Earnings Management in Pre-IPO Companies
Exploration of managerial motivations behind accrual and real earnings management practices preceding an initial public offering, and their long-term performance consequences.
Earnings management is a classic topic that never loses its relevance in financial accounting literature. This practice becomes highly aggressive when a company prepares for an Initial Public Offering (IPO), a phenomenon often referred to as window dressing. The objective is clear: maximize the stock offering price by presenting a fantastic historical performance.
Accrual vs Real Earnings Management
Researchers distinguish earnings management into two types: accrual and real. Accrual Earnings Management (AEM) is executed by manipulating accounting estimates (such as allowances for bad debts or depreciation methods) without altering actual cash flows. Conversely, Real Earnings Management (REM) involves suboptimal real operating decisions, such as drastically cutting Research and Development (R&D) budgets or offering massive year-end price discounts to momentarily boost sales volume.
Long-Term Impact (Underperformance)
Empirically, companies that engage in pre-IPO earnings management tend to experience sharp long-run operating underperformance 1 to 3 years post-IPO. This occurs because discretionary accruals ultimately reverse in subsequent periods, or because cutting R&D destroys the company's future competitive advantage.
Measurement Methodology
To measure AEM, researchers widely utilize the Modified Jones Model or Kothari Model, which separate total accruals into normal (nondiscretionary) and abnormal (discretionary) components. For REM, Roychowdhury's (2006) model is heavily relied upon, utilizing proxies like Abnormal Cash Flow from Operations (CFO), Abnormal Production Costs, and Abnormal Discretionary Expenses.