Audit quality and overvalued equity

Audit quality studies document that accruals decrease when the audit firm is large, or the audit firm is an industry specialist, or the audit‐client tenure is long. The purpose of this paper is to posit that incentives related to highly‐valued equity mitigate these results, as managers use income increasing accruals to augment earnings.

To test this assertion, the authors regress discretionary accruals on: controls, a highly valued equity indicator variable equal to 1 if the client's lagged price‐to‐earnings ratio is in the highest P/E quintile, indicator variables equal to 1 for alternative measures of audit quality, and interaction terms between the highly valued equity indicator variable and audit quality indicator variables.

Results of tests show positive and statistically significant coefficients for each of the highly‐valued equity‐audit quality interaction terms, suggesting that when a firm is highly valued the accruals' decreasing effect of high quality auditors is reduced.

Beginning with Jensen's article regarding the agency costs of overvalued equity, a stream of research examining factors associated with highly priced firms has developed. The paper extends these findings, as well as the considerable body of audit quality studies, by examining the ability of a high quality auditor to attenuate this result.