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

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.