the association between audit quality, accounting disclosures and firm-specific risk: evidence from...

Journal of Accounting and Public Policy 22 (2003) 377–400

www.elsevier.com/locate/jaccpubpol

The association between auditquality, accounting disclosures and

firm-specific risk: Evidence from initialpublic offerings

Philip Lee a, Donald Stokes b,c, Stephen Taylor c,d,*,Terry Walter c,d

a University of Sydney, Australiab University of Technology, Sydney, Australia

c Capital Markets CRC Ltd., Australiad School of Accounting, University of New South Wales, New South Wales, NSW 2052, Australia

Abstract

In an environment where expected litigation costs were relatively low and the pro-

vision of forward-looking accounting information was voluntary (Australia), we show

that IPO firms voluntarily providing an earnings forecast within the offer document are

significantly more likely to use a high quality auditor, consistent with the signaling role of

auditor attestation being at least partially dependent on the extent of voluntary, audited

disclosures. Any trade-off between auditor choice with either firm risk or retained

ownership is confined to smaller IPOs and/or those using less prestigious underwriters,

which are also those where support for the signaling role of auditors (and voluntary

disclosure) is evident using a valuation model. Our results highlight the failure of ‘‘sty-

lised’’ signaling models such as [Datar et al. (1991); Hughes (1986)] to recognize extensive

interaction between various mechanisms, resulting in multiple signaling equilibria.

� 2003 Elsevier Inc. All rights reserved.

JEL classification: G24; M40

Keywords: Auditing; Litigation risk; Underwriter quality; Initial public offering; International

* Corresponding author. Address: School of Accounting, University of New South Wales, New

South Wales, NSW 2052, Australia.

E-mail address: [email protected] (S. Taylor).

0278-4254/$ - see front matter � 2003 Elsevier Inc. All rights reserved.

doi:10.1016/j.jaccpubpol.2003.08.003

mail to: [email protected]

378 P. Lee et al. / Journal of Accounting and Public Policy 22 (2003) 377–400

1. Introduction

This paper provides additional evidence on the choice of high quality (i.e.,

Big 8) auditors by initial public offering (IPO) firms. 1 Specifically, we examine

whether the use of a high quality audit firm is associated with the extent of

voluntary disclosure within the offer document (i.e., prospectus), as well as

other potential signaling mechanisms such as the level of ownership retained

by pre-IPO shareholders. Our research is motivated by our concern that in

several models of auditor selection (e.g., Datar et al., 1991, hereafter DFH);

Hughes (1986), the precise role of an IPO auditor is not clearly specified. Forexample, DFH provide no intuitive justification of why the second signaling

variable that ‘‘trades off ’’ with the level of ownership retained by pre-IPO

shareholders should be differential audit quality, rather than any other iden-

tifiable IPO attribute. Our approach recognizes that the signaling role of dif-

ferential auditor quality reflects the extent to which auditor reputation affects

investors� reliance on information attested by the auditor and which is po-

tentially relevant to determining the value of IPO firms� shares. We thereforefocus on the extent to which voluntary audited disclosures differ between IPOfirms, in addition to testing for any trade-off between audit quality and re-

tained ownership as a function of firm-specific risk in the manner predicted by

DFH.

Our experimental design also reflects anecdotal and empirical evidence that

the selection of a high quality auditor is influenced by both deal size and the

decision to use a prestigious underwriter. For example, Willenborg (1999)

notes that large IPOs could be forced to use high quality auditors under the

terms of underwriting engagements for these issues, so that the audit marketfor new issues is segmented by issue size. Economies of scale also increase the

probability of larger IPOs selecting a high quality auditor. Finally, where

management incentives are less aligned with outside shareholders, higher audit

quality is often argued to be a substitute mechanism for reducing the level of

agency costs. Empirical evidence supports this proposition (e.g. Simunic and

Stein, 1987; Menon and Williams, 1991; Firth and Smith, 1992).

We examine the Australian IPO market prior to 1990, which has two im-

portant attributes. First, for the period we examine there is considerable di-versity in the extent to which IPO firms voluntarily provided information

about expected earnings. At least one model of IPO signaling posits a role for

direct disclosures, but only when such disclosures are ‘‘certified’’ (Hughes,

1986). Following this reasoning, we expect the demand for high quality audi-

tors to be influenced by the extent of direct, accounting related disclosures

1 For the period we examine (1976–1989) there were eight large, international auditing firms (i.e.,

the Big 8).

P. Lee et al. / Journal of Accounting and Public Policy 22 (2003) 377–400 379

made at the time of the IPO. 2 The absence of voluntarily provided earnings

forecasts (and other forward looking financial information) from United StatesIPO prospectuses means that this influence has largely been ignored in tests of

the demand for high quality auditors. In contrast, our analysis considers the

role of both direct disclosure and the extent of firm-specific risk (Datar et al.,

1991) on the demand for high quality auditors. Second, litigation of the type

common in the United States is almost completely absent from the period we

examine. Feltham et al. (1991) and Clarkson and Simunic (1994) argue that the

threat of such litigation could result in market segmentation, confounding tests

of DFH�s predictions, which are founded on IPO firms trading off the costs andbenefits of using a high quality auditor with the cost via firm specific risk of

increased retained ownership.

Our results confirm the prediction that the demand for high quality auditors

reflects the extent of direct accounting disclosure, measured as the voluntary

provision of information about expected earnings. This result holds irrespec-

tive of deal size and underwriter reputation. In contrast, we show that a sta-

tistically significant positive relation between ex ante proxies for IPO firms�riskiness and the selection of a high quality auditor only occurs for smallerIPOs and/or those using less prestigious underwriters. Further, after control-

ling for differences in risk, the level of retained ownership is negatively related

to the demand for high quality auditors, although only at very ‘‘marginal’’

significance levels. Evidence that auditor reputation and retained ownership

are, at least to some extent, substitute signals is potentially important in dis-

tinguishing between the predictions of DFH and other models predicting that

the demand for auditor quality is increasing in IPO firms� riskiness (e.g.,Willenborg, 1999), but which remain silent on the role of retained ownership.However, the relatively restricted nature of these results (i.e., they are confined

to a specific sub-set of our sample) is also consistent with more general limi-

tations of all such stylized models of IPO auditor choice. Taken together, our

results suggest that models which are limited to trading-off the benefits of two

signaling mechanisms fail to adequately reflect the underlying complexity of

the choices which IPO firms face. 3

Our results are also relevant to the debate about requiring IPOs to provide

earnings forecasts. Since 1991, most Australian industrial IPOs have pro-vided an earnings forecast within the prospectus in response to requirements

2 Although Hughes (1986) makes no explicit mention of auditors, she assumes that direct

disclosures are ‘‘certified’’ by the underwriter. We expect that the most obvious form of certification

in the instance of disclosures within an IPO prospectus is by the auditor. The institutional setting

that we study (see Section 2) reinforces this point.3 A similar conclusion is also reached by Mayhew et al. (2002), who use an experimental

economics approach to demonstrate the complexity of choices among multiple signals for IPO

valuation.


introduced into the Corporations Law. 4 However, existing evidence questions

the reliability and value relevance of these forecasts (How and Yeo, 2001). Ourstudy focuses on a period when these forecasts were voluntary, and it is no-

ticeable that, at least for smaller firms, these forecasts are value relevant, es-

pecially where they are attested by a high quality auditor.

