Audit firm industry specialisation and analyst forecast accuracy

Abstract

My thesis examines whether the extent to which audit firms concentrate their business in particular industries ('audit firm industry specialisation') improves the usefulness of published financial reports for analysts' predictions of future earnings, and whether the strength of any observed association varies in a manner consistent with the existence of a causal relationship between audit quality and analyst forecast accuracy. Prior research presents diametrically opposite predictions and results regarding the directional relationship between audit firm industry specialisation and analyst forecast accuracy. My thesis shows that the conflicting results in the literature arise largely from prior studies' focus on short-horizon (end-of-year) forecast accuracy, which is subject to competing effects related to audit quality, and which in turn renders the resulting empirical models highly sensitive to model specification. I argue that analyst long-horizon (beginning-of-year) forecast accuracy is a more direct measure of the usefulness of published earnings for the prediction of future performance, and demonstrate that regressions using this metric consistently report a significant positive relation between audit firm industry specialisation and forecast accuracy. I then examine whether the observed positive association between audit firm industry specialisation and forecast accuracy varies with factors argued to reflect the relative importance of audit quality to the predictability of earnings. First, I show that the impact of audit firm industry specialisation on forecast accuracy increases with the underlying riskiness of clients' operations (proxied by cash flow volatility and innate accrual quality). I then argue that audit firm industry specialisation should have a greater impact on the forecast accuracy of lower-quality analysts (where quality is proxied by experience, employer size, 'All-Star' status and composite measures), who rely relatively heavily on published earnings when generating forecasts. To this end, I present evidence that audit firm industry specialisation has a greater impact on forecast accuracy for: (1) firm-years where the average 'quality' of analysts covering the firm is lower, and (2) for forecasts issued by individual analysts of lower quality. My results are robust to the use of controls for the endogenous selection of industry specialist auditors. In sum, my study presents evidence that greater audit quality does improve the usefulness of financial statements for the prediction of future earnings. Show more