| If financial statement information is used to determine the market value of equity, then market values should be adjusted to reflect the uncertainty in the reliability of the information. Assurances about the reliability of financial statement information are valuable because they decrease the size of the risk adjustment impounded in market value. Although traditional valuation models do not explicitly relate uncertainty in the reliability of financial statement information to the market value of equity, it has been argued that there is an implicit relationship that arises from the positive association between uncertainty and the cost of capital.;Recent research indicates that although less uncertainty is associated with a lower cost of capital, the strength association is contingent upon the existing level of uncertainty (Botosan, 1997; Sengupta, 1998; Blackwell, et al., 1998). This study contends that the association between the earnings discount rate (the rate used to translate book values and accounting earnings into market value) and uncertainty is also contingent upon the existing level of uncertainty. Specifically, the study argues that audit quality is negatively associated with the earnings discount rate, but the association weakens as the inherent uncertainty in financial statement information decreases. It is also argued that the association between audit quality and the earnings discount rate is weakened by the presence of other factors that are negatively associated with uncertainty in the reliability of financial statement information.;The results indicate that the relationship between audit quality and the earnings discount rate is not only contingent upon, but non-linear with respect to, the inherent uncertainty in financial statement information. At high levels of inherent uncertainty, the negative association between audit quality and the earnings discount rate diminishes as inherent uncertainty in financial statement information decreases. At low levels of inherent uncertainty, the association between audit quality and the earnings discount rate is not significant. The contingent relationship indicates that there may be transitory inefficiencies in auditor selection, or there are factors unrelated to inherent uncertainty that impact auditor choice. Neither managerial ownership nor internal control strength is found to significantly affect the earnings discount rate. Neither, therefore, appears to substitute for audit quality. |
