The impact of audit quality on earnings predictability

Abstract

Purpose – This paper examines the impact of audit quality, measured by financial statements audited by the big four accounting firms, on the investors' ability to predict future earnings for profitable and unprofitable firms. Methodology – The paper uses the returns-earnings regression model developed by Collins et al. (1994) and the author interacts all independent variables in this model with a dummy variable, AUDIT, which is set to equal one if financial statements audited by the big four accounting firms, zero otherwise. Future Earnings Response Coefficient (FERC) is the measure of earnings predictability. Findings – The paper finds that investors are able to better anticipate future earnings when financial statements are audited by the big four accounting firms. However, the findings are not applicable for unprofitable firms. Practical implications – The findings of the paper have implications for auditing related academic research and the users of financial statements. In particular, the study shows that the big four accounting firms have not lost their audit quality advantage and that financial statements audited by the big four accounting firms are arguably of higher quality than those audited by non-big four accounting firms. Originality/value - To the best of the author’s knowledge, there is no UK study to date examining the association of the quality of financial statements audited by the big four accounting firms and the returns-earnings association. Consequently, this paper significantly contributes to the limited literature on the perceived value relevance of audit quality.