Earnings Management, Managerial Optimism, and IPO Valuation

Abstract

We postulate that both managerial overoptimism and earnings management using accruals to boost accounting numbers effect on initial public offering (IPO) valuation. Referring to Purnandam and Swaminathan [2004], we gauge the IPO intrinsic values with respect to the offer price and the initial price. The portion that real offer (initial) price is above the intrinsic offer (initial) price is defined as offer premium (overreaction). Using 287 Taiwan's IPOs in sampling period 2004–2008, we find that most IPO firms were overpriced rather than underpriced. The offer premium is neither affected by earnings management nor managerial optimism, which is probably due to the greater scrutiny by the associated underwriters who are less gullible to managerial optimism or earnings management. In contrast, in initial market price valuation investors are cautious to take the face value of earnings management when IPO managers are perceived of moderate optimism. However, investors directly discipline overoptimistic managers with a lower initial valuation. Managerial overoptimism is the dominant factor in explaining long-run underperformance. We find that offer premium is positively associated with overreaction. Moreover, earnings management, albeit unrelated to overoptimism and offer premium, is positively related with initial overreaction and long-run underperformance.

Keywords:

• IPO
• Managerial optimism
• Earnings management
• Offer premium
• Overreaction

ACKNOWLEDGMENTS

The authors thank the participants at the 34th European Accounting Association annual congresses. The authors would also like to thank the National Science Council of R.O.C. for the research support under Contract No. 100-2914-I-030-002-A1. We accept responsibilities for all remaining errors.

Notes

1. The reference price is determined by a weighted average of the following components (with the corresponding weights in parentheses): (a) the prior 3-year averaged EPS of the IPO firm multiplied by the average price-to-earning ratio of three comparable firms (40%), (b) the prior 3-year average dividend per share of the IPO firm divided by the average dividend-to-price ratio of three comparable firms (20%), (c) the audited book value per share (20%), and (d) the forecasted dividend per share divided by the 1-year interest rate of time deposits (20%).

2. Prior studies indicate that issuers can report unusually high earnings by adopting discretionary accounting accrual adjustments that raise reported earnings relative to actual cash flows (Teoh et al. [1998b]). However, IPO firms may subject to greater scrutiny by the associated underwriters, auditors, boards, analysts, rating agencies, press, and litigants and therefore report more conservatively (Ball and Shivakumar [2008]). The averaged earnings management of 0.21% might imply that IPO firms were not actively engaged in earnings management practices. However, this measure is widely distributed with the standard deviation of 17.07% and the maximum value of 65.08%. This indicates that some IPO firms were still active in engaging in earnings management practices even though they were subject to close scrutiny of underwriters and other interested parties.