Auditor Reputation and the Pricing of Initial Public Offerings

Author(s): Randolph P. Beatty

Source: The Accounting Review, Vol. 64, No. 4 (Oct., 1989), pp. 693-709
Published by: American Accounting Association
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THE ACCOUNTING REVIEW
Vol. LXIV, No. 4
October 1989

NOTES
Auditor Reputation and the Pricing
of Initial Public Offerings
Randolph P. Beatty

ABSTRACT: It is hypothesized that an inverse relation exists between the reputation of the
auditor of an initial public offering and the initial return earned by an investor. Specifically,
clients that hire more reputable CPA firms should exhibit lower initial returns than clients that
choose to hire CPA firms with less reputation capital at stake. Two proxies for auditor reputa-
tion are used to test this hypothesis. The first reputation proxy uses indicator variables for
auditor size. Results indicate that the widely used Big Eight/non-Big Eight classification may
measure CPA firm reputation capital with error particularlyfor the smaller Big Eight and larger
non-Big Eight firms. A second reputation proxy is developed by regressing compensation paid
to the auditing firms on measures of marginal cost of performing the audit. The initial return
to the IPO investors is regressed on the residual from the compensation regression to provide
evidence of the reputation hypothesis. Results indicate that clients that pay a premium for
their registration audit exhibit lower initial returns for their investors. Thus, the results of both
tests provide support for the hypothesized inverse relation between auditor reputation and
initial public offering initial return.

A COMPANY "going public" must pro-
vide a prospectus that includes a
description of its present and fu-
ture operations and audited financial
statements. Since privately held firms
face limited disclosure requirements, the
market usually possesses less publicly
available data from them than from
comparable publicly traded firms. This
difference in regulatory environment
provides a potentially fruitful setting in
which to consider the role of the public
accountant.
Since switching auditor just prior to
going public is widely alleged, it is
natural to investigate management's mo-
tivation for such a change (see "Small
693
The author would like to thank Linda DeAngelo,
Victor Defeo, Nick Gonedes, Pat Hughes, Prem Jain,
Rick Lambert, Bill Kinney, David Larcker, Laurentius
Marais, Jay Ritter, Rex Thompson, Ivo Welch, and
workshop participants at the Wharton School, Indiana
University, Northwestern, New York University, Uni-
versity of Southern California, Temple, Columbia, and
University of Pittsburgh for providing comments and
suggestions. I'm particularly indebted to Jay Ritter for
the construction of the database used in this project.
Financial support was provided by the Fishman-David-
son Center for the Study of the Service Sector at the
Wharton School.
Randolph P. Beatty, Graduate School
of Business, University of Chicago.
Manuscript received June 1987.
Revisions received August 1988 and March 1989.
Accepted April 1989.

