Earnings Management and Initial Public Offerings:The Case of the Depository Industry Brian AdamsKenneth CarowTod Perry Presentation Prepared for the FDIC Center for Financial Research Washington, DC October 25, 2006
Earnings Management “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 reported accounting numbers.” [Healy and Wahlen (1999)]
How mutuals differ from traditional IPOs Incentives to affect Offer Price • Traditional IPOs: Insiders are net sellers of equity • Use of accruals to enhance earnings for non-depositories prior to capital-raising events (such as IPOs and SEOs), where insiders are net sellers of equity Teoh, Welch, and Wong (1998a, 1998b), Teoh, Wong, and Rao (1998), and Erickson and Wang (1999) • Demutualization IPOs: Insiders are net buyers of equity • Use of accruals to reduce earnings for MBOs, where managers are net buyers of equity.Perry and Williams (1994)
How earnings affect Depository IPO Valuation • Unal (1997) • “regulations require an independent appraisal …, the guidelines include specific valuation equations that the appraisers must use to identify the offering price of the conversion.” • The three valuation equations include • price to earnings (P/E) • price to book (P/B) • price to assets (P/A)
Studies suggestive of managing offer price • Demutualizing IPO returns in the 1980s range from 5 to 7 percentMasulius (1987), Maksimovic and Unal (1993), Alli, Yau, and Yung (1994) • Demutualizing IPO returns in the 1990s range from 20 to 30 percentBarth, Brumbaugh, and Kleidon (1994), Cox and Roden (1999), and Carow, Cox, and Roden (forthcoming) • Carow, Cox, and Roden (forthcoming) Inside participation in mutuals is related to lower offer size and higher initial returns. Inside participation is not related to long-term stock returns or future operating performance.
How depositories manage earnings • Studies showing depositories manage LLP • Beaver, Eger, Ryan, and Wolfson (1989), Moyer (1990), Scholes, Wilson, and Wolfson (1990), Wahlen (1994), Beatty, Chamberlain, and Magliolo (1995), Collins, Shackelford, and Wahlen (1995), Beaver and Engel (1996), Liu and Ryan (1995), Liu, Ryan, and Wahlen (1997), and Karaoglu (2005)
Hypotheses • The level of loan loss provisions and the level of discretionary loan loss provisions will increase in the year prior to the IPO for demutualizing firms. • A similar pattern should be observed for the balance sheet account, reserves. • The greater the proportion of the firm purchased by insiders, the greater the incentive to manage Discretionary Loan Loss Provisions and Discretionary Reserves. • For demutualizing firms, greater levels of discretionary provisions and reserves will be positively related to first-day returns.
Sample • Depository Industry IPOs • 471 Mutuals and 84 Non-mutuals going public between 1992 and 2003 • Source: SNL DataSourceSNL provides information on firm characteristics and offering characteristics for the IPO andyearly balance sheet and income statement data on companies starting in 1991 • Each firm must have 4 years of financial data on ROA and LLP, including the two years prior to, the year of and the first complete fiscal year following the IPO
Robustness • Expanding control sample • 3-year industry adjusted returns for firms after IPO • Gains or losses from the sale of securities • Jones (1991) methodology used by Cornett, McNutt, and Tehranian (2006).
Conclusions • Managers of mutual thrifts increase the levels of loan loss provisions and reserves in the period prior to the IPO. • The level of underpricing is positively related to the level of Discretionary Loan Loss Provisions and Reserves, demonstrating that investors recognize the effect of earnings management on the offer price and properly value the firm on the first day of the offer.
Implications for Appraisers, Regulators, and Investors • Difference in incentives for demutualizing thrift IPOs (as net buyers of equity) and traditional bank IPOs (as net sellers of equity). • For mutuals, “conservative” levels of loan loss provisions (reserves) increase the potential for underpricing the IPO, which benefits insiders who participate in the offering (opposite for traditional IPOs). • Investors should evaluate the level of loan loss provisions and reserves to determine the proper pricing of the IPOs. Our evidence suggests that investors are currently doing this.