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    The Influence of Audit Firm Specialization on Analysts’ F...
    research summary posted April 16, 2012 by The Auditing Section, last edited May 25, 2012, tagged 11.0 Audit Quality and Quality Control, 11.04 Industry Experience, 14.0 Corporate Matters, 14.05 Earnings Targets and Management Behavior 
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    Title:
    The Influence of Audit Firm Specialization on Analysts’ Forecast Errors
    Practical Implications:

    The results of this study suggest that industry specialist auditors help constrain management’s tendency to manipulate earnings to achieve certain earnings thresholds.  These results do appear weaker when limiting the analysis to the post-SOX period, which could reflect the significant changes to the auditing market that occurred during and after 2002, but the post-SOX analysis is subject to limited data availability.

    Citation:

    Payne, J. 2008. The Influence of Audit Firm Specialization on Analysts’ Forecast Errors. Auditing: A Journal of Practice & Theory 27 (2): 109-136.

    Keywords:
    auditor specialization; analysts’ forecast error; audit quality
    Purpose of the Study:

    The prior literature shows that analysts’ forecasts provide information to financial market participants.  Also, it shows that managers have incentives to meet or beat analysts’ forecasts because failure to do so could result in negative stock price reactions, reduced compensation, costly legal actions, or all of the above.  However, managers also have incentives to reduce reported earnings down to analysts’ forecasted amount if earnings were to exceed the forecasted amount and establishing accrual reserves would allow  management to more easily meet future earnings expectations.  Therefore, the amount of analyst forecast error (i.e., the difference between the consensus analyst forecast and actual earnings) provides a proxy for management’s use of earnings manipulation activities.

    Prior literature also shows that higher quality auditors constrain management’s earnings manipulation activities, including their use of total and discretionary accruals.  Additionally, prior literature examines and shows a decreased level of reported earnings that just meet or beat analysts’ forecasts when the companies are audited by city-specific auditor specialists, as well as reduced analyst forecast errors for quarterly periods that are subject to financial statement audit requirements versus review requirements (i.e., the 4th quarter versus quarters 1 through 3).  However, the purpose of this paper is to fill a void in the literature and examine the impact of higher audit quality, as proxied by industry specialist auditors, on managements’ use of accruals when management has specific incentives to manipulate earnings (up or down) towards a predetermined target level.

    Design/Method/ Approach:

    To isolate industry specialization, the author examines U.S. publicly traded companies who are audited by Big N firms during the period of 1989-2005.  The author measures managements earnings manipulation by modeling  the absolute value of analyst forecast error and reported earnings exceeding analysts’ forecasts by exactly 1 cent.  Differential audit quality is based on measures for auditor specialization as proxied by the auditor’s industry market share, audit firm portfolio market share, and a combined indicator of those two measures.  The author examines both measures in the pre- and post- SOX period.

    Findings:
    • The results indicate that absolute analyst forecast errors are greater for companies audited by industry specialist auditors. 
    • Companies audited by industry specialist auditors are less likely to just meet or beat analysts’ earnings forecasts.
    • There is no difference with respect to the period absolute analyst forecast errors analysis in the pre- or post-SOX period.
    • The negative association between auditor specialists and companies that just meet or beat analysts’ earnings forecasts is weaker during the post-SOX period.
    Category:
    Audit Quality & Quality Control, Corporate Matters
    Sub-category:
    Industry Experience, Earnings Targets & Management Behavior
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