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Examining the Role of Auditor Quality and Retained Ownership in IPO Markets: Experimental Evidence

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  • BRIAN W. MAYHEW
  • JEFFREY W. SCHATZBERG
  • GALEN R. SEVCIK

Abstract

We use experimental markets to test the Datar, Feltham, and Hughes (DFH) 1991 model of entrepreneur choice of auditor and retained ownership in initial public offerings (IPOs). DFH predict that entrepreneurs use retained ownership to signal IPO value and substitute high†quality auditors for retained ownership to signal value as the risk of the IPO increases. Given the mixed support for DFH from archival research, we conduct experimental markets that directly operationalize the model's decision variables, which permits a direct test of whether the model is descriptively valid. In addition, our market setting provides a strong test of this theory by including an alternative Nash equilibrium also present in field settings, one in which only auditor quality is used by entrepreneurs to signal IPO value. Our results suggest that DFH predict entrepreneur behavior in baseline markets where both computerized investors and auditors are programmed to price consistently with the DFH equilibrium. However, the DFH model does not describe behavior when “robot†investors are replaced with human investors in the market. The results suggest that entrepreneurs and investors strategically interact in a manner that leads them away from the DFH equilibrium and toward the alternative Nash equilibrium behavior of entrepreneurs with high†value assets hiring high†quality auditors irrespective of IPO risk. Our results imply that the DFH model has limited descriptive validity, document the importance of strategic behavior on market equilibrium formation, and suggest that the mixed results found in prior DFH†based field studies may reflect the model's low descriptive validity.

Suggested Citation

  • Brian W. Mayhew & Jeffrey W. Schatzberg & Galen R. Sevcik, 2004. "Examining the Role of Auditor Quality and Retained Ownership in IPO Markets: Experimental Evidence," Contemporary Accounting Research, John Wiley & Sons, vol. 21(1), pages 89-130, March.
    • Handle: RePEc:wly:coacre:v:21:y:2004:i:1:p:89-130
    DOI: 10.1506/9T3G-LWA9-PR5Q-TH0A
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    Cited by:

    1. Denis Cormier & Daniel Coulombe & Luania Gomez Gutierrez & Bruce J. Mcconomy, 2018. "Firms in Transition: A Review of the Venture Capital, IPO, and M&A Literature," Accounting Perspectives, John Wiley & Sons, vol. 17(1), pages 9-88, March.
    2. Kazunori Miwa & Satoshi Taguchi & Tatsushi Yamamoto, 2017. "Are IPOs “Overpriced?” Strategic Interactions between the Entrepreneur and the Underwriter," Discussion Paper Series DP2017-07, Research Institute for Economics & Business Administration, Kobe University.
    3. David Bodoff & Hugo Levecq & Hongtao Zhang, 2006. "EDGAR on the internet: The welfare effects of wider information distribution in an experimental market for risky assets," Experimental Economics, Springer;Economic Science Association, vol. 9(4), pages 361-381, December.
    4. Takahiro Endo & Nidhi Srinivas & Yuki Tsuboyama, 2017. "The Role of Meta-organising in Legitimacy Recovery: The Case of Frozen Food Category in Japan," Discussion Paper Series DP2017-10, Research Institute for Economics & Business Administration, Kobe University.

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