Effects of Audit Quality on Real and Accrual Earnings Management and Subsequent Return Performance: Evidence from IPOs

Abstract

We find that IPO firms engage in real and accrual earnings management during the IPO and that big-N audit firms constrain discretionary expenses-based and accrual-based manipulations. The restriction of these forms of earnings management leads IPO firms to resort to a higher level of sales-based manipulation. Our results show that both sales-based and accrual-based earnings management predict post-IPO return underperformance, and that sales-based manipulation has the most severe negative consequences for future return performance. In addition, we find IPO firms audited by big-N audit firms experience a severe decline in post-IPO return performance due to the extensive use of sales-based manipulation that takes place during the offer year.

Keywords: Earnings management, Discretionary accruals, Real activities manipulation, Audit quality, Initial public offering, Stock return performance