The Effect of Audit Quality on The Quality of Management Earnings Forecasts: Evidence from Japan

David Lau

Abstract

In this study, I examine how audit quality (as measured by audit firm size and industry specialization) influences the quality of management earnings forecasts (as measured by forecast bias and accuracy). Specifically, I hypothesize that other factors held constant, firms with higher-quality auditors are associated with higher-quality management earnings forecasts. I test this hypothesis in a unique setting, Japan, where nearly all firms are compelled to provide earnings forecasts. Multivariate analyses provide empirical evidence in support of the hypothesis. In addition, the empirical evidence of a positive relation between audit quality and the quality of management earnings forecasts remains statistically significant and robust under numerous sensitivity tests. This study contributes to the accounting and auditing literature by scrutinizing the effect of audit quality on forecast quality with an improved and more refined research methodology that effectively control for self-selection bias, a common confounding issue in empirical models.