Earnings Management

Cooking the books around initial public offerings

A study about the pervasiveness of earnings management and investor protection regulations

Jasper Seger3

Executive summary Most prior studies suggest that firms opportunistically increase their earnings around an initial public offering (IPO). With a sample of 512 IPOs in 24 countries worldwide I find that IPO firms that are under suspicion of such behaviour, represent only a small proportion (+/-10%) of the total sample. My findings challenge the opportunistic perspective on earnings management and suggest that the information perspective is more pronounced. Furthermore, I find no evidence for a positive relationship between low investor protection regulations and opportunistic earnings management. It seems that stronger enforcement of investor protection laws do not counter self-interested behaviour.

1. Introduction Earnings management received more and more attention in the accounting literature. In the context of initial public offerings (IPOs) most researchers found pervasive evidence for earnings management (Friedlan 1994; Teoh et al. 1998, 1998a; Roosenboom et al. 2003; Pastor and Poveda 2006). They explain that IPO firms (also shortened as IPOs) use their managerial discretion to increase earnings. Researchers interpreted the evidence by suggesting that these income increasing activities are driven by opportunistic behaviour. IPOs are particularly liable to such behaviour because both incentives and possibilities are offered around the IPO process. An important incentive for IPOs is to achieve high offer prices when offering their shares to the public. Possibilities for opportunistic earnings management exist, because there is an unusually high level of information asymmetry around that time. Managers have the possibility to choose accounting methods that benefit their own interest. For investors it is difficult to access if those accounting methods reflect the true economic performance....