Earnings Forecasts in Australian IPOs: Does Transaction Expertise Matter?

Transcription

1 Earnings Forecasts in Australian IPOs: Does Transaction Expertise Matter? Ross Rugdee a Inderpal Singh a,b Richard Heaney a This draft 7 March 2014 Please do not cite without the permission of the authors. a University of Western Australia, b Corresponding author. Address: University of Western Australia, Discipline of Accounting & Finance, M250, 35 Stirling Highway, Crawley, WA 6009, Australia. Telephone: inderpal.singh@uwa.edu.au

2 Earnings Forecasts in Australian IPOs: Does Transaction Expertise Matter? Abstract This study investigates whether initial public offering (IPO) firms that engage accounting firms that are advisory specialists in transactions such as an IPO, incur higher fees and have a greater likelihood of reporting a more accurate earnings forecast in the prospectus. Prior audit research measures audit quality using audit firm size (Big N, non-big N) and industry specialisation. These studies focused on audit quality around annual reports of listed companies. The key contribution of this study is to propose an alternate measure of assurance quality specific to IPOs and disclosure of earnings forecasts. This measure emphasises expertise in transactions rather than industry specialisation. The results indicate that transaction specialists are more likely to charge higher fees for assurance services provided to companies releasing an earnings forecast in their IPO prospectus. Further, transaction specialists are more likely to be associated with greater earnings forecast accuracy. Consistent with signalling theory, these finding suggests that quality IPO firms are more likely to pay the fee premium required to engage a transaction specialist assurance provider to signal the accuracy of their earnings forecast. Keywords: industry specialisation, transaction specialisation, audit fees, initial public offerings. 2

3 1. Introduction Companies issuing an IPO may face challenges such as attracting investor attention, underpricing, raising the minimum amount of funds sought and adhering to legislation surrounding the IPO process. To cope with these challenges, companies employ the services of a range of experts, such as underwriters and accountants, for advice. The underwriter s contribution to the IPO process has been explored extensively in the literature (Ritter 1984; Beatty and Ritter 1986; Rock 1986; Loughran, Ritter and Rydqvist 1994; Ritter 2003; Kirkulak and Davis 2005; Liu and Ritter 2011). However, the literature on the contribution of accountants who specialise in providing assurance and advisory services for transactions such as an IPO is more limited. In addition to providing an opinion on the veracity of the financial information contained in a prospectus, accounting firms may also operate as corporate advisers to the IPO to guide their clients through this complex process. Most IPO firms (98.4% 1 ) engage the services of an audit firm 2 to provide an opinion on the accuracy of the financial information and disclosures in the prospectus. This review opinion is provided under an Investigating Accountant s Report which accompanies the prospectus. However, prior research has assumed that this engagement is synonymous with auditors signing audit opinions on annual reports. The inherent differences between the annual report and prospectus and hence the potentially different measures of specialisation provide the impetus for this paper. It is our contention that while industry expertise plays an important role in annual report audit quality, transaction expertise may better explain assurance quality in the IPO prospectus. 1 According to the Connect4 database, 1,619 companies issued an IPO between 1998 and Of these IPOs, only 26 were not associated with an audit firm providing the services of an IPO auditor. 2 In this paper we use the term audit firm and accounting firm inter-changeably as well as the term accountant and auditor. 3

4 The prospectus is usually the first formal document released to prospective investors by an initial public offering (IPO) firm. Without an established reputation, such companies may experience difficulties attracting investor attention in their IPO. This may be because investors are unsure of the value and prospects of the company planning the IPO. To overcome this hurdle, these companies can provide indications of their company s value by releasing an earnings forecast in their IPO prospectus. However, investors may be reluctant to have complete faith in such a disclosure and may discount the value of the entity. Companies may therefore choose to signal to prospective investors that their earnings forecasts are relatively more accurate, by paying the fee premium required to engage a specialist auditor. By associating with a specialist auditor, these companies can leverage the reputation and expertise of the specialist auditor to enhance the credibility of their disclosures. Our key research questions are whether accounting firms who specialise in transaction advisory services charge higher audit fees and are associated with a more accurate earnings forecast in the IPO prospectus. The auditing literature is rich in examples of industry specialist auditors providing higher quality audits for annual report engagements (Ferguson, Francis and Stokes 2003; Casterella, Francis, Lewis and Walker 2004; Francis, Reichelt and Wang 2005; Ferguson, Francis and Stokes 2006; Reichelt and Wang 2010). However, the literature is more scant when it comes to auditor specialisation in the IPO context. Examining auditor specialisation in association with earnings forecast accuracy in IPOs allows us to demonstrate that higher quality companies are more likely to engage specialist auditors who have greater expertise, particularly in the corporate advisory role, consistent with signalling theory. 4

