Industry-Expert Auditors and Investor Valuations in Regulated Industries: Evidence from Banking

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INTRODUCTION

Regulation can modify the nature of auditing. Regulation provides auditors with additional roles, roles that are better fulfilled by auditors who specialize in developing and understanding the subtleties and details of the regulations (e.g., interpreting regulatory disclosure effects). In a regulated environment, the skills of specialist (expert) auditors may increase the credibility of accounting numbers used by investors in the valuation process and eventually increase the demand for specialist auditor services. On the other hand, investors may view the monitoring role of regulators and auditors as equivalent. Since the regulator's role is mandated, the monitoring role of auditing becomes redundant, and therefore, the demand for auditing is reduced. Thus, regulation may a substitute for auditing.

In this study, we propose that the regulatory environment creates additional demand for specialist auditors. We hypothesize that this additional demand is reflected in the degree of reliance investors place on financial information generated by banks that employ banking industry-expert auditors. We evaluate the return-earnings relation for banks that choose industry-expert and non-industryexpert auditors. We expect that returns will be more closely associated with earnings when the accounting numbers are certified by industry-expert auditors. Support for this hypothesis implies that investors place incremental reliance on earnings numbers certified by industry-expert auditors in regulated environments.

The empirical results suggest that the choice of an industry-expert auditor differentially affects the earnings-return relation. We find that reported earnings contain greater explanatory power when certified by industry-expert versus non-industry-expert auditors. This result holds when we control for the level of regulatory attention, indicating that regulatory attention in no way substitutes for industry-expert auditors in the eyes of investors.

INVESTORS, AUDITORS, AND FINANCIAL INFORMATION

Do Investors Rely Differently on Financial Information Certified by Expert Versus Non-Expert Auditors?

While many factors influence share price (and thus investor returns), one component is earnings. By providing value-relevant earnings information, managers help shareholders anticipate returns and improve investment decisions. The choice of an auditor with a reputation as an expert to certify reported earnings is one way. A manager can improve the value-relevance of earnings. We evaluate the value-relevance of earnings by examining the association between annual stock market returns and the respective fiscal year accounting earnings. We follow the approach developed by Easton and Harris (1991), including both earnings level and earnings change variables as predictors of annual returns to minimize measurement error and increase the explanatory power of the earnings variables.

We expect earnings to be more closely related to the market valuation of the firm when accounting earnings more accurately reflect the economic value of the bank. Investors cannot directly observe the underlying economic earnings of the firm, but rely on the reported accounting earnings. External auditors certify conformance with generally accepted accounting principles (GAAP) and increase the reliability of accounting data. The more skilled the auditor, the closer the conformance of accounting earnings with the true economic value. If the market recognizes the skill of the auditor, then we expect earnings audited by skilled auditors to be more closely associated with market returns.

Teoh and Wong (1993) use audit firm size to proxy for auditor quality and earnings response coefficients to measure the association between earnings and returns. They regress abnormal stock returns on earnings surprises and test for a difference in the earnings response coefficients (ERCs) between Big Eight and non-Big Eight auditors. …