Xiong 2008

J Econ Finan (2010) 34:229–256
DOI 10.1007/s12197-008-9056-0
The economic profitability of pre-IPO earnings

management and IPO underperformance
Yan Xiong & Haiyan Zhou & Sanjay Varshney
Published online: 9 August 2008

# Springer Science + Business Media, LLC 2008
Abstract The purpose of this paper is to test the market performance of a zero-
investment trading strategy based on the knowledge of IPO underperformance and
estimates of pre-IPO earnings management. This trading strategy is implemented by
forming two-firm portfolios that take short positions in the IPOs and long positions
in control firms matched by industry and market capitalization. The first test shows
that significant positive abnormal returns can be earned trading on the knowledge of
IPO underperformance. However, the relationship between the level of abnormal
returns and the level of pre-IPO earnings management is not found to be significant.
Overall, our results suggest that existent pre-IPO earnings management plays
important roles although investors may not sophisticated enough to measure the
level of earnings management.
Keywords Market Performance . Zero-Investment Strategy . Initial Public Offering .

Earnings Management . Underperformance
JEL Classification G1 . G3 . M4
1 Introduction
Earnings management has long been a concern of academics. Management’s use of

judgment in financial reporting has both its benefits and costs. It is beneficial to
financial statement users if the reporting methods and policies selected by managers
Y. Xiong (*) : S. Varshney

College of Business Administration, California State University—Sacramento,
6000 J Street, Sacramento, CA 95819, USA
e-mail: xiongy@csus.edu
H. Zhou
Department of Accounting and Business Law, College of Business Administration,
The University of Texas—Pan American, Edinburg, TX 78539, USA
230 J Econ Finan (2010) 34:229–256
reflect the firm’s intrinsic value. In this case, managers utilize their knowledge about
their own business to increase the effectiveness of financial reporting as a form of
communication. However, the judgment allowed in financial reporting can also
create opportunities for managers to choose reporting methods and policies that
mislead financial statement users.
In recent years, especially in regards to issues surrounding the financial reporting
of publicly traded firms, earnings management has received tremendous attention by
both the popular press and accounting regulatory agencies. To address this concern,
the SEC formed an earnings management task force in 1998 to trace firms that use
creative accounting methods to manipulate their earnings.1 In addition, accounting
academia has been asked by the SEC to provide information on whether existing
disclosure requirements are useful in controlling earnings management and whether
additional standards are needed to control for earnings management.2
To get information necessary for effective standard setting on earnings
management, it is essential for standard setters to identify firms that have the
opportunities and incentives to manage earnings and then determine whether the
consequence of earnings management is serious enough to set new reporting
standards. The purpose of this study is to test whether investors are able to use their
knowledge of the IPO underperformance anomaly combined with the estimates of
pre-IPO earnings management to systematically outperform the market.
There are two anomalies that are related to IPO process. Many studies have
examined the IPO underpricing and IPO underperformance phenomena. The IPO
underpricing refers to the fact that IPOs’ initial offer prices are consistently lower
than their end-of-first-day market prices while the IPO long-run underperformance
refers to the fact that IPO firms’ long-run stock returns, measured for 3 to 6 years
after the initial offerings, are significantly less than those of a matched sample of
non-IPO firms (Ritter 1991). Prior literature treats the IPO underpricing and IPO
underperformance anomalies as two separate phenomena and attempts to use
different theories to explain them.
A number of explanations have been offered for IPO underpricing (Baron 1982;
Ritter 1984; Titman and Trueman 1986; Tinic 1988). However, with a few
exceptions, these hypotheses have been dismissed due to either conflicting empirical
evidence or the lack of sound theoretical foundations (Lowry and Murphy 2006;
Drucker and Puri 2005; Xiong et al. 2005). The four hypotheses listed below are the
prevailing hypotheses that provide reasonable and empirically testable explanations
for IPO underpricing: asymmetric-information hypothesis (Baron 1982), monopsony-
power hypothesis (Ritter 1984), the signaling hypothesis (Titman and Trueman 1986),
and the lawsuit avoidance hypothesis (Tinic 1988). Additional hypotheses of IPO
underpricing tend to be merely special cases of these four. While some support has
1
In his speech “The Numbers Game” delivered at New York University on September 28, 1998, Arthur
Levitt, former chairman of SEC, identified six accounting practices that he believes have been used in an
abusive manner to manage earnings, including “big bath” restructuring charges, premature revenue
recognition, “immaterial” accounting errors, creative acquisition accounting, “cookie jar” reserves, and
write-offs of purchased in-process R&D.
2
For instance, such a call was made in the “Current Accounting and Finance Issues” (Nov. 2006), a
document prepared by the Division of Corporation Finance, U.S. Securities and Exchange Commission,
Washington, D.C. (http://www.sec.gov/divisions/corpfin/cfacctdisclosureissues.pdf)
J Econ Finan (2010) 34:229–256 231
been indicated for each of the hypotheses, all four have also been widely criticized and
no one hypothesis is universally accepted. It is likely that these hypotheses are not
mutually exclusive, thus explaining the partial support for all. Thus, the underpricing
of IPOs remains an unexplained anomaly. One interesting commonality among these
theories is that all of them assume that IPO offer prices are purposely set below the
underlying intrinsic value. None of these theories consider the possibility that the
initial offer prices may be correct and that the first-day run ups are due to systematic
short-term overvaluation by the secondary market. A recent study (Xiong et al. 2005)
that proposes and tests an alternative explanation for this phenomenon, a hypothesis
based on the role of earnings management as an explanation of IPO underpricing.
Contrary to current beliefs, Xiong et al. (2005) find that IPOs are not initially
underpriced, but that instead, the commonly observed short-term run up in price is the
result of unsophisticated investors in the secondary market being temporarily fooled
by the pre-IPO earnings management.
The IPO underpeformance anomaly appears more consistent with this short-term
overvaluation theory than other underpricing theories found in the extant literature.
This may be due to the facts that the market could only be temporarily fooled and
that upward managed earnings have to be reversed in the future periods. One major
advantage of this short-term overvaluation theory is that it is able to provide
consistent explanations for both phenomena.
Many studies have examined the IPO long-run underperformance phenomenon.
Ritter (1991) conjectures that this phenomenon is the result of investors’
overoptimism about the earnings potential of young growth companies. Teoh et al.
(1998a) explore whether earnings management is a possible source for this
overoptimism. They find that there is a negative association between the IPO firms’
earnings management and their subsequent stock returns over 3 years. More
significantly, the studies demonstrate that at-issue discretionary accruals reverse in
subsequent years and therefore, could be used to predict the cross-sectional variation
in the post-issue underperformance of IPO firms.
While prior studies demonstrate general IPO underperformance and IPO under-
pricing phenomena, no study has attempted to determine whether these patterns can
be used to generate an actual trading strategy that will significantly outperform the
market. The primary focus of earnings management research to date has been on
detecting whether and when earnings management takes place (Healy and Wahlen
1999). Healy and Wahlen (1999) suggest that the area of earnings management
research would be more fruitful if it provided evidence on the impact of earnings
management on the capital markets. The current study’s investigation of the impact
and magnitude of earnings management on IPO firms’ long-term stock performance
provides relevant valuable information on this issue. The results of our study provide
information on both the prevalence of earnings management and its impact on the
capital markets under circumstances in which the market can likely be, at least
temporarily, fooled. Thus, our results help the regulators gauge the effectiveness of
current disclosure regulations and take further measures to protect the public interest
in the market.
This study tests the market performance of a zero-investment trading strategy
based on the knowledge of IPO underperformance and estimates of pre-IPO earnings
management. Our study is different from other studies in the literature in (1)
232 J Econ Finan (2010) 34:229–256
implementing a zero-investment trading strategy based on the IPO underperformance