5 The concept of auditor industry specialisation originates from auditors who provide statutory annual report audit and assurance services, typically for listed companies. In this paper, we focus on accounting firms that provide advisory and assurance services pertaining to a company s IPO prospectus. Since an IPO prospectus is different, in terms of the way the document is structured and the legislation that governs such a document, from an annual report, we define auditors who specialise in deals or transactions such as IPOs, as transaction specialists. One of the key differences between an IPO prospectus and an annual report is that a prospectus may contain forward-looking financial information, such as an earnings forecast, whereas the subject matter of an annual report is limited to historical financial information. The investigating accountant s role in an IPO is to review and form an opinion on the validity and accuracy of the historical financial information and the reasonableness of the assumptions underlying the prospective financial information such as the earnings forecast. It is important to note that in Australia, earnings forecasts in IPO prospectuses are voluntary. Aside from these responsibilities, the investigating accountants role does on occasion extend to general corporate advice relating to the listing. In these situations, the investigating accountant works closely with the firms underwriters (if the issue is underwritten) and solicitors. In these situations, the investigating accountant is seen as a corporate advisor as well as a provider of assurance services. The move by accounting firms to capture some of the corporate advisory market from investment banks over the past decade is part of the motivation of this paper. This is evidenced by our sample of IPO firms that issued a voluntary earnings forecast. Every 5

6 IPO firm from the period 2003 to 2011 that issued a voluntary earnings forecast in its prospectus had its forecast reviewed and signed off on by the transaction or corporate advisory arm of the accounting firm. This paper provides evidence that Big 4 firms charge higher fees and are associated with more accurate earnings forecasts. A further examination of expertise indicates that industry and transaction specialisation is both associated with higher advisory fees. These results are consistent for both national and office levels of industry and transaction expertise. It is also evident from the initial analysis that IPO deal size plays an important role in determining fees (firm size is also a key determinant of fee in the case of studies of annual report audits). We re-perform the analysis after partitioning our sample into quartiles by IPO deal size. The largest IPO firms appear to pay a fee premium to Big 4 firms and to firms that specialise in IPO audits. There is also evidence of a premium for transaction expertise for the smallest firms. We also analyse the earnings forecast accuracy and find that once the firms are arranged by deal size, transaction expertise is more highly associated with greater earnings forecast accuracy in both the largest and smallest IPO firms. This has implications for audit research undertaken in settings other than traditional annual report audits. Once client characteristics (such as size) are controlled for, there is clear evidence of audit firms that specialise in transaction advisory services such as IPOs, earning higher fees and being involved in more accurate earnings forecasts. Accounting firms that are also appointed as auditors of the IPO firm, post listing, charge a higher fee at the time of the IPO. This provides evidence of the value placed 6

7 by clients on the expanding advisory role that accounting firms fulfil in the transaction services market. Firms undertaking an IPO are able to signal their quality and prospects by engaging the services of an accounting firm that has demonstrated a track record in transaction services, particularly if the IPO firm is contemplating the inclusion of a voluntary earnings forecast. The remainder of the paper is organised as follows: Section two reviews the relevant literature pertaining to earnings forecast accuracy and auditor specialisation. Section three outlines the hypotheses for testing. Section four discusses the research method and section five presents the results. Section six provides the robustness tests. Lastly, section seven summarises this paper and also discusses the implications, limitations in addition to suggestions for avenues of future research. 2. Literature Review Audit quality is defined as the expectation that an auditor will detect and correct (reveal) any material misstatement or omissions in the financial statement (DeAngelo 1981). Audit firms attempt to increase the audit quality of their audit division by reorganising the division s service lines into industries (Mayhew and Wilkins 2003). The development of this industry expertise represents an opportunity for the audit firm to differentiate itself on a dimension other than price (Porter, 1985). Hence, audit research has identified auditor industry specialisation is a proxy for audit quality (Krishnan 2003; Reichelt and Wang 2010). The literature also provides evidence that industry specialist auditors in the audit division within the audit firm command the highest fee premium when the audit firm is an industry leader at both the national and city level (Ferguson et al. 2003; Francis et al. 2005; Basioudis and Francis 2007). 7