The remainder of the paper is organized as follows. Section 2 briefly reviews

prior research, as well as describing the institutional setting in which the IPOs

we examine occurred. Section 3 outlines the key features of our experimental

design, especially those that result in a more powerful test of the DFH model

than earlier studies. Our principal empirical results are outlined in Section 4,while Section 5 provides a discussion of some additional robustness tests.

Section 6 provides a summary and conclusions, including possible public policy

implications of our research.

2. Background

2.1. Prior research

DFH extend the model of Leland and Pyle (1977), so that audit quality

serves to reduce the necessary level of retained ownership that would otherwise

serve as a sufficient signaling equilibrium. Hence, in DFH, non-diversification

costs are reduced by hiring a high quality audit firm, and so the demand forhigher audit quality is increasing in the extent of firm-specific risk (i.e., risk

which is otherwise diversifiable). Put simply, as IPO firm-specific risk increases,

so does the signaling value associated with the use of a high quality audit

firm. 5 However, tests of DFH are generally not consistent with their primary

prediction. Tests using US IPOs (Simunic and Stein, 1987; Beatty, 1989; Fel-

tham et al., 1991) suggest that firm-specific risk and choice of audit quality are

negatively, rather than positively related. 6 Feltham et al. suggest that these

results may reflect supply-side constraints, primarily substantial potential liti-gation costs, the probability of which increases in the level of IPO firms� risk.Taken to an extreme, the market for IPO audits could be segmented, with high

4 Lee et al. (2003) summarise these requirements.5 In contrast to DFH�s model of the demand for audit quality, Titman and Trueman (1986)

predict the opposite relation (i.e., demand for audit quality is decreasing in the level of IPO firm

riskiness). However, it is difficult to compare Titman and Trueman with DFH, as their models are

derived from fundamentally different assumptions. Moreover, while empirical tests (including ours)

rely on discrete audit quality, Titman and Trueman assume continuous audit quality. The

assumption of continuous, rather than discrete audit quality is not consistent with existing evidence

of product differentiation among audit firms (e.g., Craswell et al., 1995).6 An exception is Copley and Douthett (2002).


quality auditors simply refusing to audit relatively risky IPOs, or at least

charging a prohibitive fee.In order to provide a more powerful test of the DFH model, Clarkson and

Simunic (1994) examine auditor choice among Canadian IPOs. They argue

that litigation risk for Canadian IPO auditors is substantially lower than in the

US and so demand-side influences of the type identified by DFH are more

likely observable. Their results indicate that high quality auditors are hired

more frequently by relatively risky Canadian IPO firms. However, Clarkson

and Simunic examine all Toronto Stock Exchange IPOs during 1984–1987 for

which necessary prospectus and pricing data were available, thereby includingboth mining and industrial firms. Mining companies, which are often charac-

terised as relatively risky, provide prospectuses that typically focus on geo-

logical, rather than financial data. We believe that confining the focus to

industrial IPO firms provides a more robust test of the DFH model, and this is

supported by subsequent tests that demonstrate the sensitivity of Clarkson and

Simunic�s results to the inclusion of IPOs by mining firms. 7

A further limitation of the DFH model is that, ex ante, there is no obvious

reason to believe that differential audit quality is an efficient signal, nor that ittrades-off with retained ownership any more than other possible signaling

mechanisms. One such mechanism is direct disclosure, and we note that pro-

spectus disclosures (especially those that relate to accounting results) are pre-

sumably what auditors attest. Hence, we expect that tests of IPO auditor choice

reflect the circumstances that give rise to an underlying demand for auditing.

As the demand for accounting information and the demand for auditing are

linked (Watts and Zimmerman, 1986), we argue that the differential demand

for audit quality will reflect the extent to which the selling of an IPO also relieson information attested by the auditor.

In a similar manner to DFH, Hughes (1986) also models the signaling

problem faced by IPO firms. As with DFH, her model begins with the costs of

non-diversification borne via higher levels of post-listing retained ownership.

To reduce this cost, the issuer can choose to make a direct disclosure about

firm value, which in turn is verified by the underwriter. Based on the institu-

tional features of the Australian IPO market (see below), we argue that the

most obvious form of voluntary direct disclosure is the provision of informa-tion about expected earnings, and that the reputation of the auditor likely plays

7 Although limited to a single proxy for risk (i.e., the number of risk factors stated in the

prospectus), elimination of mining IPOs from tests reported by Clarkson and Simunic (Table 4,

panel A) gives a coefficient which is insignificant at conventional levels (t ¼ 1:15), in contrast to the

significant positive coefficient they report (t ¼ 1:88). Hence, it is apparent that Clarkson and

Simunic�s results are dependent on the inclusion of mining companies. We thank Peter Clarkson forperforming this analysis at our request. Simunic and Stein (1987) yield evidence for US IPOs which

is also broadly consistent with this conclusion.


an important role in establishing the ‘‘credibility’’ of such disclosure as an

effective signal about firm value.Copley and Douthett (2002) also recognize that disclosure decisions po-

tentially impact on IPO firms� choice of auditor. For a sample of United StatesIPOs between 1990 and 1997, they use a simultaneous equations approach to

investigate the role of firm-specific risk and retained ownership in influencing

IPO firms� choice of audit quality. In contrast to earlier studies, they find thatdemand for large audit firms is increasing with the extent of firm-specific risk,

and this result holds for both the single equation and simultaneous equation

approaches. Copley and Douthett attempt to control for disclosure variationby including a proxy for disclosure within their estimate of the predicted level

of retained ownership. However, their proxy is simply a projection of earnings

from historical data using the exponential smoothing approach. This measure

captures earnings prospects, rather than any disclosure differences. Hence,

results indicating an inverse relation between retained ownership and disclo-

sure can also be interpreted as showing that where simple extrapolations of

past earnings appear relatively poor, a higher level of retained ownership is

required. In contrast to Copley and Douthett, we examine IPO auditor choicein an environment where there is observable variation in direct disclosure,

namely the provision of explicit earnings forecasts. Moreover, as we discuss in

Section 2.2 below, the auditor has at least implicitly attested these forecasts.

While both DFH and Hughes (1986) imply that the value of selecting a high

quality auditor increases with the level of firm-specific risk, this prediction is

not unique to models premised on a signaling role for differential audit quality.

