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When and why do IPO firms manage earnings?

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Abstract

There is significant disagreement about whether, when, and why IPO firms manage earnings. We precisely identify the timing and motives behind earnings management by IPO firms. The period around an IPO is characterized by two events: the IPO itself and the lockup expiration. Both the raising of capital at the IPO and the exit by pre-IPO shareholders at lockup expiration create incentives for firms to manage earnings. To disentangle the effect of these events, we examine quarterly, rather than annual, abnormal accruals. We find no evidence of income-increasing earnings management before the IPO. However, IPO firms exhibit positive abnormal accruals in the quarter before and the quarter of the lockup expiration. Positive abnormal accruals are concentrated in less scrutinized firms and firms with high selling by pre-IPO shareholders. Moreover, we find that these accruals subsequently reverse and that such reversals contribute to long-run IPO underperformance.

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Notes

  1. See, for example, Barry et al. (1990); Lerner (1995); Hellmann and Puri (2002); Gompers and Lerner (2004); Morsfield and Tan (2006); and Cadman and Sunder (2014).

  2. Shares in IPO firms are held by a variety of shareholders, many of whom are not required to report changes in ownership to the SEC on Form 4. The requirement to file Form 4 is limited to insiders, i.e., officers, non-executive directors, and beneficial owners of 10% or more of shares outstanding. Furthermore, VC firms often distribute their shares to partners, rather than selling them on the open market, circumventing the requirement to file Form 4.

  3. Ball and Shivakumar (2008) argue that strong growth in assets in young IPO firms introduces a small denominator problem when total assets as of the beginning of the fiscal period are used as a deflator. To address this concern, when estimating discretionary accruals, we deflate by the average total assets for the quarter.

  4. Field and Hanka (2001) attribute the additional trading volume after lockup expiration to selling of previously locked up shares. Thus predicted abnormal trading volume is an appropriate proxy for selling incentives.

  5. Further tests show that investors do not unravel earnings management before lockup expiration: the stock price response to earnings is not significantly different if earnings are inflated with abnormal accruals.

  6. Morsfield and Tan (2006) show that VC-backed firms have lower abnormal accruals than non-VC-backed firms do. Our results do not contradict these findings and instead suggest that the incentives to report strong performance in anticipation of selling temporarily dominate the disciplining role of these investors with respect to financial reporting quality. In untabulated tests, we confirm that, on average across all quarters, VC-backed firms report lower abnormal accruals than non-VC-backed ones do. However, the former display the same inter-temporal pattern with a significant spike in accruals in the quarter before and the quarter of lockup expiration as the latter do. This is not to say that the effect pertains to all VC-backed firms—Wongsunwai (2013) finds that firms backed by highly reputable VCs do not manage earnings after the IPO.

  7. Consistent with pre-IPO shareholders’ ability to influence managers’ career outcomes, even after lockup expiration, in untabulated univariate analysis, we find that the likelihood of CEO turnover is significantly greater for firms with lower lockup expiration returns. In particular, based on a subsample of 468 firms covered by ExecuComp, the CEO turnover rate over the year following the lockup expiration is 7.9% for the subsample with lockup expiration returns in the bottom quartile, relative to 4.5% for the subsample with returns in the top three quartiles.

  8. Blackout restrictions typically prohibit insiders from selling shares starting, at a minimum, at the end of the fiscal period-end until the earnings announcement (Jagolinzer, Larcker, and Taylor 2011). During that period, insiders are privy to information about quarterly performance not yet released to the public. We define the period in which selling is restricted accordingly.

  9. These results persist after we consider the effect of low cash flows on long-run underperformance, documented by Armstrong et al. (2016).

  10. The growth is fueled by the investment of IPO proceeds in the working capital, which, in turn, can be reflected in the measures of abnormal accruals.

  11. Wongsunwai (2013) focuses on the monitoring role of high reputation VCs and partitions his sample based on shareholder profiles of IPO firms, rather than on the selling incentives at lockup expiration. He interprets his finding that firms backed by large, reputable VCs exhibit lower abnormal accruals as evidence that high quality VCs constrain earnings management. However, this finding is also consistent with the alternative explanation that abnormal accruals result from strong post-IPO growth in working capital due to cash infusion from IPO proceeds. Specifically, IPO firms not backed by high quality VCs are more likely to invest their IPO proceeds in working capital, giving the appearance of earnings management. In contrast, firms backed by high quality VCs have better access to capital pre-IPO, and their working capital accruals are less sensitive to the post-IPO cash infusion (Carpenter and Petersen 2002; Bertoni, Colombo, and Croce 2010).

  12. Lockup agreements are widespread and over time their length has been standardized to 180 days after the IPO. Brav and Gompers (2003) find lockup agreements in 99% of the firms in their sample of 2871 IPOs. Field and Hanka (2001) report that the fraction of firms with a 180-day lockup period increased from 43% in 1988 to 91% in 1996.

  13. Volume initially increases to 185% of the previous average volume and eventually settles at a level approximately 40% higher than the lockup period volume.

  14. We begin our sample period in 1990, as our measures of abnormal accruals are based on the information derived from the cash flow statement (Hribar and Collins 2002; Ball and Shivakumar 2008) and cash flow statement for interim periods (i.e., quarterly) was only required for the fiscal years ending after July 15, 1989.

