Earnings Management in IPOs: Moral Hazard or Signaling?

Abstract

This paper sheds light on the long-standing debate between the opportunistic and information perspectives of earnings management based on a controlled laboratory experiment. We find that low-earnings firms manage earnings more than high-earnings firms, which favors the moral hazard explanation over the one based on the signaling motive. When we introduce a limit on the degree of earnings management (i.e., as a proxy for regulatory power, such as accounting standards, litigation regulations, and reversals in earnings management), earnings management acts more similar to a signaling device. In the treatments with limit, the reported earnings become a more informative indicator of actual earnings, as low-earnings firms reduce earnings inflation, while high-earnings firms increase upward earnings manipulation. Consequently, market pricing efficiency improves, leading to better investor protection. Our findings highlight the importance of accounting regulation as a tool for enhancing the market quality and protecting investor interest.

Keywords: G14, M41, D82

JEL Classification: Earnings management, IPO, Moral hazard, Signaling, Experimental finance