Costs and benefits in the choice of the audit and underwriting quality in the IPO market: An empirical analysis of competing theories

This chapter examines the choice of auditors and underwriters by entrepreneurs prior to initial public offerings (IPOs). DFH predicted that entrepreneurs who face greater future cash flow risk will benefit from hiring a high-quality auditor, whereas TT predicted that they will benefit from hiring a low-quality auditor or underwriter. This chapter focuses on developing proxy tests to evaluate empirically the supply-side effect of risk, that is the impact of firm-specific risk on the incremental cost of hiring a high-quality auditor or underwriter, and partially examines the demand-side effect of risk. Recent empirical studies indicate that riskier entrepreneurs may benefit from hiring high-quality auditors, but these studies make no direct empirical examination of the supply-side effect. Regressions with slope dummies indicate that the incremental deflated cost of hiring a high-quality auditor or a prestigious underwriter increases as firm-specific risk increases. The supply-side and demand-side findings indicate that for high firm-specific risk, the incremental costs exceed the incremental benefits of hiring a high-quality auditor or underwriter.