Auditor Reputation and the Pricing of Initial Public Offerings.

Abstract 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 reputation 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 particularly for the smaller Big Eight end 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.