phenomenon and the estimates of pre-IPO earnings management and (2) controlling
for the constraints on short-selling imposed by the Federal Reserve Board under the
Securities Exchange Act of 1934. This study contributes to the finance and
accounting literature by providing empirical evidence on market performance of a
trading strategy related to earnings management in the IPO market, that is, whether
investors’ perception of earnings management in pre-IPO period is of a magnitude
by which abnormal returns can be earned. In addition, the study extends the current
literature by examining a trading strategy based on the IPO underperformance,
which relate investors’ perception of IPO underperformance to the market
performance of trading behaviors.
This study has important implications for standard setters in determining whether
new standards and/or additional required disclosures are needed to control for
earnings management in the prior- IPO period.3 Accounting standard setters may
also find this study useful for evaluating the level of flexibility they should allow in
accounting standards which provide rooms for corporate managers of IPO firms to
manipulate reported earnings.
Furthermore, this study provides relevant information for investors. As a group,
investors have expressed concerns about firms’ use of earnings management. IPO
firms are likely candidates to employ earnings management because of the
information asymmetry between investors and issuers prior to their public offerings.
Investors in the IPO market, concerned about the relevance of earnings for
determining a new security’s value, can use the evidence from this study to better
evaluate firms’ pre-IPO reported earnings. By identifying specific relationships
between earnings management and IPO initial price changes and possibly
developing trading strategies to capitalize on this knowledge, investors should be
better able to make informed decisions regarding the earnings reported in IPO
prospectuses.
Finally, this study provides evidence to market regulators such as the SEC in
addressing their concerns over earnings management. The SEC is currently examining
new disclosure requirements and has also formed an earnings management task force to
regulate earnings management. To achieve their goals, the SEC must determine the level
of discretion that managers should be allowed to exercise in financial reporting. One of
the Information that SEC must rely on when making its decision is the impact of
earnings management on stock markets (Healy and Wahlen 1999). The current study’s
investigation of the impact and magnitude of earnings management on IPO firms’
long-term stock performance provides relevant valuable information on this issue. The
results of our study provide information on both the prevalence of earnings
management and its impact on the capital markets under circumstances in which the
market can likely be, at least temporarily, fooled. Thus, our results help the regulators
gauge the effectiveness of current disclosure regulations and take further measures to
protect the public interest.
3
For further information, please see http://www.sec.gov/spotlight/roundtables/accountround030602.htm.
J Econ Finan (2010) 34:229–256 233
2 Literature review and hypotheses development
Earnings management has attracted the attention of academic researchers for a number
of years. Recent earnings management studies focus on capital market incentives as
explanations of the opportunistic behavior of managers, i.e., the potential for managers
to intentionally mislead investors about the underlying value of their firms. For instance,
Teoh et al. (1998a, 1998b) have examined managers’ attempt to influence equity offers by
overstating earnings. Burgstahler and Eames (2003) and Kasznik (1999) have investigated
managers’ motivations to influence their short-term stock performance to meet financial
analysts’ expectation. Results of these studies indicate that in some instances, at least
temporarily, the market can be fooled when firms manage their earnings. Other recent
evidence indicates that earnings management appears to be a common practice among
firms (Heninger 2001) and has recently been made a top priority for the SEC (Levitt 1998).
IPOs literature has consistently found that IPOs underperform the market over the
long term and that the level of underperformance is related to at-issue earnings
management. For instance, Teoh et al. (1998a) find a significant and negative
association between discretionary accruals and subsequent stock returns over 3 years.
In a related study, Teoh et al. (1999) indicate that those firms reporting positive
discretionary accruals in the pre-IPO period experience a reversal of unexpected
accruals in subsequent periods. They also find that at-issue discretionary accruals
predict the post-issue earnings underperformance. When the high discretionary
accruals cannot be sustained after issue, the IPO firms’ underperform relative to their
matched firms and non-issuing industry peers in the secondary market.
This study attempts to determine whether these patterns can be used to generate an
actual trading strategy that will significantly outperform the market. To examine the
economic profitability of trading on knowledge of IPO underperformance and estimates
of pre-IPO earnings management, this study develops a zero-investment trading strategy
based on these patterns. A zero-investment trading strategy consists of taking a long
position in one set of securities and a short position in another set of securities, in which
both sets of securities are identified using a trading rule. In an ideal setting, the proceeds
from the short sale are used to purchase the securities held in the long position, i.e., in the
ideal setting this strategy involves a “zero-investment.” Investors earn positive returns
on this strategy through any combination of price decreases on the short positions and
price increases or dividends on the long positions. Zero-investment trading strategies are
commonly applied in academic research to test various market inefficiencies. The
advantage of using a zero-investment trading strategy is that it only requires a minimal
investment and it is therefore seen as a possible method for individual investors to earn
abnormal returns on these market inefficiencies.
The fact that IPOs underperform the market over the long term suggests that an
investor could earn an abnormal return with a zero-investment strategy that took short
positions in IPOs and long positions in matched control firms. This leads to hypothesis 1.
2.1 Hypothesis 1
The abnormal returns are positive under the zero-investment trading strategy, which
takes short positions in all IPOs and long positions in their control firms matched by
industry and size.
234 J Econ Finan (2010) 34:229–256
The recent literature on the association between the level of long-term

underperformance and pre-IPO earnings management further suggests that the level
of abnormal returns earned on this zero-investment strategy might be enhanced by
selectively implementing this strategy based on estimates of pre-IPO earnings
management. This leads to hypothesis 2.
2.2 Hypothesis 2
The level of abnormal returns earned on the zero-investment strategy, which takes
short positions in all IPOs and long positions in control firms matched by industry
and size, is positively correlated with the level of pre-IPO earnings management.
Hypothesis 1 is tested by calculating a single average abnormal return on the

zero-investment strategy using two-firm portfolios (long-position and short-position
portfolios) and the Alexander (2000) method that controls for the Federal Reserve
Board constraints on short selling. Hypothesis 2 is tested by first separating the two-
firm portfolios (long-position and short-position portfolios) into four groups based
on the estimated levels of pre-IPO earnings management, and then calculating an
average abnormal return for each group using the Alexander (2000) method. The
groups are formed based on highest positive, medium positive, and lowest positive,
and negative earnings management. The levels of earnings management used to
form these groups are estimated using the three models, such as discretionary
accruals, discretionary working capital accruals, and total accruals.
Support for hypothesis 1 would be consistent with the IPO underperformance
phenomenon reported in the prior literature, and would demonstrate how an investor
could outperform the market using knowledge of this phenomenon. Support for
hypothesis 2 would indicate that an investor could increase their returns by
selectively implementing this zero-investment strategy over two-firm portfolios that
took short positions in IPOs with the highest levels of estimated pre-IPO earnings
management.
3 Model identification and data collection
To test whether abnormal returns can be earned by using a zero-investment trading

strategy based on the knowledge of IPO underperformance and the estimates of pre-
IPO earnings management, we implement the zero-investment trading strategy by
controlling for the constraints on short-selling imposed by the Federal Reserve
Board under the Securities Exchange Act of 1934.
3.1 Measures of returns on zero-investment strategies
The major issue related to zero-investment trading strategies is the measurement of

the portfolio returns. For instance, DeBondt and Thaler (1985) measure the portfolio
returns as the difference of the raw returns for the securities held in the long and
short positions and find that the portfolio returns average over 8% per year.
However, these reported abnormal returns may be overstated because they made no
J Econ Finan (2010) 34:229–256 235
attempt to adjust for risk (Chan 1988). After adjusting for risk estimated with
abnormal returns based on the Capital Asset Pricing Model (hereafter referred as the
CAPM), Chan (1988) and Ball and Kothari (1989) find the portfolio returns to be
insignificant.4
However, most of the studies, even those attempted to control for risk, have failed
to consider the constraints imposed by the Federal Reserve Board under the
Securities Exchange Act of 1934.5 The first constraint is the initial margin
requirement that requires a proportion of the short sale proceeds be put in escrow
as collateral. This percentage has ranged from 50% to 100% since 1945 (Alexander
2000). The second constraint requires that a collateral investment be maintained to
deal with margin calls associated with short positions. This is referred to as a
liquidity buffer. According to Jacobs and Levy (1995), this requirement is usually
about 10% of the short sale proceeds.
Alexander (2000) made a first attempt to include the constraints imposed by the
regulators and found that the abnormal returns on the zero-investment strategy were
even less significant than those reported by Chan (1988). Thus, it is concluded that
the reported returns and economic profitability of existing zero-investment strategies
were overstated and that the higher the initial marginal requirement, the greater the
overstatement.
To control for the Federal Reserve Board restrictions, this study adopts the
procedure developed by Alexander (2000). This procedure calculates abnormal
returns after adjusting for risk and after considering the actual investment required
under the restrictions on short selling. Risk is classified as either systematic or
unsystematic. Systematic risk is that portion of uncertainty faced by a firm that is
due to common factors facing all firms: the business cycle, interest rates, in-
flation, etc. (Chan 1988). A firm’s systematic risk is captured by the β in the
CAPM. Thus, unsystematic risk is the uncertainty specific to a given firm and un-
systematic return is the return accruing to the firm after accounting for the systematic
effects. The average abnormal return is captured by α in the CAPM (DeBondt and
Thaler 1985).
4
Returns on zero-investment trading strategies are usually measured in terms of abnormal returns and
cumulative abnormal returns. The primary model used to measure abnormal returns is the time-series test
of the CAPM developed by Black et al. (1972). However, the actual approaches used in many studies do
not strictly adhere to the CAPM but are variations of it, such as the market model. This study adopts a
variation of the CAPM by including a procedure developed by Alexander (2000) to recognize the
constraints imposed by Federal Reserve Board on short selling.
5
A more recent regulation on short sales, Regulation SHO, became effective on January 3, 2005.
Regulation SHO was adopted to update short sale regulation in light of numerous market developments
since short sale regulation was first adopted in 1938. Some of the goals of Regulation SHO include: (1)
establishing uniform “locate” and “close-out” requirements in order to address problems associated with
failures to deliver, including potentially abusive “naked” short selling; (2) temporarily suspending
Commission and SRO short sale price tests in a group of securities to evaluate the overall effectiveness
and necessity of such restrictions; (3) creating uniform order marking requirements for sales of all equity
securities. This means that orders placed with broker-dealers must be marked “long,” “short,” or “short
exempt”. This new regulation simply added more constraints on short-sales and did change the original
constraints discussed in the paper.
236 J Econ Finan (2010) 34:229–256
To include these constraints in the CAPM model, a scenario is considered where