8 This finding is consistent with the concept of differentiation strategy from the management literature (Porter 1985), thereby endorsing the use of an audit firm s market share as a proxy for the firm s (industry) specialisation in the literature. Dye (1993) characterises the purpose of an audit into two roles, namely an information signalling or insurance signalling role. The idea of insurance signalling works as a litigation put option. Investors are therefore expected to pay a fee premium to their auditor, in accordance with the implied insurance coverage provided by the auditor as determined by the wealth (size) of the audit firm. In contrast, Titman and Trueman (1986) argue that a higher quality auditor provides more precise information about a firm s value and thus provides an information signal to investors. Thus, audit firms are also expected to charge more for their role in providing a higher quality audit. Prior literature that examines the association between audit quality and auditor compensation in the context of IPOs (Mayhew and Wilkins, 2003) adopts the use of audit quality proxies developed in context of annual financial report audits, such as Big N, Non-Big N and industry specialisation. Through discussions with audit practitioners and our own observations, audit firms have the option of using their audit division or their transaction services division (often referred to as the Corporate Finance division) to conduct the review of the prospectus and provide an Investigating Accountant s Report on the accuracy of the relevant financial information in the prospectus. This possible contribution made by these transaction experts has not been identified in the existing research in IPOs. We propose an alternate measure of auditor expertise in the IPO context, namely, transaction expertise. 8

9 In addition to investigating the association between auditor expertise and auditor compensation in IPOs, we also examine the association between various measures of auditor expertise and earnings forecast accuracy. McConomy (1998) and Clarkson (2000) investigate the association between earnings forecast accuracy and audit quality in the Canadian IPO markets. They find that the positive relationship between audit quality and forecast accuracy is statistically insignificant in a review engagement but is statistically significant in an audit engagement. Lee, Taylor and Taylor (2006) also examine this association using data from the Australian IPO market beginning 1991 to 1998 and find a positive yet weak relationship between audit quality and forecast accuracy. It should be noted that these studies use audit firm size as a proxy for audit quality, which ignores the industry expertise of the auditor. This is in spite of compelling evidence suggesting that auditor expertise is important in measuring audit quality (Ferguson and Stokes 2002; Ferguson et al. 2003; Francis et al. 2005; Reichelt and Wang 2010). To the best of our knowledge, the prior literature does not examine the association between auditor industry specialisation, as a proxy for audit quality, and forecast accuracy in an IPO context. Thus, this paper adds to the literature by examining if auditor industry specialisation and auditor transaction specialisation is associated with a more accurate earnings forecast. The expertise acquired by accountants from the corporate finance division may be different to auditors from the audit division of an audit firm. Therefore, companies can signal a relatively higher quality earnings forecast in their IPO prospectus by 9

10 associating with specialist auditors from the corporate finance division within an audit firm, hereafter termed transaction specialists. This may be because transaction specialist auditors enhance the credibility of an earnings forecast more than a nonspecialist auditor (Krishnan 2003; Habib 2011), which is especially important if the earnings forecast represents a good news announcement. This is because the literature suggests that investors typically react to bad news quicker than they do towards good news announcements (Williams 1996). 3. Hypothesis Development Porter (2008) argues that when firms differentiate themselves, they increase the uniqueness of the product or service they offer. He also suggests that firms following a differentiation strategy will be able to charge fee premiums to the extent that they have differentiated themselves. It has been argued that firms achieve differentiation in the audit market by reorganising their service by industry lines (Mayhew and Wilkins 2003). Doing so allows them to develop industry specialisation which allows them to better understand their client s business model. Further, it allows the auditors to identify and target the key risks involved in the assurance engagement, and thus carry out procedures that best address the risks identified. Specialist audit firms are typically associated with higher earnings quality (Krishnan 2003; Reichelt and Wang 2010), thus increasing the usefulness of the reported numbers in the financial statements of the firm for users. Indeed when users are more reliant on the information provided by firms, the level of information asymmetry decreases (Jaggi, Chin, Lin and Lee 2006). When the level of information asymmetry between the firm and new investors decreases, investors tend to be more willing to 10