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694
CPA Concern Sues an Underwriter Over
Loss of Client," The Wall Street Journal
[July 18, 1983, p. 1]). Carpenter and
Strawser [1971] describe the results of a
survey of AICPA members concerning
the displacement issue as follows:
Almost universally, the reason expressed
[for the change in auditors] was that the
underwriters informed the client that a
"nationally known firm" was necessary
to sell their offering at the highest possi-
ble price [p. 55].
This widely held view suggests that the
employment of a "nationally known"
audit firm will increase the price (reduce
the initial return) received by the initial
public offering (IPO) client.
This paper presents and tests the hy-
pothesis that audit firm reputation is in-
versely related to the initial return earned
by an IPO investor. The evidence is con-
sistent with an inverse relation between
auditor reputation and the initial return
to the IPO investor. First, tests of linear
restrictions of indicator variable coeffi-
cients are interpreted within the tradi-
tional Big Eight/non-Big Eight frame-
work to suggest a negative relation
between auditor reputation and initial
return. A second partition (Largest-Five,
Middle-Six, and Smallest-Nine audit
firms) is introduced to provide evidence
that ad hoc classification schemes may
only crudely separate the set of audit
firms by reputation capital. In particu-
lar, it appears that smaller Big Eight and
larger non-Big Eight firms exhibit sim-
ilar reputations in the IPO market. To
test the reputation hypothesis without
relying on an ad hoc classification,
reputation capital is inferred from the
observation of auditor compensation.
These tests use a measure of the residual
compensation paid to the IPO auditing
firm and provide the first direct evidence
of the hypothesized reputation relation.
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The Accounting Review, October 1989
Section I draws from the previous em-
pirical and theoretical literature to sug-
gest testable assertions relating auditor
reputation and the initial return to an
IPO investor. Section II describes the
data used in the empirical tests and pro-
vides a number of descriptive statistics.
Results of regression tests of the reputa-
tion hypothesis are presented in Section
III and, finally, Section IV concludes
with a summary.
I. UNDERPRICING
AND THEROLEOF THE
AUDITINGFiRM
Previous studies of the IPO market
have focused on an empirical phenom-
enon that has been described as "under-
pricing" of the firm's equity securi-
ties. l,2 The term "underpricing" is used
to describe the difference between the
offering price and the market clearing
price at issuance. Numerous empirical
papers have demonstrated this persistent
underpricing of equity securities [Ibbot-
son, 1975; Ibbotson and Jaffee, 1975;
and Ritter, 1984].
Various asymmetric information mod-
els have been proposed to explain this
phenomenon. In one model, the invest-
ment banker is "better informed" than
the issuing firm as to the demand for the
issuing firm's securities [Baron, 1982]. In
another, two classes of IPO investors,
informed and uninformed, are assumed
to exist [Rock, 1982 and 1986; Beatty
and Ritter, 1986]. In each of these mod-
els, the investment banker or the unin-
formed investors face uncertainty con-
cerning the IPO firm value. The precision
' For a review of the literature on the IPO market, see
Smith [1986].
2 Underpricing translates directly into the initial
return, defined as the returnearned by an investor buying
at the offering price and selling at the first-day closing
price. These terms will be used interchangeably in the re-
mainder of this paper.
Beatty
of the distribution of uncertainty of firm
value has been described as ex ante un-
certainty [Beatty and Ritter, 19861. Both
of these models imply that there is a
positive relation between ex ante uncer-
tainty and the underpricing of the IPO.
Some investigators have argued in the
agency literature that auditing services
are demanded to reduce costs arising
from conflicts of interests between
owners and managers [Jensen and Meck-
ling, 1976; Watts and Zimmerman,
1983]. Since the nature and extent of
agency costs vary across firms that at-
tempt to minimize these costs, the audit-
ing services demanded will be heteroge-
neous. This heterogeneity may lead CPA
firms to differentiate themselves on the
basis of investment in reputation capital
to facilitate the attestation function
[Kinney, 1988].
Simunic and Stein [1987] suggest that
auditor product differentiation on the
dimensions of control, credibility, and
product line motivates management's
auditor choice in the IPO market. They
conclude that the form of the under-
writer agreement, the proportion of
common stocks held by outsiders after
the IPO, and a measure of uncertainty
are related to the choice of auditing firm.
Beatty [1989] provides evidence consis-
tent with Simunic and Stein [1987] that
larger and less risky IPO clients tend to
hire Big Eight audit firms. As in this
study, preliminary evidence from indi-
cator variable regressions suggested that
auditor reputation might be related to
underpricing.
Titman and Trueman [1986] present a
signalling model that results in auditor
quality providing information useful to
investors in assessing the value of the
IPO firm. Two features of their model
lead to signalling of the IPO firm's
value. First, high quality auditors (or in-
vestment bankers) are those individuals
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695
with a comparative advantage in estab-
lishing the reported information variable
that is related to the firm value. Second,
the firm is required to pay a "price pre-
mium" for this higher quality audit.3
These two expected costs of hiring the
high quality auditor exceed the expected
benefits of misclassification for the low
firm value IPOs. This cost-benefit rela-
tion leads the entrepreneur to choose an
audit firm that "signals" firm value to
the market. Although this model does
not consider the underpricing phenom-
enon, a similar signalling environment is
used here to hypothesize a relation be-
tween auditor reputation and the under-
pricing of an IPO.
The firm's existing owners have an in-
centive to minimize underpricing since it
transfers wealth from them to the new
investors.4 The literature suggests a di-
rect relation between ex ante uncertainty
and underpricing of the IPO [Baron,
1982; Rock, 1982 and 1986; and Beatty
and Ritter, 1986]. All firms (existing
owners) have an incentive to disclose
"low" ex ante uncertainty, giving rise to
the classic "lemons" problem [Akerlof,
1970]. However, firms whose ex ante un-
certainty is in fact "high" have a greater
incentive to misrepresent.
One means of reducing the misrepre-
sentation problem is to hire an agent
who can credibly attest to the assertions
contained in the audited financial state-
ments [Kinney, 1988]. Auditors have an
incentive to investigate and report devia-
tions in application of accounting prin-
ciples since their reputation capital is
3 Klein and Leffler [19811 present a model of product
quality variation that requires a price premium for the
high quality product to assure its production.
4 The "amount of money left on the table," the dif-
ference between the offering price and the market clear-
ing price multiplied by the number of shares in the IPO, is
a measure of the wealth transferred from existing owners
to new investors.
696
reduced by expost revelation of errors or
misstatements [Palmrose, 1988]. Since
auditing firms that have invested more in
reputation capital have greater incentives
to reduce application errors, the infor-
mation disclosed in the accounting re-
ports audited by these firms will be more