Willenborg (1999) argues that high quality auditors can also provide a source

of ‘‘insurance’’ for IPO investors, and the value of any such insurance is in-creasing in the degree of firm-specific risk. Using the number of stated risk

factors as a proxy, he shows that firm-specific risk is positively associated with

the choice of a high quality auditor for firms that lack a financial history (i.e.,

development stage enterprises). However, this result does not control for

variation in the level of retained ownership, which is central to the models of

DFH and Hughes. 8

2.2. The Australian IPO environment

The setting for our empirical tests is the Australian IPO market, which is

relevant in addressing the impact of supply-side constraints on IPO firms�

8 Willenborg (1999) also demonstrates that differential audit quality impacts on IPO

underpricing, even in those cases where there is little financial history. However, interpreting

results based on ‘‘headline underpricing’’ is made difficult by the absence of any control for the

extent to which dilution and participation ratios differ substantially between IPOs (Habib and

Ljungqvist, 2001).


auditor choice, as well as the role of prospective disclosures in this process. Lee

et al. (1996) show that IPOs in Australia are concentrated in the small end ofthe market by world standards (80% of IPOs between 1976 and 1989 had an

issue size less than $AUD7.5 million). In contrast, Willenborg (1999) shows

that United States IPOs are concentrated in the large end of the international

market, with only 28% of IPOs between 1993 and 1994 being for less than

$US10 million.

Investigation of auditor choice using Australian IPO firms also offers similar

advantages to those described for Canadian IPOs by Clarkson and Simunic

(1994). Notably, the Australian legal environment displays markedly less se-curities litigation than is common in the United States. 9 Several key features of

the Australian legal system prevailing for the period we study contribute to this

situation, whereby auditors of Australian IPO firms face dramatically lower

expected litigation costs than their US equivalents. 10 These features include

the absence of class action privileges and the prohibition of contingency based

litigation. Further, successful defendants are entitled to costs from the plain-

tiff and these costs are set by an arbitrary judicial scale. There is also judicial

(rather than jury) determination of damages.Although auditors were liable for prospectus mis-statements under the

prevailing legislation and could not issue qualified reports (see below) provided

‘‘due diligence’’ was exercised, a sufficient defence was the existence of ‘‘rea-

sonable grounds’’ on which to believe, at the time of the IPO, that the state-

ment was true. The availability of a ‘‘reasonable grounds’’ defence is in marked

contrast to actions under Rule 11 of the United States federal securities laws

(as discussed by Romano, 1991). Supply-side effects of the type suggested by

Feltham et al. (1991) are therefore expected to be much weaker in Australiathan the US.

Apart from the prevailing legal system, several attributes of the Australian

IPO market are relevant for our tests. These involve the form of underwriting

agreement, the role of escrow requirements (i.e., restrictions on insider selling)

and the frequent, voluntary inclusion of prospective earnings disclosures in

addition to mandatory historic data. Lee et al. (1996) describe the method by

which Australian IPOs prior to 1990 are underwritten. They note that, until the

early 1990s, Australian IPOs are underwritten solely via stand-by arrange-ments. In contrast, relatively risky United States IPOs have tended to use a best

efforts arrangement. The use of stand-by arrangements increases the risk to

underwriters of relatively risky IPO firms, and likely increases the leverage that

9 Reviewing the enforcement of various Australian corporate rights and duties, Ramsey (1995,

p. 175) notes that ‘‘litigation commenced by shareholders appears to be a relatively rare occurrence

in Australia’’.10 As explained in Section 3, our data are drawn from IPOs between 1976 and 1989.


underwriters have over IPO firms� choice of auditor, as well as other possiblesignaling mechanisms. We therefore expect that the presence of a prestigiousunderwriter could confound attempts at identifying Australian IPO firms�underlying demand for high quality auditors. Such demand may be more ev-

ident for IPOs underwritten by less prestigious auditors.

The role of escrow requirements (i.e., restrictions on insider-selling) for Aus-

tralian IPOs enhances the possible explanatory power of signalingmodels such as

DFH, which are premised on the role of insiders� retained ownership as a sig-naling mechanism. While voluntary restrictions sometimes add to the basic re-

quirements, Australian IPO listings for the duration of our study typicallyrequired aminimum insider holding period for vendor shares of 12months. These

restrictions add weight to the ‘‘commitment’’ implied by retained ownership,

negating at least some of the criticisms directed by Gale and Stiglitz (1989) at

signaling models premised on a role for retained ownership. 11 Hence, we expect

vendors� retained ownership to be a powerful signal in the context of AustralianIPO firms, adding to the expectation that DFH is empirically descriptive. 12

Finally, an important feature of the Australian IPO market prior to 1990

was the widespread, but entirely voluntary practice of including forecast fi-nancial results (e.g., future earnings) within the prospectus. 13 In addition, it is

clear from the relevant Australian professional guidelines that IPO auditors

have been expected to be satisfied with all of the prospectus contents, not just

the historic financial statements. Unlike regular financial statements, IPO au-

ditors could not ‘‘qualify’’ their attestations as investigating accountants. 14

Although the statutory function of the auditor relates solely to the financial

statements, for the IPOs we examine the auditor clearly has a broader role in

terms of implicitly attesting to other information in the prospectus.Given that auditors have primary expertise in attesting to the ‘‘reason-

ableness’’ of financial data, we argue that the provision of forward looking

financial information could enhance the signaling role of differential audit

quality. We therefore expect that the demand for audit quality will be in-

creasing in the extent of voluntary forward looking disclosures, and that audit

quality and financial disclosure will be complementary signaling mechanisms.

11 These criticisms are based on the possibility of secondary sales by the vendor.12 Although Lee et al. (1996) fail to report a significant association between retained ownership

and underpricing for Australian IPOs, their tests focus on ‘‘headline underpricing’’ (see foot note

8).13 Following changes to the relevant Corporations Law regulations from January 1991, the

provision of earnings forecasts became ‘‘de facto’’ mandatory, with almost 100% of IPO firms

providing earnings forecasts in their prospectuses (Lee et al., 2003).14 This is made clear in AUP 3.1, ‘‘Special Purpose Auditor�s Reports’’ (paragraph 23). In this

sense the Australian requirements are quite different to the US. For relatively small IPOs,

Willenborg (1999) reports around 25% of these IPOs have going concern qualified audit reports.


3. Design of tests

3.1. Sample selection

We take advantage of the availability of a proprietary IPO database (Lee

et al., 1996) describing 266 Australian industrial IPO firms that listed from

January 1976 to December 1989. 15 The cut-off date is consistent with our

desire to limit observations to genuinely voluntary disclosures, and their effect

on auditor choice. Most of the issues (87.6%) are concentrated in the period

1984–1987. On average, these IPOs are underpriced by 11.8% (after adjustmentfor changes in the market index). 16

Table 1 provides a summary of our sample. Of the 266 IPO firms, 175 (66%)

had a Big 8 audit firm act as investigating accountant (i.e., prospectus audi-

tor) when going public. The remaining 91 firms used Non-Big 8 auditors, with

a total of 34 different audit firms being represented among this group. 17 Fol-

lowing Willenborg (1999), we would expect that the frequency with which

larger audit firms are used would increase with deal size. Given that audit fees are

small relative to issue size, the adverse signal of not using an audit firm perceivedas high quality is greatest for relatively large IPOs. However, given that Aus-

tralian IPOs are, on average, much smaller than those in theUS, any such pattern

might be expected to be less marked, and this is evident with our sample. When

IPOs are ranked on issue size (inflation adjusted), we find that the frequency with

which Big 8 audit firms are used among the largest quintile of IPOs is 74%, while

for the smallest quintile it is 58%. 18 Although not statistically significant at

conventional levels, this difference is economically sufficient to suggest that

smaller IPOs likely provide a more powerful setting within which to identify theunderlying relationship between firm risk and demand for high quality audit

firms.

