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We examine the mechanism through which higher audit fees increase the differential usefulness of financial reports for growing and contracting firms. To accomplish this, we decompose accounting entries into free-cash-flow-inducing transactions and non-cash, forward-looking accounting adjustments. Two fee relations are examined; one with the component of the income/returns relations associated with non-cash adjustments and the other between non-cash, adjusting entries and firm payoff streams. We test a sample of 33,335 US firm-years for the period 2003–2017 and find that, with higher audit fees, markets capitalize more forward-looking accruals in growing firms and less in contracting firms. This is consistent with higher audit fees differentially increasing, the value-relevance of financial statements. Through our decomposition of accruals, we (i) identify different persistence into future income than reported in the extant literature for aggregate accruals and, (ii) find that auditors increase the mapping from accruals to payoff streams through forward-looking, adjusting accruals.
Taylor et al. (Fri,) studied this question.