Swedroe: Beware IPO Earnings Management

May 26, 2016

It’s logical to believe that corporate managers have a preference for issuing equity at times when they perceive that their company’s stock price is overvalued, or high relative to some benchmark (such as price-to-earnings ratio or book-to-market ratio). What’s more, the academic research on the subject supports this hypothesis—seasoned equity offerings (SEOs) tend to be preceded by unusually high stock returns.

The literature also shows that there are incentives (such as concerns about current-period performance-based compensation, prospects for promotion, future employment, post-retirement benefits such as directorships, the potential for termination, and the hope that subsequent positive events will allow them to “bury” the negative news) that can lead to a tendency among corporate managers to hoard bad news. They withhold and accumulate bad news for an extended period of time, keeping stock prices temporarily higher (think of WorldCom and Enron).

One way to delay bad news is through the use of accruals. And one of the most well-known anomalies in finance is that stocks with high accruals underperform stocks with low accruals. However, bad news cannot be postponed indefinitely. When the accumulated bad news is eventually revealed (such as when accruals are reversed) the stock price crashes.

Understanding Managed Earnings
Yonca Ertimur, Ewa Sletten, Jayanthi Sunder and Joseph Weber—authors of the December 2015 study “When and Why Do IPO Firms Manage Earnings?”—contribute to the literature on companies delaying the publication of negative news 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 (typically six months after the IPO). To do this, the authors examine quarterly (rather than annual) abnormal accruals before and after the IPO, enabling them to pinpoint the timing of the earnings management.

They begin by noting: “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. IPOs also entail high levels of information asymmetry between new investors and IPO firm insiders. 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.”

The Timing Of Earnings Management

Ertimur, Sletten, Sunder and Weber then hypothesized: “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. 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.”

The authors, who had data covering the period 1990 through 2013, first examined quarterly abnormal accruals around the IPO issue date. Consistent with prior studies, they didn’t find evidence of positive abnormal accruals in the quarter immediately preceding the IPO. But they did find “significant [at the 1% level] positive abnormal accruals in the quarter preceding and in the quarter of the lockup expiration.”

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