Earnings Management and Earnings Management and Initial Public Offerings:Initial Public Offerings:

The Case of the Depository The Case of the Depository

IndustryIndustry Brian AdamsBrian Adams

Kenneth CarowKenneth Carow

Tod PerryTod Perry

Presentation Prepared for the Presentation Prepared for the FDIC Center for Financial ResearchFDIC Center for Financial ResearchWashington, DC October 25, 2006Washington, DC October 25, 2006

Earnings ManagementEarnings Management

““Earnings management occurs when Earnings management occurs when managers use judgment in financial managers use judgment in financial reporting and in structuring reporting and in structuring transactions to alter financial reports to transactions to alter financial reports to either mislead some stakeholders about either mislead some stakeholders about the underlying economic performance of the underlying economic performance of the company or to influence contractual the company or to influence contractual outcomes that depend on reported outcomes that depend on reported accounting numbers.accounting numbers.” [Healy and ” [Healy and Wahlen (1999)] Wahlen (1999)]

How mutuals differ from How mutuals differ from traditional IPOstraditional IPOs

Incentives to affect Offer PriceIncentives to affect Offer Price Traditional IPOs: Insiders are net sellers of Traditional IPOs: Insiders are net sellers of

equityequity Use of accruals to enhance earnings for non-Use of accruals to enhance earnings for non-

depositories prior to capital-raising events (such as depositories prior to capital-raising events (such as IPOs and SEOs), where insiders are net sellers of IPOs and SEOs), where insiders are net sellers of equity equity

Teoh, Welch, and Wong (1998a, 1998b), Teoh, Wong, Teoh, Welch, and Wong (1998a, 1998b), Teoh, Wong, and Rao (1998), and Erickson and Wang (1999)and Rao (1998), and Erickson and Wang (1999)

Demutualization IPOs: Insiders are net buyers Demutualization IPOs: Insiders are net buyers of equityof equity Use of accruals to reduce earnings for MBOs, where Use of accruals to reduce earnings for MBOs, where

managers are net buyers of equity.managers are net buyers of equity.

Perry and Williams (1994)Perry and Williams (1994)

How earnings affect How earnings affect Depository IPO ValuationDepository IPO Valuation

Unal (1997) Unal (1997) ““regulations require an independent

appraisal …, the guidelines include specific valuation equations that the appraisers must use to identify the offering price of the conversion.”

The three valuation equations include price to earnings (P/E) price to book (P/B) price to assets (P/A)

Studies suggestive of Studies suggestive of managing offer pricemanaging offer price

Demutualizing IPO returns in the 1980s range Demutualizing IPO returns in the 1980s range from 5 to 7 percentfrom 5 to 7 percent

Masulius (1987), Maksimovic and Unal (1993), Masulius (1987), Maksimovic and Unal (1993), Alli, Yau, and Yung (1994)Alli, Yau, and Yung (1994)

Demutualizing IPO returns in the 1990s range Demutualizing IPO returns in the 1990s range from 20 to 30 percentfrom 20 to 30 percentBarth, Brumbaugh, and Kleidon (1994), Cox and Barth, Brumbaugh, and Kleidon (1994), Cox and Roden (1999), and Carow, Cox, and Roden Roden (1999), and Carow, Cox, and Roden (forthcoming)(forthcoming)

Carow, Cox, and Roden (forthcoming) Carow, Cox, and Roden (forthcoming) Inside participation in mutuals is related to lower Inside participation in mutuals is related to lower offer size and higher initial returns. Inside offer size and higher initial returns. Inside participation is not related to long-term stock participation is not related to long-term stock returns or future operating performance.returns or future operating performance.

How depositories manage How depositories manage earningsearnings

Studies showing depositories Studies showing depositories manage LLPmanage LLP Beaver, Eger, Ryan, and Wolfson (1989), Beaver, Eger, Ryan, and Wolfson (1989),

Moyer (1990), Scholes, Wilson, and Moyer (1990), Scholes, Wilson, and Wolfson (1990), Wahlen (1994), Beatty, Wolfson (1990), Wahlen (1994), Beatty, Chamberlain, and Magliolo (1995), Chamberlain, and Magliolo (1995), Collins, Shackelford, and Wahlen Collins, Shackelford, and Wahlen (1995), Beaver and Engel (1996), Liu (1995), Beaver and Engel (1996), Liu and Ryan (1995), Liu, Ryan, and Wahlen and Ryan (1995), Liu, Ryan, and Wahlen (1997), and Karaoglu (2005) (1997), and Karaoglu (2005)

HypothesesHypotheses The level of loan loss provisions and the level The level of loan loss provisions and the level

of discretionary loan loss provisions will of discretionary loan loss provisions will increase in the year prior to the IPO for increase in the year prior to the IPO for demutualizing firms.demutualizing firms.

