Academic journal article Journal of Economics and Finance

The Economic Profitability of Pre-IPO Earnings Management and IPO Underperformance

Academic journal article Journal of Economics and Finance

The Economic Profitability of Pre-IPO Earnings Management and IPO Underperformance

Article excerpt

Abstract

The purpose of this paper is to test the market performance of a zero-investment trading strategy based on the knowledge of IPO underperformance and estimates of pre-IPO earnings management. This trading strategy is implemented by forming two-firm portfolios that take short positions in the IPOs and long positions in control firms matched by industry and market capitalization. The first test shows that significant positive abnormal returns can be earned trading on the knowledge of IPO underperformance. However, the relationship between the level of abnormal returns and the level of pre-IPO earnings management is not found to be significant. Overall, our results suggest that existent pre-IPO earnings management plays important roles although investors may not sophisticated enough to measure the level of earnings management.

Keywords Market Performance * Zero-Investment Strategy * Initial Public Offering * Earnings Management * Underperformance

JEL Classification G1 * G3 * M4

1 Introduction

Earnings management has long been a concern of academics. Management's use of judgment in financial reporting has both its benefits and costs. It is beneficial to financial statement users if the reporting methods and policies selected by managers reflect the firm's intrinsic value. In this case, managers utilize their knowledge about their own business to increase the effectiveness of financial reporting as a form of communication. However, the judgment allowed in financial reporting can also create opportunities for managers to choose reporting methods and policies that mislead financial statement users.

In recent years, especially in regards to issues surrounding the financial reporting of publicly traded firms, earnings management has received tremendous attention by both the popular press and accounting regulatory agencies. To address this concern, the SEC formed an earnings management task force in 1998 to trace firms that use creative accounting methods to manipulate their earnings.1 In addition, accounting academia has been asked by the SEC to provide information on whether existing disclosure requirements are useful in controlling earnings management and whether additional standards are needed to control for earnings management.2

To get information necessary for effective standard setting on earnings management, it is essential for standard setters to identify firms that have the opportunities and incentives to manage earnings and then determine whether the consequence of earnings management is serious enough to set new reporting standards. The purpose of this study is to test whether investors are able to use their knowledge of the IPO underperformance anomaly combined with the estimates of pre-IPO earnings management to systematically outperform the market.

There are two anomalies that are related to IPO process. Many studies have examined the IPO underpricing and IPO underperformance phenomena. The IPO underpricing refers to the fact that IPOs' initial offer prices are consistently lower than their end-of-first-day market prices while the IPO long-run underperformance refers to the fact that IPO firms' long-run stock returns, measured for 3 to 6 years after the initial offerings, are significantly less than those of a matched sample of non-IPO firms (Ritter 1991). Prior literature treats the IPO underpricing and IPO underperformance anomalies as two separate phenomena and attempts to use different theories to explain them.

A number of explanations have been offered for IPO underpricing (Baron 1982; Ritter 1984; Titman and Trueman 1986; Tinic 1988). However, with a few exceptions, these hypotheses have been dismissed due to either conflicting empirical evidence or the lack of sound theoretical foundations (Lowry and Murphy 2006; Drucker and Puri 2005; Xiong et al. 2005). The four hypotheses listed below are the prevailing hypotheses that provide reasonable and empirically testable explanations for IPO underpricing: asymmetric- information hypothesis (Baron 1982), monopsonypower hypothesis (Ritter 1984), the signaling hypothesis (Titman and Trueman 1986), and the lawsuit avoidance hypothesis (Tinic 1988). …

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