11 invest in the company because they are more informed and less likely to be subject to the winner s curse problem (Beatty and Ritter 1986; Rock 1986; Jog and McConomy 2003). Thus, firms should be willing to pay the premium associated with a specialist auditor to decrease the level of information asymmetry, thereby increasing the credibility and reliance on the earnings forecasts by potential investors. A number of studies support the argument that specialist audit firms do charge a fee premium for their higher quality service (Ferguson and Stokes 2002; Ferguson et al. 2003; Casterella et al. 2004; Francis et al. 2005; Ferguson et al. 2006). Further, Ferguson et al. (2003), Francis et al. (2005) and Ferguson et al. (2006) find that the fee premium for specialisation is higher when specialisation is measured at the city level than on a national level. These studies also find that the premium is highest when the audit firm is a joint city and national level specialist. However, the fee premium disappears when the audit firm is only a national level specialist. It should be noted that these studies use dichotomous variables to represent arbitrary levels of market share to capture auditor specialisation. We use continuous measures of market share to develop our measures of specialisation. When audit firm size is used to proxy audit quality, Basioudis and Francis (2007) find that Big 4 audit firms have the highest fee premium, when measured on a city level. This is consistent with the literature that uses the market share approach to proxy audit quality. It is noteworthy that when specialisation is measured using a market share approach, an auditor s prominence (reputation) and expertise are collectively and implicitly considered. This is important because the IPO literature have only considered an auditor s prominence thus far, which has been measured using audit 11

12 firm size. However, the concept of auditor specialisation incorporates an additional element, namely an auditor s expertise. The auditing literature examining assurance engagements pursuant to annual reports has noted that audit firms tend to specialise by industry lines (Payne 2008), giving rise to the concept of industry specialisation. We expect that a higher quality auditor, which we proxy using industry specialisation, will expend greater resources in ensuring that the earnings forecast released by a firm, in their IPO prospectus is of a higher quality, and thus charge higher audit fees. H1A: There is a positive relationship between the auditor s degree of industry specialisation at the national level and city level and IPO audit fees charged. The purpose of an IPO prospectus is different from an annual report. A key difference is that an IPO prospectus typically contains prospective financial information. On the other hand, an annual report typically contains historical financial information. It is thus likely that the audit risk involved in providing assurance for prospective financial information, such as earnings forecasts, will be different from providing assurance for an annual report. Auditors that specialise in IPO transactions may develop expertise, which differs from industry specialist auditors. Notably, these auditors tend to play the role of a corporate advisor to the IPO process. Hence, these advisers may not be viewed as auditors from a day to day standpoint, as they advise on transactions rather than provide audit opinions on company annual reports. To account for auditors that specialise in 12

13 transactions such as an IPO, we proxy specialisation for these auditors using IPO audit fees instead of annual report audit fees. We label an auditor who specialises in transactions such as an IPO, a transaction specialist. Using the concept of transaction specialisation, we re-examine the association between auditor specialisation and the amount of audit fees charged. H1B: There is a positive relationship between the auditor s degree of transaction specialisation at the national level and city level and IPO audit fees charged. Auditors who are associated with the IPO prospectus will not want to associate with a potentially inaccurate earnings forecast (Clarkson 2000). Specialist auditors have been found to enhance the credibility of information more than non-specialist auditors (Krishnan 2003; Habib 2011). Thus, firms can signal the credibility of their earnings forecast to new investors by engaging a specialist audit firm. A specialist auditor is expected to provide a higher quality audit (Cahan et al. 2011). Further, a specialist audit firm is unlikely to associate with a low quality earnings forecast because doing so may damage its reputation (Cahan et al. 2011). A damaged reputation for a specialist audit firm may result in the audit firm losing its status as specialist. This could result in lost future business associated with clients seeking a specialist audit firm that enhances the credibility of their financial statements. Prior studies have used audit firm size as a proxy for audit quality when examining the association between audit quality and forecast accuracy in the IPO context. Audit firm size ignores the expertise of the audit firm as it merely looks at the prominence 13

14 of the audit firm. However, prior studies find that larger audit firms are more likely to be associated with lesser absolute earnings forecast errors, in an IPO earnings forecast, than small audit firms (Clarkson 2000; Hartnett 2006; Lee et al. 2006). Industry specialist auditors develop expertise in the industry of their client due to significant training and experience in a particular industry (Ferguson et al. 2003; Kwong 2011; Habib and Bhuiyan 2011). Industry specialist audit firms are able to produce a higher quality audit (Krishnan 2003; Lim and Tan 2008; Reichelt and Wang 2010) and are thus more capable of detecting errors in a firm s financial information. Thus, we expect industry specialist audit firms to be associated with a more accurate earnings forecast. H2A: There is a negative relationship between the auditor s degree of industry specialisation at the national level and city level and absolute earnings forecast errors in the IPO prospectus. As noted earlier, the IPO context is different from the annual report context insofar as the extent of prior knowledge available on the firm. This is because firms having an IPO may be new to the market, which is in contrast to a firm that is listed. In addition, auditors who perform annual report audits typically focus on historical financial information, whereas auditors (corporate advisors) who perform a review of a prospectus typically focus on prospective financial information. Hence the expertise of these auditors is likely to be different. Thus, we specifically examine the association between absolute earnings forecast errors and auditors who specialise in transactions such as an IPO, namely a transaction specialist. 14