A similar pattern should be observed for the A similar pattern should be observed for the balance sheet account, reserves.balance sheet account, reserves.

The greater the proportion of the firm The greater the proportion of the firm purchased by insiders, the greater the purchased by insiders, the greater the incentive to manage Discretionary Loan Loss incentive to manage Discretionary Loan Loss Provisions and Discretionary Reserves. Provisions and Discretionary Reserves.

For demutualizing firms, greater levels of For demutualizing firms, greater levels of discretionary provisions and reserves will be discretionary provisions and reserves will be positively related to first-day returns.positively related to first-day returns.

SampleSample Depository Industry IPOsDepository Industry IPOs

471 Mutuals and 84 Non-mutuals going 471 Mutuals and 84 Non-mutuals going public between 1992 and 2003public between 1992 and 2003

Source: SNL DataSourceSource: SNL DataSourceSNL provides information on firm SNL provides information on firm characteristics and offering characteristics characteristics and offering characteristics for the IPO andfor the IPO andyearly balance sheet and income yearly balance sheet and income statement data on companies starting in statement data on companies starting in 19911991

Each firm must have 4 years of financial Each firm must have 4 years of financial data on ROA and LLP, including the two data on ROA and LLP, including the two years prior to, the year of and the first years prior to, the year of and the first complete fiscal year following the IPOcomplete fiscal year following the IPO

Sample Summary Sample Summary CharacteristicsCharacteristics

Non-mutual Firms Mutual Firms Diff. in Means

Variable N Mean Median N Mean Median p-value Ln( Assets) 81 12.40 12.23 462 12.03 11.92 0.01 Exchange 84 89.29% N/A 471 73.46% N/A 0.00 Core 79 12.56% 10.67% 443 19.11% 16.71% 0.00 Growth 77 29.17% 14.30% 454 8.07% 4.08% 0.00 ROA (Year Prior to IPO) 84 0.82% 0.87% 471 0.68% 0.74% 0.17 P/B 42 109.91% 119.50% 456 65.41% 66.60% 0.02 IND_P/B 84 143.55% 140.60% 471 91.55% 91.50% 0.00 Inside shares bought at offering N/A N/A 444 8.74% 7.17% N/A 1-Day Return 59 8.11% 5.55% 422 21.23% 19.73% 0.00

ROA for Depository IPOs ROA for Depository IPOs

0.40

0.50

0.60

0.70

0.80

0.90

1.00

-3 -2 -1 0 1 2Year Relative to

IPO

Non-mutual

Mutual

Per

cent

Loan Loss Loan Loss Provisions/Average Loans Provisions/Average Loans

for Depository IPOsfor Depository IPOs

0.0000

0.1000

0.2000

0.3000

0.4000

0.5000

0.6000

0.7000

-3 -2 -1 0 1 2

Year Relative to IPO

Non-mutual

Mutual

Per

cent

Loan Loss Reserves/Average Loan Loss Reserves/Average Loans for Depository IPOs Loans for Depository IPOs

0.5000

0.7000

0.9000

1.1000

1.3000

1.5000

1.7000

-3 -2 -1 0 1 2

Year Relative to IPO

Non-mutual

Mutual

Per

cent

First-Stage RegressionFirst-Stage Regression Independent

Variables

LLP/Avg. Loans

RESERVES/Avg. Loans

0.256 0.142 Intercept (10.27)*** (5.95)***

0.922 0.075 CHARGE-OFFS (77.25)*** (6.54)***

-0.087 0.816 RESERVEST-1 (-11.78)*** (115.68)***

0.037 0.064 NPA T-1 /LOANS (6.26)*** (11.25)***

0.136 0.162 ΔNPA/LOANS (14.84)*** (18.44)***

-0.002 -0.001 CORE (-5.04)*** (-2.44)***

-0.135 -0.036 THRIFT (-13.18)*** (-3.71)***

Observations 4135 4135 Adjusted R2 0.683 0.839 p-value of F-test <.0001 <.0001

Second Stage RegressionsSecond Stage RegressionsDiscretionary LLP and Discretionary LLP and

