Pertanika J. Soc. Sci. & Hum. 5(1): 59-64 (1997) ISS : 0128-7702© Universiti Putra Malaysia Press

Auditing Firm Reputation, Ex Ante Uncertainty and the Underpricing ofInitial Public Offerings on the Second Board of the Kuala Lumpur

Stock Exchange: 1990-1995

SHAMSHER MOHAMAD and ANNUAR MD NASSIRDepartment of Accounting and FinanceFaculty of Economics and Management

Universiti Putra Malaysia43400 UPM Serdang, Selangor, Malaysia

Keywords: underpricing, initial public offers, auditor firm reputation, second board

ABSTRAK

Firma-firma audit mempunyai inseI1lif untuk menyemak secara terperinci dan melaporkan kesahihan segalaaktiviti yang tercatat dalam penyata-penyata kewangan yang disediakan oleh pihak pengurusan firma yangmemohon UI1luk disenaraikan di Bursa Saham Kuala Lumpur. Insentif ini berdasarkan keinginan ul1tukmempenahankan reputasi mereka sebagai agensi yang benanggungjawab. Oleh itu pelabur dapatmenjangkakan nilai sebenar firma-firma yang akan disenaraikan itu dengan lebih tepat dan ini mengurangkantahap ketidakpastian ex-ante dan dijangka menghasilkan premium yang rendah sewaktu penyenaraian. Kajianmengenai kaitan reputasi firma audit dan tahap premium sewaktu penyenaraian telah dibuat atas 100 firmayang di senarai di papan kedua Bursa Saham Kuala Lumpur, UI1luk jangkamasa 1990 hingga 1995. Enamfirma audit yang terkenal di kelaskan sebagai big-six dan firma audit yang selainnya dianggap mempunyaitahap reputasi yang lebih rendah dan dikelaskan sebagai non big-six. Penemuan kajian menunjukan tidak adakaitan signifikan antara reputasi firma audit dengan tahap premium penyenaraian yang diperolehi oleh firmayang diaudit. Ini bermaksud, pelabur di Malaysia menganggap bahawa semua firma audit yang berlesenmemberi perkhidmatan homogen. Penemuan kajian menunjukan reputasi penajajamin dan preslasi kenlunganyang lepas ada kaitan negatif, manakala, arah ali ran pasaran saham dan sisihan piawai pulangan sekitarpenyenaraian ada kaitan positif dengan tahap premium yang di perolehi semasa penyenaraian.

ABSTRACT

Reputable auditing firms have an incentive to investigate and repon irregularities since their reputation is atstake, therefore engaging their services enables investors to estimate the value of the firm more precisely andreduce ex ante uncenainty. This will attract more investors to bid for the IPO shares and consequently IPOsattested by reputable auditing firms will have a lower premium level. This study tests the conjectured inverseeffect of reputation of auditing firms on the level of IPO underpricing of 100 companies listed on the secondboard of the Kuala Lumpur Stock Exchange, for the period 1990-1995. The reputable auditing firms are theBig Six accounting firms; the others are classified as less reputable. The findings do not support thisconjecture, which implies that Malaysian investors assume that all qualified and licensed auditing firmsprovide homogeneous services. However, the findings show that the undenvriter reputation (UV{) and thepast profitability of the firm (NPM) variables are inversely related, whereas the market trend and the standarddeviation variables are positively associated to the level of IPO underpricing.

INTRODUCTION

Documented evidence on the premiums earnedby investors in initial public offers (IPOs) indeveloped share markets (Ibbotson 1975;Ibbotson and Jaffe 1975; Ritter 1984; Aggrawaland Rivoli 1990) suggests a general underpricing.Studies on the underpricing of Malaysian IPOs(Ariff and Johnson 1990; Shamsher et al. 1994)

suggest an average underpricing of 130% at theend of the first day of listing and 77% if theshares are held and old three years after listing.This excessive underpricing is the highest in theworld and cannot be completely explained bythe fundamental and market factors. Unlikeother markets, there is little documentedevidence on the explanations for the

Shamsher Mohamael anel Annuar Mohel Nassir

underpricing of IPOs in Malaysia. However,Shamsher et at. (1994) suggest that the publicpolicy goal of equitable wealth distributionamong the various ethnic groups as a rationalefor the intentional excessive underpricing.Various [actors have been suggested in theliterature as the possible reasons forunderpricing, such as ex ante uncertainty andstate of the market prior to issue (McGuinness1992), asymmetric information betweenunderwriter and issuer (Leyland and Pyle 1977),adverse selection problem of uninformed andinformed investors (Rock 1986), adverseincentives of undenvriters to reduce undenvritingrisk (Baron 1982), insider signalling todifferentiate the quality of issues (Ritter 1984;Beatty and Ritter 1986), and price pressuresduring the initial period of issue (Aggrawal andRivoli 1990). The inverse effect of auditing firmreputation on the level of IPO underpricing isdocumented in the literature, but the findingsare inconclusive as Balvers et al. (1989) andBeatty (1989) suggest a significant inverserelationship whereas McGuinness (1992) andNg et at. (1994) suggest no significantrelationship.