precise, ceteris paribus. This reduction in
measurement error will allow uninformed
investors to estimate more precisely the
distribution of firm value. Since the high
reputation auditor attests to a report that
reduces uninformed investors' ex ante
uncertainty, this comparative advantage
will be priced in the market for audit ser-
vices. Value-maximizing owners of the
IPO firm will choose the auditing firm
with reputation capital that equates the
marginal benefit of less underpricing
with the marginal cost of a higher quality
audit.
The preceding arguments have two im-
plications. First, the initial return of an
IPO will be inversely related to the repu-
tation of the auditing firm attesting to
the accounting reports. Second, the pre-
mium paid for a high quality auditing
firm will be inversely related to the initial
return of the IPO client.
II. DATA AND DESCRIPTIVE
STATISTICS
The data used in the empirical tests are
drawn from the population of 2,567
IPOs from 1975-1984. The final sample
was reduced to 2,215.5 The main data
sources for the variables are the IPO's
registration statement and amendments
and Going Public: The IPO Reporter
(published weekly).
The initial return for a firm going pub-
lic is defined as the first day gross return
to an investor who acquires a share and
sells at the closing bid price on the first
day of public trading.6 For 1975-1984,
the average initial return is 22.1 percent.
A test of the compensation premium
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The Accounting Review, October 1989
implication of the reputation hypothesis
requires a measure of the fee paid to the
auditor. A proxy for this fee that is avail-
able for the entire sample is the cash
compensation. This measure includes
auditing, printing, legal, and other mis-
cellaneousfees (such as "Blue Sky" reg-
istration fees). The average cash com-
pensationfor 1975-1984is $218,929.
Aftermarketstandarddeviationis pre-
sented as an ex post proxy for ex ante
uncertaintyto assess cross-sectionaldif-
ferences in ex ante uncertaintyfor the
sample.The aftermarketstandarddevia-
tion is computedas the standarddevia-
tion of returns for the first 20 trading
days excluding the initial return using
bid prices. This measureis availablefor
only 1,807 firms since the remaining
firms were not listed on NASDAQ or
another exchange. The average after-
marketstandarddeviationin the sample
is .033.
I
Each IPO included in the final sample had initial re-
turn, age, type of offering, gross proceeds, sales, book
value of equity, and cash expenses (auditor fees, legal
fees, and miscellaneous fees) available in their SI or S18
registration statement or other publicly available
sources. Regulation A registrations, small public offer-
ings, were not included in this study due to data limita-
tions. An initial public offering that is registered under
Regulation A is significantly smaller than the average
offering in this sample. Prior to 1978, the maximum
amount raised in a Regulation A offer was $500,000.
After 1978, the limit was raised to $1,500,000. Missing
registration statements and the lack of an observable bid
price (firms trading in the "pink sheets") account for the
reduction in observations from 2,567 to 2,215.
6 The first day closing price is not always available.
The closing bid price is available for 1,499 of the IPOs
within one day of the closing date. An additional 412 bid
prices are available within one week of the closing date.
Bid prices are available for 236 IPOs within a month of
the closing date of the IPO. The remaining 68 firms' bid
price is obtained within one year of the offering. For
IPOs listed on NASDAQ (82.6 percent), the first avail-
able closing bid price from the Daily Stock Price Record
has been used to construct the initial return. Finally, 12.4
percent of the IPOs in this study were not listed on
NASDAQ. These firms required the use of other data
sources to estimate the initial returns for these securities
[Ritter, 19841.
Beatty
Table 1 presents selected descriptive
statistics for audit firm IPO clients. The
identified firms audited at least ten IPOs
during the 1975-1984 period and the Big
Eight firms audited 58 percent of the
IPO clients.7 The statistical tests suggest
a number of differences in IPO clients by
Big Eight/non-Big Eight distinction.
First, larger clients generally are audited
by Big Eight firms.8 However, the tradi-
tional Big Eight/non-Big Eight distinc-
tion does not completely capture differ-
ences in client size. In particular, Peat
Marwick, Touche Ross, and Coopers
& Lybrand clients exhibit similar mag-
nitudes of median sales revenue as
Laventhol Horwath, Seidman & Seid-
man, and Alexander Grant clients.
Panels A and B of Table 1 suggest that
auditor compensation is larger for Big
Eight audit firms relative to competing
non-Big Eight firms.9 Aftermarket stan-
dard deviation is smaller for Big Eight
compared to non-Big Eight clients. Fi-
nally, initial return is significantly
smaller for Big Eight compared to non-
Big Eight clients. These differences in
risk and return suggest that clients of
particular subsets of CPA firms may not
be homogeneous with respect to ex ante
uncertainty.
III. UNDERPRICING,Ex Ante
UNCERTAINTY,AND AUDITINGFIRM
REPUTATION
In this section, an indicator variable
approach is used to test for a relation
between auditing firm reputation and the
underpricing of initial public offerings.
The regression model controls for ex
ante uncertainty (client age, type of
underwriting contract, and percentage
ownership offered in the IPO), indus-
try affiliation (oil and gas indicator
variable), and other reputation effects
(underwriter indicator variable). The
marginal impact of a particular CPA
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697
firm is tested with an indicatorvariable
for each of the 20 CPA firms auditing
more than ten IPOs in the 1975-1984
period, and the reputationhypothesisis
evaluated by testing linear restrictions
on the estimatedcoefficients of the Big
Eight/non-Big Eight indicator vari-
ables.10Finally, sensitivityof the results
to the traditional Big Eight/non-Big
Eight grouping is considered by alter-
native groupingsbased on client size.
The estimatedmodel is:
Initial Return,
=a+b (Age of Clienti)
+ c (Type of Underwriting
Contract)
+d (Percentage of Ownership
Offered)
+e (Oil & Gas Indicatori)
+f (Underwriter Reputation
Indicator)
+r (Auditing Firm (1-20) Indi-
catori). (1)
Indicator VariableRegression
Client age is used as a controlvariable
in the regression model (panel A of
Table 2) since a longer operatinghistory
may providemarketparticipantswith in-
7
This percentage is consistent with the 59 percent, 68
percent, and 62 percent concentration ratios for publicly
traded clients reported in Simunic [1980], Palmrose
[1986], and Francis and Simon [1987].
8 Book value of equity, age, gross proceeds, and net
proceeds provide additional support for the notion that
larger clients tend to be audited by Big Eight firms
[Beatty, 1989].
9 For a subsample of 1,276 IPOs (1981-1984), auditor
fees for preparation of the registration document were
collected from Part II of the registration statement. Typ-
ically, this involves obtaining amendments to the regis-
tration statement since the auditing fees are rarely sub-
mitted with the final prospectus. The correlation between
reported accounting fees (Part 2 of the prospectus) and
cash compensation is .771, suggesting that the cash com-
pensation (available for the entire sample) provides a
reasonable proxy for the auditor's compensation for re-
viewing the prospectus.
'? Testing linear restrictions on estimated coefficients
is described in Judge et al. [1980, pp. 61-62].
698 The Accounting Review, October 1989