  15. We exclude firms that had an IPO in the previous five years from the estimation.

  16. Because IBCY, OANCFY, and XIDOCY are year-to-date values, for fiscal quarters two through four, we adjust the values as the reported value in quarter q less the reported value in quarter q-1.

  17. An announcement quarter starts on the earnings announcement date of quarter t-1 and ends on the day before the earnings announcement date of quarter t.

  18. Ideally, we would number quarters relative to both the IPO and the lockup expiration and conduct a single set of univariate analysis. This, however, is not possible because the number of announcement quarters between the IPO quarter and the lockup quarter varies depending on (i) the length of the lockup period and (ii) when the issue date and the lockup expiration date fall relative to earnings announcements. While for the majority of IPO firms (52%), the lockup expires in QuarterIPO + 2, for 31% of the IPOs the lockup expires in QuarterIPO + 3, with the remaining 17% of lockup expirations falling in other event quarters, relative to the IPO. In additional tests in Section 4.1, to provide evidence on accruals quarter-by-quarter from before the IPO to after the lockup expiration in the same test, we use the most common case: the subsample of firms with lockup expiration in QuarterIPO + 2.

  19. There are fewer observations for the QuarterIPO-1 and QuarterIPO primarily because computing abnormal accruals for any quarter t using the cash flow statement approach requires data for both quarter t and quarter t-1 and not all firms report cash flows for QuarterIPO-1 and QuarterIPO-2.

  20. While it would be ideal to compute annual accruals over the sample period used by Teoh et al., the annual cash flow statement was only required starting from 1987, precluding computation of cash-flow-statement-based accruals for the years prior to 1987. As explained by Hribar and Collins (2002), the balance sheet approach to computing accruals is problematic.

  21. The IPO literature considers abnormal trading volume shortly after lockup expiration as arising from the sales by pre-IPO shareholders (Field and Hanka 2001; Bradley et al. 2001; Ertimur et al. 2014).

  22. Note realized abnormal trading volume is subject to significant look ahead bias and is a much nosier measure of selling incentives, reducing the power of our tests.

  23. Because we require the availability of accruals from quarter minus one in addition to our regular set of control variables, our sample declines to 8556 observations.

  24. Under Rule 144, in any quarter an insider is prohibited from selling shares that exceed the greater of 1% of the total shares outstanding or the average weakly trading volume.

  25. Note that earnings from QuarterLockup-1 are less salient as the earnings announcement of QuarterLockup approaches.

  26. Our results are qualitatively similar when using one, three, and five days as alternative thresholds.

  27. Similar to Armstrong et al. (2016), for performance-matched accruals, we exclude observations where the absolute difference in earnings before extraordinary items scaled by average total assets between an IPO firm and its matched control is more than 0.10. For size-age-growth-matched accruals, we follow the matching algorithm described on p. 1326 of Armstrong et al. (2016), i.e., we keep the match that minimizes the squared difference in propensity scores between the IPO firm-quarter and the non-IPO firm-quarter.

  28. Recent literature expresses concerns about the two-stage approach to estimating abnormal accruals (Chen et al. 2017). To address these concerns, we follow the procedure suggested by Chen et al. (2017) and regress the residual from the first-step of the modified Jones model on the combination of all independent variables from Table 3 as well as all the first-step regressors (including industry*quarter fixed effects). Our results are robust to this correction.

  29. Inferences are unchanged when we use equal-weighted average abnormal buy-and-hold returns (not tabulated).

  30. We describe our bootstrapping procedure in Table 9.

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Acknowledgements

We thank Matthew Cedergren, Amy Hutton, Richard Frankel, Sugata Roychowdhury, Richard Sloan (editor), Dan Taylor (discussant), two anonymous referees, attendees of the 2017 Review of Accounting Studies Conference, and seminar participants at Boston College, University of Florida, MIT, Singapore Management University, Washington University, the 2016 Darden Accounting Spring Camp, the NYU Accounting Summer Camp, and the 2016 American Accounting Association Annual Meeting for valuable comments and suggestions.

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Authors and Affiliations

  1. Boston College, 140 Commonwealth Ave, Fulton 552 B, Chestnut Hill, MA, 02482, USA

    Ewa Sletten

  2. Leeds School of Business, University of Colorado at Boulder, 419 UCB, 995 Regent Drive, Boulder, CO, 80309, USA

    Yonca Ertimur

  3. University of Arizona, 1130 E Helen St, Suite 301G, Tucson, AZ, 85712, USA

    Jayanthi Sunder

  4. Sloan School of Management, MIT, E62-664, 100 Main Street, Cambridge, MA, 02142, USA

    Joseph Weber

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  1. Ewa Sletten
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  2. Yonca Ertimur
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Correspondence to Ewa Sletten.

Appendices

Appendix 1

Table 11

Appendix 1 Variable definitions
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Appendix 2

Table 12.

Appendix 2 Abnormal trading volume prediction model
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Sletten, E., Ertimur, Y., Sunder, J. et al. When and why do IPO firms manage earnings?. Rev Account Stud 23, 872–906 (2018). https://doi.org/10.1007/s11142-018-9445-3

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