The Sharpest Tool in the Shed: An Examination of Financial Statement Management Tools during IPOs

• In Event: Are Financial Statements Useful?

Abstract

The current literature presents conflicting evidence as to whether IPO firms manage earnings. Two major shortcomings of prior studies are their assumptions that: 1) investors primarily care about bottom-line earnings; and 2) all firms, regardless of their operating models, only manage earnings. We relax those assumptions by examining the application of discretion over various accounting items across different sectors. We find cross-sectional variation in the application of discretion over sales, R&D (R&D overinvestment), and other earnings items, with discretion being significantly associated with the relative importance of the items for IPO valuation. We further show that sales growth possesses the greatest value relevance, and the majority of IPO firms correspondingly manage sales. Lastly, we show that managed sales, and to a lesser degree managed other earnings items, are negatively associated with future stock returns. Overall, we provide robust evidence of use of discretion by IPO firms over various accounting items, depending on the firm’s operating model.

Authors

• Tatiana Fedyk, Arizona State University

• Zvi Singer, McGill University

• Mark T Soliman, University of Washington-Seattle