Earnings quality decline and the effect of industry specialist auditors: An analysis of the late 1990s

Abstract

This study investigates whether earnings quality declined during the late 1990s, a period marked by extraordinary stock market activity, and whether industry specialist auditors were effective in stemming any such decline. Specifically, we examine whether the magnitude of discretionary accruals increased and the Earnings Response Coefficient (ERC) decreased in the 1997–1999 period relative to those of the 1990–1996 period. Our findings are as follows. First, we find a significant increase in the magnitude of discretionary accruals and a significant decrease in ERC in our sample, which suggests an overall decrease in earnings quality across the periods. Next, both the increase in discretionary accruals and the decrease in ERC are shown to be significantly smaller for clients of industry specialist auditors. Finally, it is shown that the effectiveness of industry specialist auditors was limited and that they were associated with some earnings quality decline. Collectively, these results imply a pervasive earnings quality decline during the late 1990s that even high quality auditing was insufficient to fully prevent.