an investor purchases one dollar worth of a long portfolio, using an initial margin
investment m and borrowing (1−m) from the broker (Alexander 2000). The investor
goes short by borrowing a dollar’s worth of stock and by investing in additional
collateral amounting to m dollars per dollar of short sale. The investor must also
maintain a liquidity buffer amounting to c per dollar of short sale to take care of
margin calls associated with short selling. Overall, the investor must invest 2m+c to
initiate one dollar’s worth of a zero-investment strategy.
Furthermore, it assumes that the investor earns a risk-free rate of return rft on both
the short sale collateral investment m and the liquidity buffer c, and pays a risk-free
rate of return rft for the margin loan (1−m). In addition, the investor receives an
interest rate of rspt on the short proceeds. In general, the interest rate rspt on the short
proceeds is less than the risk-free rate of return rft earned by the investor on the
collateral investment and the liquidity buffer. This phenomenon is called a “haircut”
denoted as h, which is equal to the difference between the risk-free rate of return rft
and the interest rate on short-sale proceeds rspt (i.e., h=rft −rspt). According to
Jacobs and Levy (1995), this difference is usually between 25 and 30 basis points
per year or 0.021% per month for the typical easy to locate stock. The calculation of
returns on the zero-investment strategy (rpt) with these constraints on short-selling
considered is as follows:
rpt ¼ rft þ ðLMSt hÞ=ð2mþcÞ:
Where:
rpt the monthly return on the zero-investment strategy in month t considering the
constraints imposed on short-selling;
rft the monthly risk-free rate of return in month t;
LMSpt the monthly return on the zero-investment strategy in month t, equal to the
monthly raw return on the long portfolio minus the monthly raw return on the
short portfolio;
h the “haircut,” equal to the difference between the risk-free rate of return on
the collaterals rft and the interest rate on the short-sales proceeds rspt (i.e.,
h=rft −rspt);
m the required margin investment; and
c the liquidity buffer, that is, an investment to take care of margin calls
associated with short selling.
The zero-investment strategy’s abnormal return αp under restricted short selling
can then be determined by using the following procedure for measuring returns on
zero-investment strategies in the CAPM model:

LMSpt h ð2m þ cÞ ¼ ap þ bp ðrmt rft Þ þ ept :
Where
αp the average monthly abnormal return over all of the two-firm zero-investment
portfolios as in the Alexander (2000) model, which controls for the Federal
Reserve Board constraints on short selling;
J Econ Finan (2010) 34:229–256 237
βp the difference in systematic risk between the securities held in the long and
short positions;
ept error term;
and all the other variables are as previously defined.
3.2 Measures of earnings management
Earnings management cannot be directly measured. However, a number of methods

have been used in the literature to obtain proxies for earnings management. Three
methods are employed in this study to test the robustness of the earnings
management measures: the discretionary accruals method, the discretionary working
capital accruals method and the total accruals method.
First, we use the discretionary accruals method since it has been widely employed in
tests of the earnings management hypothesis. The major difficulty in using this method is
the need to identify and separate total accruals into unmanaged and managed components.
The most frequently used models for separating expected and discretionary accruals are
the Jones (1991) and modified Jones (Dechow et al. 1995) models. Following Teoh et al.
(1998a), the current study adopts the modified Jones model as the means of
decomposing total accruals into their unmanaged and managed components.
Each sample IPO firm is first matched with all firms on the Research Insight
database with the same three-digit SIC code. Total accruals are regressed on gross
property, plant, and equipment and the adjusted change in revenues for each group
of control firms matched with a given sample firm. Data for the regression is taken
from the fiscal year prior to the sample firm’s initial offering and all variables are
scaled by beginning of the period total assets.

TACit TAit1 ¼ a0j ð1=TAit1 Þ þ a1j ðΔREVit ΔRECit Þ=TAit1 þ a2j ðPPEit =TAit1 Þ þ eit :
Where
TACit the total accruals (net income before extraordinary items minus cash flow
from operations) in year t for the i’th control firm;
TAit the total assets in year t for the i’th control firm;
ΔREVit the change in revenues from year t−1 to year t for the i’th control firm;
ΔRECit the change in receivables from year t−1 to year t for the i’th control firm;
PPEit the gross property, plant, and equipment in year t for the i’th control firm; and
eit the regression error terms, assumed cross-sectionally uncorrelated and
normally distributed with mean zero.
The estimated coefficients from the control-firm regressions are then used to
estimate the level of managed accruals for each sample IPO firm by subtracting the
estimate of unmanaged accruals from total accruals as follows:

TAEMj;t ¼ TACjt =TAjt1 a0j 1 TAjt1 a1j ΔREVjt ΔRECjt TAjt1 a2j PPEjt TAjt1 :
Where
TAEMj,t the managed component of total accruals for IPO sample firm j in year t,
which is equal to discretionary accruals, and all other variables are as
previously determined.
238 J Econ Finan (2010) 34:229–256
Second, a working capital accrual model is also considered because there has
been considerable concerns on the efficiency of the modified Jones model in
detecting earnings management (Kang and Sivaramakrishnan 1995; Guay et al.
1996) and empirical evidence shows that the modified Jones model controls for only
a small amount of normal working capital accrual activities (Peasnell et al. 2000). To
maintain consistency between the discretionary accruals model and the working
capital model, the change in revenue is adjusted for the change in receivables. The
coefficients for unmanaged accruals are obtained by regressing working capital
accruals on changes in revenues, cross-sectionally, for each group of control firms
matched with a given sample firm. The control firm regression is:

WACi;t TAi;t1 ¼b0j 1 TAi;t1 þb1j ðΔREVit ΔRECit Þ TAi;t1 þei;t :
Where
WACi,t the working capital accruals (sum of changes in inventory, accounts
receivable, and other current assets less the sum of changes in accounts
payable, income taxes payable, and other current liabilities) in year t for
the i’th control firm; and the other variables are as described previously.
The estimated coefficients from the control-firm regressions are then used to
estimate the level of managed working capital accruals for each sample IPO firm by
subtracting the estimate of unmanaged working capital accruals from total working
capital accruals as follows:

WCEMj;t ¼WACj;t TAj;t1 b0j 1 TAj;t1 b1j ΔREVjt ΔRECjt TAj;t1 :
Where
WCEMj,t the managed component of working capital accruals for IPO sample firm
j in year t, which is equal to discretionary working capital accruals, and
all other variables are as previously described.
Third, as Warren Buffett, the legendary investor, has cautioned investors who are
obsessed with earnings, generally accepted accounting principles (GAAP) give
managers great discretion in determining reported earnings and managers are likely
to utilize this discretion to produce earnings numbers they prefer (Individual Investor
Group 2001). Buffett recommends that individual investors use cash flow from
operations as a check on the quality of a company’s earnings. In situations where
there is a large discrepancy between a firm’s reported earnings and its cash flow
from operations, the firm is likely engaging in a certain degree of earnings
management. Thus, an easy way for ordinary investors to identify earnings
management is to examine the difference between cash flows from operations and
reported earnings.
Moreover, Hribar and Collins (2002) argue that accruals based on balance sheet
approaches (i.e., the discretionary accrual method and the working capital accrual
method) suffer from measurement errors due to mergers and acquisitions, and
recommend measuring accruals using the cash flow statement information.
Therefore, a third measure is adopted. The earnings management in this model is
defined as the difference between net income and cash flow from operations
J Econ Finan (2010) 34:229–256 239
following Healy’s (1985) theoretical proposal.6 To be consistent with the prior

measures, both reported earnings and cash flows from operation are scaled by
beginning-of-period total assets.
The earnings management for firm i during year t is measured as:

CFOEMj;t ¼NIj;t TAj;t1 CFOijt TAj;t1 :
Where
CFOEMj,t the managed component of earnings for IPO sample firm j’s during
period t, which is equal to total accruals;
NIj,t the reported net income for IPO sample firm j during period t;
CFOj,t the cash flow from operations for IPO sample firm j during period t; and
total assets (TAj,t−1) is as described previously.
Although this measure is noisy in detecting the magnitude of earnings
management, and can not identify the exact level of managing earnings, it can
provide an indication of the existence of earnings management. Moreover, it
provides an easy way for investors to evaluate the relative likelihood that a firm is
engaging in earnings management without the use of sophisticated statistical
methods.
3.3 Data collection
Data for this study are based on initial public offerings filed between January 1998
and December 2000, which was a period of widespread IPO activity. In addition, the
period coincides with the growing concern of the SEC regarding the increase in
earnings management. The combination of the large number of IPOs and the
likelihood of pre-IPO earning management makes this period relevant to the research
questions addressed in this study.
We collect data from four sources: (1) IPOs are identified using three Internet
websites—finance.yahoo.com, www.123jump.com, and iporesources.org.7 These
websites also provide initial IPO market data, including the date on which the IPO
was filed, the company’s name, ticker symbol, SIC Code, industry, the number of
shares that were issued in the IPO, and the initial offer price; (2) the Lexis–Nexis
database contains IPO prospectuses that provide pre-IPO accounting information for
the sample firm; (3) accounting information for the non-IPO control firms is
obtained from the Research Insight database. This information is used to provide
expected levels of unmanaged accruals which are then used to estimate pre-IPO
discretionary accruals (i.e., the managed component of earnings) for the sample of
6
There are some differences between total accruals as measured in this study and the measure used by
Healy (1985). Since the statement of cash flows was not available until 1987, Healy (1985) estimated cash
flow from operations as working capital from operations (reported in the funds statement) less changes in
inventory and receivables and plus changes in payables and income tax payable. Cash flow from
operations in this study is obtained directly from the statement of cash flows.
7
The three Internet sites used to identify IPOs include two commercial websites, finance.yahoo.com and
www.123jump.com, and the academically oriented website iporesources.org. The website finance.yahoo.
com provides lists of IPOs by year and by industry. The other two websites are included to insure that the
sample is as complete as possible.
240 J Econ Finan (2010) 34:229–256
IPO firms; (4) post-IPO market information for both the sample IPO firms and
matched control firms is obtained from the CRSP database, which is used to
compute the abnormal returns for the zero-investment trading strategy.
In particular, we hand-collected the financial information for each IPO firm from
the prospectus from the Lexis–Nexis Academic Universe database and each matched
control firm from the Research Insight database. These financial information
include: cash flow from operations, net income, total assets, total accruals (net
income before extraordinary items minus cash flow from operations), working
capital accruals (sum of changes in inventory, accounts receivable, and other current
assets less the sum of changes in accounts payable, income taxes payable, and other
current liabilities), gross property, plant and equipment, and revenues.
The initial selection criteria included all firms listed as non-financial/service firms
on finance.yahoo.com that made their initial offerings between January 1998 and
December 2000 (see Table 1). The initial sample includes 312 IPOs.8 To be included
in the final sample, the IPOs must be offered at a price of more than $1 per share or
have a total offering of more than $1 million. Firms that do not meet these criteria
are omitted because they are not required to disclose all of the data necessary to
compute the earnings management measures (DuCharme et al. 2001). In addition,
the IPO firms must have all necessary prospectus financial data and subsequent stock
return data available. Eleven firms were excluded due to missing SIC codes or their
initial after-market prices and 17 firms were excluded because their prospectuses
were not found. An additional 17 firms were eliminated due to lack of available data
to compute a meaningful earnings management proxy. Thus, 267 prospectuses were
obtained. Finally, 160 firms were eliminated due to negative reported earnings in the
year prior to their initial offering.9 The earnings management measures computed
from negative reported earnings could have different meanings than those from
positive reported earnings.10 The final sample consists of 107 IPOs.
There are two sets of control firms used in this study. The first set of control firms
is used to calculate earnings management. The second set of matched control firms is
used in the zero-investment trading strategy which takes short positions in each IPO
firm and long position in the control firm matched to the IPO firm by industry and
size. The first set of control firms is identified by matching each sample IPO firm
with all firms in the Research Insight database having the same three-digit SIC code
8
Seasonal offerings and preferred share offerings are excluded. Also, offerings withdrawn within the 3-year
period are excluded.
9
In examining of the IPO firms lost to the negative earnings screen, there is some significant clustering by
industry. In terms of the percentage of IPOs lost in each industry, the industries that lost the biggest
percentages include the pharmaceutical products (75%), computer (70%), and electronic equipment (68%)
industries. In terms of IPOs lost in each industry as a percentage of the total umber of IPOs lost, those
industries with the biggest percentages include the electronic equipment (39%), the pharmaceutical
products (19%), and the computer (9%) industries. The statistics indicate that the IPOs lost to the negative
earnings screen cluster in the high-tech industry and in the later 2 years of this study. This is not surprising
given that there were a large number of start-up, high-tech companies going public during the sample
period and that many of these firms were not profitable prior to going public
10
Firms with negative reported earnings could have different motivations in earnings management than
firms with positive earnings. For instance, firms with negative earnings are more likely to take big bath
(understate earnings when earnings is negative) so that they could report earnings boost in the future years
(Kirschenheiter and Melumad 2002; Zhou and Koong 2006).
J Econ Finan (2010) 34:229–256 241
Table 1 Sample selection
Sample selection procedure Numbers of firms (obs.)
Firms listed as non-financial/service firms on finance.yahoo.com that made 312

their initial offerings between January 1998 and December 2000
Less: firms missing SIC codes or missing initial after-market prices 11
Less: firms with share price less than $1 per share or have a total offering of 17
more than $1 million (firms lack of data necessary to compute the earnings
management measures)
Less: firms’ prospectus financial data are not available 17
Less: firms with negative reported earnings in the year prior to 160
their initial offering
Total firms available for analysis 107
in the year prior to the sample firm’s initial public offering. There are 70 different
industry matching groups corresponding to the 107 IPO sample firms. The industry
matching groups contain between six and 605 firms. The second set of control firms
is identified by ranking all the first set control firms by market capitalization within
each industry matching group and select one firm that has the closest market
capitalization to the sample IPO firm as the matched control firm for the trading
strategy. The market capitalization for each sample IPO firm is obtained by
multiplying the number of outstanding shares and the actual offer price, while that
for each control firm is calculated by multiplying the number of outstanding shares
and the close market price on the initial offering date of the matched IPO firm.
4 Empirical results
Table 2 presents the summary statistics for the estimated coefficients that provide the
benchmarks used to estimate pre-IPO unmanaged accruals for the sample IPO
firms.11 “Discretionary accruals” presents the estimated coefficients for discretionary
accruals and “Discretionary working capital accruals” presents the estimated
coefficients for discretionary working capital accruals. There are 70 different
industry matching groups corresponding to the 107 IPO sample firms (three-digit
SIC code). All 107 matching groups corresponding to the 107 IPOs are used for
estimating the summary statistics reported in Table 2. Since the summary statistics
are used to estimate pre-IPO unmanaged accruals for all 107 sample IPOs, the
inclusion of a matching group for each sample IPO firm is necessary to make an
accurate estimate. This is especially important with a small sample size. Therefore,
in cases where two IPOs had the same three-digit SIC code and went public in the
same year, control group estimates were included twice in calculating the summary
statistics. The industry matching groups contain between six and 605 firms. The
11
As indicated in the notes to Table 2, total accruals are regressed on changes in revenues adjusted for
changes in receivables (DREV−DREC) and gross property, plant, and equipment (PPE) cross-sectionally
for all firms in the same three-digit SIC code as each sample IPO firm, excluding the sample IPO firm, in
the year prior to its initial public offering. All variables are scaled by beginning-of-period firm assets. This
regression model provides the benchmark coefficients used to estimate pre-IPO unmanaged total accruals
for the sample IPO firms.
242 J Econ Finan (2010) 34:229–256
Table 2 Estimated coefficients in accrual models
Estimates Mean Median SD Min Max t-Statistica (p-value)
Discretionary
accrualsb
TACi;t TAi;t1 ¼ a0j 1 TAi;t1 þ alj ðΔREVit ΔRECit Þ TAi;t1 þ a2j PPEi;t TAi;t1 þ eit
a0 −0.23 0.24 1.85 −11.1 2.65 −1.27 (0.210)
a1 0.15 0.13 0.14 −0.23 0.92 11.33c (0.000)
a2 −0.18 −0.05 0.52 −2.73 1.25 −3.58c (0.000)
d
Discretionary
working capital
accruals

