This study investigates the relation between audit regulation and cost of equity capital. There is scant empirical evidence on this relation because changes in audit regulation are frequently accompanied by other major regulatory changes. We exploit variation in the timing of regulatory changes induced by foreign governments' staggered allowance of PCAOB inspections. Using a difference‐in‐differences design, we find that foreign SEC registrants with auditors from countries that allow PCAOB inspections enjoy a lower cost of capital, relative to foreign SEC registrants with auditors from countries that prohibit inspections. Furthermore, we find that this cost of capital effect is attenuated for companies with higher‐quality governance mechanisms. Finally, we document that inspection access is associated with higher‐quality analyst forecasts, which suggests that this change in audit regulation reduces information risk for market participants.

Responsive regulation (RR) theory posits that effective regulators enforce compliance by escalating penalties only if persuasion fails, otherwise risking formation of a culture of resentment. Using RR theory as a lens, we examine the interactions between large audit firms and the PCAOB during the initial years of PCAOB regulation, when annually-inspected auditors utilized negative tone within their inspection response letters to express public disagreement with their inspection reports. Consistent with our expectations, we find that negative tone within response letters is positively associated with (1) future Part I inspection findings that result in a restatement of a client’s financial statements and (2) the likelihood that Part II of a future inspection report will be publicly disclosed. We triangulate these results and the underlying theory in semi-structured interviews of eight PCAOB inspectors and six audit partners involved in these early interactions between the largest firms and the PCAOB. Consistent with RR theory, the PCAOB viewed public disagreement as indicators of noncompliance, incorporated public disagreement into subsequent inspections, and escalated penalties for noncompliance. Contrary to RR theory’s prescriptions, the PCAOB did not use persuasion as a first reaction to noncompliance. In response, the firms stopped publicly disagreeing, but may have formed a culture of resentment toward the PCAOB.