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Auditor Quality and the Role of Accounting Information in Explaining UK Stock Returns

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  • Clatworthy, Mark A

    () (Cardiff Business School)

  • Pong, Christopher K.M.
  • Wong, Woon K.

Abstract

In this paper, we examine the relative importance of the cash flow and accruals components of earnings in explaining the variation in UK company equity returns, together with the extent to which these relationships vary by auditor quality. We use a multivariate time-series approach that can be reconciled to a log-linear theoretical valuation model and, unlike the standard linear regression of returns on earnings components, accommodates time varying discount rates. Based on a decomposition of the variance of equity returns, cash flows and accruals, our results indicate that both cash flow news and accruals news are important drivers of equity returns, though cash flows are more influential than accruals. We also find that auditor quality moderates these relationships, since variation in both earnings components has a more significant effect for clients of large auditors. Finally, our results indicate that the impact of auditor quality is highest for the accruals component of earnings.

Suggested Citation

  • Clatworthy, Mark A & Pong, Christopher K.M. & Wong, Woon K., 2009. "Auditor Quality and the Role of Accounting Information in Explaining UK Stock Returns," Cardiff Economics Working Papers E2009/9, Cardiff University, Cardiff Business School, Economics Section, revised Oct 2011.
  • Handle: RePEc:cdf:wpaper:2009/9
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    References listed on IDEAS

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    1. Kormendi, Roger & Lipe, Robert, 1987. "Earnings Innovations, Earnings Persistence, and Stock Returns," The Journal of Business, University of Chicago Press, vol. 60(3), pages 323-345, July.
    2. Tuomo Vuolteenaho, 2002. "What Drives Firm-Level Stock Returns?," Journal of Finance, American Finance Association, vol. 57(1), pages 233-264, February.
    3. repec:bla:joares:v:29:y:1991:i:1:p:19-36 is not listed on IDEAS
    4. Campbell, John Y, 1991. "A Variance Decomposition for Stock Returns," Economic Journal, Royal Economic Society, vol. 101(405), pages 157-179, March.
    5. Wong, Woon K, 2008. "A Unique Orthogonal Variance Decomposition," Cardiff Economics Working Papers E2008/10, Cardiff University, Cardiff Business School, Economics Section.
    6. Govindarajan, Vijayaraghavan, 1980. "The objectives of financial statements: An empirical study of the use of cash flow and earnings by security analysts," Accounting, Organizations and Society, Elsevier, vol. 5(4), pages 383-392, October.
    7. Jeffrey L. Callen & Dan Segal, 2004. "Do Accruals Drive Firm-Level Stock Returns? A Variance Decomposition Analysis," Journal of Accounting Research, Wiley Blackwell, vol. 42(3), pages 527-560, June.
    8. repec:bla:joares:v:37:y:1999:i::p:53-87 is not listed on IDEAS
    9. Andreas Charitou & Colin Clubb & Andreas Andreou, 2001. "The Effect of Earnings Permanence, Growth, and Firm Size on the Usefulness of Cash Flows and Earnings in Explaining Security Returns: Empirical Evidence for the UK," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 28(5-6), pages 563-594.
    10. Jeffrey L. Callen & Ole-Kristian Hope & Dan Segal, 2005. "Domestic and Foreign Earnings, Stock Return Variability, and the Impact of Investor Sophistication," Journal of Accounting Research, Wiley Blackwell, vol. 43(3), pages 377-412, June.
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