WACi;t TAi;t1 ¼b0j 1 TAi;t1 þb1j ðΔREVit ΔRECit Þ TAi;t1 þeit
b0 0.73 0.60 4.42 −26.3 14.6 1.70 (0.093)
b1 0.15 0.12 0.17 −0.28 1.17 8.98c (0.000)
This table presents summary statistics for the estimated coefficients that provide benchmarks used to
estimate pre-IPO unmanaged accruals for the sample IPOs using the discretionary accruals model and
discretionary working capital accruals model.
a
The t-statistics and p-values are for two-tailed tests of the null hypothesis that the mean of a coefficient is
equal to zero.
b
Total accruals are regressed on changes in revenues adjusted for changes in receivables (ΔREV−ΔREC)
and gross property, plant, and equipment (PPE) cross-sectionally for all firms in the same three-digit SIC
code as each sample IPO firm, excluding the sample IPO firm, in the year prior to its initial public
offering. All variables are scaled by beginning-of-period firm assets. This regression model provides the
benchmark coefficients used to estimate pre-IPO unmanaged total accruals for the sample IPO firms.
c
Significant at 0.01 level
d
Working capital accruals are regressed over changes in revenues adjusted for changes in receivables
(ΔREV−ΔREC) cross-sectionally for all firms in the same three-digit SIC code as each sample IPO firm,
but excluding the sample IPO firm, in the year prior to its initial public offering. All variables are scaled
by beginning-of-period firm assets. This regression model provides benchmark coefficients used to
estimate pre-IPO unmanaged working capital accruals for the sample IPO firms.
mean (median) number of firms in the industry matching groups is 67 (21). Table 2
also reports the t-statistics and p-values for two-tailed tests of the null hypothesis that
the mean of each coefficient is equal to zero.
The mean value of the change in adjusted revenue coefficient is 0.15 in both the
discretionary accruals model (a1) and the discretionary working capital accruals
model (b1). These are similar to those reported in prior IPO studies (DeFond and
Jiambalvo 1994; DuCharme et al. 2001; Heninger 2001). The t-statistics and p-
values for the means are significant at the 1% level for both models, indicating that
the means are significantly different from zero. The coefficient estimates for the
change in adjusted revenue (a1 and b1) and the property, plant, and equipment (PPE)
variables (a2) are of the expected signs—positive and negative, respectively.
To test hypothesis 2, the sample IPOs are broken down into four groups based on
their level of pre-IPO earning management. The sample IPOs with positive earnings
management are first divided evenly into three groups based on the level of estimated
pre-IPO earnings management under each earnings management measurement method:
highest positive, medium positive, lowest positive. Then all the IPOs with negative
earnings management are left as the negative earnings management group. A non-
issuing control firm is found for each of the sample IPO in each group matched by its
industry and market capitalization. A zero-investment strategy is implemented by
forming two-firm portfolios that take short positions in IPOs and long positions in their
matched control firms.
J Econ Finan (2010) 34:229–256 243
Table 3 provides descriptive statistics on the estimates of earnings management

per share for the four groups. “Earnings management defined as discretionary
accruals per share” reports the descriptive statistics of pre-IPO earnings management
per share for the IPOs in the four groups when earnings management is defined as
discretionary accruals per share. There are 19 IPOs in the highest positive, 18 in the
medium positive, 18 in the lowest positive and 56 in the negative groups. Similarly,
“earnings management defined as discretionary working capital accruals per share”
and “earnings management defined as total accruals per share” report the descriptive
statistics of pre-IPO earnings management per share for the IPOs in the four groups
when earnings management is defined as working discretionary accruals per share
and total accruals per share, respectively. The number of sample IPO firms in each
group is different for each measurement method.
Table 3 also shows that the mean estimates of pre-IPO earnings management per
share in the highest positive group are statistically different for all the three
measures. However, the mean estimates of pre-IPO earnings management per share
in the medium positive, lowest positive and negative groups are similar across all the
three measures (p≥0.500).
Table 4 presents the distribution of the sample IPOs in four groups based on the
estimated levels of pre-IPO earnings management by industry. “Earnings manage-
ment defined as discretionary accruals per share” reports the distribution of IPOs by
industry in each group with pre-IPO earnings management defined as discretionary
accruals per share. “Earnings management defined as discretionary working capital
accruals per share” and “earnings management defined as total accruals per share”
report similar information but with pre-IPO earnings management defined as
discretionary working capital accruals per share and total accruals per share,
respectively. These results show that the IPOs in the four groups are not evenly
distributed by industry and that the industries in each group vary with the three
measures of earnings management. However, no one industry completely dominates
others in any of the panels except the electronic equipment industry.
Table 5 reports the average proceeds for IPOs by group and year. These results show
that the IPOs in these groups are almost evenly distributed in terms of the number of
offers but are not evenly distributed in terms of the average proceeds. In “earnings
management defined as discretionary accruals per share”, the maximum (minimum)
levels of pre-IPO earnings management, measured as discretionary accruals per share,
are $15.12 ($1.50), $1.42 ($0.41), $0.37 ($0.00) for the highest, medium and lowest
positive earnings management groups, respectively. Although the average proceeds for
1999 seem larger, none of the annual differences are significant (p≥0.380).
In “earnings management defined as discretionary working capital accruals per
share”, when pre-IPO earnings management per share is estimated as discretionary
working capital accruals per share, the maximum (minimum) values for high,
medium, and low positive earnings management per share groups are $21.98
($2.06), $1.95 ($0.43), $0.40 ($0.00) respectively. None of the annual differences are
significant (p≥0.150). Finally, in “earnings management defined as total accruals per
share”, when pre-IPO earnings management per share is estimated as total accruals
per share, the maximum (minimum) values for high, medium, and low positive
earnings management per share groups are $5.60 ($1.40), $1.17 ($0.46), $0.45
($0.00), respectively.
244
Table 3 Descriptive statistics for estimated earnings management per share in the four groups
IPOs with the highest positive EM IPOs with medium positive EM IPOs with the lowest positive EM IPOs with negative EM
19 firms 26 firms 19 firms 18 firms 25 firms 19 firms 18 firms 25 firms 18 firms 52 firms 31 firms 51 firms
a
Earnings management defined as discretionary accruals per share
Mean $3.90 $0.83 $0.16 −$2.05
Median $2.13 $0.79 $0.15 −$0.81
SD 3.81 0.33 0.12 3.23
Min $1.50 $0.41 $0.00 −$18.49
Max $15.12 $1.42 $0.37 −$0.02
Earnings management defined as discretionary working capital accruals per shareb
Mean $5.92 $0.90 $0.18 −$2.88
Median $3.36 $0.75 $0.16 −$0.75
SD 5.12 0.45 0.14 6.17
Min $2.06 $0.43 $0.00 −$28.96
Max $21.98 $1.95 $0.40 −$0.00
Earnings management defined as total accruals per sharec
Mean $2.36 $0.74 $0.19 −$2.14
Median $1.99 $0.69 $0.17 −$0.56
SD 0.98 0.23 0.13 3.53
Min $1.40 $0.46 $0.00 −$18.48
Max $5.60 $1.17 $0.45 −$0.02
This table presents the descriptive statistics of estimated pre-IPO earnings management per share in the four groups. The groups are formed by first dividing the sample IPOs with
positive earnings management evenly into three groups based on the levels of estimated pre-IPO earnings management under each earnings management measurement method:
highest positive, medium positive, lowest positive and then leaving all the IPOs with negative earnings management as the last group. A non-issuing control firm is found for
each of the sample IPO matched by its industry and market capitalization.
a
The results when the level of earnings management per share is estimated as discretionary accruals per share.
b
The results when earnings management per share is estimated discretionary working capital accruals per share.
c
The results when earnings management per share is estimated as total accruals per share.
J Econ Finan (2010) 34:229–256
J Econ Finan (2010) 34:229–256 245
Table 4 Distribution of IPO earnings management group by industry
Industry IPOs with the IPOs with IPOs with the IPOs with
highest positive medium positive lowest positive negative EM
EM EM EM
Number Percent Number Percent Number Percent Number Percent
Earnings management defined as discretionary accruals per sharea

Machinery 3 15.8 1 5.6 2 3.8
Business service 2 10.5 1 5.6 1 5.6
Construction materials 2 10.5 3 5.8
Electronic equipment 2 10.5 5 27.8 5 27.8 17 32.7
Wholesale 2 10.5 1 5.6 3 16.7 4 7.7
Auto & truck 1 5.3 1 5.6 1 5.6 1 1.9
Chemicals manufacturing 1 5.3 1 1.9
Fabricated products 1 5.3 1 1.9
Measuring equipment 1 5.3 5 9.6
Pharmaceutical products 1 5.3 2 11.1 7 13.5
Recreational products 1 5.3 1 5.6 2 3.8
Printing & publishing 1 5.6 2 3.8
Consumer goods 1 5.6 1 1.9
Computers 2 11.1 3 16.7
Food products 1 5.6 2 3.8
Beverage 1 5.6 1 5.6
Rubber and plastic products 1 5.6 1 1.9
Shipping containers 1 1.9
Miscellaneousb 2 10.5 2 11.1 1 5.6 2 3.8
Total 19 100 18 100 18 100 52 100
b
Earnings management defined as discretionary working capital accruals per share
Machinery 2 7.7 1 4.0 1 4.0 2 6.5
Auto & truck 1 3.8 3 9.7
Beverages 1 3.8 1 4.0
Construction materials 1 3.8 1 4.0 3 9.7
Consumer goods 1 3.8 1 3.2
Food products 1 3.8 1 4.0 1 3.2
Measuring equipment 1 3.8 3 12.0 2 8.0
Printing & publishing 1 3.8 1 4.0 1 3.2
Wholesale 1 3.8 1 4.0 4 16.0 3 9.7
Computers 3 12.0 1 4.0 1 3.2
Rubber and plastic products 2 8.0
b
Miscellaneous 1 3.8 2 8.0 1 4.0 4 12.9
Total 26 100 25 100.0 25 100.0 31 100.0
Earnings management defined as total accruals per sharec
Machinery 3 15.8 2 11.1 1 1.9
Wholesale 3 15.8
Auto & truck 1 5.3 1 5.6 2 3.8
Beverages 1 5.3 1 1.9
Computers 1 5.3 4 22.2
Construction materials 1 5.3 1 5.6 3 5.8
246 J Econ Finan (2010) 34:229–256
Table 4 (continued)
Industry IPOs with the IPOs with IPOs with the IPOs with
highest positive medium positive lowest positive negative EM
EM EM EM
Number Percent Number Percent Number Percent Number Percent

