Earnings Management, IPO Underpricing, and Post-Issue Stock Performance of Chinese SMEs

Abstract

This article empirically examines the association between earnings management and initial public offering (IPO) performance (underpricing and post-issue stock performance) of Chinese small and medium enterprises (SMEs). The analysis is based on a sample of 464 IPOs listed on the Shenzhen Stock Exchange (SZSE) SME board during 2006–2010. Consistent with our expectations, this article finds that a higher level of total discretionary accruals prior to the IPO is associated with a higher level of underpricing and poorer long-term stock performance. However, when total discretionary accruals are decomposed into current and long-term accruals, the associations are insignificant. The results are robust with respect to several alternative measures of earnings management and stock performance. Statistics also show, on average, Chinese SMEs have positive 3-year long-term stock returns relative to various benchmarks, and only firms with income-increasing accruals suffer long-term underperformance. Findings from this article add important new evidence to the literature as Chinese SME IPOs tend to perform differently compared with main board firms, likely because of their unique features.

Keywords:

• Earnings management
• IPO
• stock performance
• SMEs

Notes

There are some exceptions, such as Cao, Tang, and Yuan (2013) and Anderson, Chi, and Wang (2013). However, none of the previous studies examined both the short-term and long-term stock performance of firms listed on the SME board or if earnings management is a determinant.

The SZSE SME board was designed to supplement the SZSE main board. Smaller firms satisfying the main board listing standards are allowed to be traded exclusively on the SZSE SME board. In another board, ChiNext, to enable private, innovative, and high-growth firms to access Chinese capital markets. ChiNext has lower listing requirements on profitability and firm size compared to the main board. Because of the very short listing history of ChiNext, firms listed on the ChiNext are not included in the sample of this article.

Firms may initiate action to list but subsequently withdraw applications. For this article, only firms that formally applied and listed are included in the initial sample.

Because the composite market index of the SME board is unavailable for the first 2 years after the SME board was established, 50 firms listed between June 25, 2004, and December 31, 2005, are removed from the sample.

Every event month has 21 successive trading days.

The top 10 underwriters are Citic Securities, China International Capital Corporation, BOCI Securities, Guotai Junan Securities, UBS China, China Galaxy Securities Company Limited, Haitong Securities, GF Securities, Guosen Securities, and Cinda Securities Co. Ltd (Su & Bangassa, 2011a). This list is identified according to percentage of market shares of each underwriter.

The top 10 auditors are PwC Zhongtian, Deloitte Huayong, KPMG Huazhen, EY Huaming, Zhongrui Yuehua, Lixin, Xinyong Zhonghe, Tianjian, Guofu Haohua, and Daxin, according to percentage of market shares (CICPA, 2010).

Thirteen major industry groups defined by CSRC in China are agriculture, mining, manufacturing, utilities, construction, transportation, information technology, wholesales and retails, finance, real estate, social services, media, and conglomerate. IPO firms from the financial industry are excluded from the sample pool in this article. In the main analysis, the CSRC industry classification is used, and all sample firms are categorized into 12 industries.

However, the tables are available upon request.

Matched firms are selected based on their closest size (measured by market value at the end of the issuing month) and B/M ratio (measured by book value at the end of the fiscal year prior to the IPO divided by market value at the end of the issuing month) following suggestions by Barber and Lyon (1997).

This approach followed suggestions by Kothari, Leone, and Wasley (2005) who took ROA into accruals consideration. More specifically, in the performance-matched model, each IPO firm is matched with a non-issuing firm (excluding IPO i and any firm listing within 2 years of the IPO year −1) in the same industry (Fan, 2007). The criterion to select matched firms is similar to ROA within a 20% variation in the same industry. If there is no firm with ROA within 20% of the IPO firm, the closest ROA firm in the same industry is chosen. The discretionary accruals for matched firms are estimated as the unstandardized residuals in the cross-sectional regressions based on industry classification. Then the performance-matched discretionary accruals of IPO firm i in the IPO year −1 are calculated as the difference between discretionary accruals from the modified Jones (1991) model and the corresponding discretionary accruals of the performance-matched firm.