15 The database excludes oil and gas IPOs. However, as we have noted, these firms typically

supply very little historic financial (as compared to geological) data, and were typically discouraged

by the regulatory authorities from making explicit forecasts of earnings. The database also excludes

capital reconstructions, offerings by non-Australian firms and the like, but is otherwise complete.16 Detailed evidence for these IPOs of both short and long run returns is contained in Lee et al.

(1996).17 Another feature worth noting from Table 1 is the large number of IPO audits conducted by

the then largest Non-Big 8 auditor in Australia, KMG Hungerfords (since absorbed into KPMG).

Section 5.2 reports results of sensitivity analysis on the treatment of KPMG.18 When we rank by thirds rather than quintiles, our results are similar (i.e., 72% versus 61%).

Further evidence of a monotonic relation is demonstrated by looking at the 20 largest IPO deals,

where the Big 8 share is 85%.


3.2. Auditor choice model

In order to investigate the relationship between firm-specific risk and the

demand for auditor quality by IPOs, we estimate coefficients for the following

model, based upon those used by Simunic and Stein (1987) and Clarkson and

Simunic (1994). 19

19 A

theory

audito

214). W

papers

as diff

factors

and th20 T

applyin

month

in the p

G

As an a

with fir21 O

detail,

the fol

period

and fo

AUDi ¼ b0 þ b1RISKi þ b2DISCi þ b3LEVi þ b4ISSUEi þ b5UWQi

þ b6RETOWNi þ b7FUTEQi þ ei ð1Þ

The dependent variable is auditor quality (AUD), measured using a ð0; 1Þdummy variable with a value of 1 assigned if the auditor is in the high quality

group (i.e., the Big 8).

The independent variables that we utilise are as follows:

RISK firm-specific risk of a company�s future cash flows as proxied ex postby the standard deviation of residual returns (STDDEV) or ex anteby either the asset composition of the firm (GOPT) or the extent of

operating history (AGE). 20

DISC the level of prospective accounting disclosure made in the prospectus,

measured by either a ð0; 1Þ dummy variable with a value 1 indicatingthat the firm made an explicit forecast of future earnings, or a con-

tinuous disclosure index capturing the extent of detailed prospective

earnings information. 21

limitation of models such as ours and the Clarkson and Simunic model is that existing

does not identify endogenous relations among the variables typically used in models of

r choice and the underlying set of exogenous variables (see Clarkson and Simunic, 1994, p.

e also note that the variables included in our model are not identical to those used in prior

. The differences reflect constraints from the proprietary IPO database that we access, as well

erences between Australian and Canadian (and US) IPOs. For example, ‘‘specific risk

’’ were not routinely provided in Australian IPO prospectuses for the period we examine,

ere is also no cross sectional variation in the issue method.

he ex post proxy (STDDEV) is the standard deviation of the residual returns, estimated by

g the familiar zero-one market model to the first 12 monthly returns after listing, excluding the

inwhich listingoccurred.Ourfirst ex antemeasure (i.e., one observable prior to listing, as shown

ro-forma balance sheet), is the asset composition of the firm (GOPT). This is measured as

OPT ¼Max 1

��Net tangible assets ðexcluding cashÞ per share

Issue price; 0

�

lternative exmantemeasure, we use the length of the firm�s operating history (AGE), measuredms having more than 10 years of operating history bounded at that figure.

ur disclosure index recognizes the extent to which prospective earnings data are provided in

along with dividend and cash flow forecasts. Firms receive one point for disclosing each of

lowing items: forecast earnings; detailed revenue estimates; detailed expense estimates; multi-

forecast earnings; planned capital expenditure; planned financing details; forecast cash flow;

recast dividends. Full details are available from the authors on request.

Table 1

Summary of audit firms acting as prospectus auditor for a sample of 266 Australian industrial IPOs

from 1976–1989

Audit firm Frequency %

Panel A: Big 8

Coopers and Lybrand 29 10.9

Peat Marwick Mitchell/Peat Marwick 28 10.5

Price Waterhouse 25 9.4

Arthur Andersen 23 8.6

Arthur Young 20 7.5

Deloittes 20 7.5

Ernst and Whinney 17 6.4

Touche Ross 13 4.9

175 65.8

Panel B: Non-Big 8

KMG Hungerfords 22 8.3

Bentley and Co. 8 3.0

Pannel Kerr and Foster 7 2.6

Horwarth and Horwarth 6 2.3

Nelson Wheeler 5 1.9

Widin and Co. 5 1.9

Duesburys 4 1.5

Priestley and Morris 4 1.5

Gould Ralph and Co. 2 0.8

Hendry Rae and Court 2 0.8

Palmer and Partners 2 0.8

Thompson Douglas and Co. 2 0.8

Othersa 22 8.3

91 34.2

266 100.0

aAll firms in this group had a frequency of one.


LEV financial leverage, as measured by the ratio of total debt to total

equity

ISSUE size of the IPO issue, measured in 1990 Australian dollars

UWQ underwriter quality, measured using a ð0; 1Þ dummy variable with avalue of 1 assigned if a high prestige underwriter is appointed

RETOWN percentage of post-listing ownership retained by the entrepreneur

measured as [1) proportion of post-listing paid-up capital sold to thepublic]

FUTEQ a ð0; 1Þ dummy variable with a value 1 indicating the IPO firm sub-

sequently made a public equity issue in the two years following the

IPO.


Apart from our proxies for IPO firms� riskiness and their voluntary disclosureof expected earnings, the model reflects demand-side variables found to be rel-evant in prior studies of auditor selection. For example, leverage is typically

associated with the demand for more credible financial data, although it is also

possible that leverage could be an additional proxy for risk. 22 The issue size

variable controls for the extent to which variation in auditor selection is expected

to cluster around the smaller issues (Willenborg, 1999). Prior research suggests

that underwriters with substantial reputations rely on high quality auditors to

reduce their risk of holding unallotted shares (Simunic and Stein, 1987; Menon

and Williams, 1991; Willenborg, 1999). With no observable independent ‘‘rat-ing’’ scheme similar to the US (e.g., Carter and Manaster, 1990), we rely on the

classifications developed by Taylor (1991). These ratings are intended to capture

the extent to which an underwriter will be viewed as prestigious. The ranking is

based on the presence (¼ 1) or absence (¼ 0) of one or more of the followingattributes: the underwriting firm is a registered bank or majority owned by a

bank; or the underwriting firm is among the top six by market share; or the

underwriting firm has a national rather than a regional presence.

