Factors Associated With Earnings Forecast Disclosure and Auditing Practices of IPO Firms

Abstract

This study examines the impact of information asymmetry, firm-specific risk, inside share ownership, and other factors on the earnings forecast disclosure and auditing practices of initial public offering (IPO) firms. The issues examined are: (l) level of disclosure of earnings forecast information in IPO prospectuses; (2) auditor choice by IPO firms; and (3) voluntary review of earnings forecast information in IPO prospectuses. Hypotheses underlying the present study are drawn primarily from agency and signalling research studies which have considered factors affecting voluntary disclosure, the demand for audit quality, and the voluntary appointment of auditors. The results of the study are consistent with the hypotheses that earnings forecast disclosure and auditing practices of IPO firms are related to the information asymmetry and to firm-specific risk associated with these firms. Increase in variance of sharemarket returns is associated with increase in disclosure of earnings forecast information and with increase in the quality of auditors employed. Further, firms without operating histories tend to disclose more earnings forecast information and to voluntarily engage independent auditors or accountants to review earnings forecast information. However, the impact of operating history on auditor quality is complex and is dependent on the type of operating history. Consistent with expectations, firms converting from unlisted to listed firms and which are expected to have relatively low risk, are most likely to use lower-quality auditors compared to the firms without operating histories and firms formed by merging or acquiring existing firms. However, firms without operating histories and which are expected to have relatively high risk, are more likely to use lower-quality auditors compared to those formed through the acquisition or merging of existing firms. This latter result is contrary to predictions. It is argued that supply-side cost factors could explain the complex relationship between operating history and auditor quality. There is weak evidence that the proportion of inside share ownership, which may be a proxy for agency costs or a signal of firm value, is negatively related to the extent of earnings forecast disclosure, auditor quality, and the voluntary review of earnings forecast information. However, this relationship was at best marginally significant. Other major results found in the studies are that: (l) firms with lower expected short-term earnings disclose longer-range forecasts; and (2) larger firms tend to employ higher-quality auditors. Overall, the results of the empirical studies suggest that the degree of information asymmetry and firm-specific risk are the major factors driving the forecast disclosure and auditing practices of IPO firms.