Audit Quality and the Market Valuation of Banks’ Allowance for Loan Losses*

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AbstractThe recent banking crisis has led market participants to focus on the adequacy and quality of banks’ balance sheet items such as the allowance for loan losses. Beaver and Engel (1996) document that the capital market prices the nondiscretionary component of loan loss allowance negatively and the discretionary component less negatively. Using data from the pre‐crisis period and three measures of audit quality, auditor type (i.e., Big 5 versus non–Big 5), auditor industry specialization/expertise, and audit and nonaudit fees paid to auditors, we examine the effect of audit quality on the market valuation of the discretionary component of the allowance for loan losses. We find that, relative to the nondiscretionary component, the market valuation of the discretionary component of loan loss allowance is higher for banks audited by Big 5 auditors than for banks audited by non–Big 5 auditors. We also find that the relative market valuation of the discretionary component of loan loss allowance is increasing in auditor expertise. Regarding the impact of fees paid to auditors, we find that banks paying higher audit fees have higher relative market valuation of the discretionary component of the allowance for loan losses, but banks that pay higher nonaudit fees do not.