AUDIT QUALITY AND ITS IMPACT ON EARNING QUALITY AND CAPITAL COSTS DURING FINANCIAL CRISIS. EVIDENCE FROM PAKISTAN

Abstract

This study investigates the impact of audit quality on earnings quality and the cost of capital, with particular attention to the mediating role of earnings quality and the moderating effect of financial crises in Pakistan. Using panel data from non financial firms listed on the Pakistan Stock Exchange, the study employs descriptive statistics, correlation analysis, panel regressions and mediation moderation analysis to examine these relationships. Audit quality is proxies by auditor type, earnings quality is measured through discretionary accruals and the cost of capital is computed using the weighted average of equity and debt costs. The results reveal that high audit quality significantly improves earnings quality (β = 0.087, t = 4.21, p < 0.01), indicating that reputable auditors constrain managerial opportunism and enhance the reliability of financial reporting. Audit quality is also associated with a lower cost of capital (β = -0.021, t = -3.76, p < 0.01), while higher earnings quality independently reduces financing costs (β = -0.039, t = -4.11, p < 0.01). Mediation analysis shows that earnings quality partially transmits the effect of audit quality on the cost of capital (indirect effect β = -0.012, t = 3.58, p < 0.01). Furthermore, the interaction between audit quality and financial crisis periods is significant (β = -0.018, t = -2.95, p < 0.01), indicating that audit quality plays a more pronounced role in lowering financing costs during economic uncertainty. These findings highlight the importance of high quality auditing and reliable financial reporting in reducing information asymmetry and improving capital market efficiency in emerging markets. The study provides practical implications for regulators, corporate managers and investors in strengthening governance and enhancing investor confidence, particularly during periods of financial distress.

Keywords: Audit quality, Earnings quality, Cost of capital, Financial crisis, Pakistan, Panel data, Discretionary accruals.