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

Abstract

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 markets 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 models 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).