Earnings Quality at Initial Public Offerings

Abstract

Financial reporting around the time of IPOs is consistent with listed firms reporting more conservatively than previously as private firms, consistent with the results in Ball and Shivakumar (2005). We hypothesize that IPO firms supply the higher quality financial reports demanded by public investors, who face higher information asymmetry than private investors. The market mechanisms for enforcing this demand include monitoring by internal and external auditors, boards, analysts, rating agencies, the press and other parties. Once public, firms are subject to greater regulatory scrutiny and penalties. From the point of releasing the public prospectus document onwards, IPO firms face a greater threat of shareholder litigation and regulatory action if they do not meet higher reporting standards. The evidence is overwhelmingly in favor of this hypothesis. We show that the evidence reported by Teoh, Welch and Wong (1998) in support of the alternative hypothesis, that IPO firms opportunistically inflate earnings to influence the IPO price, is unreliable for a variety of reasons. We provide cleaner evidence, from samples of U.K. and U.S. IPOs, that IPO prospectus financials are conservative by several standards. We conjecture that the types of bias we observe in conventional estimates of "discretionary" accruals occur in a broad genre of studies on earnings management around large transactions and events.

Keywords: IPO, earnings management, conservatism, earnings quality

JEL Classification: M41, M44, M47, G24, G29, G33, G34, G38, K22