The Effect of Institutions and Big 4 Audits on Properties of Analyst Forecasts

Abstract

This paper investigates how political and legal institutions affect the governance role of auditors for a sample of firms originating in 42 countries. Prior studies focus on investor protection, but I focus on political rights as well. Specifically, I investigate how institutions and audit quality affect financial statement users’ decision-making by considering properties of analysts’ earnings forecasts. The evidence shows that forecast accuracy is lower and forecast dispersion higher for firms operating in countries with fewer political rights. Of particular interest is the finding that the association between Big 4 audits and earnings forecast properties is stronger in weak political environments. This finding suggests that auditors play an important — and up to now undocumented — governance role when political rights are low and political forces influential. My results also indicate that reporting reliability increases as investor protection becomes stronger. However, this result only holds for Big 4 clients, consistent with the notion that audits play a greater governance role in stronger legal environments.