The Sharpest Tool in the Shed: IPO Financial Statement Management of STEM vs. Non-STEM firms

Abstract

The valuation of STEM (Science, Technology, Engineering and Math) firms has gained attention in the literature over the past two decades. Research has shown that for valuation of STEM firms, accounting items such as sales growth and R&D expenditures are more important than bottom-line earnings. In this paper, we examine whether, around the time of the IPO, managers of STEM firms apply discretion over the same accounting items most weighted by investors for their valuation. We find that investors tend to weigh sales growth and R&D more heavily than earnings in determining market value of STEM firms and that managers respond by managing those items rather than bottom-line earnings. This is in contrast to findings in the literature of a bottom-line earnings management by IPO firms; wherein STEM firms are not examined separately. Further, we find that the negative association between abnormal accruals and future stock returns found in prior research is limited to non-STEM firms, whereas for STEM firms, stock returns are associated with sales management. Our results shed light on the differential behavior of STEM vs. non-STEM mangers and highlight the importance of a departure from the traditional IPO earnings management paradigm, which assumes that firms mainly manage their earnings.

Keywords: STEM firms; Initial public offering; discretion over accounting items; IPO valuation; earnings management