When And Why Do IPO Firms Manage Earnings?
University of Colorado at Boulder – Department of Accounting
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University of Arizona – Eller College of Management
Massachusetts Institute of Technology (MIT) – Sloan School of Management
December 8, 2015
We provide new evidence on the timing and motives behind earnings management by IPO firms. The period around IPOs is characterized by two distinct events: the IPO itself and the lockup expiration. Both the raising of capital at the time of the IPO and the large-scale exit by pre-IPO shareholders at lockup expiration approximately 180 days later create incentives for firms to engage in earnings management. To disentangle the effect of these two events, we examine quarterly, rather than annual, abnormal accruals. We find no evidence of income- increasing earnings management in anticipation of the IPO. However, IPO firms exhibit positive abnormal accruals in the quarter before and the quarter of the lockup expiration. We demonstrate that positive abnormal accruals are concentrated in firms for which we predict intense selling by pre-IPO shareholders at lockup expiration. We also confirm the findings of Teoh, Welch and Wong (1998) that positive abnormal accruals are associated with long-run IPO underperformance.
When And Why Do IPO Firms Manage Earnings? – Introduction
Initial public offerings (IPOs) are characterized by the inflow of significant capital. Approximately six months after the IPO, there is large-scale exit of pre-IPO shareholders when firm-imposed selling restrictions, known as lockups, expire.1 IPOs also entail high levels of information asymmetry between new investors and IPO firm insiders (i.e., management and pre-IPO shareholders). Thus, the quality of financial reporting is particularly important for new investors. Opportunistic reporting by the IPO firm can lead to wealth transfers from new investors when they buy shares at the IPO or from pre-IPO shareholders at lockup expiration.
Prior research examines earnings management around IPOs, with mixed results. In an influential study, Teoh, Welch and Wong (1998) document high abnormal accruals in the year firms go public and interpret their findings as evidence of earnings management intended to mislead IPO investors. Later studies (Ball and Shivakumar 2008; Armstrong, Foster and Taylor 2015) question whether IPO firms manipulate earnings and conclude that the abnormal accruals in the IPO year result from growth and economic activity after the investment of IPO proceeds in working capital. We revisit this question while addressing the empirical challenge of disentangling two distinct and important events—the IPO and the lockup expiration.
Identification of earnings management relies both on isolating the timing of incentives for the earnings management and linking the positive abnormal accruals to those incentives (Dechow, Schrand and Ge 2010). We depart from the prior literature by separately considering the incentives stemming from the two significant events that IPO firms experience within a short span of time, the IPO itself and the lockup expiration. Relatedly, we examine quarterly (rather than annual) abnormal accruals before and after the IPO. This enables us to pinpoint the timing of the earnings management. Prior studies focus mostly on annual accruals or aggregate accruals over multiple quarters. Teoh et al. (1998a and 1998b), for their part, recognize share sales by pre-IPO shareholders following lockup expiration as one of the potential incentives for firms to continue earnings management after the IPO date. However, the annual accruals from the IPO year they examine cannot be used to discern whether earnings management results from the incentives at the IPO date or those at the lockup expiration date.2 Considering the IPO and the lockup expiration separately enables us to identify which incentive drives earnings management—the desire to influence the issue price or the price at which pre-IPO shareholders sell their shares.
We conjecture that IPO firms manage earnings before lockup expiration, not before the IPO, because pre-IPO shareholders can sell or distribute their holdings only upon lockup expiration.3 Thus their gains are increased by inflating the stock price at lockup expiration, rather than at the IPO, which affects the proceeds to the offering firm. Consistent with this intuition, Ertimur, Sletten and Sunder (2014) find that pre-IPO shareholders’ selling incentives induce firms to inflate the stock price via selective voluntary disclosure ahead of lockup expiration. While managers may also have incentives to use earnings management to inflate the issue price, studies after Teoh et al. (1998a and 1998b) argue that the extensive scrutiny of financial statements reported in the prospectus discourages this (Ball and Shivakumar 2008; Venkataraman, Weber and Willenborg 2008). Indeed, these studies provide evidence that firms report conservatively in the year before going public.
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