TABLE 1
(1975-1984)
DESCRIPTIVESTATISTICS
CLIENTSIZE, RETURN, AND Ex ANTEUNCERTAINTYMEASURES
MEDIAN SALESREVENUE,AUDITORCOMPENSATION, INITIALRETURN,
AND STANDARDDEVIATIONBY AUDITOR

Cash Aftermarket Number

Sales Compensation' Initial Standard of Clients3
Auditor (000's) (000's) Return Deviation2 (N,, N2)

Panel A. Big Eight Audit Firm Clients:

Ernst & Whinney (EW) $10,423 $219 .025 .027 141, 125
Deloitte Haskins & Sells (DHS) 6,437 241 .023 .034 122, 102
Price Waterhouse (PW) 5,939 240 .021 .030 141, 128
Arthur Young & Co. (AY) 6,404 252 .038 .031 163, 149
Arthur Andersen & Co. (AA) 5,695 230 .053 .034 225, 207
Peat, Marwick, Mitchell & Co. (PMM) 4,110 210 .028 .026 191, 171
Touche Ross & Co. (TR) 3,220 199 .050 .030 153, 139
Coopers & Lybrand (CL) 2,246 185 .018 .033 146, 133
Big Eight 4,926 220 .031 .031 1282, 1154

Panel B. Non-Big Eight Audit Firm Clients:

Laventhol Horwath (LH) $ 4,321 $180 .050 .034 59, 49
Seidman & Seidman (SS) 3,668 175 .042 .037 27, 25
Alexander Grant (AG) 2,300 175 .042 .035 55, 45
Main Hurdman (MH) 1,755 188 .033 .033 78, 67
Mann Judd Landau (MJL) 1,631 112 .044 .033 16, 12
McGladrey Hendrickson (MHD) 778 108 .250 .034 18, 16
Oppenheim, Appel (OAD) 307 147 .150 .040 10, 7
All Others 87 90 .068 .040 577, 372
Fox, Fox & Co. (FOX) 96 85 .125 .038 37, 33
Hein & Sikora (HS) 6 75 .375 .062 13, 12
Newman & Co. (NEW) 3 58 .188 .037 12, 10
Lehman, Butterwick (LB) 1 56 .125 .034 10, 4
Roth (R) 0 50 .600 .073 21, 1
Non-Big Eight 154 101 .067 .038 933, 653

Panel C. Non-Parametric Statistical Comparisons of Big Eight and Non-Big Eight Clients:
Aftermarket
Cash Initial Standard
Statistic Sales Compensation Return Deviation

Big Eight, non-Big Eight Comparison

Mann-Whitney U-Test -15.390 -15.452 2.435 -6.100
(Probability) .000 .000 .015 .000
Median Test Chi-Square 159.608 191.257 7.610 27.374
(Probability) .000 .000 .006 .000

I Cash Compensation =Auditor fees + Legal fees +Printing fees+Miscellaneous fees.

2
Aftermarket Standard Deviation=standard deviation of return 2 through 21.
3 Panels A and B present medians for selected variables by individual audit firm and Big Eight/non-Big Eight dis-
tinction. In the final column of panels A and B N. = the number of IPO clients and N2 = the number of clients avail-
able to compute aftermarket standard deviation. Panel C presents the Mann-Whitney U-test and Median test for dif-
ferences in the selected variables by Big Eight/non-Big Eight.

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Beatty 699

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700 TheAccountingReview,October1989