Raising additional public equity soon after listing could also influence IPOfirms� auditor selection. IPOs which return to the capital market shortly afterlisting effectively submit themselves to monitoring (i.e., judgement) by the

capital market. To the extent that high quality auditors are seen to provide

similar post-listing monitoring, there could be a trade-off between auditor

choice and capital rationing (Francis and Wilson, 1988). Alternately, firms

which select a high quality auditor could be more likely to return to the capital

market on the basis of post-listing results which are viewed as more credible. In

adopting a two year window, we have assumed that these actions reflect ex anteplanning for subsequent equity raisings. However, the prospectuses of our

sample IPOs provided few indications of planned equity raisings.

4. Results

4.1. Descriptive statistics

Table 2 compares IPOs selecting Big 8 and Non-Big 8 auditors. We present

separate results for the full sample (panel A) of IPOs, as well as two subsets,

namely those IPOs underwritten by less prestigious underwriters (panel B) and

22 Leverage may be a proxy for risk, although the direction of the association is unclear. On the

one hand, IPO firms� riskiness may be viewed as increasing in the level of financial risk (i.e.,

leverage). However, we also expect that firms with lower operating (as distinct form purely

financial) risk are likely to have higher leverage [Smith and Watts (1992), Gaver and Gaver (1993)].

Table 2

Descriptive statistics for a sample of 266 Australian industrial IPOs (panel A), and partitioned by

underwriter prestige (panel B)a and jointly by underwriter prestige and deal size (panel C)

Variableb Panel A: Full sample Panel B: Non-prestigious

underwriters

Panel C: Small deals: Non-

prestigious underwriters

Auditor quality Auditor quality Auditor quality

High

(n ¼ 175)

Low

(n ¼ 91)

High

(n ¼ 74)

Low

(n ¼ 42)

High

(n ¼ 28)

Low

(n ¼ 23)

LEV 0.57 0.36 0.62 0.35 0.79 0.43

0.22 0.17 0.33 0.30 0.43 0.41

(1.08) (0.49) (0.94) (0.34) (0.88) (0.34)

t-valuec 2.18�� 2.22�� 1.97�

z-valuec 0.96 0.82 0.65

STDDEV 14.58 16.14 15.25 15.94 16.74 13.69

12.39 13.77 12.22 13.55 9.81 10.62

(12.15) (9.79) (16.55) (10.46) (25.51) (8.71)

t-value )1.13 )0.28 0.59

z-value )1.63� )1.03 )0.71

GOPT 0.72 0.74 0.73 0.66 0.68 0.59

0.85 0.83 0.84 0.67 0.72 0.62

(0.31) (0.28) (0.31) (0.30) (0.32) (0.28)

t-value )0.35 1.20 1.09

z-value )0.25 1.37 1.37

AGE 4.59 4.30 4.38 4.69 4.25 6.13

5.00 5.00 4.50 5.00 4.00 5.00

(3.99) (3.77) (4.02) (3.71) (3.59) (3.43)

t-value 0.59 )0.42 )1.91�

z-value 0.50 )0.43 )1.87�

ISSUE 128815 95355 103235 55974 25298 21448

62657 61905 61963 36957 24123 22321

(172522) (138473) (146435) (50167) (10014) (10507)

t-value 1.72� 2.53�� 1.33

z-value 1.56 2.31�� 1.23

ASSETS 617831 275326 377897 167252 176996 95724

197032 152703 173912 113559 91124 95295

(2468240) (436749) (756284) (156662) (319564) (13178)

t-value 1.78� 2.31� 1.31

z-value 2.18�� 2.57�� 0.86

DINDEX 1.86 1.40 2.03 1.36 2.5 1.52

2.00 1.00 2.00 1.00 2.00 1.00

(1.78) (1.53) (1.90) (1.58) (1.69) (1.44)

t-value 2.23�� 2.04�� 2.23��

z-value 2.06�� 1.84� 2.23��

(continued on next page)


Table 2 (continued)

Variableb Panel A: Full sample Panel B: Non-prestigious

underwriters

Panel C: Small deals: Non-

prestigious underwriters

Auditor quality Auditor quality Auditor quality

High

(n ¼ 175)

Low

(n ¼ 91)

High

(n ¼ 74)

Low

(n ¼ 42)

High

(n ¼ 28)

Low

(n ¼ 23)

RETOWN 54.60 54.54 54.48 54.23 60.03 65.81

57.10 59.20 59.00 56.90 65.55 65.50

(22.14) (22.66) (22.06) (23.85) (20.32) (13.98)

t-value 0.02 0.06 )1.20z-value 0.00 0.04 )0.76

Amounts shown are the mean, median and standard deviation (in brackets).�Significant at the 10% level (two-tailed).��Significant at the 5% level (two-tailed).��Significant at the 1% level (two-tailed).

aHigh quality auditors are defined as the Big 8 audit firms.bVariables are defined as follows:

LEV total debt� total equity, based on the pro-forma (i.e., post-issue) balance sheetSTDDEV standard deviation of monthly returns for the first 12 post-listing months using a

zero-one market model

GOPT Max 1� net tangible assets per share ðexcluding cashÞissue price per share

; 0h i

AGE operating history of the firm prior to the IPO, as disclosed in the prospectus, with

values between 5 and 10 recorded as 5, and greater than 10 years capped at 10

ISSUE equity raised in the IPO, adjusted by a CPI factor to be in constant 1990 dollars

(thousands)

ASSETS total assets (in millions) from the pro-forma balance sheet, adjusted by a CPI factor

to be in constant 1990 dollars

DINDEX disclosure index comprising eight disclosure attributes of the financial forecast

information in the IPO prospectus, with observations scored as an integer between

zero and eight

RETOWN 1 ) fraction of post-listing paid-up capital sold to the publicc t-values and Wilcoxon z-values are based on the differences between high- and low-quality

auditors.


those which also fall within the smallest third of deal size (panel C). Thesesubsets reflect the expectation that tests of DFH are likely confounded by the

influence of prestigious underwriters and/or deal size.

From Table 2 (panel A), it is apparent that there is no support for the model

proposed by DFH. None of the three risk proxies differ significantly between

the two groups, except for our ex post risk proxy STDDEV, for which the non-

parametric Wilcoxon-z value is significant at the 10% level (one-tailed).

However, the result suggests that IPO firms choosing a Big 8 auditor are less

(rather than more) risky than those selecting a Non-Big 8 auditor. This isopposite to the prediction of DFH. While there is evidence (parametric test


only) of IPO firms choosing higher quality auditors being more highly lever-

aged, the interpretation of this result as consistent with the model of DFH issubject to leverage actually capturing IPO firms� riskiness.However, the picture changes somewhat once tests are restricted to IPO firms

using a non-prestigious underwriter. Panel B of Table 2 shows that although

none of the three risk proxies differ significantly between IPO firms choosing

high or low quality auditors, the differences for both ex ante proxies are in the

direction predicted by DFH. Moreover, when tests are restricted to IPO firms

using a non-prestigious underwriter and which are in the smallest third of deal

size (panel C), one of the two ex ante risk proxies (AGE) differs significantlybetween the two groups. This result supports the DFH prediction that riskier

IPO firms will choose high quality audit firms. As with the full sample results,

firms choosing high quality auditors continue to be more highly leveraged.

