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SUMMARY
Accrual-based earnings is considered superior to cash flows. Accruals allow managers to 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 would 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.
Data Availability: The data used in this study are publicly available from the sources Indicated in the text.
JEL Classificadons: M41, G14.
INTRODUCTION
The issue of how capital markets process accounting information, in particular earnings and its components, is of interest to participants of the capital market. Accrual earnings is considered superior to cash flows because it overcomes the timing and mismatching problems inherent in measuring cash flows (Dechow 1994). In addition, accruals let managers communicate their private, inside information and thereby improve the ability of earnings to reflect underlying economic value. At the same time, managers could abuse the flexibility permitted by GAAP by engaging in aggressive reporting of accruals that can seriously undermine the informativeness of reported earnings. However, outsiders cannot directly observe this opportunistic behavior by managers. In response, investors and creditors may demand a higher cost of capital. Thus, high-accrual firms face greater agency costs relative to low-accrual firms (Francis et al. 1999). Auditing plays an important role in mitigating these agency costs by constraining opportunistic management of accruals. However, evidence on whether the stock market recognizes the role of auditing in pricing of accruals is limited. This study examines whether there is a linkage between audit quality and pricing of discretionary accruals where...