Abstract

This research examined the effects of audit quality on the characteristics of discretionary accruals based on firms voluntarily forecasted their earnings (hereafter the forecast firms). Discretionary accruals were estimated using a cross-sectional version of the Jones model. In contrast of prior research, the audit quality was captured by a combined measure of the auditor's market share and client concentration. The market share measured the auditor's competence (industry specialty) and the client concentration measured the auditor's independence. To reduce the impact of measurement errors of proxy variables, a design of group comparisons was employed to make the pattern of discretionary accruals of the forecast firms more evident. The results showed that firms with optimistic forecasts used discretionary accruals, in the year before earning forecasts were announced, to signal future cash flows. However, it later managed earnings opportunistically in the forecast year. Stronger associations between discretionary accruals and future cash flows were documented for optimistic forecast firms audited by higher quality auditors. Firms with pessimistic forecasts used discretionary accruals to make earnings better reflect firms' performance and hence, decreased the serial correlation of changes in earnings. Significant difference in the pattern of changes in earnings was observed between pessimistic forecast firms audited by lower quality auditors and those audited by higher quality auditors. As a means of information disclosure, voluntary forecasts that exceeded the previous realized pretax earnings were not necessarily credible. In respect of the impact of auditing function on management forecast, audit quality was strongly associated with signaling discretionary accruals, but could not deter opportunistic discretionary accruals effectively.