Do more reputable financial institutions reduce earnings management by IPO issuers?☆
Introduction
The pricing of initial public offerings (IPOs) is a particularly challenging process since prior to going public, there is no public market in the stock and only a few sources of financial information are available to help investors evaluate prior firm performance. Thus, investors must rely heavily on information in IPO prospectuses, which typically include only two years of annual and quarterly financial statements. This accounting information is very influential because underwriters as a standard practice use industry price-earnings ratios and issuers' current earnings to help set IPO offer prices, while financial analysts base their investment recommendations on the earnings reports of newly public firms. This has periodically raised serious concerns since issuers have considerable discretion in meeting their financial reporting requirements. Thus, managers in privately owned firms often are able to make accounting decisions that raise their reported earnings, which is commonly termed earnings management (EM). Reporting favorable earnings information not only can raise IPO offer prices, but it has the added benefits of increasing the probability of IPO completion and the number of shares sold. Thus, managers in privately owned firms can often realize significant short term benefits by managing earnings around IPOs.
IPO issuers are frequently associated with two specialized financial intermediaries (FIs) prior to going public, namely investment banks (IBs) that act as IPO underwriters and venture capital (VC) firms that act as important private equity investors. These FIs also act as advisors to issuers and exert a strong influence over firms' going public decisions. IBs undertake in-depth due diligence investigations of firms planning to go public and can choose to withdraw their services up to the time of the IPO. VCs are major equityholders prior to the IPO and generally hold control rights that are disproportionally large relative to their shareholdings and are very frequent on the IPO firm's board of directors. These influential FIs are in a position to restrain or encourage EM by IPO issuers and have strong incentives not to be indifferent to this activity as explained in the next section. IBs and VCs also often have pre-existing relationships, which complicate analysis of their individual influences on IPO firms. However, there is currently little in the way of convincing evidence about the impacts of these two important FIs on issuer EM. Thus, one of our major objectives is to explore the extent to which the reputations of individual FIs influence an IPO issuer's EM.
It is well known that accounting earnings are a closely followed firm performance measure that is a major source of information for investors and industry analysts and is widely used in debt covenants and managerial compensation and performance evaluation. Graham et al. (2005) survey more than 400 executives and find that financial officers view earnings, not cash flows, as the most important metric reported to outsiders. Accounting earnings are often used as a critical element in IPO share valuation (Dechow et al., 1998, Liu et al., 2002). Therefore, securities regulation and auditing standards place some clear limits on issuer discretion over their financial reports. Before going public, a company must be audited by an independent accounting firm to verify compliance with generally accepted accounting principles (GAAP). Furthermore, deliberately reporting false and/or misleading accounting information can result in shareholder lawsuits and SEC regulatory and criminal actions against the issuing company and its officers.2 However, these penalties are imperfect deterrents against EM since GAAP accounting permits considerable discretion in timing the recognition of revenues and expenses, which affect a firm's reported earnings through its level of discretionary accruals. More seriously, detection of clear misstatements through audits of financial statements is a very imperfect science.3 In this context, many studies show that accruals reported by IPO issuers are especially vulnerable to manipulation and thus, provide a useful measure of the significance of agency conflicts between managers and investors.
It is not surprising that earnings and its manipulation have elicited extensive academic investigation. Several studies report evidence that IPO issuers frequently manage earnings to increase offer prices when they go public. For example, Teoh et al., 1998a, Teoh et al., 1998b report that IPO firms raise earnings by adopting more income increasing depreciation policies and allocating smaller reserves for uncollectible receivables than their matched non-issuer firms. Teoh et al. (1998a) examine the relation between EM and the long-run IPO issuer performance and present evidence that issuers with high accruals in the IPO year exhibit weaker long-run stock return performance. This body of evidence finds that issuers artificially raise earnings through higher short term accruals, which ultimately are reversed. Evidence on the importance of EM is also found in several other recent studies examining its relationship to seasoned common stock offers (DuCharme et al., 2004, Teoh et al., 1998a), reverse leverage buyouts (Chou et al., 2006), M&A transactions (Erickson and Wang, 1999, Gong et al., 2008a, Gong et al., 2008b, Louis, 2004), corporate governance mechanisms (Beasley, 1996, Cornett et al., 2008, Klein, 2002, Warfield et al., 1995), equity flotation costs (Lee and Masulis, 2009), and IPOs (Morsfield and Tan, 2006).
In this study, we examine the importance of VC and IB reputations in restraining earnings overstatements by IPO issuers, since it is well known that IPO outcomes can be affected by the reputations of both VCs and IBs. Given the long standing relationships that these two FIs often have, it is particularly important to simultaneously examine their effects on EM. In this study, we jointly analyze the relationships of VC and IB to EM by positing three hypotheses about the roles of these two FIs on IPO issuer EM, which we discuss in Section 2.
