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Does High Quality Auditing Mitigate or Encourage Private Information Collection?

In this paper we contend that higher audit quality could crowd out private information or encourage its collection. We examine which one of these two effects influences investors’ pricing decision by investigating the relation between audit quality and idiosyncratic return volatility. Using a large sample of 51,559 firm-year observations for 8,261 U.S. firms spanning the period from 2000 to 2010, we find that the firms, audited by higher quality auditors, exhibit lower overall idiosyncratic return volatility and higher concentration of idiosyncratic return volatility at the time of earnings announcements. Our findings support the argument that audit quality improves public financial statement information to an extent that crowds out the private information collection. In further analysis, we show that the effect of audit quality on idiosyncratic return volatility is incremental to the effect of accruals quality. Our findings are robust to alternative measures of audit quality and idiosyncratic return volatility, as well as to endogeneity issues.