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Review of Accounting Studies

Erschienen in:

01.03.2007

Underwriter choice and earnings management: evidence from seasoned equity offerings

verfasst von: Hoje Jo, Yongtae Kim, Myung Seok Park

Erschienen in: Review of Accounting Studies | Ausgabe 1/2007

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Abstract

Using a sample of seasoned equity offerings (SEOs), this paper examines the association between the choice of financial intermediary and earnings management. We contend that with more stringent standards for certification and intense monitoring, highly prestigious underwriters restrict firms’ incentives for earnings management to protect their reputation and to avoid potential litigation risks, while firms with greater incentives for earnings management avoid strict monitoring by choosing low-quality underwriters. Consistent with our predictions, we find an inverse association between underwriter quality and issuers’ earnings management. In addition, we find that underwriter quality is positively related to SEOs’ post-issue performance, even after controlling for the effect of earnings management. We also find that firms with low-underwriter prestige and high levels of earnings management under-perform the most. However, the effect of underwriter choice on post-issue performance does not last long.

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For example, Healy (1985) documents that in a costly contract setting, managers adjust discretionary accruals to report a high level of earnings.

Schipper (1989) defines earnings management as “purposeful intervention in the external reporting process, with the intent of obtaining some private gain to managers or shareholders.” Healy and Wahlen (1999) define earnings management as follows: Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on the reported accounting numbers. We follow these definitions of earnings management throughout the paper.

Since firms conducting SEOs are usually larger, older, and better covered by analysts than IPOs, the underwriter reputation concern might be more serious in SEOs.

We acknowledge that it is not entirely a firm’s decision to select the underwriters. Fernando, Gatchev and Spindt (2005) suggest that issuers and underwriters mutually select each other. We examine whether prestigious underwriters avoid equity issuers with aggressive pre-SEO earnings management in the later analyses. In addition, due to the fact that high-quality underwriters are not equally accessible to small firms, it is more difficult for small firms to hire prestigious underwriters. Thus, we control the size variable in the following analyses.

Zhou and Elder (2004) provide evidence of the negative relation between auditor quality and earnings management around the SEOs. Although high-reputation underwriters use high-quality auditors more frequently (Balvers et al., 1988), we argue that the effect of underwriter reputation is distinct from that of auditor quality. As shown in Tables 5 and 6, after controlling for the auditor variable, underwriter reputation always shows a significant association with earnings management, and the association is stronger than that of the auditor variable. We find that the auditor variable becomes significant when the underwriter variable is dropped from the earnings management equation. Our findings are in line with the theory (Hansen & Torregrosa, 1992; Chemmanur & Fulghieri, 1994).

Another possible interpretation is that well-known information-processing biases, like optimism, also play a role. As Dichev and Piotroski (2001) point out, optimism naturally results in more erroneous conclusions when applied to fairly negative situations, and thus negative situations are followed by subsequent, more extreme adjustments in stock prices.

McLaughlin et al. (2000) suggest that hiring a low-quality underwriter is a bad signal to the market. It is also known that the issues with low-quality underwriters are underpriced more. Therefore, issuers will hire low-quality underwriters only if the benefits of earnings management exceed the costs of not hiring reputable underwriters (Hansen & Torregrosa, 1992). Kim and Park (2005) provide empirical evidence that underpricing is smaller for issuers that aggressively manage earnings. Their result suggests that the benefits of earnings management exist.

See the reduction of information asymmetries in an IPO context from Titman and Trueman (1986), Carter and Manaster (1990), Michaely and Shaw (1994), Chemmanur and Fulghieri (1994), and Carter et al. (1998), among others.

Several studies, including Altınkılıç and Hansen (2003), Corwin (2003), and Mola and Loughran (2004), report that the underpricing of SEOs has become commonplace and that the magnitude of SEO underpricing has increased more dramatically in the 1990s than it did during earlier periods. Corwin (2003) documents that SEO underpricing increased to 2.92% for offers during the 1990–1998 period from 1.15% for offers in the 1980s and that the average reached a high of 3.72% in 1996.

Although an updated list of the Carter–Manaster ranks is available on the Jay Ritter’s web site, it is inappropriate for our sample offerings because Ritter’s rankings are based on data up to 2000. Since our sample period ends in 1997, updated underwriter reputation rankings based on the deals up to 2000 are unavailable for issuers in our sample.

The change in revenues is adjusted for the change in receivables (Eq. 2), when the normal, current accruals are estimated. This implicitly assumes that all changes in uncollected credit sales at the end of the event period result from earnings management. The reasoning behind this modification is that earnings are easier to manage via credit sales than cash sales (Dechow et al., 1995).

If there are less than ten firms in the same two-digit industry group, then the observation is dropped to mitigate the error in the prediction model.

Following Chung and Pruitt (1994), Tobin’s q is calculated as: {[Market value of common stock + Book value of preferred stock + Book value of long-term debt + Book value of current liabilities − (Book value of current assets − Book value of Inventories)]/Book value of total assets} in the last fiscal year ending before the SEO announcement.

In Eq. 6, ΔROA₁ is the proxy for the expected changes in performance in the near future. If ΔROA₁ and unexpected accruals (DA₀) are positively associated, then issuers manage earnings to signal their improving future performance. In such a case, the correlation between underwriter quality and unexpected accruals is not necessarily negative. In addition, DeFond and Park (1997) find that a firm’s current accruals are inversely related to the firm’s future earnings performance. Thus, if a firm expects that its performance is improving, it is less likely to use accruals to make its investor image more positive. To control these effects, ΔROA₁ is included in the regression.

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Titel: Underwriter choice and earnings management: evidence from seasoned equity offerings
verfasst von: Hoje Jo
Yongtae Kim
Myung Seok Park
Publikationsdatum: 01.03.2007
Verlag: Kluwer Academic Publishers-Plenum Publishers
Erschienen in: Review of Accounting Studies / Ausgabe 1/2007
Print ISSN: 1380-6653
Elektronische ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-006-9019-7

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