Accounting Discretion, Audit Quality and Earnings Predictability of Listed Firms in Kenya

Abstract

For earnings information to be considered relevant, it must demonstrate both predictive value and confirmatory value. Investors and other users of financial statements rely on the extent to which reported earnings can effectively forecast future firm performance. In Kenya, despite listed firms occasionally posting positive EPS, the NSE 20 Share Index has experienced sharp decline dropping from an all-time high of Ksh 6,161.46 billion in January 2007 with lowest numbers recorded between 2016 and 2020. We investigate whether discretionary accounting practices enhance or diminish the predictability of earnings for listed firms in Kenya. The research is anchored on the efficient contracting theory, information signaling theory, the efficient market hypothesis and agency theory, it conceptualizes on four key measures of accounting discretion: cost classification shifting, fair value accounting estimates, voluntary disclosures, and accruals earnings management. Empirical literature reviewed identifies audit quality as a moderating variable that mitigates the effects of accounting discretion. An unbalanced panel dataset comprising 650 firm-year observations was utilized, reflecting variations in data availability across the 13-year period between 2010 and 2022. The empirical analysis employed descriptive statistics, Pearson correlation, and multiple regression models, followed by moderated regression analysis to assess interaction effects. Descriptive statistics revealed notable heterogeneity across firms, with variables exhibiting both positive and negative skewness and kurtosis, indicating non-normal distributions and the presence of extreme values. This supported the use of robust estimation techniques. Pearson correlation results indicated that earnings predictability had a significant negative association with cost classification shifting and fair value accounting estimates, while being positively and significantly correlated with audit quality. Simple linear regression results showed that cost classification shifting significantly reduced earnings predictability, while fair value accounting estimates had the strongest negative impact. Accruals earnings management exhibited a positive effect on earnings predictability, whereas voluntary disclosures had no statistically significant effect. The overall multiple regression model, incorporating all four measures of accounting discretion, explained 49.0% of the variation in earnings predictability. Within this model, fair value accounting estimates and cost classification shifting retained their negative effects, while accruals earnings management maintained a positive influence. Voluntary disclosures remained statistically insignificant. Moderated regression analysis revealed that audit quality significantly enhanced the positive impact of accruals earnings management on earnings predictability and reduced the adverse effect of fair value accounting estimates. The moderated model explained 56.3% of the variance in earnings predictability, indicating strong explanatory power. The findings suggest that certain forms of accounting discretion, particularly fair value measurements and classification shifting, undermine earnings predictability, potentially due to their reliance on subjective estimates and opportunities for opportunistic financial reporting. In contrast, accrual-based discretion can enhance predictive accuracy, particularly when subject to high-quality external audit oversight. The study makes several contributions: empirically, it provides evidence from an African emerging market context, where financial reporting environments differ significantly from developed economies; methodologically, it validates the use of unbalanced panel data in corporate finance research; and practically, it offers policy insights for regulators, investors, and corporate boards. Key recommendations include enhancing IFRS compliance, improving cost allocation transparency, mandating higher audit quality standards, and implementing targeted training for preparers of financial statements.