A similar pattern of results is observed for the secondary prediction of DFH,

namely that retained ownership will be lower for IPO firms using high quality

auditors. While tests using the full sample of IPOs fail to yield evidence con-

sistent with these predictions, the results reported in panel C for small IPOs

using low quality underwriters, while not significant, are in the hypothesizeddirection. This is also consistent with our argument that tests which eliminate

the influence of high quality underwriters and deal size are likely to yield more

powerful tests of DFH�s predictions.At least two other results in Table 2 are noteworthy. First, all three samples

yield results consistent with our argument, derived from Hughes (1986), that

prospective financial disclosures and high quality auditors are complementary

signaling mechanisms, such that the signaling value of a high quality auditor is

expected to increase with the extent of voluntarily disclosed prospective ac-counting data. Second, IPO firms using high quality auditors are significantly

larger (and make significantly larger issues). Once the tests are confined to the

smallest third of deals this difference is no longer statistically significant.

Table 3 reports frequency distributions for auditor quality and both future

equity issues (FUTEQ) and the voluntary disclosure of expected earnings

(DISC). In addition, panel A of Table 3 also reports the relationship between

IPO firms� choice of auditor quality and underwriter prestige (UWQ). Al-

though there is no significant association between the level of audit qualityselected and the use of prestigious underwriters, this could reflect differences in

the influence of prestigious underwriters on large versus small issues. 23

The results reported in Table 3 provide evidence of an association between

choice of audit quality and future equity issues. In addition, there is strong

evidence that IPO firms making voluntary earnings forecasts are more likely to

23 Further (unreported) analysis supports this view. As deal size decreases, the correlation

between auditor quality and underwriter prestige increases monotonically.

Table 3

Frequency distributions for auditor quality and underwriter prestige, for auditor quality and future equity raising and for auditor quality and dis-

closures for a sample of 266 Australian industrial IPOs from 1976–1989 (panel A), and partitioned on the basis of deal size while also having a non-

prestigious underwriter (panel B)a and jointly by underwriter prestige and deal size (panel C)

Underwriter

quality

(UWQ)b

Auditor quality Future equity

raising

(FUTEQ)b

Auditor quality Disclosure

(DISC)bAuditor quality

Low High Total Low High Total Low High Total

Panel A: Full Sample

Low 42 74 116 No 43 66 109 No 58 90 148

High 49 101 150 Yes 48 109 157 Yes 33 85 118

Total 91 175 266 Total 91 175 266 Total 91 175 266

Chi-square¼ 0.36 Chi-square¼ 2.25 Chi-square¼ 3.67�

Panel B: Non-prestigious underwriter

No 23 21 44 No 29 37 66

Yes 19 53 72 Yes 13 37 50

Total 42 74 116 Total 42 74 116

Chi-square¼ 7.92�� Chi-square¼ 3.96��

Panel C: Non-prestigious underwriter: Smallest third by deal size

No 12 7 19 No 15 9 24

Yes 11 21 32 Yes 8 19 27

Total 23 28 51 Total 23 28 51

Chi-square¼ 3.99�� Chi-square¼ 5.55��Significant at the 10% level.��Significant at the 5% level.��Significant at the 1% level.

aHigh quality auditors are defined as Big 8 audit firms.b Variables are defined as follows:

UWQ high quality (coded 1) if the underwriter is either a registered bank and/or majority owned by a bank and/or among the

top six underwriters by market share and/or has a national distribution network

FUTEQ the presence (coded 1) of a subsequent public equity issue in the two years following the IPO

DISC the presence (coded 1) of an earnings forecast in the IPO prospectus

392

P.Leeetal./JournalofAccountingandPublicPolicy22(2003)377–400


select a high quality auditor. This is consistent with the results for our dis-

closure index reported in Table 2, and holds irrespective of IPO deal size andunderwriter prestige.

4.2. Multivariate tests

Table 4 summarises the results of logistic regressions used to establish the

marginal explanatory power of our risk proxies in explaining the choice of a

high quality auditor. Consistent with Tables 2 and 3, we report separate esti-

mates of Eq. (1) for the full sample (n ¼ 266), IPOs using less prestigious un-derwriters (n ¼ 116) and finally, IPOs using less prestigious underwriters that

are also, based on deal size, from among the smallest third of our sample. In

each case, we report two estimates, first using our measure of the extent to which

firms� share prices reflect growth opportunities rather than assets-in-place

(GOPT) and second, firm age (AGE). We do not report results using our ex post

proxy for firm risk (STDDEV), as the coefficient is consistently insignificant. 24

The results in Table 4 are strongly consistent with the view that, subject to

eliminating the influence of prestigious underwriters, there is empirical supportfor the prediction of DFH that relatively risky IPO firms will demand high

quality audit firms. As with our univariate results, we find no evidence of this

prediction for the full sample, except for the possible interpretation of leverage

as an additional proxy for risk. However, when tests are confined to the IPOs

using non-prestigious auditors both of our ex ante risk proxies (GOPT and

AGE) have statistically significant coefficients in the predicted direction. These

results are even stronger when tests are also confined to relatively small IPOs.

Once again both ex ante risk proxies have significant coefficients, consistentwith the prediction of DFH. Deal size (ISSUE) is not significantly associated

with auditor choice for our full sample tests, but is significant when observa-

tions are confined to those IPOs with less prestigious underwriters. As ex-

pected, further confining tests to the smallest third of deal size results in an

insignificant coefficient on this variable. Leverage continues to be significantly

associated with the demand for high quality auditors in all our tests.

The results in Table 4 also strongly support the role of planned future equity

issues and voluntary disclosures in determining the demand for high qualityauditors. 25 The latter result is consistent with our argument that the primary

24 This result could reflect the failure of STDDEV to adequately capture variation in IPO firms�riskiness. As Habib and Ljungqvist (2001) note, while greater variation in returns is to be expected

for relatively risky IPOs, price support (or at least stabilization) is also more likely for these IPOs,

thereby reducing the observed variation in returns.25 The tests reported in Table 4 uses a dummy variable (DISC) to denote the presence or absence

of an explicit earnings forecast within the prospectus. Our results are very similar when we use the

self-constructed index of forward-looking financial disclosures.