15 H2B: There is a negative relationship between the auditor s degree of transaction specialisation at the national level and city level and absolute earnings forecast errors in the IPO prospectus. 4. Data and Research method Data on all IPOs successfully listing from 1 st January 2003 to 31 st December 2011 was obtained from Connect4. This included data on listing date, deal size, audit firm signing off on the prospectus, IPO audit fee as well as other financial data. This resulted in 1,193 IPOs being identified as listing in our sample period. Real estate or investment trusts and funds are excluded as the operating structure and taxation of dividends and capital gains are different for these IPOs from a typical IPO (Lee et al. 2006). Foreign incorporated firms were also excluded as these firms operate in a different environment and they often engage overseas auditors. We also exclude firms with missing data. These exclusions resulted in 102 firms being removed from our final sample. We then manually search all prospectuses to identify firms that issue at least a one year earnings forecast and are represented by an audit firm with a national presence 3. In total, there were 192 IPOs that met the aforementioned criteria. Forecasted earnings data was then hand collected from the relevant prospectuses. Actual earnings data was obtained from the Aspect Huntley DatAnalysis database. A sample of matched firms that do not release an earnings forecast in their IPO prospectus was compiled to determine if there are differences between firms that do not release an earnings forecast from firms that do release an earnings forecast in their IPO prospectus. In creating a sample of IPOs that do not release an earnings forecast, 3 This is to allow a consistent analysis across both national and office levels of expertise. 15

16 we employ the matched firms method discussed in Barber and Lyon (1996). Thus, we match our sample of firms that release an earnings forecast with a sample of firms that do not release an earnings forecast on the basis of GICS industry groupings and IPO deal size. There are some instances whereby the number of IPOs that release earnings forecasts from an industry exceeded the number of IPOs that do not release earnings forecasts from the same industry. In those instances, we matched a control firm to more than one IPO that released an earnings forecast. Thus, in total, our sample of matched firms consists of 123 IPOs. Refer to Table 1 for sample selection details. [ Insert Table 1 about here ] In this paper, two measures of auditor specialisation are used for analysis, namely industry and transaction specialisation. More than one measure of specialisation exists because auditors can provide assurance services for annual reports or an IPO prospectus. Often, the Investigating Accountant s Report that forms part of the prospectus is signed off by an audit partner if the financial report comprises historical (and pro-forma) figures. In our sample, forward looking numbers such as in an earnings forecast are exclusively signed off by the Director of a separate division of the audit firm, usually referred to as Transaction Services. Transaction services divisions (often labelled as Corporate Finance Services or simply Transaction Services in accounting firms) are typically responsible for transaction based services such as IPOs, mergers and acquisitions, valuations for sales of business and so on. While industry specialisation tends to be the mainstay of the traditional audit division, we posit that in the IPO domain, transaction specialisation should matter, particularly when the work is being performed and signed off by the transaction services division. 16

17 Industry specialist auditors are labelled INDSPEC. In creating the INDSPEC variable, we follow the traditional measure used in the literature as per Gramling and Stone (2001) and Krishnan (2003). INDSPEC is calculated using the concept of market share as follows. Where FEES is the amount of fees charged for services provided pertaining to annual reports, for audited firm f, audited by auditor a, in industry i, for year y. This measure is provided at national (INDSPECNAT) and office level (INDSPECOFF). IPOSPEC is the level of market share that an audit firm has in providing IPO audit services to listing firms. To calculate this measure of specialisation, the total market share is computed as the total IPO audit fees charged by all audit firms for clients listing from 2003 to We calculate IPOSPEC as follows. (a, y) (ipof, a, y) (ipof, a, y) Where FEES represent IPO audit fees earned from providing services pursuant to IPO prospectuses (this includes all IPOs in our sample period regardless of whether they issue an earnings forecast in their prospectus) for audited IPO prospectus ipof, audited by auditor a for year y. This variable is also calculated at national (IPOSPECNAT) and at the office (IPOSPECOFF) levels. To test both hypotheses, we use a Heckman two stage model to deal with selection biases (Lennox, Francis and Wang, 2011) inherent in auditor selection studies. We 17