Since EM studies investigate non-random samples, it is necessary to construct an adequate control sample for comparison purposes, so as to avoid bias in estimating treatment effects. To address this concern, Kothari et al. (2005) develop a performance-matched discretionary accruals procedure, where performance matching is based on a firm's ROA and industry membership. However, this omits other potentially important factors that need to be matched in constructing an adequate control sample, which more recent research has uncovered. We extend the analysis of Kothari et al. (2005) to facilitate the construction of a matched sample based on a number of firm characteristics that prior studies find affect EM. 4 We employ propensity score matching (PSM) as an attractive method to efficiently match on multiple dimensions in evaluating the treatment effects of VCs and IBs. Moreover, the PSM methodology can address the potential endogeneity problems associated with VC investment and IB underwriting decisions, which we discuss in Section 5.
To preview our major findings, more reputable IBs are associated with IPO issuers exhibiting less EM, even after controlling for VC-backing, VC reputation, and issuer and IB matching. VC-backed issuers are associated with less EM, but not after we control for IB reputation. Moreover, the inhibiting effect of VC investors on EM is also lost when the endogeneity of VC-backing is taken into account. However, once VC firms are categorized by reputation, we find that more reputable VCs are associated with significantly less EM, even after controlling for IB reputation and the endogeneity of VC backing. Furthermore, the reduction in EM is most pronounced when more reputable VCs are matched with more reputable IBs. These two results continue to hold after adjustments for endogeneity.
The rest of this paper is organized as follows. In Section 2, the hypotheses are developed and a literature review is presented. Data sources and sample characteristics are discussed in Section 3. Section 4 then describes the methods used to measure EM and presents empirical results based on regression analysis. In Section 5, we explore the robustness of our results and address the issue of endogeneity of VC investment criteria and issuer–underwriter matching, and develop and test a treatment model based on PSM. Finally, Section 6 discusses our conclusions and contributions.
Section snippets
Investment bank reputation hypothesis
We begin with an analysis of the relation between IBs as underwriters and the degree of EM at the time of IPOs. U.S. issuers typically employ IBs to underwrite, market, and distribute new issues. IBs also play an important role in decreasing the information asymmetry that arises between issuers and outside investors (Beatty and Ritter, 1986, Booth and Smith, 1986, Carter et al., 1998, Carter and Manaster, 1990, Chemmanur and Fulghieri, 1994, Dunbar, 2000). In the course of assisting in the
Sample description
Our sample consists of 1346 IPOs by U.S. issuers from 1993 to 2004, and is taken from the Securities Data Company (SDC) New Issue database. The sample criteria requires each IPO to consist of only one class of common stock by a U.S. issuer, listed on the NYSE, NASDAQ, or AMEX. Unit issues, rights issues, spin-offs, ADRs, reverse LBOs, closed-end funds, unit investment trusts, REITs and IPOs with offer prices under $5 are excluded. Financial service (SIC code 6xxx) and utility (SIC 49xx) issuers
Measurement of earnings management
Reported earnings consist of cash flow from operations plus or minus accounting adjustments called accruals. Prior research argues that when EM occurs, managers are more likely to influence accruals, rather than cash flow components of earnings, since cash flows allow less managerial discretion in their calculation. Following the extant literature (Gong et al., 2008a, Gong et al., 2008b, Louis, 2004, Louis et al., 2008, Louis and White, 2007, Teoh et al., 1998a, Teoh et al., 1998b), we proxy
Endogeniety : VC-backing and issuer–underwriter matching
One concern with the prior analysis is that the methodology is vulnerable to an endogeneity bias associated with the prior selection by IPO firms of VC investors and IPO underwriters. Without accounting for the endogenous nature of the VC and underwriter selection processes, the least squares estimation is biased, and the prior findings regarding IB reputation, VC reputation, and IB–VC collaboration could be misleading.21
Conclusion
Underwriters rely heavily on industry price-earnings ratios to help set IPO offer prices, while financial analysts base their investment recommendations on earnings reports of newly public firms. Issuers reporting favorable accounting information increase their probability of a successful IPO and the likelihood of higher offer proceeds. Thus, issuers in serious need of capital face strong incentives to overstate their earnings so as to be able to go public and raise more capital. We examine
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2021, Journal of International Accounting, Auditing and TaxationCitation Excerpt :Specifically, their findings show that high DCA and post-IPO underperformance is more likely with low reputation underwriters. Lee and Masulis (2011) explore the joint relationship between investment banks and venture capital. They show that venture capital and investment bank monitoring are complementary and additive in nature, further reducing pre-IPO earnings management.
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We are grateful to Phil Brown, Paul Chaney, Bill Christie, David Denis (editor), Yanqin Fan, Laura Field, Debra Jeter, Veronika Pool, Craig Lewis, Bill Megginson, Lakshmanan Shivakumar, and Hans Stoll and an anonymous referee for their helpful comments and suggestions. We are also grateful for comments of workshop participants at the University of Alabama, Vanderbilt University, and the 2007 AAA annual meetings. This study is based on a chapter of Gemma Lee's dissertation completed in July 2006.
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