Theory on the Association between Audit Quality and the Accuracy and Dispersion of Analysts’ Earnings Forecasts

Abstract

In this study, we establish a link between audit quality and various characteristics of analysts’ earnings forecasts (i.e., accuracy and dispersion) and present theory which suggests that the audit quality enhances the market’s earnings expectation. Our proposition is that enhancing audit quality improves the quality of accounting numbers, which in turn affects analysts’ forecasting ability. Although prior empirical studies investigated this relation by using various proxies, none of them directly show the relation with theoretical base. In this paper, we model that accounting earnings are in autoregressive process and influenced by earnings shock. The earnings shock is composed of unpredictable random shock and accounting errors. Then we show that high-quality audit can reduce the accounting errors which in turn influence the analysts’ earnings forecasts. The model’s predictions are: (1) forecast accuracy is higher, and (2) forecast dispersion is smaller for