Theory on the Association between Audit Quality and the Accuracy and Dispersion of Analysts’ Earnings Forecasts

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Choi, JongHag; Kwon, Young K.
Issue Date
College of Business Administration (경영대학)
Seoul Journal of Business Vol14(2): 93~107(2008)
audit qualityanalysts’ forecastsforecast accuracyforecast dispersion
In this study, we establish a link between audit quality and various
characteristics of analysts’ earnings forecasts (i.e., accuracy and
dispersion) and present theory which suggests that the audit quality
enhances the market’s earnings expectation. Our proposition is that
enhancing audit quality improves the quality of accounting numbers,
which in turn affects analysts’ forecasting ability. Although prior
empirical studies investigated this relation by using various proxies,
none of them directly show the relation with theoretical base. In this
paper, we model that accounting earnings are in autoregressive process
and influenced by earnings shock. The earnings shock is composed of
unpredictable random shock and accounting errors. Then we show that
high-quality audit can reduce the accounting errors which in turn
influence the analysts’ earnings forecasts. The model’s predictions are:
(1) forecast accuracy is higher, and (2) forecast dispersion is smaller for firms audited by high-quality auditor. These theoretical predictions are
largely consistent with empirical findings in prior studies, especially a
recent study of Behn et al. (2008).
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College of Business Administration/Business School (경영대학/대학원)Dept. of Business Administration (경영학과)Seoul Journal of BusinessSeoul Journal of Business Volume 14, Number 1/2 (2008)
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