Perceived Auditor Quality and the Earnings Response Coefficient

TLDR

Auditor reputation is believed to enhance earnings report credibility, yet it is unclear whether auditor size reflects quality, a question that shapes investor reactions to earnings surprises. The study tests whether the earnings response coefficient differs between Big Eight and non‑Big Eight audited firms, thereby evaluating auditor size as a proxy for credibility and the modified Holthausen‑Verrecchia model. ERCs are significantly higher for Big Eight clients than for non‑Big Eight clients, a pattern that persists across matched and switch samples and remains robust to controls for growth, risk, size, and disclosure environment.

Abstract

SYNOPSIS AND INTRODUCTION: An auditor's reputation lends credibility to the earnings report that he audits. An unresolved issue is whether auditor size is correlated with auditor quality, where a high-quality auditor is defined as one who brings about more credible earnings reports. According to basic intuition and a modified Holthausen-Verrecchia (1988) model, investors' response to an earnings surprise will depend on the perceived credibility of the earnings report. In this study, we examine whether the earnings response coefficient (ERC) differs between Big Eight (B8) and non-Big Eight (NB8) audited firms. This provides a test of the joint hypotheses that auditor size is a proxy for auditor credibility and of the modified H-V model. Consistent with the joint hypotheses, we find that the ERCs of Big Eight clients are statistically significantly higher than for non-Big Eight clients. The result obtains in both a matched sample of firms paired according to industry membership, and a switch sample of firms grouped according to shifts from and to B8 and NB8 auditors. Furthermore, the result is robust with respect to the inclusion of other explanatory factors for ERC that have been suggested by previous studies: growth and persistence, risk, firm size, and predisclosure information environment.