This study focuses on the effect of reputationof auditing firms on the level of IPO underpricingon the second board of the Kuala Lumpur StockExchange. One hundred IPOs were analysed forthe period 1990-1995.

THEORETICAL RELATIONSHIP BETWEENAUDITOR FIRM REPUTATION AND IPO

UNDERP~CING

Managers of IPOs are assumed to have privateinformation abollt the future prospects of thecompany and it is in their interest to convey theinformation to prospective investors to reduceunderpricing of the IPOs. This information isusually provided through a prospectus whichincludes information on financial status, futureprospects and audited financial statements. InMalaysia, it is a mandatory requirement underthe Companies Act 1965 for IPOs to issue aprospectus including audited financialstatements, which are considered an importantelement in the prospectus. Financial statementsaudited by more reputable auditing firms areperceived to be more credible to prospectiveinvestors than those audited by less reputableauditing firms. This preference on the part ofprospective investors may be explained in terms

of the need to minimize monitoring cost.Auditing services are demanded as monitoringdevices to minimize agency cost because of theconflict of interest bet>veen owners and managers(Watts and Zimmerman 1983).

Since very little is known of the IPOs, andprospective investors must rely on the disclosuresin a prospectus to evaluate the future prospects,credible financial statements are required toenable investors to trust the disclosed infonnationto eliminate the need to search for alternativesources of information for verification purposes.Since in Malaysia the allocation of shares to thepublic is based on the lottery system, the costs ofan information search (if verification is required)may not be compensated by the number ofshares allocated, therefore requiring a greaterlevel of underpricing to attract potential investors.The provision of credible financial statementsserves to reduce the monitoring cost.

DeAngelo (1981) and Simunic and Stein(1987) suggest that the credibility of financialstatements depends on the perceived quality ofthe audit. A higher perceived quality of audit ismore likely to be associated with a morereputable auditing firm because of their largercollateral properties (and therefore greaterpresumed reputation at stake) and confidenceof investors in the auditing firm's reputation foraccuracy and reliability of information audited.Therefore, the more reputable the auditing firmemployed by an IPO, the less the chance ofmisrepresentation by the managers' disclosures,consequently lower costs of monitoring and lowerunderpricing of the IPO.

Beatty and Ritter (1986) suggest that thegreater the ex ante uncertainty, the greater theexpected underpricing of the IPO. The ownersof the company have an incentive to signal theirprivate information about the firm's futureprospects to reduce ex ante uncertainty. However,the effectiveness of this mechanism is mitigatedby the IPO companies with relatively high ex anteuncertainty to signal low ex ante uncertainty. Therole of an auditing firm in providing credentialsto disclosed information is important to mitigatethis problem.

Reputable auditing firms have an incentiveto investigate and report irregularities since theirreputation is at stake, therefore engaging theirservices enables investors to estimate the valueof the company more precisely and reduce exante uncertainty. This will attract more investors

IiO Pertanika.J. Soc. Sci. & Hum. Vol. 5 No.1 1997

Auditing Firm Reputation, I~x Anff Uncertaillt\' and the nderpricing of Initial Public Offerings

The AGE variable represents the age of theIPO company from the date of incorporation. Alonger operating history provides moreinformation on the quality of management andenables investors to evaluate the prospective valueof the company from past information. Anarbitrary benchmark of 10 years was chosen withthe hope that a longer history reduces investorex anIe uncertainty about the true value of thecompany, and therefore results in lessunderpricing of the IPO.

The % OFFER variable reflects the expectedmonitoring costs. Jensen and Meckling (1976)suggest that the lower the percentage of sharesheld by insiders (therefore the higher percentageheld by outsiders) the higher the monitoringcosts and the lower the level of underpricing. Inthis respect, Downes and Heinkel (1982) andBeatty (!989) show that the percentage retainedby insiders signals private information tooutsiders.

The standard deviation of returns (SD)variable denotes the ex posl proxy for the ex anIeuncertainty to control for ex anle uncertain ty inthe sample. Beatty and Ritter (1986) suggest apositive relationship between SD and level ofunderpricing. The average net profit margin(NPM) for the last five years reflects the expectedfuture performance of the the company.

Higher expected future performancereduces the risk of buying the IPO and thereforereduces the level of underpricing.

