in-differences where the change in treatment is fixed to a unit magnitude. The same research design is employed by Heider and Ljungqvist (2015) and Ljungqvist et al. (2017). The state-level tax rate changes in their paper correspond the auditor-level deficiencies over time in this paper.

  25. If the clients of deficient auditors remediate their deficiencies, I expect that an increase in intangible impairments occurs in year t (i.e., one-year after the fieldwork of inspections), in line with the timing in prior studies that examine the contents of inspection reports (DeFond and Lennox 2017; Aobdia et al. 2021). Although managers can learn from their audit firms about pending issues that the PCAOB may include in inspection reports (PCAOB 2012), in the context of intangible valuation, managers have strong incentives to delay the recognition of intangible impairments and therefore are expected to delay until the inspection reports are released in year t (Li et al. 2011).

  26. If audit deficiencies regarding the valuation of intangibles reduce clients’ use of external innovation strategies, managers need to reconsider ongoing M&A. The decrease in deals, which are discrete events, is likely to affect clients’ investment in external innovation strategies in a timely fashion. Luo (2005) shows that, once managers learn from negative market reactions around M&A announcements, they quickly withhold a significant number of ongoing deals. Therefore, I expect that, if the decrease in M&A is salient, the change occurs in year t (i.e., one-year after the fieldwork of inspections). This expectation is also consistent with the notion that real effects arise when managers expect that financial statement users would update their knowledge about fundamentals.

  27. For example, the patent expiration of medicines affects innovation in the pharmaceutical industry. The government policy that subsidizes electric vehicles likewise spurs companies in the automobile industry to invest more in innovative technologies. deHaan (2020) shows that a narrowly defined fixed effects structure that leaves little variation could pose a significant threat to the reliability of the treatment effect. For the nondiscrete control variables in my regression model, I find that the residual standard deviation after fixed effects remains similar, suggesting that the industry-year fixed effects adequately control for the time-varying industry variations without imposing significant econometric concerns.

  28. Audit deficiencies significantly increase impairment losses of intangibles (coefficient = 0.0021; t-stat. = 3.07) when the deficiencies disclosed in 2010 are not considered treatments. As expected, the magnitude of this coefficient is slightly smaller than the magnitude of coefficient reported in Table 3 (0.0025).

  29. This across-auditor spillover effect is distinct from the spillover effect across clients of the same auditor. The effect across auditors is less likely to occur because the regulatory uncertainty about the valuation of intangibles and the costs of preemptive actions are higher.

  30. In examining the effect of PCAOB inspection results, I primarily focus on deficiencies from specific audit engagements (i.e., Part 1 findings) for several reasons. First, the research design using Part 1 findings can be implemented on a wide range of audit firms over long time-series. The research design using firm-wide quality control issues (i.e., Part 2 findings) is feasible only when audit firms receive Part 2 findings and fail to remediate adequately within a one-year period. Second, Part 2 findings are only selectively disclosed, depending on the auditors’ remediation results. That is, researchers cannot tell whether the absence of publicly disclosed Part 2 findings means (1) no quality control issues in the first place or (2) quality control issues remediated within one year. Third, to the extent that auditors with Part 2 findings also have related Part 1 findings that are immediately disclosed, the estimates from the above regression model include the effect of Part 2 findings remediated within a one-year period. Given the strong incentive to avoid the public disclosure of quality control issues (Aobdia 2020), the deficient auditors likely try to remediate as soon as possible. Therefore, by focusing on Part 1 findings, the economic magnitude estimated from the above model captures most of the (unobservable) entire effect from PCAOB inspections on the valuation of intangibles. Nonetheless, to supplement the research design based on Part 1 findings, in Table 5, I estimate the effect of repeated deficiencies, which are likely to capture systematic audit failures, and find stronger effects.

  31. The untabulated variance inflation factors are not larger than 1.40 for company- and auditor-level control variables in this regression, suggesting that multicollinearity is not substantial.

  32. In an untabulated test, I find that audit fees paid by the clients of deficient auditors are significantly higher than those of non-deficient auditors, where audit fees proxy for auditor effort (Acito et al. 2018). I also examine the audit clients in the non-M&A sample. These clients are on the extensive margin, with significantly less intangibles on their financial statements and weaker incentives to avoid or delay the recognition of intangible impairments. I find consistent evidence that these clients do not significantly change intangible impairments when their auditors are deemed deficient in the valuation of intangibles.

  33. I also examine the distribution of the fitted values to check the reasonableness of the linear probability model. According to Long (1997), the linear probability model can fit the data as well as the logistic model if the fitted values are between 20 and 80% of the discrete dependent variable’s range. This is because, in the absence of extreme probabilities (e.g., 1% or 99%), the relationship between the log odds from the nonlinear model and the probability from the linear model is almost linear. The minimum of -0.495 is above the left threshold of -0.6, and the maximum of 0.593 is below the right threshold of 0.6, validating the usage of the linear probability model in my setting.

  34. Using the coefficient on ∆Deficiency from Column (1) of Table 4 and the mean value of Impair from Table 2, 0.01/0.1 = 10%. Similarly, 0.0025/0.015 = 16.7% = (1 + 6.1%)(1 + 10%) – 1, where 10% comes from the first calculation.

