The Effect of Audit Quality on the Relationship between Accounting Earnings and Stock Returns

Accounting earnings include cash and accrual components. Accrual components can be classified as discretionary accruals and non-discretionary accruals. In dominant literature of earnings management, discretionary accruals have been identified as opportunistic items; a feature that weakens earnings informativeness. However, managers can also use discretionary accruals to signal unaccessible private information to outsiders to allow them to have a better assessment of firm’s future economic value. Since the reliability of financial statements, including earnings, heavily depends on the quality of audit work, understanding how the capital market focuses on the audit quality during valuation of accounting earnings and its components, is very important. For this purpose, panel data of 125 firms listed in Tehran Stock Exchange (TSE) for the period of 2011 to 2015, have been used to investigate the impact of audit quality on valuation of earnings and its components by capital market in Iran. The results showed that accounting earnings have a positive and significant impact on stock returns. The findings also showed that audit quality mitigates the positive relationship between accounting earnings and stock returns; and audit quality does not affect the relationship of total accruals, discretionary and non-discretionary accruals, and operating cash flows with stock returns.