Earnings Management And The Long-Run Market Performance Of IPOs via CSInvesting
Siew Hong Teoh, Ivo Welch, And T. J. Wong
Abstract
Issuers of initial public offerings (IPOs) can report earnings in excess of cash flows by taking positive accruals. This paper provides evidence that issuers with unusually high accruals in the IPO year experience poor stock return performance in the three years thereafter. IPO issuers in the most “aggressive” quartile of earnings managers have a three-year aftermarket stock return of approximately 20 percent less than IPO issuers in the most “conservative” quartile. They also issue about 20 percent fewer seasoned equity offerings. These differences are statistically and economically significant in a variety of specifications.
Earnings Management And The Long-Run Market Performance Of IPOs – Introduction
Several studies find that initial public offerings (IPOs) underperform after the issue.1 Over a three-year holding period after the offering, Ritter (1991) reports substantially lower stock returns ~mean of 227 percent and median of 255 percent! for a sample of 1,526 IPOs going public between 1975 and 1984 than for a size- and industry-matched sample of seasoned firms. Ritter conjectures that “investors are periodically overoptimistic about the earnings potential of young growth companies.”
Our paper explores a possible source for this overoptimism. Issuers can report unusually high earnings by adopting discretionary accounting accrual adjustments that raise reported earnings relative to actual cash f lows. If buyers are guided by earnings but are unaware that earnings are inflated by the generous use of accruals, they could pay too high a price. As information about the firm is revealed over time by the media, analysts’ reports, and subsequent financial statements, investors may recognize that earnings are not maintaining momentum, and the investors may thus lose their optimism. Other things equal, the greater the earnings management at the time of the offering, the larger the ultimate price correction. Therefore, our study examines whether discretionary accruals predict the cross-sectional variation in post-IPO long-run stock return performance.
Our accruals variable is reported in the fiscal year when the firm goes public, which includes both pre-IPO and post-IPO months; thus, we only predict stock returns several months after this financial reporting date. The lack of readily available machine-accessible data precludes us from doing a large sample study using strictly pre-IPO data to measure earnings management.2 Because the incentives to manage earnings are likely to persist in the months immediately after the offering, we use accruals data from the first public financial statement, which includes both pre- and post-IPO months, to measure our earnings management proxy. As described in Section II, entrepreneurs usually cannot dispose of their personal holdings until at least several months after the IPO. Furthermore, firms face unusual legal and possibly reputational scrutiny in the IPO aftermath. Immediate accounting reversals may render earnings management activities transparent enough to trigger lawsuits against the firm and its management. Thus, issuers who aggressively manage their pre-IPO earnings probably also manage their first post-IPO earnings.
We relate the accruals from the first fiscal year financial statements of the IPO firm to the stock market performance from three to six months after the fiscal year end ~which allows investors in the market to implement our strategy!. We focus on IPO firms’ current working capital accruals that are unusual when compared to industry peers ~termed “discretionary”!. We find that these discretionary current accruals are good predictors of subsequent three-year stock return performance in a wide variety of specifications. Depending on benchmark specification, IPO firms that are ranked in the highest quartile based on IPO-year discretionary current accruals (“aggressive” IPOs) earn a cumulative abnormal return of approximately 20 to 30 percent less than the cumulative abnormal return of IPO firms ranked in the lowest quartile (“conservative” IPOs). The equivalent buy-and-hold return differential between the aggressive and conservative quartiles is 15 to 30 percent.
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