Hathaiwan Vongsuwan – Hengmin Zhang Jonnell Tyler – Jose Navarrete – Kamoldis

Theamkachit

Earnings Management and the Long-Run Market Performance of Initial Public Offerings

• Initial Public Offering (IPO) - Public offering where shares of stock in a company are sold to the general public on a securities exchange for the first time• A private company transforms into a public company

• Used by companies to raise expansion capital, monetize the investments of early private investors, and to become publicly traded enterprises

• IPO’s underperform after the issue

I. Earnings Management in Initial Public Offerings

II. Sample Selection Data

III. Empirical Results

IV. Post-Issuing Activity

Introduction

• The IPO Process• Opportunities to manage earnings

• Lock up period of 180 days

• Pressure to meet earnings

• In offering prospectus, accounting reports undergo verification of GAAP compliance

• Cash flows are the ultimate bottom line for valuation

I. Earnings Management in Initial Public Offerings

• Measures of Earnings• Reported Earnings

• Cash Flows and Accruals

• Total Accruals’• Current and Long-Term

• Current• Short-term assets and Liabilities• Manipulated by:• Advancing recognition of revenues with credit

sales• Delaying recognition of expenses for bad debt• Deferring recognition of expenses when cash is

advanced to suppliers

• Long-Term• Long-Term Net Assets• Manipulated by:• Decelerating Depreciation• Decreasing deferred taxes• Realizing unusual gains

Earnings Management in Initial Public Offerings (Cont.)

• Measures of Earnings• Appropriate and Necessary Accruals• Fixed-asset intensive firms• High Depreciation

• Rapidly Growing Firms• Revenues exceed cash sales

• Cross Sectional Regression• Current accruals are regressed• Performed each fiscal year

• Post-IPO stock return underperformance• Earnings management create an over valuation of an IPO

• Negative returns would not be observed if market was fully efficient

• No discount for earnings management

• Management manipulation of accruals

Stock Prices and Earnings Management

II. Sample Selection & DataInitial Samples of domestic U.S (IPO’s) consist of:

• 1980 – 1984: 1,974 IPO’s

• 1985 – 1992: 3,197 IPO’s

For inclusion in Final Sample, IPO’s must have:

a. Available COMPUSTAT financial data

b. CRSP stock return data

c. Offer price exceeding $1.00

d. Market capitalization of at least 20 million

Final Sample size: 1,649 IPO’s

II. Sample Selection & Data cont…

Fiscal Year -1: ends before the date of the IPOFiscal Year 0: the IPO occurs (includes both pre and post IPO information, financial statements taken from year 0 as well

II. Sample Selection & Data cont…Sample Characteristics: SIC Distribution

II. Sample Selection & Data cont…Sample Characteristics: Time Distribution

II. Sample Selection & DataSample Characteristics: Post-IPO characteristics

III. Empirical Results• Key objective: managed accruals have an influence on the

long-run abnormal stock return performance of IPO firms

• All tests indicate that discretionary current accruals reliably predict post-IPO returns

III. Empirical Results• Distribution of Stock Returns by DCA Quartile

• Event-Time Cross-Sectional Regressions

• Time-Series Regressions Using Book-to-Market and Market Capitalization Adjusted Returns

• Fama-MacBeth Panel Regression

A. Distribution of Stock Returns by DCA Quartile • DCA： Discretionary Current Accruals

• Inferences on the magnitude of IPO long-run underperformance are sensitive to the abnormal return computation

• More conservative firms outperform more aggressive firms by a margin that is economically significant

B. Event-Time Cross-Sectional Regressions• Add four accrual variables to the regression to examine the

incremental influence of the accrual variables on post-issue stock return underperformance

• Only the DCA variable is consistently robust across a variety of alternative regression specifications

C. Time-Series Regressions Using Book-to-Market and Market Capitalization Adjusted Returns

• Aggressive IPOs have statistically significantly poorer post-issue performance than conservative IPOs

D. Fama-MacBeth Panel Regression • It is incrementally important during an initial public offering

for the earnings management variable to explain post-IPO long-run performance

• Aggressive Earnings Management Leads to Poorer after-market performance

Post-Issuing Activity

Conclusion

• Discretionary current accruals (DCA) (proxy for earnings management) are high around the IPO

• Issuers with higher (DCA) have poorer stock returns• Aggressive firms, on average, 15-30% worst performance than

conservative firms• Conservative firms, seasoned equity offering 20% more

frequently

Long-run post-IPO return underperformance

IPO firms’ earnings management

ConclusionImplications

• Investors: should look at pre-offering accounting accruals to discriminate amongst issuers

• Entrepreneurs: legitimate accounting choices can lower firm’s cost of equity capital

• Accounting standard setters: results may be useful for evaluating the amount of discretion you give corporate managers

The end