18 identify four variables that would be closely associated with the likelihood of an IPO firm issuing an earnings forecast. As the decision to include an earnings forecast is voluntary in Australia, and may come at a cost, the listing firm must have justifiable cause for including the forecast in the prospectus. IPO firms with higher levels of managerial ownership have incentives to signal the quality of their firm given the information asymmetry at listing. Firms that have their offer underwritten will be more confident of making an earnings forecast as they have been backed by an underwriter. Firms with a higher book to market ratio will be more confident of issuing a forecast as majority of the assets in place are known to the firm. To test the first hypothesis, we employ the following model. i i i i i i i i i i i i Where SPEC is INDSPECNAT and INDSPECOFF for H1A, and IPOSPECNAT and IPOSPECOFF for H1B. The definitions for all the variables used in Equation 1 can be found in Table 2. To test the second hypothesis, we employ the following model. 18

19 Where SPEC is INDSPECNAT and INDSPECOFF for H2A, and IPOSPECNAT and IPOSPECOFF for H2B. The definitions for all the variables used in Equation 1 can be found in Table 2. [ Insert Table 2 about here ] Sample Description Of the 1,091 IPOs identified between 2003 and 2011, 192 (18% of all IPOs in the sample period) have voluntarily issued a forecast while the remaining 899 do not disclose earnings forecasts. The highest number of IPOs were issued in 2007 (235 IPOs) while the least number of IPOs (37 IPOs) were issued in This is consistent with the impact of the Global Financial Crisis on the IPO market. Of the 192 IPOs that issued an earnings forecast, 116 (60%) were audited by a Big 4 firm while 76 (40%) forecasters were audited by Non-Big 4 firms. The largest sub-group of IPOs were that of non-forecasters audited by Non-Big 4 firms (709 IPOs). Overall, 28% of IPOs firms engaged a Big4 audit firm as the Investigating Accountant. Refer to Panel A of Table 3 for a detailed breakdown. While the least number of IPOs were listed in 2009, the average deal size was highest in 2009 for firms that forecast earnings ($407 million) and the lowest average deal 19

20 size across all years for non-forecasters ($7 million). The high average deal size in 2009 was driven by the listing of Myer Holdings Limited. Panel B of Table 3 also indicates a significant difference in the audit fees paid to audit firms that sign-off on IPOs including an earnings forecast as opposed to IPOs that do not include an earnings forecast. Panel C of Table 3 shows that the highest number of IPOs fall under the Materials GICS 2-digit classification (47.02%) while the Consumer Discretionary classification has the most number of IPOs that issue earnings forecasts (69.12%). Only 2.73% of IPOs under the Materials classification include an earnings forecast. This is not surprising given the high risk nature of the mining business. The same rationale applies to the Energy sector (3.27% of firms issuing a forecast). [ Insert Table 3 about here ] Table 4 provides a breakdown of the market share of IPO audits by audit firm. The Big 4 audit firms are engaged by 28% of all IPOs to prepare an Investigating Accountant s Report on the prospectus. Big 4 audit firms account for 60% of the market share of audit services of IPOs that issue an earnings forecast. Ernst & Young have the highest proportion of IPOs firms (9.62%) while PricewaterhouseCoopers leads the market in IPO audits with earnings forecasts (19.79%). Of the Non-Big 4 firms that are active in the market for IPO firms who issue an earnings forecast, PKF is the market leader (7.81% of forecasters) followed by Grant Thornton (6.77%), Pitcher Partners (5.73%) and BDO (4.17%). [ Insert Table 4 about here ] 20

21 Table 5 provides a distribution of the absolute forecast error and absolute forecast error scaled by issue size. The distribution indicates that only 27 out of 192 forecasting firms had an absolute forecast error under 5%. A majority of firms (85 of 192) had an absolute forecast error greater than 25%. This distribution changes when we scale the absolute forecast error by issue size. The majority of forecasting firms (81 out of 192) exhibit an absolute forecast error of less than 5% when the absolute forecast error is scaled by deal size. This illustrates the importance of scaling forecast error by size as the deal size of IPOs in our sample varies greatly. We used the scaled measure in our main analysis as it takes into account the economic intuition underlying the forecast error (Lee et al., 2006). [ Insert Table 5 about here ] Descriptive Statistics The average audit fees charged for our sample of 192 IPOs is $460,000. The median fee is $180,000. This suggests that the majority of IPOs are relatively small and hence incur a relatively low audit fees. This is further evidenced by the skewness of the audit fees. The maximum fee charged was $6.7 million. This was charged by KPMG to the issuers of QR National Limited (Queensland Rail) which listed in The average earnings forecast error for our sample is 15% while the minimum and maximum is 0% and 182% respectively. The earnings forecast accuracy is also skewed to the right, similar to audit fees. In terms of forecast accuracy, 95 IPOs underestimated their actual earnings and 97 IPOs overestimated their actual earnings. Thus, IPOs that include an earnings forecast are typically unbiased as this difference between the number of firms that overestimate and the number of firms that underestimate is not found to be statistically significantly different using a t-test. The 21

