A Comparative Analysis of Real and Accrual Earnings Management around Initial Public Offerings under Different Regulatory Environments

While earnings management around IPOs has been researched in a number of settings, there has been a relative absence of work that analyses the impact of the regulatory environment on such activities. We find that the regulatory environment does impact the real and accrual earnings management activities of IPO firms. Our results show that IPO firms listing on the lightly regulated UK Alternative Investment Market (AIM) have higher (lower) levels of accrual‐based and sales‐based (discretionary expenses‐based) earnings management around the IPO than firms listing on the more heavily regulated Main market in the UK.     

Earnings management in IPOs: Post-engagement third-party mitigation or issuer signaling?

Initial public offering (IPO) firms typically hire auditors, underwriters, and attorneys to assist in the IPO process. Many firms that take the IPO route are also backed by venture capitalists. In the extant literature, these four specialists (auditors, underwriters, attorneys, and venture capitalists) are termed third-party certifiers. In this study, we examine 3900 IPOs from 1985 to 2005 and document a significant negative and robust correlation between IPO firm earnings management and the presence of prestigious third-party certifiers. Next, we test if this correlation is driven by (1) IPO firms attempting to signal firm quality or (2) third-party certifiers mitigating earnings management in the issuing firm. Using a two-stage multivariate model, we find empirical support for the signaling hypothesis — IPO firms self-select prestigious certifiers for IPOs. We do not find support for post-engagement mitigation hypothesis — after engagement, third-party certifiers do not significantly impact earnings management in IPOs.     

Internal control weaknesses and evidence of real activities manipulation

We examine whether US public firms that file internal control weakness (ICW) disclosure reports with the Securities and Exchange Commission, as part of the reporting requirements under Section 404 of the Sarbanes–Oxley (SOX) Act, exhibit higher levels of real activities manipulation (RM), compared to firms that do not file such reports. Using firm-level data for the post-SOX period, 2004–2010, we find a positive relationship between firms reporting internal control weaknesses and real activities manipulation. Further, those ICW-firms that use RM to beat earnings benchmarks have lower performance in the subsequent year. Our results also show that firms do not use discretionary accruals as a substitute for RM when they report internal control weaknesses. Overall, our findings suggest that ICW-firms are prone to using real activities manipulation as a form of earnings management. Our findings also have implications for audit quality as auditors need to gain a better understanding of how real activities manipulation influences the operations of the firm.     

Earnings management and initial public offerings: Evidence from the Netherlands

This paper presents one of the first studies of earnings management by initial public offering (IPO) firms in a European country. Using a sample of 64 Dutch IPOs, we investigate the pattern of discretionary current accruals (DCA) over time. We find that managers manage their company's earnings in the first year as a public company but not in the years before the IPO. We also examine the impact of earnings management on the long-run stock price performance of IPOs. We find a negative relation between the size of the DCA in the first year as a public company and long-run stock price performance over the next 3 years. A number of additional tests support these findings.     

Underwriter reputation,earnings management and the long‐run performance of initial public offerings

This study contributes to the extant literature on the nature of earnings management surrounding initial public offerings (IPOs) by investigating the role of underwriter reputation. We argue that prestigious underwriters will protect their reputation by carefully monitoring and certifying financial information on IPO firms, thereby limiting any potential earnings manipulation. As a result, those IPO firms that are associated with more prestigious underwriters are likely to exhibit substantially less‐aggressive earnings management. Conversely, we find the existence of a negative relationship between earnings management and the post‐offer performance of an IPO firm’s stocks only for those firms associated with less‐prestigious underwriters.     