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Beatty
formation concerning managerial pro-
duction-investmentdecisions.This addi-
tional information may allow investors
to marginallyreducetheir estimateof ex
ante uncertainty.The estimated coeffi-
cient is negative and statisticallysignifi-
cant at the .06 probability level. This
resultsuggeststhat largerclient age indi-
cates lower ex ante uncertainty.11
The second controlvariableis the type
of underwritingcontract, firm commit-
ment or best efforts.12 The type of
underwriteragreement may provide a
proxy for the underwriter'sassessment
of the price uncertaintyfor an IPO. The
type of offering (best efforts=0, firm
commitment=1) is inversely related to
the initialreturnfor the IPO at the .0001
probabilitylevel. This resultis consistent
with lower ex ante uncertaintyfor firm
commitmentunderwritingcontracts.
Researchby Leland and Pyle [1977]
and Downes and Heinkel [1982]suggests
that the percent ownershipretained by
insiders signals private information
possessed by the owner/managerto in-
vestors. The percentage offered by
ownersin the IPO is positivelyrelatedto
the initial return at the .04 level con-
sistent with Leland and Pyle's model.
Table 2 reports two final indicator
variablecoefficientsfor each regression.
The oil and gas indicator variable (oil
and gas = 1, others=0) is considered
since Ritter [1984]observesa significant
association between industry affiliation
and initialreturnduringthe "Hot Issue"
market of 1980. Panel A of Table 2
shows that, as in the previousstudy, oil
and gas IPOs exhibit significantpositive
initial returns."3The underwriterindi-
cator variable controls for underwriter
reputation. Beatty and Ritter [1986]
argue that underwriter reputation is re-
lated to the level of underpricing of an
initial public offering. This study uses an
indicator variable (top 18 = 1, others = 0)
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701
for the 18 largest underwritersby total
capital that are members of the Secu-
rities IndustryAssociation.14 The under-
writer indicator variable regressionco-
efficient is significantat the .03 level.
Panel B of Table 2 summarizesthe in-
dicator variables for the 20 identified
CPA firms. Four CPA firm indicator
variablesare positive and significantat
the .05 level. They are Fox, Fox & Co.;
Hein & Sikora;McGladrey,Hendrickson
& Co.; and Allen Roth. Clientsof these
four non-Big Eight firms exhibited sig-
nificantly higher initial returns than
those of other auditors.
Two sets of tests of linear combina-
tions of the coefficientsof the CPA firm
indicatorvariablesarepresentedin panel
C of Table 2. First, the traditionalBig
Eight/non-BigEight dichotomyis inves-
tigated. The second is partitionedbased
upon the largest-five, middle-six, and
" It has been suggested in Manegold [1987] that dis-
tinguishing between startup and operating firms may
control for client risk. In unreported regressions, a
startup/operating indicator variable replaced the age
variable. The results were consistent with the reported
results and the startup/operating variable was not
significant.
12 A "firm commitment" underwriting agreement
specifies that the underwriter purchases the shares from
the client to be offered for resale. In a "best efforts"
underwriting arrangement, an underwriter agrees to
place as many securities as a "best effort" permits.
13 Elimination of the oil and gas firms from the sample
does not alter any of the inferences of the tests. Also, an
indicator variable for "high tech" firm was considered
with insignificant results.
14 The Securities Industry Association is an organiza-
tion that lobbies for members' interests. Membership is
restricted to "reputable" securities industry members.
As with other voluntary organizations, the definition of
reputable member of the securities industry is not well-
defined. The SIA has summarized the capital ranks for
their membership in an annual publication, Securities
Industry Yearbook. The top 18 underwriters have been
assigned to the "highly" reputable category for pur-
poses of the underwriter indicator variable. The top 18
underwriters capital as of January 1, 1985 exceeded
$200,000,000. Alternative classifications of underwriter
reputation by capital rank did not appreciably change the
qualitative results.
702
smallest-nine audit firm median client
sales revenue.
Panel C reports tests of the linear re-
strictions on the coefficients of the Big
Eight and non-Big Eight indicator vari-
ables. The results indicate significant dif-
ferences in initial return based upon the
Big Eight/non-Big Eight distinction. The
trichotomous partition tests indicate that
the middle-six CPA firms are more simi-
lar to the largest-five CPA firms than to
the smallest-nine CPA firms. This sensi-
tivity analysis suggests that the tradi-
tional Big Eight/non-Big Eight distinc-
tion may measure reputation with error
since the smallest Big Eight and largest
non-Big Eight appear to exhibit substan-
tial similarities. Finally, the correlation
matrix (not reported) indicates that cor-
relations across covariates are small (all
less than .32) and, thus, multicollinearity
is not expected to affect the results.
These results provide evidence of a
relation between auditor classification
and the initial return. However, inter-
preting these results as consistent with a
relation between reputation and initial
return requires the maintained hypoth-
esis that a particular partition, such as
the traditional Big Eight/non-Big Eight
distinction, captures differences in firm
reputation capital. Since choice of an
appropriate partition is rather ad hoc, an
alternative approach that does not rely
on arbitrary classifications to test the
reputation hypothesis is considered in
the next subsection.
Two-Stage Regression Approach
There are two salient features of the
reputation hypothesis that suggest the
use of an omitted variables technique to
establish a proxy for reputation. First, a
firm's reputation capital is unobserv-
able. Second, the reputation hypothesis
implies that the IPO client is charged a
premium for employing the auditor's
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The Accounting Review, October 1989
reputation capital. A two-stage approach
estimates an auditor compensation re-
gression with observable independent
variables. Then the residuals from the
first regression are used as a proxy for
the unobservable variable, reputation
capital. The relation between the resid-
ual of the estimated auditor compensa-
tion regression and the unobservable
reputation variable is illustrated and
then the "omitted variables" formula-
tion is applied to test the reputation hy-
pothesis.
A compensation regression model that
does not include the omitted variable can
be estimated as follows:
Cash Comp,
= a1+ b1 (Gross Proceeds,)
+c1 (Sales1)
+d1 (Equityi)+ui.5 (2)
However, the reputation hypothesis as-
serts that the correct specification of the
regression equation is:
Cash Compi
=a1* +b * (Gross Proceeds )
+c1* (Salesi)
+dd* (Equityi)
(3)
+e,* (Ri)+vi.
If one assumes that the omitted variable,
R (a firm's reputation capital), is un-
correlated with the other independent
variables, the sign of the correlation be-
tween the estimated residual and the
omitted variable is directly related to the
sign of e1*. Formally, this correlation is:
corr(ui, Ri)
S ei* Ea(Ru-E(R))tP
/(std. devu)(std. deVR). (4)
Since we assume that the IPO client is
15
The chosen independent variables in the compen-
sation regression are intended to proxy for the marginal
cost of the audit. Omitted variables analysis is discussed
in Kmenta [1986], pp. 392-395.
Beatty
charged a premium for the auditor's
reputation, the sign of the omitted vari-
able coefficient, e1*, is positive. Thus, u,
from equation (2) provides a measure
that is positively correlated with the vari-
able of interest. The second-stage regres-
sion relates the initial return to the con-
trol variables and the residual from the
compensation regression as follows:
Initial Returni
=a2+b2 (Age of Clients)
+ c2 (Type of Underwriting
Contract,)
+dd2(Percentage of Ownership
Offered)
+e2 (Oil & Gas Indicator,)
+f2 (Underwriter Reputation
Indicator,)
+r2 (Ui).
A negative coefficient on the unexpected
cash compensation, ui, is consistent with
the reputation hypothesis.
Table 3 presents results of the two-
stage least squares approach used to
assesss the relation between audit firm
reputation and initial return. In the first
stage, auditor compensation is regressed
on three size variables, gross proceeds,
sales revenue, and book value of equity.
The residual from the regression should
be interpreted as the price paid to a par-
ticular audit firm above or below the
average price paid for auditor reputation.
The average price paid for reputation is
imbedded in the constant term in equa-
tion (2). From the analysis in Section II,
as the price paid for the CPA firm's repu-
tation capital is increased, less "money
is left on the table" in the form of under-
pricing, which suggests an inverse rela-
tion with initial return. The reputation
hypothesis predicts that the coefficient
on the residual auditor compensation
variable will be negative in the second
stage regression.
Sales revenue, book value of equity,
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703
and gross proceeds provide proxies for
the size variables that have been found
by previous studies to be related to
auditor compensation. Although these
three measures are different from the in-
dependent variables suggested by previ-
ous researchers of auditor compensation
[Simunic, 1980; Mayer et al., 1985; and
Francis and Simon, 19871, they provide
similar control for the marginal cost of
performing an audit. For instance, in-
creased sales revenue can be expected to
be directly related to increased inven-
tories and accounts receivable. In addi-
tion, one would expect that larger firms
(measured by book value of equity and
gross proceeds) would more likely ex-
hibit more consolidated subsidiaries,
two-digit SIC codes, and foreign opera-
(5)
tions. It should be noted that the
R-squared for equation (2) of Table 3 is
.18, which is comparable to Simunic's
less-than-$125,000,000 regression results
of .28. However, the results of this anal-
ysis rest on the assumption that any
missing variables are uncorrelated with
the initial return of the IPO.
The coefficients for gross proceeds
and sales revenue in panel A of Table 3
are positive and significantly related to
cash compensation," suggesting that as
the size of the IPO client increases the
total payment to auditor, lawyer, and
printing fees increases (see Simunic
[1980] and Mayer et al. [19851).
Panel C of Table 3 provides average
and median residuals from equation (2)
that suggest Big Eight firms are being
16 Panel B of Table 3 discloses relatively higher corre-
lations between sales, book value of equity, and gross
proceeds than any other correlations of other indepen-
dent variables. Thus, the estimated coefficients in equa-
tion (2) should be viewed with caution. This high level of
multicollinearity may explain the negative and signifi-
cant coefficient on stockholders' equity. The purpose of
this regression is merely to filter out the size related costs
of performing an audit, not to emphasize the magnitudes
of the coefficients in equation (2).
 704 The Accounting Review, October 1989

