This study examines the association between measures of earnings quality and auditor industry specialization. Prior work has examined the association between auditor brand name and earnings quality, using auditor brand name to proxy for audit quality. Recent work has hypothesized that auditor industry specialization also contributes to audit quality. Extending this literature, we compare the absolute level of discretionary accruals (DAC) and earnings response coefficients (ERC) of firms audited by industry specialists with those of firms not audited by industry specialists. We restrict our study to clients of Big 6 (and later Big 5) auditors to control for brand name. Because industry specialization is unobservable, we use multiple proxies for it. After controlling for variables established in prior work to be related to DAC and the ERC, we find clients of industry specialist auditors have lower DAC and higher ERC than clients of nonspecialist auditors. This finding is consistent with clients of industry specialists having higher earnings quality than clients of nonspecialists.
The release of the full set of financial statements in Form 10–Q provides investors with the data necessary to estimate the discretionary portion of earnings, thereby allowing them to better assess the integrity of reported quarterly earnings. We thus expect a negative association between unexpected discretionary accruals estimated using 10–Q disclosures and stock returns around 10–Q filing dates. Consistent with our expectations, we document a negative association between unexpected discretionary accruals and cumulative abnormal returns over a short window around the 10–Q filing date. Furthermore, this association varies systematically with investor sophistication. Finally, results from portfolio tests indicate that this association is economically as well as statistically significant. One interpretation of our findings is that accruals management has substantial valuation consequences, which are quickly impounded into stock prices.
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