Audit Quality

The second empirical research question of this thesis (chapter six) examines the impact of enhanced audit quality on real and accrual earnings management at the IPO. Data concerning audit quality (the name of auditors, audit tenure, and audit fees) for IPO firms are collected from Fame and cross checked with the prospectuses. Financial and non-financial data are collected from several databases such as WorldScope, DataStream, ICC Plum, and Lexis-Nexis. All missing data are manually collected from IPO prospectuses. An audit firm is classified as a big N auditor (high quality auditor) if it is considered as one of the big 4 audit firms.17 With regards to audit tenure, Fame just provides the name of previous auditors and the period for each one of them. Thus, auditor’s tenure is constructed by calculating (accumulating) the number of years that the auditor was auditing the IPO client. Finally, and following Mayhew and Wilkins (2003) and Reichelt and Wang (2010), an auditor is identified as an industry expert if the auditor is the largest provider of audit services in the industry and the difference in market share between the largest provider and second provider is greater than 10 percent in a specific industry and year. The market share for each auditor is calculated based on the total audit fees and just for big N audit firms to avoid a brand name effect (Craswell et al. 1995).

After imposing the restriction to all non-financial IPO firms with available prospectuses and the necessary data to analyze the impact of audit quality on real and accrual earnings management, the final sample consists of 240 IPOs audited by big N and 275 IPOs audited by non-big N audit firms over the period 1998-2008. Table 4.7 (Panel A) presents descriptive statistics for IPO firms audited by big N audit firms. Panel A shows that the market capitalization of IPO firms audited by big N on average £199.59 million with a median of £57.62 million. The minimum market capitalization amount is £2.39 million and the maximum amount is £2,020.68 million. While for IPO firms audited by non-big N Table 4.7 (Panel B) shows that the mean (median) market capitalization is £24.83 million (£15 million) with a minimum amount of £1.44 million and a maximum amount of £147.66 million. This large difference in market values between IPO firms audited by big N

17 _{The classification for audit firms as big8, big 6, and big 5 is changed over time after series of}

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and IPO firms audited by non-big N is consistent with view that large IPO firms have strong incentives to hire high quality auditors to send a positive signal about IPOs to outsiders (Titman and Trueman, 1986; Brau and Fawcett, 2006). In other words, large IPO firms can afford to pay the high costs of those reputable audit firms which allows them to send positive signals about the offer. Moreover, the other figures of Table 4.7, namely total assets and money raised, show similar evidence that IPO firms audited by big N are larger in size than IPO firms audited by non-big N audit firms.

Table 4.8 (Panel A) reports the distribution of IPOs over the period 1998 to 2008 and shows that for IPO firms audited by big N auditors the years 2000, 2004, and 2005 account for more than 50% of the sample, while the majority of other years have similar percentages of IPOs. For IPO firms audited by non-big N audit firms Table 4.8 (Panel A) shows that more than 50% of IPOs have gone public during 2004, 2005, and 2006 with the highest number of IPOs (57 IPOs) is in 2005. Table 4.8 (Panel B) shows the frequency of IPOs relative to the industry standard classification, measured by 2-digit SIC codes. For both IPO firms audited by big N and non-big N Table 4.8 (Panel B) shows that the Business Services industry accounts for more than 30% of the sample, while the majority of other industries show similar percentages of IPOs ranging from 1% to 13%.

Table 4.7 Descriptive statistics for sample IPO firms during 1998-2008 by audit quality

Total assets

Net income

Market

value Money raised

(£ mill.) (£ mill.) (£ mill.) (£ mill.)

Panel A: IPO clients of big N audit firms sample (n=240)

Mean 102.78 3.95 199.59 75.44

Median 9.65 0.17 57.62 21.73

Std. dev 319.86 38.21 380.08 169.42

Minimum 0.20 -124.10 2.39 0.28

Maximum 1969.10 397.47 2020.68 1499.85

Panel B: IPO clients of non-big N audit firms sample (n=275)

Mean 8.97 0.05 24.83 10.97

Median 2.03 -0.07 15.00 3.50

Std. dev 42.33 3.88 29.45 56.62

Minimum 0.07 -11.84 1.44 0.14

Maximum 671.60 37.67 147.66 928.80

Table 4.7 presents sample descriptive statistics for IPO clients of big N auditors and IPO clients of non-big N auditorsover the period 1998-2008. All variables are previously defined.

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Table 4.8Time and industry distribution of IPOs during 1998-2008 by audit quality

Panel A: Time distribution

Big N clients non- Big N clients

Year Freq % Freq %

1998 24 10.00 9 3.27 1999 10 4.17 16 5.82 2000 59 24.58 35 12.73 2001 17 7.08 24 8.73 2002 15 6.25 14 5.09 2003 9 3.75 11 4.00 2004 38 15.83 47 17.09 2005 31 12.92 57 20.73 2006 21 8.75 44 16.00 2007 15 6.25 18 6.55 2008 1 0.42 - - Total 240 100.00 275 100.00

Panel B: Industry distribution

Big N clients non-Big N clients

Industry SIC 2-digit Freq % Freq %

Oil and gas extraction 13 9 3.75 15 5.45

Food products 20 3 1.25 8 2.91

Printing and publishing 27 5 2.08 6 2.18

Chemicals and allied products 28 19 7.92 16 5.82

Industrial machinery 35 9 3.75 6 2.18

Electronic equipment 36 17 7.08 16 5.82

Instruments and related products 38 10 4.17 12 4.36

Communications 48 15 6.25 12 4.36

Electric, gas, and sanitation 49 2 0.83 6 2.18

Durable goods 50 5 2.08 5 1.82

Eating and drinking establishments 58 5 2.08 9 3.27

Retail 59 3 1.25 5 1.82

Business services 73 87 36.25 86 31.27

Media and entertainment 78 1 0.42 4 1.45

Amusement and recreation 79 7 2.92 19 6.91

Engineering and management services

87 19 7.92 37 13.45

All others - 24 10.00 13 4.75

Total 240 100.00 275 100.00

Table 4.8 reports time and industry distributions for IPO clients of big N auditors and IPO clients of non-big N auditors over the period 1998 -2009.