Earnings management in the pre-IPO process: Biases and predictors

We analyze a sample of 3,293 IPOs from 29 countries to investigate the firm, industry, and country characteristics related to earnings management during the IPO process. We find that IPO firms tend to have significantly positive discretionary accruals (DCA) both prior to and after the IPO, suggesting that IPO firms tend to engage in pre-IPO earnings management. However, we also find that using a proxy for earnings management in the IPO year may lead to biased conclusions concerning pre-IPO earnings management. Firms that are more likely to need access to capital markets in the future (firms with high leverage, and firms backed by a venture capitalist) are less likely to engage in pre-IPO earnings management. Firms operating in countries with a superior rule of law are also less likely to engage in earnings management. Lastly, we find that firms may engage in pre-IPO earnings management in part to avoid returning to the capital markets to raise more funds (capital market staging). This result is robust to possible endogeneity bias stemming from management self-selection.     

Forecasts in IPO Prospectuses: The Effect of Corporate Governance on Earnings Management

Prior research suggests that managers may use earnings management to meet voluntary earnings forecasts. We document the extent of earnings management undertaken within Canadian Initial Public Offerings (IPOs) and study the extent to which companies with better corporate governance systems are less likely to use earnings management to achieve their earnings forecasts. In addition, we test other factors that differentiate forecasting from non‐forecasting firms, and assess the impact of forecasting and corporate governance on future cash flow prediction. We find that firms with better corporate governance are less likely to include a voluntary earnings forecast in their IPO prospectus. In addition, we find that while IPO firms use accruals management to meet forecasts; the informativeness of the discretionary accruals depends on whether or not the firm would have missed its forecast without the use of discretionary accruals.     

Predicting Subsequent Management Forecasting Behavior at the Date of an Initial Public Offering

In this study, we examine the conditions and choices of firms at dates of initial public offerings (IPOs) as a basis for predicting their likelihood of management earnings forecast disclosure in post-IPO periods. Using a sample of 944 IPOs, we demonstrate that firms choosing to reduce IPO information asymmetries or signal issue quality by choosing prestigious underwriters, high quality auditors, and higher percentages of retained ownership tend to issue management forecasts in the post-IPO period. These relationships exist after controlling for IPO date measures of risk/stability, a construct that prior management forecast research has found to be a key determinant of the forecasting act.     

Does pedigree matter? Earnings quality of U.S. listed domestic firms via reverse mergers

This paper examines earnings quality of U.S. domestic firms that access capital markets via a reverse merger transaction (RM firms) compared to those via the more traditional initial public offering (IPO firms) during the period from 1997 to 2011. In order to mitigate confounding effects of legal regime, law enforcement, and culture, we require both the acquiring and target firms to be incorporated and headquartered in the U.S. to be included in our sample. We also use the Heckman (1976) procedure to control for self-selection bias. To capture earnings quality, we use a battery of measures established in prior literature, including discretionary accruals, discretionary revenues, real activities earnings management, and accrual estimation errors. Our measures have both convergent and discriminant validity and therefore appear to capture earnings quality fairly well. We find consistent evidence that U.S. domestic RM firms have lower earnings quality compared with U.S. IPO firms. Our evidence suggests that investors and other stakeholders should take into account the fact and consequences of the method that firms use to access capital markets in their investment decision making process.     

Evaluating the effect of industry specialist duration on earnings management

This study examines whether auditor industry specialist duration (i.e., the cumulative number of years an audit firm can be deemed an industry specialist) affects earnings management. Using a sample of 17,546 observations during the period of 2006 to 2014, we find that audits performed by firms with longer industry specialist durations are associated with lower levels of earnings management, as proxied by the absolute value of discretionary accruals. This finding enhances the industry specialization literature by showing that, in the long run, specialist auditors constrain the accrual management activities of their clients. However, we also find that audits performed by firms with longer industry specialist durations are associated with greater levels of real earnings management. In turn, this is consistent with real earnings management surfacing as an unintended consequence of specialist auditors being able to better constrain the accrual management activities of their clients (Chi, Lisic, & Pevzner, 2011).     

Auditor choice and accruals patterns of cross-listed firms

We examine the association between auditor choice and the accruals patterns of Chinese listed firms that cross-list in Hong Kong. Our evidence suggests that the clients of Big 4 auditors report lower unsigned discretionary accruals relative to the clients of non-Big 4 auditors. Further, we find that cross-listed firms with non-Big 4 auditors are more likely to understate their earnings and experience larger reversals of accruals in the future than cross-listed firms with Big 4 auditors. These findings suggest that Big 4 auditors play a meaningful role in improving earnings quality for cross-listed firms, which helps to explain why cross-listed firms have higher earnings quality than their domestic counterparts, as documented in the previous literature.     