Food products 1 5.6 2 3.8
Consumer goods 2 3.8
Wholesale 1 5.6 2 11.1 3 5.8
Measuring equipment 1 5.6 5 9.6
Printing & publishing 1 5.6 2 3.8
Rubber and plastic products 2 3.8
Miscellaneous 3 15.8 1 5.6 4 7.7
Total 19 100.0 18 100.0 18 100.0 52 100.0
This table reports the distribution of the sample IPOs in the four groups with different levels of pre-IPO
earnings management per share making public offerings between 1998 and 2000 by industry.
a
In “earnings management defined as discretionary accruals per share”, earnings management per share is
estimated as discretionary accruals per share.
b
In “earnings management defined as discretionary working capital accruals per share”, earnings
management per share is estimated as discretionary working capital accruals per share.
c
In “earnings management defined as total accruals per share”, earnings management per share is
estimated as total accruals per share.
Table 5 also reports the results of two-tailed t-tests of the null hypothesis that the
mean proceeds of the IPOs in each of the four groups are equal to the mean proceeds
of the IPOs with positive pre-IPO earnings management per share. The results show
that except one case in the negative pre-IPO earnings management group (“earnings
management defined as discretionary working capital accruals per share”, year 2000)
none of the other t-statistics and p-values are significant at the 5% level, indicating
that the mean proceeds of the IPOs in each of the four groups are not different from
the mean proceeds of all IPOs with positive pre-IPO earnings management. Hence, it
suggests that the IPO proceeds are not relevant to the level of upward earnings
management.
Table 6 reports the descriptive statistics for the raw returns on both the long and
short portfolios. “Earnings management defined as discretionary accruals per share”
to “earnings management defined as total accruals per share” report the results of the
raw returns when earnings management is defined as total discretionary accruals per
share, discretionary working capital accruals per share, and total accruals per share,
respectively.
The monthly raw return for each control firm held in a long position is computed
using the closing price at the end of month t minus the closing price at the end of
month t−1 scaled by the closing price at the end of month t−1. The minimum value
of the raw returns for the long portfolios should be no less than negative one. The
monthly raw return of each IPO held in a short position is computed using the
closing price at the end of month t minus the closing price at the end of month t−1
Table 5 Distribution of average IPO proceeds by earnings management group and year
IPO IPOs with the highest positive EM IPOs with medium positive EM IPOs with the lowest positive EM IPOs with negative EM
year
Number Average t-Statistica Number Average t-Statistica Number Average t-Statistica Number Average t-Statistica
proceeds (p-value) proceeds (p-value) proceeds (p-value) proceeds (p-value)
(millions) (millions) (millions) (millions)
Earnings management defined as discretionary accruals per shareb

1998 8 $100 −0.25 (0.810) 7 $181 1.20 (0.260) 10 $73 −0.89 (0.380) 20 $82 −1.01 (0.320)
J Econ Finan (2010) 34:229–256
1999 6 $631 −0.25 (0.800) 5 $1046 0.22 (0.830) 0 N/A N/A (N/A) 15 $341 −0.94 (0.370)
2000 5 $252 0.59 (0.580) 6 $207 0.25 (0.810) 8 $116 −1.12 (0.280) 17 $324 0.97 (0.340)
Total 19 18 18 52
Earnings management defined as discretionary working capital accruals per sharec
1998 9 $55 −1.02 (0.310) 12 $145 0.33 (0.750) 10 $99 −0.09 (0.930) 14 $101 −0.06 (0.950)
1999 6 $84 −1.33 (0.200) 5 $878 1.06 (0.340) 4 $26 −1.69 (0.110) 10 $609 0.69 (0.500)
2000 11 $259 1.43 (0.170) 8 $75 −2.39 (0.022) 11 $114 −1.08 (0.290) 7 $53 −3.35 (0.002)
Total 26 25 25 31
d
Earnings management defined as total accruals per share
1998 8 $41 −0.94 (0.350) 8 $79 0.38 (0.710) 7 $62 0.03 (0.980) 22 $147 1.31 (0.200)
1999 6 $62 −0.68 (0.980) 4 $96 1.93 (0.064) 1 $155 N/A (N/A) 14 $727 2.17 (0.049)
2000 5 $164 0.37 (0.720) 6 $197 0.53 (0.620) 10 $96 −1.26 (0.220) 16 $137 −0.08 (0.940)
Total 19 18 18 52
This table reports the distribution of the IPOs in the four groups with different levels of pre-IPO earnings management per share making public offerings between 1998 and 2000
in terms of the number of offers and the average proceeds by year.
a
The t-statistics and p-values are for two-tailed tests of the null hypothesis that the mean proceeds of the IPOs in each of the four groups is equal to the mean proceeds of all IPOs
with positive earnings management per share.
b
Earnings management per share is estimated as discretionary accruals per share. In this group, the maximum (minimum) values for the high, medium, and low positive earnings
management per share groups are 15.12 (1.50), 1.42 (0.41), 0.37 (0.00), respectively.
c
Earnings management per share is estimated discretionary working capital accruals per share. In this group, the maximum (minimum) values for high, medium, and low positive
earnings management per share groups are 21.98 (2.06), 1.95 (0.43), 0.40 (0.00) respectively.
d
Earnings management per share is estimated as total accruals per share. In this group, the maximum (minimum) values for high, medium, and low positive earnings
management per share groups are 5.60 (1.40), 1.17 (0.46), 0.45 (0.00), respectively.
247
248
Table 6 Monthly raw returns on the long portfolios and short portfolios of the zero-investment trading strategy
All IPOs IPOs with the highest positive EM

107 firms, 107 firms, 107 firms, 19 firms, 26 firms, 19 firms,
Na =2,484 Na =2,484 Na =2,484 Na =418 Na =594 Na =434
Raw returnsb Long Short Long Short Long Short Long Short Long Short Long Short
c
Earnings management defined as discretionary accruals per share
Mean 0.02 −0.07 0.02 −0.09
Median −0.01 −0.02 −0.01 −0.03
Max 5.00 0.69 1.46 0.69
Min −0.88 −8.66 −0.72 −8.66
SD 0.29 0.37 0.22 0.55
t-Statisticd 3.26e −9.07e 1.40 −3.07e
Earnings management defined as discretionary working capital accruals per sharef
Mean 0.02 −0.07 0.01 −0.04
Median −0.01 −0.02 −0.01 −0.01
Max 5.00 0.69 1.26 0.64
Min −0.88 −8.66 −0.72 −3.64
SD 0.29 0.37 0.23 0.28
t-Statisticd 3.26e −9.07e 1.37 −3.47e
Earnings management defined as total accruals per shareg
Mean 0.02 −0.07 0.02 −0.06
Median −0.01 −0.02 −0.01 −0.03
Max 5.00 0.69 1.38 0.98
Min −0.88 −8.66 −0.72 −3.64
SD 0.29 0.37 0.24 0.31
J Econ Finan (2010) 34:229–256
t-Statisticd 3.26e −9.07e 1.56 −3.63e

IPOs with medium positive EM IPOs with the lowest positive EM IPOs with negative EM
18 firms, 25 firms, 19 firms, 18 firms, 25 firms, 18 firms, 52 firms, 31 firms, 51 firms,
Na =403 Na =600 Na =432 Na =422 Na =575 Na =415 Na =1,241 Na =715 Na =1,203
Raw returnsb Long Short Long Short Long Short Long Short Long Short Long Short Long Short Long Short Long Short
Earnings management defined as discretionary accruals per sharec

