Earnings Management and the Long-Run Market Performance of Initial Public Offerings Hathaiwan Vongsuwan – Hengmin Zhang Jonnell Tyler – Jose Navarrete – Kamoldis Theamkachit Now we will talk about the article “Earnings Management and the Long-Run Market Performance of Initial Public Offerings.”

Introduction Initial Public Offering (IPO) - Public offering where shares of stock in a company are sold to the general public on a securities exchange for the first time A private company transforms into a public company Used by companies to raise expansion capital, monetize the investments of early private investors, and to become publicly traded enterprises IPO’s underperform after the issue Earnings Management in Initial Public Offerings Sample Selection Data Empirical Results Post-Issuing Activity But first let me give you a basic definition of what an Initial Public Offering is, an IPO is a public offering where shares of stock in a company are sold to the general public on a securities exchange for the first time Through this process, a private company transforms into a public company And companies usually do this in order to raise capital for expansion, monetize on investments for early private investors, and/or become publicly traded enterprises Oddly enough, studies show that IPOs underperform after the issue Now the topics we will be going over are: Earnings Management in Initial Public Offerings The Sample Selection Data gathered through this process The Empirical Results And, Post-Issuing Activity that occurs

Earnings Management in Initial Public Offerings The IPO Process Opportunities to manage earnings Lock up period of 180 days Pressure to meet earnings In offering prospectus, accounting reports undergo verification of GAAP compliance Cash flows are the ultimate bottom line for valuation Now, let’s talk about “Earnings Management in Initial Public Offerings.” The IPO process gives entrepreneurs the opportunity to manage earnings. After filing an IPO, these entrepreneurs enter a lock up period, usually around 180 days, in which they are not able to sell their personal holdings. This filing comes at a price because the company is pressured to meet their expected earnings in order to avoid a lawsuit. Also, in order to avoid any wrongful manipulation of earnings, the company who is filing for an IPO undergoes GAAP verification of its accounting reports. Overall, the ultimate bottom line for valuation is the company’s cash flows

Earnings Management in Initial Public Offerings (Cont.) Measures of Earnings Reported Earnings Cash Flows and Accruals Total Accruals’ Current and Long-Term Current Short-term assets and Liabilities Manipulated by: Advancing recognition of revenues with credit sales Delaying recognition of expenses for bad debt Deferring recognition of expenses when cash is advanced to suppliers Long-Term Long-Term Net Assets Decelerating Depreciation Decreasing deferred taxes Realizing unusual gains Measures of Earnings Appropriate and Necessary Accruals Fixed-asset intensive firms High Depreciation Rapidly Growing Firms Revenues exceed cash sales Cross Sectional Regression Current accruals are regressed Performed each fiscal year Now, let’s talk about how earnings are measured: Reported earnings are measured by Cash Flows and Accruals Total Accruals are composed of current and long-term accruals. Entrepreneurs have more discretion over short-term than long-term accruals Current accruals are composed of short-term assets and liabilities which support day-to-day operations Now, managers have the power of manipulating these accruals by: Advancing recognition of revenues with credit sales Delaying recognition of expenses for bad debt Deferring recognition of expenses when cash is advanced to suppliers

Stock Prices and Earnings Management Post-IPO stock return underperformance Earnings management create an over valuation of an IPO Negative returns would not be observed if market was fully efficient No discount for earnings management Management manipulation of accruals So what exactly cause a company’s stock price to underperform post-IPO? Earnings Management over valuates an IPO If the market was fully efficient, negative returns would not be observed The stock price of an IPO is not discounted enough to factor in earnings management Overall, the main cause of Post-IPO stock return underperformance is associated with manager’s manipulation of accruals

II. Sample Selection & Data Initial Samples of domestic U.S (IPO’s) consist of: 1980 – 1984: 1,974 IPO’s 1985 – 1992: 3,197 IPO’s For inclusion in Final Sample, IPO’s must have: Available COMPUSTAT financial data CRSP stock return data Offer price exceeding $1.00 Market capitalization of at least 20 million Final Sample size: 1,649 IPO’s

II. Sample Selection & Data cont… Fiscal Year -1: ends before the date of the IPO Fiscal Year 0: the IPO occurs (includes both pre and post IPO information, financial statements taken from year 0 as well

II. Sample Selection & Data cont… Sample Characteristics: SIC Distribution

II. Sample Selection & Data cont… Sample Characteristics: Time Distribution

II. Sample Selection & Data Sample Characteristics: Post-IPO characteristics

III. Empirical Results Key objective: managed accruals have an influence on the long-run abnormal stock return performance of IPO firms All tests indicate that discretionary current accruals reliably predict post- IPO returns

III. Empirical Results Distribution of Stock Returns by DCA Quartile Event-Time Cross-Sectional Regressions Time-Series Regressions Using Book-to-Market and Market Capitalization Adjusted Returns Fama-MacBeth Panel Regression

A. Distribution of Stock Returns by DCA Quartile DCA：Discretionary Current Accruals Inferences on the magnitude of IPO long-run underperformance are sensitive to the abnormal return computation More conservative firms outperform more aggressive firms by a margin that is economically significant

B. Event-Time Cross-Sectional Regressions Add four accrual variables to the regression to examine the incremental influence of the accrual variables on post-issue stock return underperformance Only the DCA variable is consistently robust across a variety of alternative regression specifications

C. Time-Series Regressions Using Book-to-Market and Market Capitalization Adjusted Returns Aggressive IPOs have statistically significantly poorer post-issue performance than conservative IPOs

D. Fama-MacBeth Panel Regression It is incrementally important during an initial public offering for the earnings management variable to explain post-IPO long-run performance

Post-Issuing Activity Aggressive Earnings Management Leads to Poorer after-market performance

return underperformance Conclusion Discretionary current accruals (DCA) (proxy for earnings management) are high around the IPO Issuers with higher (DCA) have poorer stock returns Aggressive firms, on average, 15-30% worst performance than conservative firms Conservative firms, seasoned equity offering 20% more frequently Long-run post-IPO return underperformance  IPO firms’ earnings management

Conclusion Implications Investors: should look at pre-offering accounting accruals to discriminate amongst issuers Entrepreneurs: legitimate accounting choices can lower firm’s cost of equity capital Accounting standard setters: results may be useful for evaluating the amount of discretion you give corporate managers

The end