Conservatism And International IPO Underpricing by SSRN
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Indiana University – Kelley School of Business – Department of Finance
Chad J. Zutter
University of Pittsburgh – Finance Group
May 26, 2015
We study the impact of country-level accounting conservatism on IPO underpricing. Examining 10,103 IPOs from 36 countries, we find that the timely incorporation of news into earnings, both good and bad, is negatively correlated with underpricing. Most notably, IPOs are underpriced less in countries where the incremental speed of bad news recognition relative to good news recognition (i.e., conservatism) is greater. These findings indicate that conservatism is an efficient contracting mechanism that constrains managerial opportunism and reduces bias in accounting measures leading to a reduction in information asymmetry and, therefore, a reduction in IPO underpricing. Additionally, we find that the relation between conservatism and underpricing is stronger in countries that promote the rule of law, which suggests that conservatism helps mitigate the need to underprice to insure against future liability.
Conservatism and International IPO Underpricing – Introduction
In general, accounting conservatism leads to accelerating the recognition of economic losses, bad news, and delaying the recognition of economic gains, good news. Although prior research suggests that conservatism is an efficient contracting mechanism that constrains managerial opportunism and reduces bias in accounting measures leading to a reduction in information asymmetry, the Financial Accounting Standards Board (FASB) has consistently expressed opposition to conservatism, on the grounds that the disclosure of financial information should be neutral.1 Presumably, FASB believes that conservatism results in biased financial statements and greater information asymmetry. Despite FASB’s opposition, academic research finds that conservatism is pervasive (e.g., Basu, 1997; Ball, Kothari, and Robin, 2000; Watts, 2003b) and associated with more efficient financial market outcomes (e.g., Ahmed, Billings, Morton, and Stanford, 2002; Kim, Li, Pan, and Zuo, 2013; LaFond and Watts, 2008). In this paper we examine the role country-level accounting conservatism plays in explaining IPO underpricing. Ljungqvist (2007) notes that within the expanse of literature no explanation for IPO underpricing receives more support than information asymmetry, so to the extent that conservatism determines the level of information asymmetry between the firm and its investors, we expect country-level conservatism to be a valuable explanatory variable for international IPO underpricing.
LaFond and Watts (2008) argue that by reducing a managers’ incentives and their ability to manipulate and overstate their firm’s financial performance, conservatism results in less information asymmetry between the manager and outside investors. This suggests that IPOs are an ideal setting for studying conservatism given the impact of information asymmetries on IPO outcomes. For example, underpricing, which refers to the initial return experienced on an IPO’s first trading day, is often attributed to information asymmetry. Prior research suggests that underpricing is a response to information disparities between (i) issuers and investment banks (Baron, 1992), (ii) issuers and investors (Welch, 1989), and (iii) different investor groups (Rock, 1986). We investigate whether some of the cross-country IPO underpricing variation documented in the literature and shown in Figure 1 may be explained by differences in country-level accounting conservatism.
We test our hypothesis using a sample of 10,103 IPOs issued in 36 countries from 1998 to 2008. Our measure of conservatism is motivated by Basu (1997), which calculates the sensitivity of reported earnings to stock market returns. If conservatism means that firms’ financial statements report the effects of unfavorable events more quickly than the effects of favorable events (e.g., if firms quickly report asset impairments in response to bad news, but are slower to report asset gains in response to good news), then we should see a stronger correlation between reported earnings and stock returns when those returns are negative than when they are positive. Suppose that a firm receives favorable information about the value of an asset that it owns, and suppose that some or all of that information is publicly available. The firm’s stock return will be higher as a result of this news, but conservatism means that the positive effect on earnings of the asset’s increased value will be spread out over time. However, if the firm receives bad news (and again, some or all of this information is public), the firm’s stock return will be lower, and conservatism means that the loss in value will be reported quickly. Thus, earnings and returns exhibit a stronger correlation in response to bad news. Consistent with this notion of conservatism, Basu (1997) finds that the sensitivity of earnings to negative returns tends to be substantially greater than the sensitivity of earnings to positive returns among U.S. firms. Subsequent research, including Ball, Kothari, and Robin (2000) and Bushman and Piotroski (2006), extends the study of conservatism to international markets and documents substantial differences in conservatism across countries.
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