Does audit quality matter more for firms with high investment opportunities?

This paper examines the association of firms with high investment opportunities with high quality audits (proxied by Big 5 auditors) and whether that association results in a lower likelihood of earnings management. Firms with high investment opportunities may demand high quality audits for curbing earnings management. This is because they have more flexibility in the provision of discretionary accruals that arises from the attendant operating uncertainty which creates particular monitoring problems. Big 5 auditors will provide high quality audits that will constrain earnings management for firms with high investment opportunities because the risk of losing (and hence the likelihood of maintaining) auditor independence is higher. Results show the following. First, firms with high investment opportunities are more likely to hire Big 5 auditors than firms with low investment opportunities. Second, firms with high investment opportunities are more likely to have more discretionary accruals but this relationship is weaker when they have Big 5 auditors. These results are robust to various sensitivity tests.     

Overvaluation and earnings management: Does the degree of overvaluation matter?

We examine whether the choice of earnings management strategies employed by managers of overvalued firms depends on the degree of market overvaluation. By distinguishing between substantially overvalued (SOV) and relatively overvalued (ROV) firms, we find that SOV firms significantly inflate earnings using both accruals-based and real earnings management. In contrast, managers of ROV firms do not engage in accruals-based earnings management and their firms’ accounts tend to report higher discretionary expenses. The reported higher discretionary expenses of ROV firms are comparable to the discretionary expenses of firms in the expanding stage of their business life cycle, a pattern consistent with ROV firms increasing discretionary expenses to finance growth and hence justify the high market valuation. Overall, we show that the existing evidence on income-increasing earnings management by overvalued firms is mainly driven by the pressure to sustain the high market valuation of firms that are substantially overvalued.     

Do firms change earnings management behavior after receiving financial forecast warnings?

This study investigates whether government-issued financial forecast warnings are associated with earnings management in Taiwan. In particular, we examine whether firms receiving warnings use different earnings management tools than firms without warnings. We find that firms that were warned prefer to use real activities manipulation than accrual-based earnings management to avoid potential litigation and penalties. In addition, we document that firms receiving warnings employed both accrual-based and real activities earnings management especially through over-production in response to the regulatory change from mandatory to voluntary disclosure in 2005. Our results suggest that while the government warning mechanism might constrain the forecasting firms from using accrual-based earnings management, the adoption of voluntary financial forecast disclosure did not necessarily prevent them from engaging in accrual-based manipulation.     

An empirical study of the effect of venture capital participation on the accounting information quality of IPO firms

Using a sample of IPO companies on the Shenzhen Small and Median Enterprise Board and the ChiNext Stock Market between 2005 and 2009, this paper analyzes the effect of venture capital participation on accounting information quality. We find that venture capitalists have a significant effect on earnings management, with reduced discretionary accruals before the expiration of the equity lock-up period and enhanced discretionary accruals after the expiration of the equity lock-up period. Our findings support the moral hazard hypothesis of venture capital, but not the certification/monitoring role of venture capital in IPOs. In addition, we find that venture capital plays a more important role in the earnings management of non-state-owned IPO companies than of state-owned companies.     

The impact of abnormal real earnings management to meet earnings benchmarks on future operating performance

Motivated by agency conflicts of real earnings management (e.g., opportunistic and signalling perspectives), this study investigates the association between firms that manipulate their business operations to meet earnings benchmarks (i.e., zero earnings, last year's earnings) and subsequent operating performance. We examine the effects of the magnitude of real earnings management on firms' future performance for the period 2009 to 2015 for UK firms. Our analysis shows that the manipulation of operating activities such as sales, discretionary expenditures, and production costs to meet earnings benchmarks has a significantly positive consequence for firms' subsequent operating performance and signals firms' good future performance. We also find that firms that manipulate their operating activities in the absence of meeting earnings benchmarks experience a decline in their subsequent operating performance. The findings of this research lend support to our understanding of the process that management follows to evaluate costs and benefits of real earnings management.     