Mean 0.03 −0.08 0.02 −0.06 0.02 −0.06
Median −0.03 −0.02 −0.02 −0.02 −0.01 −0.02
Max 2.33 0.64 1.48 0.69 5.00 1.00
J Econ Finan (2010) 34:229–256
Min −0.73 −4.69 −0.61 −1.86 −0.88 −2.52

SD 0.36 0.40 0.24 0.30 0.30 0.29
t-Statisticd 1.34 −3.79e 1.27 −3.97e 2.03 −7.63e
Earnings management defined as discretionary working capital accruals per sharef
Mean 0.02 −0.08 0.02 −0.11 0.02 −0.05
Median −0.01 −0.03 −0.03 −0.03 −0.01 −0.01
Max 1.46 0.69 2.33 0.61 5.00 0.57
Min −0.73 −4.69 −0.65 −8.66 −0.88 −2.14
SD 0.27 0.39 0.29 0.52 0.34 0.25
t-Statisticd 1.72 −4.87e 1.48 −5.05e 1.93 −5.02e
249
Table 6 (continued)
250
g
Mean 0.03 −0.07 0.00 −0.11 0.02 −0.05
Median −0.01 0.00 −0.01 −0.04 −0.02 −0.02
Max 1.86 0.69 1.40 0.69 5.00 0.61
Min −0.73 −8.66 −0.01 −4.69 −0.88 −2.07
SD 0.29 0.52 0.24 0.47 0.31 0.26
t-Statisticd 2.05h −2.69e 1.21 −4.79e 2.43h −6.71e
This table reports the descriptive statistics of monthly raw returns on the securities held in long and short positions. The sample IPOs are broken down into four groups based on
their level of pre-IPO earning management, highest positive, medium positive, lowest positive, and negative earnings management. A non-issuing control firm is found for each
of the sample IPO matched by its industry and market capitalization. The two-firm portfolios are formed immediately following the first day of trading on the IPO.
a
N is the actual number of observations for each zero-investment trading strategy. Theoretically, N would be equal to the number of the sample IPOs in the group times 24 (the
number of months in the holding period). Because some of the return data for either the sample IPOs or their control firms are not available, the actual number of observations is
less than the theoretical number of observations.
b
The monthly raw return for each control firm in the long position is computed using the closing price at the end of month t minus the closing price at the end of month t−1
scaled by the closing price at the end of month t−1. The minimum value of the raw returns for the long portfolios should be no less than negative one. The monthly raw return of
each IPO firm in the short position is computed using the closing price at the end of month t minus the closing price at the end of month t−1 scaled by the closing price at the end
of month t. Negative values for the short position represent positive returns. The maximum value of the raw return for the short position should be less than one. The monthly
raw returns for each of the sample IPO and its matching firm are computed for up to 24 months immediately following its first day of trading. Note that the first monthly raw
returns for each of the sample IPO and its control firm are computed over the period from the first trading day of the sample IPO to the last day of the following month.
c
d
The t-statistics are for the two-tailed t-tests of the null hypothesis that the mean raw return is equal to zero.
e
Significant at 0.01
f
The results when earnings management per share is estimated discretionary working capital accruals per share.
g
h
Significant at 0.05
J Econ Finan (2010) 34:229–256
J Econ Finan (2010) 34:229–256 251
scaled by the closing price at the end of month t. The maximum value of the raw
return for the short position should be less than one. The monthly raw returns for each
of the sample IPOs and its matched control firm are computed for up to 24 months
immediately following its first day of trading.12 Table 6 also reports the t-statistics and
p-values for the two-tailed t-tests of the null hypothesis that the mean raw return is
equal to zero. N is the actual number of monthly observations for each zero-investment
trading strategy. Theoretically, N would be equal to the number of sample IPOs in the
group times 24 (the maximum number of months in the holding period). The actual
number of observations is less than the theoretical number of observations because
some of the return data for either the sample IPOs or their matched control firms are
not available. The results show that positive raw returns are earned on the control firm
securities held in long positions over all the groups, however, many of these are not
significant. The IPO short-sale raw returns are all negative and highly significant.
However, a review of the median raw returns indicates that the potential for abnormal
returns using a zero-investment trading strategy, that takes long positions in matched
control firms and short positions in IPOs, may be driven by extreme cases. All the median
raw returns on the matched control firms are negative and all the negative median raw
returns on the IPOs are smaller than the negative mean raw returns in absolute values. The
results indicate that an investor can earn a significant abnormal return by using a zero-
investment strategy to trade on the knowledge of IPO underperformance
Table 7 presents the abnormal returns for the zero-investment trading strategy.
“Earnings management defined as discretionary accruals per share” to “earnings
management defined as total accruals per share” report the abnormal returns when
earnings management is defined as discretionary accruals per share, discretionary
working capital accruals per share, and total accruals per share, respectively. The αp
coefficient represents the abnormal returns earned on a zero-investment trading
strategy. The αp coefficients reported in Table 7 are positive and significant at the
1% level with a single exception for the medium positive earnings management
group when earnings management is defined as discretionary accruals per share (p=
0.104). With this exception, the positive and significant αp coefficients imply that
abnormal returns on these groups range from 2% to 6% per month, where all sample
IPOs are held in short positions and their matched control firms are held in long
positions. As indicated earlier, the αp coefficients is defined as the average monthly
abnormal return over all of the two-firm zero-investment portfolios as in the
Alexander (2000) model, which controls for the Federal Reserve Board constraints
on short selling, and is estimated as the residual of the regression model over all the
two-firm portfolios (long and short). This provides empirical support for hypothesis
1, that is, the investors could outperform the market with a zero-investment trading
strategy based on the knowledge of IPO underperformance.
However, the αp coefficients in the trading strategy with the IPOs with the highest
level of positive earnings management per share held in short positions and their
matched control firms held in long positions are no greater than those earned with
the other IPOs. These results indicate that the level at which the informed investors
12
Note that the first monthly raw returns for each of the sample IPO and its matched control firm are
computed over the period from the first trading day of the sample IPO to the last day of the following
month.
Table 7 Abnormal returns on the zero-investment trading strategy under restricted short selling
252
All IPOs IPOs with the highest positive EM IPOs with medium positive EM IPOs with the lowest positive EM IPOs with negative EM
107 firms, 107 firms, 107 firms, 19 firms, 26 firms, 19 firms, 18 firms, 25 firms, 19 firms, 18 firms, 25 firms, 18 firms, 52 firms, 31 firms, 51 firms,
N a =2,484 Na =2,484 Na =2,484 Na =418 Na =594 Na =434 Na =403 Na =600 Na =432 Na =422 Na =575 Na =415 Na =1,241 Na =715 Na =1,203
Earnings management defined as discretionary accruals per shareb

αp 0.04c 0.05c 0.01 0.03c 0.04c
t-Statistic 9.60 3.31 1.63 4.46 7.45
(p-value)d (0.000) (0.001) (0.104) (0.000) (0.000)
Earnings management defined as discretionary working capital accruals per sharee
c
αp 0.04 0.02c 0.04c 0.06c 0.03c
t-Statistic 9.60 3.96 5.36 5.17 4.90
(p-value)d (0.000) (0.000) (0.000) (0.000) (0.000)
f
c
αp 0.04 0.03c 0.05c 0.04c 0.03c
t-Statistic 9.60 3.90 3.33 3.93 6.85
(p-value)d (0.000) (0.000) (0.001) (0.000) (0.000)