Table 4

Logistic regression analysis of auditor choicea for 266 Australian industrial IPOs from 1976–1989

Variableb Panel A: full sample

(n ¼ 266)

Panel B: non-presti-

gious underwriters

(n ¼ 116)

Panel C: non-prestigious

underwriter: Smallest third

by deal size (n ¼ 51)

Model 1 Model 2 Model 1 Model 2 Model 1 Model 2

INTERCEPT )0.2483 )0.1316 )3.2269 )1.6872 )2.7021 )0.1628Chi-square 0.16 0.08 7.63�� 4.16�� 1.31 0.00

LEV 0.4343 0.4778 1.4321 1.4116 2.8016 3.1703

Chi-square 2.71� 2.92� 6.38�� 6.43�� 8.11�� 7.91��

GOPT 0.1198 – 1.5502 – 2.4939 –

Chi-square 0.06 – 3.57� – 2.97� –

AGE – )0.0236 – )0.1386 – )0.4321Chi-square – 0.33 – 3.89�� – 7.72��

ISSUE 1.6450 1.6470 12.0000 11.0000 5.1000 42.0000

Chi-square 2.22 2.26 6.78�� 6.07�� 0.02 0.79

UWQ 0.1182 0.1267 – – – –

Chi-square 0.19 0.22 – – – –

RETOWN )0.0019 )0.0012 )0.0008 0.0012 )0.0440 )0.0460Chi-square 0.09 0.03 0.00 0.01 2.59 2.20

FUTEQ 0.5054 0.4999 1.5789 1.6092 2.5204 2.6861

Chi-square 3.45� 3.37� 10.84�� 11.09�� 7.09�� 6.84��

DISC 0.4599 0.4928 0.9390 1.1540 1.6084 2.3006

Chi-square 2.86� 3.12� 4.11�� 5.73�� 3.65� 6.26��

Log likelihood

ratiosc

v2 of model 328.45�� 328.18�� 121.06 120.64 45.67 37.66

v2 of covariates 13.32� 13.59� 30.81�� 31.22�� 24.54�� 32.55��

Amounts shown are the coefficient value, along with a Chi-square statistic.�Significant at the 10% level (two-tailed).��Significant at the 5% level (two-tailed).��Significant at the 1% level (two-tailed).

aHigh quality auditors are specified as a Big 8 Audit firm.bVariables are defined as follows:

LEV total debt� total equity, based on the pro-forma (i.e., post-issue) balance sheetGOPT Max 1� net tangible assets per share ðexcluding cashÞ

issue price per share; 0

h iAGE operating history of the firm prior to the IPO, as disclosed in the prospectus, with values

with values between five and 10 recorded as five, and greater than 10 years capped at 10

ISSUE the natural logarithm of the equity raised in the IPO, adjusted by a CPI factor to be in

constant 1990 dollars. The coefficient has been multiplied by 106 for display purposes

RETOWN 1-fraction of post-listing paid-up capital sold to the public

FUTEQ the presence (coded 1) of a subsequent public equity issue in the two years following the

IPO

DISC the presence (coded 1) of an earnings forecast in the IPO prospectusc The logistic regression models are evaluated using the )2 Log likelihood statistic.



value of IPO auditors as a signaling mechanism relates to their attestation of

financial data. Put differently, the signaling value of differential audit quality islikely subject to investors� reliance on information to which the auditor attests.One such indicator is the decision by the IPO firm to voluntarily provide an

(audited) earnings forecast. Finally, we note that there is also some limited

evidence consistent with the secondary prediction of DFH, namely that there

will be a degree of substitution between retained ownership and the level of

audit quality selected. In (unreported) tests using only those IPOs with less

prestigous auditors and that are drawn from the smallest third of deal size, we

find that the coefficient on retained ownership is statistically significant if ourdeal size measure (ISSUE) is not included in the regressions. However, when

deal size is included (as reported in Table 4), the coefficient is in the predicted

direction but is only statistically significant at levels marginally below the

‘‘conventional’’ level of 10% (i.e., 12%).

5. Additional tests

5.1. Matched pairs analysis

To address the potential endogeneity problem in regression tests of the type

reported in Table 4, we use a similar procedure to Clarkson and Simunic (1994)

and Feltham et al. (1991). We construct matched pairs of IPOs audited by Big

8 and Non-Big 8 auditors, with the matching based on issue size. Matching is

on issue size (rather than firm size) because Table 2 shows that issue size is

associated with auditor choice, possibly reflecting the ‘‘warranty effect’’ de-

scribed by Willenborg (1999), as well as a greater presence of prestigious un-derwriters among larger IPOs. This matching results in a total of 89 pairs of

matched firms for the full sample, 39 pairs for those with non-prestigious

underwriters and 20 pairs for those which are also in the smallest third of issue

size. 26 Table 5 provides descriptive statistics and reports the results of these

additional tests.

As with both the univariate and multivariate tests reported in Section 4, we

find no evidence of differences in risk using our ex post measure (STDDEV).

However, for both of our ex ante measures (GOPT and AGE), Table 5 pro-vides additional evidence that IPO firms selecting high quality auditors are

relatively riskier, subject to the tests controlling for the possible influence of

underwriter prestige and/or deal size. For tests using the entire sample (panel

A), we again find no difference for any of our risk proxies between IPO firms

using high or low quality auditors.

26 Our matching is based on an allowable variation of 10% in our issue size measure.

Table 5

Relation between risk proxies and auditor quality for a size-matched sample of 266 Australian

industrial IPOs (panel A), a sample of 116 IPOs with non-prestigious underwriters (panel B) and a

sample of 51 IPOs which have a deal size among the smallest one-third of the total sample and have

a non-prestigious underwriter (panel C) from 1976–1989

Risk proxya Relative frequenciesb proportion of pairs in which the firm with the high-

quality auditor is riskier than the firm with the low-quality auditor

Panel A: full sample Panel B: non-prestigious

underwriters

Panel C: small deals

non-prestigious

underwriters

STDDEV (ex post) 41/89¼ 0.46(89 pairs, 0 ties)

20/39¼ 0.51(39 pairs, 0 ties)

8/20¼ 0.40(20 pairs, 0 ties)

GOPT (ex ante) 40/83¼ 0.48(89 pairs, 6 ties)

21/36¼ 0.58(39 pairs, 3 ties)

15/20¼ 0.75(20 pairs, 0 ties)

AGE (ex ante) 35/69¼ 0.51(89 pairs, 20 ties)

19/32¼ 0.59(39 pairs, 7 ties)

9/15¼ 0.60(20 pairs, 5 ties)

aRisk proxies are:

STDDEV standard deviation of monthly returns for the first 12 post-listing months using a

zero-one market model

GOPT Max 1� net tangible assets per share ðexcluding cashÞissue price per share

; 0h i

AGE operating history of the firm prior to the IPO, as disclosed in the prospectus, with

values with values between five and 10 recorded as five, and greater than 10 years

capped at 10bThe frequencies reported omit ties.


5.2. Audit quality proxy

Table 1 shows that KMG Hungerfords (the then largest Non-Big 8 practice

in Australia) had 8% of IPO audits in our sample, which is the fifth highest

share. KMG Hungerford�s market share could signal they provide quality-

differentiated audit services from other Non-Big 8 auditors. 27 We therefore

repeated our analysis first excluding KMG Hungerfords from the Non-Big 8

group and then including them with the Big 8 to effectively create a Big 9.Under the exclusion approach, the results are qualitatively similar to those

reported in Table 4, and this is also true when we include KMG Hungerfords

in a ‘‘Big 9’’.