  35. The examples in Appendix 2 show that inspectors mention operating profits, suggesting that they pay attention to profitability measures to infer suggestive evidence about whether intangibles are overstated. Hence, between the two alternative interpretations, the former is less likely to explain the insignificant coefficient on the interaction term.

  36. To further illuminate the economic nature of the intangible impairments, I conduct a test on patent citations. I use the average number of truncation-adjusted citations per patent as a proxy for the efficiency or qualitative aspect of innovation. The result, untabulated, shows that the clients of deficient auditors are associated with more patent citations per patent in subsequent years. This result suggests that the (unintended) intervention by the PCAOB associates positively with the efficiency in corporate innovation. However, the patent citation test result should be interpreted as suggestive evidence because the connection between PCAOB auditor inspection and patents is relatively remote.

  37. To illustrate, suppose an auditor has a client. The auditor receives a deficiency regarding the valuation of intangibles in 2015. In light of the uncertainties surrounding inspections and the general preference of clients not to recognize intangible impairments, auditors increase the level of scrutiny modestly. As a result, the client recognizes $100,000 more intangible impairments, which could have been as large as $300,000 if fully remediated. However, suppose that the remediated level of auditor scrutiny still falls short of the expectation of inspectors in the next year. Hence, the auditor receives a repeated deficiency and now conducts even more stringent procedures, resulting in an incremental impairment recognition of $200,000 on the client’s financial statements.

  38. I find that the inclusion of intangible impairments as an additional control attenuates the significance of the coefficient on the main independent variable, suggesting that the decrease in discretion in the valuation of intangibles contributes to the real effects.

  39. I check the robustness of the joint venture test when the accounting for joint ventures was modestly altered in 2007 when SFAS 141R was passed and in 2009 when the SEC recommended more use of fair value accounting at the formation of joint ventures. In untabulated results, I find that the coefficients on ∆Deficiency remain insignificantly negative when the sample period is restricted to 2007–2015 and 2009–2015, respectively.

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Acknowledgements

I greatly appreciate my dissertation committee Baruch Lev (chair), Stephen Ryan, Yiwei Dou, and William Greene for their guidance and support. I am especially grateful to Lakshmanan Shivakumar (editor) and an anonymous reviewer for their helpful suggestions. I thank Aleksander Aleszczyk, Daniel Aobdia, Hye Sun Chang, Christine Cuny, Ilan Guttman, Heedong Kim, Aaron Yoon, and seminar participants at Chinese University of Hong Kong, City University of Hong Kong, CKGSB, Singapore Management University, Hong Kong Baptist University, New York University, and Tilburg University for helpful comments. I gratefully acknowledge financial support from the Fubon Center for Technology, Business and Innovation and the Center for Global Economy and Business at the Stern School of Business, and the Samsung Ph.D. Scholarship Foundation. I also thank three anonymous PCAOB inspectors for sharing their experience in implementing inspections and Serena Lee and Joyce Park for sharing their experience in receiving inspections.

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Appendices

Appendix 1

Table 8 Definitions of variables
Full size table

Appendix 2: Examples of audit deficiencies regarding the valuation of intangibles

This appendix contains the relevant excerpts from the PCAOB inspection reports.

  1. [1]

    2010 Inspection of Deloitte & Touch LLP

 

“The Firm failed to perform sufficient procedures to evaluate the reasonableness of the revenue growth assumptions that the issuer used in its analyses of the potential impairment of goodwill and indefinite-lived intangible assets. Specifically, there was no evidence in the audit documentation, and no persuasive other evidence, that the Firm had considered the adverse implications of industry forecasts that indicated annual declines in a key component of revenue, as opposed to the growth that the issuer projected.”

“The Firm failed to perform sufficient procedures to evaluate the reasonableness of certain significant assumptions that the issuer used in its analyses of the potential impairment of certain of its goodwill and indefinite-lived intangible assets. Specifically, for certain reporting units, the Firm failed to evaluate the issuer’s projected net sales growth, divisional operating profit, and capital expenditures and, for another reporting unit, the Firm’s procedures to test these projections were limited to inquiries of management and reviewing management-prepared memoranda.”

“The Firm failed to test the completeness and accuracy of the computer-generated information that it relied upon in its testing of the issuer’s analyses of the potential impairment of goodwill and other indefinite-lived intangible assets.”

  1. [2]

    2005 Inspection of PricewaterhouseCoopers LLP

“The issuer recorded an impairment charge related to goodwill in its third-quarter financial statements. The Firm failed to perform sufficient procedures related to the impairment charge. Specifically, there was no evidence in the audit documentation, and no persuasive other evidence, that the Firm had performed procedures to test the assumptions and underlying data that management used to calculate the impairment charge, including the allocation of goodwill to reporting units. The Firm failed to obtain evidence regarding the fair value of certain assets and liabilities of the impaired reporting unit, including evidence as to the existence and valuation of other intangible assets that existed as of the date of the impairment test.”

Appendix 3

Table 9 Amendments to accounting standards related to intangibles
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Kim, J. The effect of PCAOB inspections on corporate innovation: evidence from deficiencies about the valuation of intangibles. Rev Account Stud 29, 1491–1523 (2024). https://doi.org/10.1007/s11142-022-09750-9

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