22 mean forecast error for firms that underestimated their actual earnings is %, whereas the mean forecast error for firms that overestimated their actual earnings is 53.32%. Big4 auditors are engaged by 60% of the sample firms. This relatively high percentage is in contrast with the low market share (28%) of the Big4 across all IPOs as discussed earlier. The mean market share of industry specialist auditors at the national and office level is 16% and 17% respectively. The mean market share of transaction specialists at the national and office level is 15% and 24% respectively. The average deal size of our sample IPOs is $155 million. The least amount of funds sought was $1.45 million, while the largest deal was for the capital raising of $3,586 million. On average, 57% of the company shares were retained by the pre-ipo owners. The age of the companies on average was 5 years at the time of listing. Also, 60% of the sample firms, engaged an underwriter for the IPO. A table illustrating the descriptive statistics for the other variables used in this paper can be found in Table 6. [ Insert Table 6 about here ] Correlations The correlations reported in Table 7 indicate that all measures of audit quality (Big 4, industry specialisation and transaction specialisation) are statistically significantly correlated (significant at 1%) with both dependent variables, IPO audit fees and absolute forecast error scaled by deal size. The various measures of audit quality are also statistically significantly correlated with each other, ranging from for BIG4 22

23 and INDSPECNAT to for INDSPECOFF and IPOSPECOFF. The higher correlations tend to be with BIG4 as firm size is expected to be associated with other measures of market share. The lower correlations between measures of industry specialisation and transaction specialisation suggest at least at the bi-variate level that the factors influencing industry expertise and transaction expertise are somewhat different. Deal size measured as ISSUESIZE is also highly correlated with FEES (0.694; significant at 1%). As expected, there is a negative correlation between AFE and measures of auditor specialisation (significant at 1%). [ Insert Table 7 about here ] 5. Main Results The decision of IPO firms to voluntarily include an earnings forecast in their prospectus is intentional and not random. This introduces selection bias into our analysis. We use the Heckman two-step procedure to account for selection bias in our audit fee model and earnings forecast error model. We identify four variables that would explain the decision to issue an earnings forecast - the level of retained ownership, if the IPO was underwritten, if the IPO firm switched audit firms after the listing, and the level of assets in place compared to the market value of the firm. These variables are included in the first stage model and then removed for the second stage models. The two stage model is used for both the fee model as well as the earnings forecast model. Heckman two-stage procedure Table 8 presents the results of Equation (1), our selection model. The results indicate that IPO firms with a higher level of retained ownership, those that have their issues 23

24 underwritten, firms that switch auditors after the IPO and firms with higher ratio of assets in place to total market value, tend to issue an earnings forecast in their prospectus. [ Insert Table 8 about here ] Hypothesis One We initially examine the main effects of each measure of auditor size and specialisation. The coefficients for BIG4, INDSPECNAT and IPOSPECNAT are positive and statistically significant at 1%. These results are reported in columns 1, 2 and 4 in Table 9. The coefficients for INDSPECOFF and IPOSPECOFF are positive and statistically significant at 10% and 5% respectively These results are reported in columns 3 and 5 in Table 9. Both industry and transaction specialist auditors at the national and office levels are more likely to charge higher audit fees for services provided to companies that issue an earnings forecast, which is in support of both H1A and H1B. This finding is consistent with the literature, which has previously used BIG4 as a proxy for audit quality (Francis et al. 2005; Basioudis and Francis 2007). This finding is not surprising due to the large investments that these audit firms make, thus in order to recoup the cost of their investment, it is expected that audit firms will charge higher fees. Equally, audit firms that invest in developing transaction expertise will also charge higher audit fees to recover the investment that was made. These higher fees are also likely to reflect the advisory nature of the engagement. Given the strong influence of firm size on our results, we partition the sample into 4 quartiles (by IPO deal size). For the largest group of IPO firms (Quartile 1), Big 4 firms still appear to earn a fee premium. However, the association between fees and 24