ReservesReserves Independent Variables

Discretionary Loan Loss Provisions

Discretionary Loan Loss Reserves

-0.014 -0.009 Intercept

(-3.61)*** (-2.15)** 0.041 0.010 IPO YEAR

(3.61)*** (0.91) 0.061 0.068 1 YEAR PRIOR TO IPO

(5.12)*** (6.00)*** 0.010 0.012 2 YEARS PRIOR TO IPO (0.63) (0.74) 0.034 -0.023 IPO YEAR, NON-MUTUAL (1.31) (-0.95) -0.006 -0.035 1 YEAR PRIOR TO IPO,

NON-MUTUAL (-0.22) (-1.27) -0.041 -0.023 2 YEARS PRIOR TO IPO,

NON-MUTUAL (-1.10) (-0.64) Observations 4135 4135 Adjusted R2 0.010 0.008 p-value of F-test <.0001 <.0001

Inside Purchases andInside Purchases andDiscretionary Provisions and Discretionary Provisions and

Reserves Reserves Intercept 50.094 (13.26)***

49.902 (13.20)***

Ln(Assets) -2.885 (-9.41)***

-2.875 (-9.37)***

Exchange -2.122 (-2.71)***

-2.078 (-2.65)***

Core -0.130 (-4.21)***

-0.128 (-4.15)***

Growth 0.004 (0.20)

0.008 (0.40)

ROA (Year Prior to IPO) 0.397 (0.81)

0.362 (0.74)

IND_P/B -0.031 (-4.06)***

-0.031 (-4.04)***

DLLP for mutuals 1.453 (1.35)

DRES for mutuals 0.771 (0.76)

Observations 407 407 Adjusted R2 .311 .309

p-value of F-test <.0001 <.0001

First-day Returns andFirst-day Returns andDiscretionary Provisions and Discretionary Provisions and

Reserves Reserves Intercept -52.344 (-4.71)***

-53.075 (-4.79)***

Ln(Assets) 2.728 (3.17)***

2.735 (3.18)***

Exchange -0.160 (-0.07)

-0.032 (-0.01)

Core 0.043 (0.46)

0.051 (0.55)

Growth 0.082 (1.63)

0.103 (2.11)**

ROA (Year Prior to IPO)

3.507 (2.72)***

3.537 (2.77)***

IND_P/B 0.138 (7.04)***

0.138 (7.04)***

THRIFT 24.477 (8.35)***

24.625 (8.44)***

DLLP for mutuals 6.040 (1.83)*

6.456 (2.06)**

DRES for mutuals

DLLP for Non-mutuals 5.429 (0.58)

8.698 (0.87)

DRES for Non-mutuals

Observations 447 447 Adjusted R2 .184 .187

p-value of F-test <.0001 <.0001

RobustnessRobustness

Expanding control sample Expanding control sample 3-year industry adjusted returns for 3-year industry adjusted returns for

firms after IPOfirms after IPO Gains or losses from the sale of Gains or losses from the sale of

securities securities Jones (1991) methodology used by Jones (1991) methodology used by

Cornett, McNutt, and Tehranian Cornett, McNutt, and Tehranian (2006).(2006).

ConclusionsConclusions

Managers of mutual thrifts increase Managers of mutual thrifts increase the levels of loan loss provisions and the levels of loan loss provisions and reserves in the period prior to the IPO.reserves in the period prior to the IPO.

The level of underpricing is positively The level of underpricing is positively related to the level of Discretionary related to the level of Discretionary Loan Loss Provisions and Reserves, Loan Loss Provisions and Reserves, demonstrating that investors recognize demonstrating that investors recognize the effect of earnings management on the effect of earnings management on the offer price and properly value the the offer price and properly value the firm on the first day of the offer.firm on the first day of the offer.

Implications for Implications for Appraisers, Regulators, and Appraisers, Regulators, and

InvestorsInvestors Difference in incentives for demutualizing Difference in incentives for demutualizing

thrift IPOs (as net buyers of equity) and thrift IPOs (as net buyers of equity) and traditional bank IPOs (as net sellers of equity).traditional bank IPOs (as net sellers of equity). For mutuals, “conservative” levels of loan loss For mutuals, “conservative” levels of loan loss

provisions (reserves) increase the potential for provisions (reserves) increase the potential for underpricing the IPO, which benefits insiders who underpricing the IPO, which benefits insiders who participate in the offering (opposite for traditional participate in the offering (opposite for traditional IPOs).IPOs).

Investors should evaluate the level of loan loss Investors should evaluate the level of loan loss provisions and reserves to determine the provisions and reserves to determine the proper pricing of the IPOs. Our evidence proper pricing of the IPOs. Our evidence suggests that investors are currently doing suggests that investors are currently doing this.this.