Real and accrual earnings management, regulatory environments, audit quality and IPO failure risk

This thesis builds on information asymmetry, agency conflicts and litigation-risk backgrounds to examine real and accrual earnings management activities around Initial Public Offerings (IPOs), mitigating factors (regulators and auditors), and consequences for future performance (stock return and IPO survivability). The IPO event is associated with higher levels of information asymmetry and agency conflicts between insiders and outsiders that are found to provide managers with strong incentives and more flexibility to engage in earnings management activities to maximise their wealth instead of shareholders. Due to the existence of information asymmetry around IPOs, IPO firms hire high quality auditors during the IPO to send positive signals about the offer to outside investors (Titman and Trueman, 1986). The first empirical study (chapter five) of this thesis examines whether different regulatory environments impact the use of real and accrual earnings management around IPOs via an analysis of the heavily regulated Main market of the London Stock Exchange and the more lightly regulated Alternative Investment Market (AIM), and whether these different regulatory burdens (restrictive vs. lighter) have different mechanisms/capabilities to correct stock prices that were inflated by earnings management during the IPO. The results of this study show that IPO firms in the UK manage earnings upward utilizing both real and accrual earnings management around IPOs, and that IPO firms on the lightly regulated AIM market exhibit higher levels of sales-based and accrual-based and a lower level of discretionary expenses-based earnings management than IPO firms on the heavily regulated Main market. Further, the results show that real and accrual earnings management, which take place during the IPO year, have severe negative consequences for post-IPO stock return performance, and that the heavily regulated Main market of the London Stock Exchange has better mechanisms-capabilities to correct stock prices that were inflated by earnings management during the IPO year than the lighter regulated AIM market. audit quality impacts real earnings management activities that occur during the IPO, whether enhanced audit quality impacts managers’ tendency to choose between real and accrual earnings management, and whether enhanced audit quality affects the association between real and accrual earnings management and post-IPO stock return performance. The results show that high quality auditors mitigate real earnings management activities that occur through discretionary expenses-based manipulation during the IPO year, and that IPO firms audited by high quality auditors (big N audit firms) undertake a higher level of sales-based manipulation to avoid the monitoring of discretionary expenses-based and accrual-based manipulations. Further, IPO firms audited by high quality auditors are found to experience a severe decline in post-IPO stock return performance due to the extensive use of sales-based manipulation at the IPO year. Thus, this evidence confirms that high quality auditors impact the relationship between real and accrual earnings management and post-IPO stock return performance. Finally, the third empirical study (chapter seven) explores whether real and accrual earnings management that occur during the IPO year are associated with post-IPO failure and survivability in the subsequent periods. The results show that IPO firms with high levels of real and accrual earnings management during the IPO year have a higher probability of failure in the subsequent period. Further, IPO firms that engage in high levels of real and accrual earnings management during the IPO year have lower survival rates in the post-IPO period. In summary, the main findings of this thesis suggest that real and accrual earnings management activities are utilized by IPO firms, that the level of utilizing these activities is dependent on the regulatory environment and audit quality, and that these activities are negatively associated with future stock performance and post-IPO survivorship. Regulators and audit firms should consider the fact that managers switch between real and accrual earnings management to avoid external monitoring. Further, the greater restriction on discretionary expenses-based and accrual-based manipulation seems to lead managers to engage extensively in sales-based manipulation.