25 industry specialisation no longer holds. We see similar results when analysing the smallest IPO firms (Quartile 4). These results imply that once the client characteristics such as size are controlled, the fee premia associated with traditional measures of expertise no longer apply as strongly in the IPO setting. Clients of IPO firms seek out transaction or advisory expertise, particularly when the engagement is complicated by the need to sign off on earnings forecasts. This demand for IPO specific expertise is further evidenced by IPO firms (that issue an earnings forecast) switching audit firms post-ipo when there is no longer a need for the specific transaction expertise. The results pertaining to this additional analysis are not tabulated in this version of the paper. [ Insert Table 9 about here ] Hypothesis Two The coefficients for the BIG4 and IPOSPECNAT are negative and statistically significant at 1%. The coefficients on INDSPECNAT and INDSPECOFF are negative and significant at 5% and 10% respectively. While IPOSPECOFF is negatively associated with earnings forecast error, the association is not statistically significant. These preliminary results suggest that our measures of audit firm size and specialisation are associated with better earnings forecast accuracy at the national level but there is little support for the hypothesis at the office level for transaction expertise. These results are reported in columns 1 to 5 in Table 10. As we did in the test of H1, we further examine the sample by partitioning it into 4 quartiles based on total assets. We find similar results relating to earnings forecast accuracy. Once we control for client characteristics such as size, our measure of transaction expertise better explains the difference in earnings forecast accuracy 25

26 compared to the Big 4 and the industry specialisation measures. Again, the results for this additional analysis are not tabulated in this version of the paper. [ Insert Table 10 about here ] 6. Robustness tests We re-examine the multivariate results for our forecast accuracy model using the alternative Lee et al. (2006) method of scaling forecast error by the number of shares on issue and find qualitatively similar results. This paper also uses continuous measures of specialisation for industry and transaction specialisation. For robustness, we create dummy variables for these specialisation variables where a value of one is assigned when the audit firm achieves a market value greater than or equal to 20%, zero otherwise. The multivariate results for our determinants of audit fees model are weaker when dummy variables are used. This provides support for the use of continuous variables to capture market share. We use one year lagged measures of IPOSPEC (at the national and office levels) for our main regressions. In order to test the robustness of this measure, we use 2 year lagged measures of market share to compute IPOSPECNAT and IPOSPECOFF. Our results are qualitatively similar which implies that transaction expertise built up over a short period of time is captured in the contemporaneous measure. 7. Conclusion This paper has examined the role that a specialist auditor plays as a corporate advisor to the IPO process. Prior research has considered the amount of fees an auditor charges as an indication of audit quality (Mayhew and Wilkins 2003) separately from 26

27 the association of higher quality auditor with earnings forecast accuracy in the IPO context (Clarkson 2000; Lee et al. 2006). Further, prior studies examining these concepts in the IPO context have not considered auditor specialisation; rather, these studies use a dummy variable to indicate if an auditor belongs to the Big category. This dummy variable has been argued by DeAngelo (1981) to be an effective proxy for audit quality. However, the literature has since developed better measures of audit quality, namely auditor specialisation, which is measured on the basis of an auditor s market share (Krishnan 2003). Further, studies indicate that a specialist auditor provides a much higher quality audit than a Big auditor (Francis et al. 2005; Reichelt and Wang 2010). However, the pitfall of these studies is that specialisation is also measured as a dichotomous variable, which ignores the degree of expertise of an auditor (Bedard and Chi, 1992). This paper addresses the issues in the literature by introducing a continuous measure of specialisation. Next, we introduced the concept of auditor specialisation in the IPO context and we classified these auditors as transaction specialists. The concept of transaction specialisation is important because these auditors may play the role of a corporate advisor to the IPO process (rather than solely an audit role) and thus have greater expertise specific to the IPO process. This transaction expertise is even more important when examining IPOs that issue earnings forecasts as these IPOs will be exclusively audited by transaction experts rather than auditors with industry expertise. Lastly, we combine the literature examining the association between audit fees and audit quality with the literature examining audit quality in association with IPO earnings forecast accuracy. By examining these streams of research together, we are able to provide an overview of the amount of fees a specialist auditor charges and 27

28 secondly, examine if specialist auditors are associated with a more accurate earnings forecast. Consistent with prior literature, we find a significant and positive association between the fees an industry specialist auditor (both at the national and office level) charges and their degree of specialisation. As expected, this finding also holds for transaction specialist auditors (both at the national and office level) implying that transaction specialist auditors charge higher fees to recover the investment in developing industry or transaction expertise. When we control for client specific characteristics such as size (deal size and total assets), we discover that transaction expertise better explains the variation in both fees as well as earnings forecast accuracy. This is the case in both the largest and the smallest firms in our sample suggesting that transaction expertise is sought by clients of all sizes and is not restricted the largest IPOs. 28

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