Using a system of three simultaneous equations, we test the predictions of Datar, Feltham, and Hughes 1991 and Hughes 1986 between auditor choice, earnings disclosures, and retained ownership in U.S. firms making initial public offerings of securities. Using a sample of initial public offerings between 1990 and 1997, we find that the demand for high-quality auditors increases with firm risk. Additionally, we find that auditor choice, earnings disclosure, and risk are determinants of retained ownership, which is consistent with the predictions of Datar et al. and Hughes that auditor choice and direct disclosure are substitute signals for ownership retention. Further, our results suggest that the signals chosen (i.e., retained ownership, auditor choice, and disclosure) are related through their cost structures and are chosen jointly to minimize the overall cost to the entrepreneur.

[Often overlooked in empirical analyses of the relation between audit quality and audit fees is the recognition that they are mutually determined by the interaction of the client's demand for, and the audit firm's supply of, audit quality. Failure to account for this endogeneity can lead to biased inferences concerning the audit quality/audit fee relation. We adopt a simultaneous equations estimation procedure (offered by Amemiya 1978) applicable to jointly determined endogenous variables when one of the variables (in our case the quality review outcome) is qualitative in nature.1 To illustrate the procedure, we use a dataset developed by the United States General Accounting Office (GAO 1987) in its study of the audit procurement practices of entities receiving federal financial assistance. Inferences using this procedure differ from those of single-stage analyses. The results suggest that within the context of the application examined, audit fees appear to be positively related to the supply of audit quality and inversely related to the demand for audit quality. These findings have implication for studies involving audit fees and studies examining the demand characteristics of auditing.]

Examines simultaneous equations analysis of the relations between audit quality and audit fees by recognizing the role of audit quality's supply and demand. Pressures on audit fees; Studies of audit fee and audit demand; Statistics from the United States General Accounting Office; Supply and demand for audit in a simultaneous equations framework.

Using a system of three simultaneous equations, we test the predictions of Datar, Feltham, and Hughes 1991 and Hughes 1986 between auditor choice, earnings disclosures, and retained ownership in U.S. firms making initial public offerings of securities. Using a sample of initial public offerings between 1990 and 1997, we find that the demand for high‐quality auditors increases with firm risk. Additionally, we find that auditor choice, earnings disclosure, and risk are determinants of retained ownership, which is consistent with the predictions of Datar et al. and Hughes that auditor choice and direct disclosure are substitute signals for ownership retention. Further, our results suggest that the signals chosen (i.e., retained ownership, auditor choice, and disclosure) are related through their cost structures and are chosen jointly to minimize the overall cost to the entrepreneur.

Paul A. Copley, Jennifer J. Gaver, Kenneth M. Gaver, Simultaneous Estimation of the Supply and Demand of Differentiated Audits: Evidence from the Municipal Audit Market, Journal of Accounting Research, Vol. 33, No. 1 (Spring, 1995), pp. 137-155