TABLE3
Two-STAGE REGRESSION ESTIMATES:
EQUATION(2) = CASH COMPENSATION PREDICTIONMODEL
EQUATION(5) = UNDERPRICINGMODELWITHDEPENDENTVARIABLE = INITIALRETURNAND
INDEPENDENTVARIABLES =AGE, TYPE OF OFFERING,PERCENTRETAINEDBY OWNERS,
OIL AND GAS INDICATOR,UNDERWRITERINDICATOR,AND
UNEXPECTEDCASH COMPENSATION
(n = 2,215)

Panel A. Regression Results:

Dependent Variable-Cash Expenses for Audit, Legal, Printing, and Miscellaneous Fees
Cash Comp, = a, + b1 (Gross Proceeds,) + c, (Sales,)
+d1 (Equityi) +uj (2)
Gross Book Value
Constant Proceeds Sales of Equity

Equation (2) 178.90638 .003632 .00036 -.00011

(4.40544) (.000233) (.00006) (.00003)
t=40.61 t= 15.61 t=5.88 t= -3.22
R2=.183 F-statistic = 165.293*

Dependent Variable-Initial Return

Initial Returni=a2+ b2 (Age of Client,) + c2 (Type of Underwriting Contracti)
+d2 (Percentage of Ownership Offered,)
+e2 (Oil and Gas Indicatori)
+f2 (Underwriter Reputation Indicators)
+r2 (us) (5)

Type of Percent by Underwriter Residual from

Constant Age Offering Owner Oil and Gas Indicator Equation (2)