The underwriter replllation variable (UW)controls underwriter reputation as Balvers pi al.(1989) found thal underwriter reputation has

to bid for the IPO shares, and consequentlyIPOs attested by reputable auditing firms willhave lower level of premiums.

This study tests whether there is a significantinverse relationship between auditing firmreputation and underpricing of Malaysian IPOs.Specifically, IPO companies that engage theservices of more reputable firms should exhibitlower underpricing than companies that engagethe services of less reputable auditing firms. Forthe purpose of this study, the reputable auditingfirms are those that are internationally classifiedas the Big Six operating in the market and therest are classified as non-Big Six.

DATA AND METHODOLOGY

The data for this study were drawn from 100IPOs from the second board of the KualaLumpur Stock Exchange for the period1990-1995. The source for the variables used inthe regression analysis was the companies'prospectuses, and the share prices were extractedfrom the daily diary published by the KualaLumpur Stock Exchange. Following theguidelines by McGuinness (1992) and g et al.(1994), a regression model was used to test theconjectured inverse relationship betweenauditing firm reputation and level of IPOunderpricing. The factors of ex ante uncertainty,perception of company value, other reputationeffects and state of the market prior to the IPOwere controlled in the step-wise regression model.The auditor reputation conjecture was tested bythe estimated coefficients of the more reputableauditing firms (Big Six) and the less reputableauditing firms (non-Big Six) indicator variables.The linear regression model is expressed asfollows:

UPi = bo + bi (AGE) + b~ (%OFFER) + b" (SD)+ b

l( TPM) +b,; (UW) + bti (MKT) + b 7 (AUD)

+ e i

where

UP the level of underpricing at theend of first day after listing;

AGE operating history of the company;a dummy variable approach is usedwith a benchmark of 10 years;

%OFFER = percentage of shares owned byoutside investors after the offering;

SD standard deviation of daily returns

NPM

UW

MKT

AUD

e

for days 2-14 after first tradingday;the company's average profitmargin for the last 5 years;underwriter reputation group;indicator variable takes a value of1 if it is from reputable group,otherwise 0;the state of the market prior tothe listing, measured by themoving average of 15 days' returnson the KLSE Composite Index;auditor reputation group; indi­cator variable takes a value of 1 ifit is from the reputable group(Big Six), otherwise 0;error term

Pertanika.J. Soc. Sci, &: Hum. Vol..~ No. I 1997 1,1

Shamsher Mohamad and Annuar Mohd Nassir

AGE AUD INSIDER NPM SO U'vV1.00 -0.0456 -0.03]5 -0.151 -0.0818 .00082

1.00 02674 0.108301226 -0.]607] .00 0.0783 -0.0688 0.0845

1.00 0.1096 0.08961.00 0.] 679

1.00

AGEAUDIi\:SIDERNPMSDUW

(b) Regression Results

TABLE 2Correlation matrix for the explanatory variablesin the regression analysis (Second Board IPOs)

TABLE 3Regression Results for the auditor finn reputation

model (Second Board)

Six ranges from 59 to 101 % and there is nosignificant difference (F = 0.18) between theaverage level of underpricing among them.Thelevel of average underpricing for all the Big Sixfirms was 76% and not significantly different (F=1.11) fmm the 72% for the Non Big Six firms.

Table 2 presents the correlation matrix forthe independent variables used in the study.The correlation matrix indicates that thecorrelation among the independent variables issmall (less than 0.20), implying that there is nosignificant multicollinearity problem that couldaffect the interpretation of the results of theregression analysis. Kaplan (1982) and Emory(1982) suggest that multicollinearity could be aproblem when the correlation exceeds 0.80.

FINDINGS

DesClijJlive Analysis

Table 1 shows the statistics for the second boardIPOs. The average underpricing is 74%, which isrelatively high and is a common feature of theMalaysian IPOs. Among the Big Six auditingfirms, KPMG Peat Marwick, Ernst & Young andCoopers and Lybrand audited 45 IPOs in total,which is 70% of those audited by the Big Six.The level of average underpricing within the Big

an impact on the level of IPO underpricing.IPOs with reputable underwriters have a lowerlevel of underpricing. The reputation of theunderwriters is proxied by their LUrnover duringthe period of study, assuming large underwritershave a greater reputation at stake.

The state of the market prior to the date oflisting of the IPO is controlled by the variableMKT in the regression model. The underpricingof IPOs is conjectured to be larger during bullishmarkets (therefore positive coefficient for thisvariable) than during bearish markets. Forexample, the average underpricing of IPOs onthe second board during 1990-1992 (bearishperiod) was 40% whereas in 1993-1995 (thebullish period) the average premiums were 85%(Cheng et al. 1996). The MKT variable ismeasured by the first-order moving average ofthe 15-day market trend prior to the first day oflisting. The market trend is proxied by the dailyreturns on the Kuala Lumpur Stock Exchange'sComposite Index.