5.3. Mining companies

Our analysis to this point has only incorporated industrial IPOs. To assess

whether the findings we have generated are sensitive to this selection criterion,

27 For example, Craswell et al. (1995) provide fee-based evidence that auditor expertise and

industry market shares are linked. In what follows, we effectively treat IPO audits as an ‘‘industry’’.


we reperformed the analysis on a sample of 120 mining IPOs over the years

1977–86 inclusive for which the necessary data was also available. Approxi-mately half this sample is audited by Big 8 auditors (n ¼ 58). Given limitations

of the available data, an ex post proxy for IPO risk is measured as the standard

deviation of raw monthly returns over the first 12 months of trading. The

univariate results on this variable indicate that riskier firms choose low quality

auditors. 28 These results suggest that even for mining IPOs, our findings are

not consistent with Clarkson and Simunic (1994).

5.4. Signaling and valuation

We further investigate the role of audit quality and voluntary disclosure via

a valuation model. Consistent with DFH and Clarkson and Simunic (1994), we

estimate the following model:

28 T

audito

on the

signific29 F30 T

whethe

Vi ¼ b0 þ b1ALPHAi þ b2ISSUEi þ b3DISCi þ b4AUDi þ ei ð2Þ
where V ¼ market capitalisation following the IPO, ALPHA ¼ ½lnð1�RETOWNÞ þRETOWN, ISSUE, DISC and AUD are as defined above.Our results are consistent with the argument that the signaling role of audit
quality is contingent on both the size of the IPO and underwriter quality, as

well as the extent of forward looking earnings disclosures. 29 In tests that use

the full sample of IPOs, we find evidence of a signaling role for retained

ownership, but not for audit quality or disclosure. However, when we confine

tests to IPOs that are relatively small and/or which use a less prestigious un-

derwriter, we find that value is positively and significantly related to both

disclosure choice and audit quality. This is especially evident when we includean interaction term capturing voluntary disclosure of forward looking earnings

information and the choice of a high quality auditor. 30

6. Summary and conclusions

Our primary objective is to document the factors which give rise to a de-

mand for differential audit quality among IPO firms, and especially the extent

to which the signaling value of differential audit quality is dependent on the

extent of (attested) financial data provided by the issuer. Our tests combine the

he results also show that firms with a smaller issue size are more likely to select a Non-Big 8

r and larger firms (based upon asset size) are more likely to select a Big 8 auditor. The results

other risk based measures (i.e., years of operation, growth options) are not statistically

ant.

or brevity we do not tabulate these results. Full details are available from the authors.

hese results are somewhat sensitive to the exact specification of the model, and also to

r ISSUE is included as an independent variable or used to scale the regression.


advantage of a low litigation environment (Australia) with the recognition that

large IPOs likely use a high quality auditor for several reasons, including theinfluence of prestigious underwriters. Hence, we concentrate our attention on

IPOs underwritten by less prestigious underwriters, as well as those issues that

are also relatively small. When our tests are confined this way, we find evidence

consistent with DFH�s primary prediction that relatively riskier IPOs demand ahigher level of audit quality. Both of our ex ante risk proxies (asset composi-

tion and length of operating history) are statistically significant in the direction

predicted by DFH. Only our ex post proxy (post listing price volatility) does

not differ between IPOs firm using high and low quality audit firms. Theseresults suggest that prior United States-based tests of DFH have indeed been

confounded by market segmentation. Absent high expected litigation costs and

the influence of prestigious underwriters, there is also some weak evidence that

issuers trade-off the signaling role of retained ownership and audit quality in

the manner predicted by DFH.

Our results also yield evidence consistent with the signaling value of differ-

ential audit quality being dependent on the extent of audited financial data

provided by the issuer. Using either a dummy variable to capture the voluntaryprovision within the prospectus of an earnings forecast, or an index measure

designed to capture the level of detail about expected performance, we find a

statistically significant relation with the demand for high quality audit firms. This

result holds irrespective of the influence of either issue size or choice of under-

writer. Overall, we characterize our results as giving support to the signaling

perspective on IPO auditor choice. However, at the same time, it is apparent that

relatively stylized models of auditor choice such as those of DFH and Hughes

(1986) fail to recognize the wide range of potential signaling mechanisms that areavailable. We expect that future research will focus on the extent to which

multiple signaling mechanisms interact, as well as the additional complexity of

simultaneously modelling supply side and demand side influences.

From a policy perspective, our results suggest that the economic demand for

auditing varies according to IPO firms� circumstances, and also reflects the

extent to which firms engage in greater financial disclosure, including forecast

data. Variable demand for audit quality is consistent with the view that im-

position of an arbitrary level of audit quality may result in over production of‘‘high quality’’ auditing. More importantly, it is also consistent with a wide

range of signaling and/or monitoring mechanisms, some of which may be

complimentary and some of which may serve as substitutes. While our tests

suggest that retained ownership may substitute for costly signaling mechanisms

such as high quality auditing, the use of a high quality auditor likely compli-

ments the signaling value of increased voluntary disclosure. In countries such

as the US, where forecast data is neither actively encouraged nor mandatory,

there is scope to review the role for such disclosures in IPO prospectuses, aswell as other forms of investment offerings where audited historical and for-


ward looking financial data is expected to be relevant to potential investors. In

countries such as Australia, where earnings forecasts are now mandatory, theseresults demonstrate the dual signalling role fulfilled by such disclosures and

their attestation by high quality auditors.

Our results also suggest that the imposition of ‘‘one size fits all’’ notions of

best practice may be counter-productive. Recent high profile business collapses

in the US, Australia and elsewhere have resulted in considerable regulatory

pressure on the extent of flexible disclosure. In the context of the IPOs we

examine, it is apparent that the choice of signaling mechanisms, including the

extent of disclosure, is quite variable. IPOs are an especially relevant group offirms in this respect, because no-one forces investors to purchase shares in the

IPO. Hence, it is clear that some firms see an important role for additional

disclosures, while others do not.

Finally, our results also highlight how one form of alleged investor pro-

tection (i.e., the relatively litigious nature of US capital markets) can be

counter productive. Although the threat of litigation could result in consid-

erable ‘‘filtering’’ of IPO firms, it could also result in reduced voluntary dis-

closure, and our results suggest that voluntary disclosures of forward lookingfinancial information such as earnings forecasts is value relevant information.

Acknowledgements

We acknowledge the comments and suggestions of Mike Bradbury, AllenCraswell, Jere Francis, Denzil Fiebig, Gene Imhoff, Dan Simunic and espe-

cially Peter Clarkson, as well as Marty Loeb (the editor), two anonymous

referees and participants in workshops at the Australian National University,

the University of Auckland, the University of Newcastle, the University of

New England, the University of Southern Queensland and the American Ac-

counting Association annual meeting. We are grateful for the research assis-

tance of Harischand Madhoo, Peter Taplin and Sarah Taylor.

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