Equation (5) .34275 -.00204 -.21628 .10011 .13753 -.05873 -.00018

(.03586) (.00096) (.02720) (.07378) (.03712) (.03191) (.00006)
t=9.56 t= -2.13 t= -7.95 t= 1.36 t=3.71 t= - 1.84 t= -2.74
R2= .085 F-statistic = 34.116*
Standard errors are in parentheses. The mean of the dependent variable (audit fees, legal fees, and miscellaneous
expenses) for equation (2) is $218,929. The means of the independent variables, gross proceeds, sales, and book value
of equity, are $9,173,808, $20,825,369, and $7,409,655, respectively. The final variable (residual from eq. (2))
represents the difference between the OLS estimate of auditor, legal, and printing fees and the actual observed fees by
IPO client.
* Significant at the .01 level.

paid relatively more than non-Big Eight
firms after controlling for client size dif-
ferences. The residuals for the audit
firms that were statistically significant in
the indicator variable regressions (Fox,
Fox & Co.; Hein & Sikora; McGladrey
Hendrickson; and Roth) tend to have the
largest negative residuals.
Panel D of Table 3 partitions the CPA
firms based on the largest-five, middle-
six, and smallest-nine audit firms by
client sales revenue from Table 1. These
results indicate that the auditor compen-
sation premium is significantly larger for
the largest-five firms than for the two
remaining groups. In addition, the fee

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Beatty 705

TABLE 3-Continued

Panel B. Pearson Product-Moment Correlation:

Type of Percent by Gross Book Value
Age Offering Owners Oil and Gas Underwriter Proceeds Sales of Equity

Gross Proceeds .236* .209* -.124* -.063 .375*

Sales .328* .160* -.122* -.053 .321 * .538*
Book Value of Equity .084* .035 -.065* -.072* .089* .336* .525*
Residual from Equation (2) .142* .368* -.222* -.060 .279* .000 .000 .000
* Significant at the .01 level.

Panel C. Average Residualfrom Equation (2) Panel A by Audit Firm and Big Eight/Non-Big Eight Classification:
Big Eight

A verage Median A verage Median

Residual Residual Residual Residual

(1) AA (225) 29.258 2.769

(2) AY (163) 26.901 11.068
(3) CL (146) 9.081 -34.347
(4) DHS (122) 24.377 22.288 23.867 -2.231
(5) EW (141) 28.824 -17.952
(6) PMM (191) 34.964 -6.217
(7) PW (141) 21.309 7.297
(8) TR (153) 10.349 -14.796
Non-Big Eight

A verage Median
Residual Residual

(9) AG (55) -18.877 -31.567

(10) FOX (37) -69.082 -106.279
(11) HS (13) -105.641 -114.743
(12) LB (10) -124.984 -129.163
(13) LH (59) 3.298 -30.437
(14) MH (78) 20.577 -24.392 -32.795 -86.003
(15) MHD (18) -73.237 -83.854
(16) MJL (16) 36.502 -76.752
(17) NEW (12) -116.726 -127.294
(18) OAD (10) 30.847 -40.083
(19) SS (27) 23.831 -20.503
(20) R (21) -112.410 -130.719
(21) Oths (718) -27.343 -84.363
Mann- Whitney Probability
U- Test (two-tailed)

-12.744 .0000
Chi-Square Probability
Median Test (two-tailed)

140.636 .0000
The number of CPA firm clients during the 1975-1984 period is listed in column 2. Columns 3 and 4 present the
average and median residual from the regression model of Table 3 for each of 20 CPA firms and the other category.
These residuals are the result of relating cash compensation (audit fees, legal fees, and miscellaneous fees) to gross
proceeds, sales revenue, and book value of equity. Columns 4 and 5 summarize the average and median residuals by
the Big Eight/non-Big Eight classification.

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706 The AccountingReview,October1989

TABLE3-Continued

Panel D. AverageResidualfrom Equation(2) Panel A by Audit Firm and Largest-Five,Middle-Six,and

Smallest-NineAudit Firm Clientsby MedianSales RevenueClassification:
Largest-Five

A verage Median A verage Median

Residual Residual Residual Residual

(1) EW (141) 28.824 -17.952

(2) DHS (122) 24.377 22.288
(3) PW (141) 21.309 7.297 26.529 6.216
(4) AY (163) 26.901 11.068
(5) AA (225) 29.258 2.769
Middle-Six

A verage Median
Residual Residual

(6) PMM (191) 34.964 -6.217

(7) TR (153) 10.349 -14.796
(8) CL (146) 9.081 -34.347
(9) LH (59) 3.298 -30.437 14.877 -15.375
(10) SS (27) 23.831 -20.503
(11) AG (55) -18.877 -31.567
Smallest-Nine

A verage Median
Residual Residual

(12) MH (78) 20.577 -24.392

(13) MJL (16) 36.502 -76.752
(14) MHD (18) -73.237 -83.854
(15) OAD (10) 30.847 -40.083
(16) Oths (718) -27.343 -84.363
(17) FOX (37) -69.082 -106.279 -38.381 -92.363
(18) HS (13) -105.641 -114.743
(19) NEW (12) -116.726 -127.294
(20) LB (10) -124.984 -129.163
(21) R (21) -112.410 -130.719
Mann- Whitney Probability
U-Test (two-tailed)

Largest-Five, Middle-Six -2.379 .0174

Middle-Six, Smallest-Nine -10.383 .0000
Chi-Square Probability
Median Test (two-tailed)

Largest-Five, Middle-Six 8.789 .0030

Middle-Six, Smallest-Nine 105.453 .0000
Column I lists the 20 CPA firms by Largest-Five, Middle-Six, and Smallest-Nine firms by client sales revenue
classification from Table 1. The firms are listed by median client sales revenue. The number of firm clients during the
1975-1984 period is listed in column 2. Columns 3 and 4 present the average and median residual from the equation
(2) for Table 3 for each of 20 firms and the other category. These residuals are the result of relating cash compensa-
tion (audit fees, legal fees, and miscellaneous fees) to gross proceeds, sales revenue, and book value of equity.

