Earnings Management Prior to Initial Public Offerings: Evidence from Secondary Share Data

Introduction Since Ritter (1991) first documented the long-run underperformance of initial public offering (IPO) firms, the cause of this anomaly has been debated. Ritter (1991), Lemer (1994), Loughran and Ritter (1995 and 2000), and Baker and Wurgler (2000) offer theories based on asymmetric information. They suggest that managers take advantage of asymmetric information by issuing stock when it is overvalued, leading to negative abnormal returns as the market corrects the mispricing. Fama (1998) and Eckbo and Norli (2004) disagree. They offer rational explanations based on omitted risk factors and methodological issues. Teoh, Welch, and Wong (1998a), and Teoh, Wong, and Rao (1998) extend the asymmetric information argument, adding an earnings management component. They suggest that firms may not only take advantage of mispricing by issuing stock when it is overvalued, but also may contribute to or induce mispricing by manipulating earnings prior to a stock issue. In this paper, I use primary and secondary share data to further examine the earnings management theory for underperformance. Specifically, I compare the performance-matched discretionary accruals and abnormal stock performance of firms issuing only primary shares with those of firms that issue a combination of primary and secondary (or all secondary) shares. I then use regression analysis to determine if the presence of secondary shares explains the level of discretionary accruals, and to examine how these variables impact the abnormal stock performance following the IPO. Consistent with the liability avoidance theory, I find evidence that firms issuing only primary shares manage earnings upwards, while firms issuing secondary shares do not manage earnings upwards or manage earnings downwards. In addition, I find that the abnormal stock performance of these groups is consistent with the hypothesis that earnings management contributes to the underperformance of IPO firms. Related Literature Ritter (1991) first documented the long-run underperformance of initial public offerings. He found that IPO firms underperformed non-issuing firms, matched by size and industry, by an average of 27 percent over the three years following the issue. Loughran and Ritter (1995) found similar underperformance for both IPO and SEO firms. This underperformance following IPOs and SEOs has become known as the new issues puzzle. (1) Since these initial studies, several studies have shed more light on the issue. The majority of the literature in this area examines possible explanations of this anomaly, and these explanations have become the subject of much research and debate. The debate centers on whether a market inefficiency exists. One potential inefficiency explanation is discussed by Ritter (1991), Lerner (1994), Loughran and Ritter (1995 and 2000), and Baker and Wurgler (2000). They suggest that managers take advantage of asymmetric information by issuing stock when their firms' stock specifically or equities in general are overvalued. As the true value of the firm is revealed through time, the stock price corrects, resulting in underperformance. Rangan (1998), Teoh, Welch, and Wong (1998a and 1998b), and Teoh, Wong, and Rao (1998) extend this idea. They suggest that some firms may manage earnings upwards to induce mispricing. The incentive for doing so is clear. Higher earnings produce higher stock prices, and higher stock prices produce greater proceeds from the stock issue with less dilution of earnings and control. To test this hypothesis for IPO firms, Teoh, Welch and Wong (1998a) divide their IPO sample into quartiles based on discretionary accruals (their proxy for earnings management) and examine the abnormal returns across the quartiles. Consistent with this hypothesis, they find firms in the lowest quartile (those with the lowest levels of earnings management as proxied by discretionary accruals) significantly outperform those firms in the highest quartile (high earnings management firms) by about 20 percent over the three years following the issue. …