The Effect of IPO Risks on Auditors’ Decisions: Auditor Designation Case

This study examines the effect of audit risks in the Korean initial public offering (IPO) market on the designated auditors’ decisions. The Korean External Audit Act requires firms to switch from incumbent to new auditors designated by the Securities and Futures Commission after the firm announces a future IPO. This study shows the effects of audit risks by examining if the quality of reported earnings and audit fees significantly differs between IPO‐eligible and IPO‐ineligible firms. Empirical tests first show that discretionary accruals are significantly lower for IPO‐ineligible firms than for IPO‐eligible firms in both the IPO designation period and the following review period. We interpret this result to mean that designated auditors evaluate the IPO‐ineligible (and eventually failed) firms’ listing possibility as low. Second, audit fees are higher for IPO‐ineligible firms in the auditor designation period. This reflects the fact that designated auditors are exposed to future audit risks associated with firms’ post‐IPO financial market troubles if IPO‐ineligible firms attempt to go public. Our study contributes to IPO‐related research by showing the effects of auditors’ risk evaluation on discretionary accruals and audit fees. This study also contributes to accounting policymaking regarding auditor independence.     

Earnings management in Malaysian IPOs: The East Asian crisis, ownership control, and post-IPO performance

We find evidence of income-increasing earnings management in Malaysian IPOs, which occurs primarily for IPOs during a period of severe economic stress (the East Asian crisis). Within the high-ownership-concentration Malaysian market, post-IPO control concerns also appear to constrain IPO earnings management: owners seem willing to accept reduced IPO proceeds and signaling opportunities to increase the likelihood of retaining control of the company post-IPO. The requirement to provide a profit guarantee does not seem to greatly affect earnings management. IPO companies engaging in aggressive income-increasing earnings management have significantly worse market-based performance than their more conservative counterparts, but again only for IPOs issued during the economic crisis period. Overall, the results suggest that personal liquidity concerns are an important factor in IPO decisions during the economic crisis.     

Earnings management and initial public offerings: The case of the depository industry

In a typical IPO, insiders are “net sellers” of IPO shares; however, in a demutualizing thrift, insiders are “net buyers” of IPO shares. Using a sample of mutual depository IPOs, we find evidence consistent with earnings management prior to the conversion of mutual thrifts. We find on average that mutuals report lower ROA and increased loan loss provisions and loan loss reserves in the period prior to the demutualization. Using a two-stage approach, we also find that the level of discretionary loan loss provisions and discretionary reserves are positively related to both the level of insider participation in the IPO and the first-day returns to investors. Our results are consistent with management of mutual thrifts benefiting at the conversion from reduced pre-IPO earnings and book equity resulting from earnings management.     

Regulations,earnings management,and post-IPO performance: The Chinese evidence

In this study, we examine whether government regulatory initiatives in China involving IPO by SOEs may have contributed to opportunistic behaviors by the issuer. We focus on two sets of IPO regulations issued between January 1, 1996 and February 11, 1999: pricing regulations, which stipulate that IPO prices be a function of accounting performance, and penalty regulations, which penalize IPO firms for overly optimistic forecasts. We find that IPO firms that report better pricing-period accounting performance have larger declines in post-IPO profitability, lower first-day stock returns and worse long-run post-IPO stock performance. Furthermore, IPO firms that make overoptimistic forecasts also have lower first-day returns and worse post-IPO stock performance. Using non-core earnings as the proxy for earnings management, we document some evidence that IPO firms that report higher pricing-period accounting performance have engaged in more income-increasing earnings management. Hence, pricing regulations may have induced IPO firms to inflate pricing-period earnings and affect the post-IPO performance negatively. On the other hand, penalty regulations have deterred IPO firms from making overoptimistic earnings forecast and therefore have a positive impact on the behavior of IPO firms.