Simultaneous Estimation of the Supply and Demand of Auditor Reputation in the Market for Initial Public Offerings

Abstract:     
This study investigates factors that determine the choice of auditor in the market for new issues of securities. While ex post benefits of selecting a high reputation auditor are well documented in the literature (e.g., higher IPO proceeds), researchers have had less success in establishing the ex ante determinants of the demand for auditor reputation. To address this problem, we use an improved research design which explicitly considers the confounding supply side effects of audit fees on demand. We specify a system of simultaneous equations and utilize a two-stage generalized least squares estimation procedure to investigate the determinants of the demand for auditor reputation (proxied by auditor size) in the market for initial public offerings. Using a sample of firms issuing securities between 1991 and 1994, we find that audit fees are an important variable omitted in previous audit demand studies and that audit fees and demand are endogenously determined. We find that the demand for auditor reputation is inversely related to the ownership percentage retained by the entrepreneur/owners and to the proportion of the IPO proceeds used for investment purposes. Additionally, the demand for auditor reputation is found to be inversely related to a measure of firm-specific risk reflecting the likelihood that the issuing company will fail within three years following the IPO.

JEL Classifications: M40, M49, G12, D23, L14

Working Paper Series