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Beatty
premium is significantlylarger for the
middle-six than for the smallest-nine
audit firms. This substantialvariationin
premiumssuggests that, within the his-
torical Big Eight/non-Big Eight classifi-
cation, audit firms may not be homoge-
neous [Kinney, 1986]. Again, these
results suggest that the traditional Big
Eight/non-Big Eight distinction for
reputationcapital may suffer from sub-
stantialmeasurementerror.
In the second stage regression,the re-
sidualsfrom equation(2) and the control
variablesare regressedon the initial re-
turn.17 Table 3 resultsare similarto the
indicator variableregressionresults for
each of the controlvariables.The coeffi-
cient on the residualsfrom equation (2)
is significantlynegativelyrelatedto the
initial return at the .003 level (one-
tailed). For payments to the auditor
above that predictedby equation(2), the
initial returnwill be lower, ceterispari-
bus. 18 These results provide direct evi-
dence of a positive relationbetweenthe
compensationpaid to an auditorand the
wealth of the incumbent owners of a
client. This evidence is consistent with
the propositionthat an IPO client hires
the reputationcapitalof an auditingfirm
to "signal" its ex ante uncertaintyto
IPO investors.
Signallingmodels (e.g., Downes and
Heinkel[1982]and Titmanand Trueman
(1986])rely on the firm signallinginfor-
mation to the market by undertakinga
costly activitythat cannot be duplicated
by firms not possessing the signalled
characteristic.In the market for IPOs,
firms appear to signal their ex ante
uncertainty by hiring a "nationally
known" CPA firm to perform the
registrationaudit. This "signal" is credi-
ble to the marketsince auditorcompen-
sation is higherceterisparibus for those
firms that are commonly viewed as ex-
hibiting firm-specificreputationcapital.
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707
The two-stageleast squaresmethodpro-
vides a directtest of the relationbetween
the cost (auditor fees) and the benefit
(lower initial return)of this signal.
IV. CONCLUSIONS
It has been argued that the auditor
performsthe role of attestingto the level
of ex ante uncertaintyfaced by the IPO
investor. Since owners of the IPO firm
choose an auditor from a set of com-
peting CPA firms, value-maximizing
owners will choose to employ a particu-
lar CPA firm's reputationcapital when
the marginalbenefit equatesto the mar-
ginal cost.
It was conjectured that a marginal
benefit of employing a more reputable
audit firm is an increasein the price ob-
tained by the firm that offers the IPO
ceteris paribus. The descriptiveresults
suggestthat the assumptionof homoge-
neity in ex ante uncertaintydoes not hold
for particularsubsets of IPOs. Larger
and less riskyclientswereauditedby Big
Eight firms. Although this result is not
new [Simunicand Stein, 1987; Beatty,
1989], the cross-sectionaltests of the
reputationhypothesisnecessitatecontrol
for differences in client ex ante uncer-
tainty there are unrelated to auditor
reputation.
Two separatemethods of considering
auditor reputation were considered.
First, a positive relation between four
non-Big Eight firm indicator variables
and the IPO's initial return was docu-
mented. The analysis of linear restric-
17 An unreported
two-stage least squares model using
reported auditor fees from Part II of the registration
statement for the 1982-1984 subperiod is consistent with
the Table 3 model results. These results are available on
request.
18 The second stage of the two-stage least squares
model was analyzed employing a bootstrap technique
[Marais, 1984]. Inferences from the probability levels of
observing the OLS coefficients with this resampling
technique are unchanged.
708 The Accounting Review, October 1989

tions implies that there are significant
differences in the relation between the
initial return and various subsets of audit
firms. With the maintained hypothesis
that the Big Eight/non-Big Eight dichot-
omy or largest-five/middle-six/smallest-
nine firm trichotomy proxy for differ-
ences in firm-specific reputation capital,
the results are consistent with the repu-
tation hypothesis. An omitted variables
method that measures reputation as the
amount of auditor compensation unex-
plained by measures of the marginal cost
of performing the audit was applied. It
shows that the residual from the auditor
compensation regression is positively
correlated with the unobservable audit-
ing firm reputation capital. The results
of the two-stage least squares approach
provide stronger and more direct evi-
dence of a relation between auditor repu-
tation and the initial return than the
traditional indicator variable approach.
In both approaches, an omitted vari-
ables problem may produce errors in in-
ference. For the indicator variable ap-
proach, an omitted variable may explain
the relation between the four firms and
the initial return. The two-stage regres-
sion approach is based upon the notion
that the residual from the first regression
captures the unobservable reputation
variable. An omitted variable in the
underpricing regression that is positively
related to both the auditor's unexplained
compensation and the underpricing of
the IPO may explain the observed rela-
tion. This omitted variables problem
should temper the interpretation of the
results of this test of reputation. Despite
this limitation, the relation observed in
the indicator variable approach and the
results provided by the residual approach
suggest that hiring of a "nationally
known" audit firm is related to less
underpricing of an initial public offering
of equity securities.

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