TABLE 1Descriptive analysis of average underpricing by

auditing firms and auditing firm reputationof IPOs on the Second Board of KLSE

Regression Results

Table 3 summarizes the results of the regressionanalysis of second board IPOs. All the signs ofthe coefficients are in the expected direction.The standard deviation (SD) and the net profitmargin ( PM) variables are significant at 5%

Intercept -0.805 1.371 -0.587AGE -0.251 0.869 -0.289INSIDER -0.873 0.137 -0.637SD 6.4] 2.44 2.63* +NP~"I -0.256 0.091 -2.87':'U\\' -0.864 0.091 -9.49*MKT 0.026 0.007 3.71* +AUD -0.348 0.916 0.379

R"=8.53 F=1.94 N=100

Auditing Firm

By ClassificationBig SixKPlvlG Peat ManvickEmst & YoungCoopers & LybrandArthur AndersenPlice WaterhouseDeloine Ross Tohmatsu

All Big SixNon Big sixOverall

NumberOf IPOs

191412972

6337

100

AverageUnderpricing

(%)

79.659.665.485.3

101.675.1

75.672.374.4

CoefTi­cient

Standard t - Statistic ExpectedError Sign

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Auditing Firm Reputation, Ex Anle Uncertainty and the Underpricing of Initial Public Offerings

level whereas the underwriter reputation (UW)and the market trend variable (MKT) aresignificant at 1% level. These findings suggestthat the underpricing of IPOs is positively relatedto the ex anle uncertainty and underpricing ofIPOs is larger during bullish rather than bearishmarkets, consistent with the findings of Beattyand Ritter (1986). The financial measure ofexpected IPO vahlt, as estimated by the NPMvariable suggests I hat the level of premiums isinversely related LO the expected financi;dperformance. The underwriter reputation i,perceived as risk surrogate by investors as th,'level of premiums is inversely related to thisvariable. The AGE and the INSIDER variablesare not significant. The variable of interest,auditor reputation, does not support theconjecture that the level of premiums is inverselyrelated to the auditor reputation. The measureof auditor firm reputation based on the Big Sixor otherwise is a crude measure and therefore amore robust measure would be in terms of thecompensation paid to the auditing firm, sinceIhe larger the compensation of the reputableauditing firm, the less ex an/f' uncertainty andtherefore the lower the level of premiums.However, information on the amount ofcompensation to the auditing firms and thecosts of performing the audit (this informationis required to run the two-stage least squareregression) is not made available upon request.Therefore the refinement of the present analysisis not possible. Another possible surrogate ofauditor firm reputation variables is the numberof the companies audited by the auditing firmswithin the Big Six group. A dummy variableregression was run to test the auditor reputationhypothesis with a value of 1 assigned for IPOsaudited by KPMG Peat Manvick, Ernst & Youngand Coopers & Lybrand, and zero othenvise.The results (not reported here) are notsignificantly different from those reported inTable 3, suggesting no significant relationshipbetween auditor firm reputation and the level ofunderpricing of second board IPOs. Theseresults, however, could be due to the weaknessof the surrogate variable of auditor firmreputation.

CONCLUSION

In this study it is conjectured that the reputableauditing finns auest to the accuracy of the IPOmanagement disclosures in prospectuses and

therefore reduce the ex anle uncertaintyregarding the potential value of the firm. Thisimplies an expected inverse relationship betweenlevels of underpricing of IPOs associated withreputable auditing firms. The findings, however,do not support this conjecture. The coefficientor the auditor reputation variable (AUD) isnegative but not statistically significant, evenafter taking another surrogate (the number ofthe companies audited by each of the big-sixaudit firms) of auditing firm reputation. Thefindings imply that Malaysian investors do notdifferentiate between the services of reputableand those considered less reputable auditingfirms. The invesl.ors assume that all qualifiedand licensed auditing firms providehomogeneous services. These findings areinconsistent with those of Balvers el al. (1989)

and DeAngelo (1981) on the US market andconsistent with the findings of Ng el al.(1994)

on the Hong Kong market. The findings on theUS market suggest that investors do differentiatebetween the services of reputable auditing finnsand those considered less reputable, whereasthe study on the Hong Kong market suggests asupply of homogenous auditing services.

However, the findings show that theunderwriter reputation (UW) and the pastprofitability of the company (NPM) variables areinversely related to the level of second boardIPO underpricing. The market trend and thestandard deviation variables are positivelyassociated 1.0 the level of IPO underpricing.These findings supports the ex ante uncertaintyhypothesis suggested by Beatty and Ritter (1986).

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(Received 27 December 1996)

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