Audit Quality and the Pricing of Discretionary Accruals

Abstract

Accrual-based earnings is considered superior to cash flows. Accruals let managers communicate their private and inside information and thereby improve the ability of earnings to reflect underlying economic value. However, managers could engage in aggressive reporting of accruals that can seriously undermine the informativeness of reported earnings. Since outsiders cannot directly observe earnings, high-accrual firms face greater agency costs relative to low-accrual firms. Auditing plays an important role in mitigating these agency costs by constraining opportunistic management of accruals. This study examines whether there is a linkage between audit quality and pricing of discretionary accruals. The findings indicate that the association between stock returns and discretionary accruals is greater for firms audited by Big 6 auditors than for firms audited by non-Big 6 auditors. Further, discretionary accruals of clients of Big 6 auditors have a greater association with future profitability than discretionary accruals of clients of non-Big 6 auditors.

Keywords: audit quality, big 6 firms, discretionary accruals, earnings management, valuation, capital markets

JEL Classification: M41, M43, M49, G12, G14