Model 6 : LMSpt h ð2mþcÞ¼ap þbp ðrmt rft Þþept
This table reports the abnormal returns for the zero-investment trading strategy that involve going short in the IPOs of the four different groups while going long in their control
firms. The IPOs are sold short immediately after their first day of trading while the control firms are purchased at the same time and for the same dollar amounts. The holding
period for these portfolios is for up to 24 months. The monthly abnormal returns on each trading strategy are the αRs from the regression model.
LMSpt The monthly returns on the zero-investment strategy, equal to the monthly return on the control firm held in a long position minus the monthly return on the IPO held in a
short position; h the “haircut,” equal to the difference between the risk-free rate of return on the collateral rft and the interest rate on the short-sales proceeds rspt, set at the 0.021%
level; m the required margin investment, which is set at 100%; c liquidity buffer, that is, an investment to take care of margin calls associated with short selling, which is set at the
20% level; αp the measure of the portfolio’s average monthly abnormal return; βp the measure of the investment strategy’s systematic risk, equal to the difference between the
system risk of the long position and the system risk of the short position; rft the monthly risk-free rate of returns obtained from the CRSP database; rmt the value-weighted returns
on market index obtained from the CRSP database
a
N is the actual number of observations for each zero-investment trading strategy. Theoretically, N would be equal to the number of the sample IPOs in the group times 24 (the
number of months in the holding period). Because some of the return data for either the sample IPOs or their control firms are not available, the actual number of observations is
less than the theoretical number of observations.
b
c
Significant at 0.01
d
The t-statistics and p-values are for one-tailed tests of the hypothesis that αR is greater than zero.
e
The results when earnings management per share is estimated as discretionary working capital accruals per share.
f
J Econ Finan (2010) 34:229–256
J Econ Finan (2010) 34:229–256 253
would outperform the market is not related to the level of the estimates of pre-IPO
earnings management, which is not consistent with hypothesis 2. A possible
explanation could be that existent pre-IPO earnings management plays more
important roles than the level of earnings management in the perceptions of
investors. Another possibility is that investors may not be sophisticated enough to
measure the level of earnings management, so that they simply treat the existence of
earnings management as a qualitative benchmark to set up trading strategy.
The βp coefficient represents the difference in systematic risk between the IPOs
and the matched control firms (not reported). If the IPOs were matched with the
control firms by systematic risk, the βp coefficient would be zero. Positive β
coefficients reflect that the systematic risks of the control firms are higher than those
of the IPOs, while negative β coefficients reflect that the systematic risks of the
control firms are lower than those of the IPOs.
There is one positive and significant untabulated β coefficient associated with the
results reported in Table 7, which is for the medium positive earnings management
group with earnings management defined as discretionary accruals. In contrast, there
are several negative and significant untabulated β coefficients found for all IPOs,
medium positive earnings management group with discretionary working capital
accruals measure, and lowest positive earnings management group with discretion-
ary accruals measure.
These results indicate that while the control firms are matched with the IPOs on
year, industry, and market capitalization, the matched pairs are not necessarily all
matched on systematic risk. While matching on year, industry, and market
capitalization can be accomplished with information available prior to the initial
public offerings, no common measure of systematic risk exists for the IPOs prior to
the initial offerings. The mixture of positive, negative, and zero βp coefficients
indicates that the systematic risks of IPOs are not always higher or lower than those
of the matched control firms.
5 Conclusions and limitations
Following several high profile earnings management cases, the SEC has made
earnings management a top priority and has called upon accounting researchers to
provide information on the usefulness of existing disclosure requirements in
controlling for earnings management. In order to truly understand the impact of
earnings management on the capital markets, regulators not only have to understand
the extent of earnings management, but also its impact on resource allocation within
the capital markets. The purpose of this study is to provide information regarding the
impact of earnings management of IPO firms on capital market, in particular,
whether capital markets are efficient enough to perceive the pre-IPO earnings
management and post-IPO underperformance.
This study explores the relationship between pre-IPO earnings management and
IPO underperformance. Prior research has found that there is a negative
association between pre-IPO earnings management and subsequent stock returns
over a 3-year period, and more significantly, that IPOs underperform non-IPO
firms matched by industry and size. However, whether knowledge of these
254 J Econ Finan (2010) 34:229–256
relationships could be used by investors to systematically outperform the market

has not been tested.
This study empirically tests the economic profitability of trading on knowledge of
IPO under performance and on estimates of pre-IPO earnings management with a
zero-investment trading strategy. This zero-investment strategy involves forming
two-firm portfolios that take short positions in IPOs immediately after their first day
of trading and long positions in their matched control firms at the same time and for
the same dollar amounts. The control firms are matched by three-digit SIC code and
by market capitalization. A procedure developed by Alexander (2000) is adopted to
control for the Federal Reserve Board restrictions on short selling.
Whether investors could outperform the market by trading on knowledge of IPO
underperformance is tested by computing a single average abnormal return over all
of the two-firm zero-investment portfolios. Whether investors could earn additional
abnormal returns on this phenomenon by including estimates of pre-IPO earnings
management in this trading strategy is tested by computing separate abnormal
returns for portfolios based on estimated levels of pre-IPO earnings management.
The results of these tests indicate that an investor can earn a significant abnormal
return by using a zero-investment strategy to trade on the knowledge of IPO
underperformance. However, the results of these tests fail to indicate that investors
could earn additional abnormal returns by implementing this strategy selectively for
those IPOs with the highest estimated levels of pre-IPO earnings management.
The results of this study provide insights to the SEC regarding both the prevalence
of pre-IPO earnings management and the impact of pre-IPO earnings management on
the capital markets under circumstances in which the market could be, at least
temporarily, fooled. In addition, this study provides information about market
inefficiency related to earnings management in the IPO market. That is, whether or
not an investor could outperform the market by trading on the knowledge of IPO
underperformance and estimates of pre-IPO earnings management. The results of this
study should help standard setters determine whether new standards and/or additional
required disclosures are needed to control for earnings management in the IPO market.
Finally, by identifying specific relationships between pre-IPO earnings management
and post-IPO underperformance and developing trading strategies to capitalize on the
knowledge of such a relationship, investors would be able to make better informed
decisions regarding the pre-IPO earnings reported in IPO prospectuses.
This study has some limitations. First, the sample size is small due to the data
availability. Only 107 IPO firms are used in this study. When the sample IPOs are
further divided into four groups based on their levels of pre-IPO earnings management
per share, the size of the samples is even smaller and therefore limits the statistical
power of the tests. A second limitation of this study is that the data used in this study is
from a limited time period from 1998 to 2000. Since this period is short, there is a
possibility that factors unique to this time period may influence the results.
Furthermore, it is known that the market performance in this period was unique,
especially in regards to the performance of high-tech stocks. Approximately 40% of the
sample IPOs used in this study are high-tech firms, so the results obtained from this
study might have limited external validity to other time periods and other industries.
Third, while this study controls for industry, year, and market capitalization
effects when selecting the matched control firms, this study does not match on
J Econ Finan (2010) 34:229–256 255
systematic risk. This study attempts to control for differences in systematic risk
between the sample IPOs and the matched control firms by including a β coefficient
in the regression model. To the extent that this β coefficient does not fully capture
the effects of differences in systematic risk, the estimated abnormal returns on the
zero-investment trading strategy may not be completely accurate.
Fourth, about 60% of the IPOs were eliminated from the final sample because
they reported negative pre-IPO earnings. As the IPOs in the final sample are only
valued by a single factor, pre-IPO earnings, the results of this study are limited to
IPOs reporting positive pre-IPO earnings.
Finally, since none of the existing measures are perfect in measuring earnings
management, three measures of earnings management are used in this study.
Although results obtained over the three measures of earnings management are not
completely consistent, the fact that all three measures generally support similar
conclusions indicates that the results of this study are not driven by any bias from
using a single measure of earnings management.
The limitations noted above further identify possible areas of future research.
First, future study could use a larger data set over a longer period of time to test the
reliability of the results obtained in this study. Second, future study could examine
the abnormal returns on trading in IPOs with negative pre-IPO reported earnings to
test the IPO long-term underperformance hypothesis and further test the relationship
between pre-IPO earnings management and IPO underperformance. We would like
to leave these areas for future studies.
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J Econ Finan (2010) 34:229–256

The economic profitability of pre-IPO earnings

Yan Xiong & Haiyan Zhou & Sanjay Varshney

Published online: 9 August 2008

Keywords Market Performance . Zero-Investment Strategy . Initial Public Offering .

Earnings management has long been a concern of academics. Management’s use of

Y. Xiong (*) : S. Varshney

implementing a zero-investment trading strategy based on the IPO underperformance

2 Literature review and hypotheses development

The recent literature on the association between the level of long-term

Hypothesis 1 is tested by calculating a single average abnormal return on the

3 Model identification and data collection

To test whether abnormal returns can be earned by using a zero-investment trading

3.1 Measures of returns on zero-investment strategies

The major issue related to zero-investment trading strategies is the measurement of

To include these constraints in the CAPM model, a scenario is considered where

3.2 Measures of earnings management

Earnings management cannot be directly measured. However, a number of methods

following Healy’s (1985) theoretical proposal.6 To be consistent with the prior

3.3 Data collection

Table 1 Sample selection

Sample selection procedure Numbers of firms (obs.)

Firms listed as non-financial/service firms on finance.yahoo.com that made 312

Table 2 Estimated coefficients in accrual models

Estimates Mean Median SD Min Max t-Statistica (p-value)

Table 3 provides descriptive statistics on the estimates of earnings management

Table 4 Distribution of IPO earnings management group by industry

Number Percent Number Percent Number Percent Number Percent

Earnings management defined as discretionary accruals per sharea

Number Percent Number Percent Number Percent Number Percent

Pharmaceutical products 1 5.3 2 11.1 7 13.5

Earnings management defined as discretionary accruals per shareb

All IPOs IPOs with the highest positive EM

t-Statisticd 3.26e −9.07e 1.56 −3.63e

Earnings management defined as discretionary accruals per sharec

Min −0.73 −4.69 −0.61 −1.86 −0.88 −2.52

Earnings management defined as discretionary accruals per shareb

5 Conclusions and limitations

relationships could be used by investors to systematically outperform the market

Alexander JC (2000) On back-testing “zero-investment” strategies. J Bus 73:255–278

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