Entrepreneur Choice of Auditor and Retained Ownership in IPO Markets : Experimental Evidence

We use experimental economic markets to test the Datar, Feltham and Hughes (DFH) (1991) model of entrepreneur choice of auditor and retained ownership in initial public offering markets. The mixed evidence provided by prior research using archival data motivated our experimental approach. Experimental markets inherently exhibit considerably more control over the model's decision variables than do archival studies. This enables us to test whether the model adequately describes human behavior and examine the effect of an important decision variable cited by prior research. Our results provide considerable support for the DFH model of entrepreneur behavior in treatments where investors are programmed to price consistent with the DFH equilibrium. We also found support in similar treatments for a modified DFH model that included the impact of client risk on auditor fees. However, the model was far less predictive of entrepreneur behavior in markets with human investors instead of programmed investors. The results suggest that human entrepreneurs and investors adapt to the choices each made within a particular market, such that less than half of the markets conformed to DFH's predictions while the rest followed an alternative equilibrium where only the entrepreneur's choice of auditor signaled firm value. Our results suggest that in signaling models like DFH, theorists should consider market environments and interactions that can lead to one equilibrium versus another