A Comparative Analysis of Real and Accrual Earnings Management around Initial Public Offerings under Different Regulatory Environments

• Author: M. Alhadab,K. Keasey,I. Clacher
• Published date: 01 July 2016
• Date: 01 July 2016
• DOI: http://doi.org/10.1111/jbfa.12201

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 43(7) & (8), 849–871, July/August 2016, 0306-686X

doi: 10.1111/jbfa.12201

A Comparative Analysis of Real and

Accrual Earnings Management around

Initial Public Offerings under Different

Regulatory Environments

M. ALHADAB,I.CLACHER AND K. KEASEY∗

Abstract: While earnings management around IPOs has been researched in a number of

settings, there has been a relative absence of work that analyses the impact of the regulatory

environment on such activities. We find that the regulatory environment does impact the real

and accrual earnings management activities of IPO firms. Our results show that IPO firms listing

on the lightly regulated UK Alternative Investment Market (AIM) have higher (lower) levels of

accrual-based and sales-based (discretionary expenses-based) earnings management around the

IPO than firms listing on the more heavily regulated Main market in the UK.

Keywords: accounting choices, earnings management, initial public offerings, regulatory

environment

1. INTRODUCTION

This paper reports the results of a comparative investigation into the impact of the

regulatory environment on both the real and accrual earnings management activities

of IPO firms. Specifically, we examine real and accrual earnings management activities

around IPOs for firms listing on both the heavily regulated Main market of the London

Stock Exchange, and the more lightly regulated Alternative Investment Market (AIM).

The UK stock market provides a unique environment to test directly the effect of the

regulatory environment on earnings management. All UK listed firms are governed by

the same legal regime, accounting standards, and general economic environment, but

are subject to differing listing requirements and monitoring depending on whether

they list on the Main market or the AIM.

The findings of this paper contribute to the literature by showing that IPO firms

engage in both real and accrual earnings management around IPOs, and more specif-

ically, that the regulatory environment matters. IPO firms on the AIM market engage

∗The first author is from the Faculty of Finance and Business Administration, Al al-Bayt University, Jordan.

The second and third authors are from Leeds University Business School, University of Leeds, UK. (Paper

received October 2014, revised revision accepted March 2016).

Address for correspondence: M. Alhadab, Faculty of Finance and Business Administration, Al al-Bayt

University, Mafraq 025110, Jordan

e-mail: M.Alhadab@aabu.edu.jo

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in higher levels of sales-based and accrual-based, and lower levels of discretionary

expenses-based manipulations compared to IPO firms on the Main market.

Prior studies have presented evidence that IPO firms manipulate earnings using

accrual earnings management around IPOs (e.g., Friedlan, 1994; Teoh et al., 1998a;

Gramlich and Sorensen, 2004; and Morsfield and Tan, 2006). However, little research

has examined real earnings management and IPOs. Analysing real earnings manage-

ment is important as manipulating real activities represents managerial decisions that

deviate from normal business practice, such as reducing research and development

(R&D) expenses or increasing sales by offering greater price discounts and/or more

lenient credit terms (Roychowdhury, 2006).

Moreover, and given the increasing interest in real earnings management, recent

research finds evidence that stronger regulation has a direct impact on managers’

tendency to choose between real and accrual earnings management. Ewert and

Wagenhofer (2005) provide evidence that the level of real earnings management

increases after accounting standards are strengthened. In line with the evidence of

Ewert and Wagenhofer (2005), Cohen et al. (2008) investigate the effect of the 2002

Sarbanes-Oxley Act (SOX) on real and accrual earnings management, and document

that US firms switch from accrual-based manipulation pre-SOX, to manipulating real

activities post-SOX. The evidence of Cohen et al. (2008) suggests that more stringent

regulation mitigates accrual-based earnings management leading to a greater use

of real earnings management. Further, Zang (2012) finds evidence that managers

substitute real and accrual-based manipulation to manage reported earnings. This is

consistent with the survey results of Graham et al. (2005) that managers prefer real

over accrual earnings management to avoid the scrutiny of regulators. Therefore, and

in the light of previous evidence, levels of real and accrual earnings management are

likely to differ depending on the regulatory environment in which a firm operates.

In the UK, the London Stock Exchange comprises two different regulatory environ-

ments; that is, the Main market and the AIM. While IPO firms on the Main market

are monitored and regulated by the UK Listing Authority (UKLA), IPO firms on the

AIM have to appoint and retain a Nominated Adviser (Nomad), who undertakes the

role of regulator. Nomads are private companies that play the role of adviser and

regulator for IPO firms listed on the AIM. Compared with the Main market, and other

developed markets such as those in the US, the AIM requires lower levels of corporate

governance, disclosure and transparency, and a lighter set of listing requirements. For

example, while IPO firms on the Main market are required to comply with the UK

Corporate Governance Code, the AIM only requires listing firms to have appropriate

corporate governance and, therefore, there is a lower requirement for corporate

governance mechanisms as compared to the Main market.1However, whether these

different regulatory burdens (restrictive versus lighter) lead to different impacts on the

disclosure system and financial reporting quality and, therefore, the level of earnings

management by companies listed on these markets is still an open question.

Prior literature indicates that a lower quality disclosure system and lower quality

financial reporting in the capital markets are associated with agency conflict (Jensen

and Meckling, 1976; and Watts and Zimmerman, 1986) and information asymmetry

1 The UK Corporate Governance Code, formerly known as the Combined Code, is a set of standards

and principles of good corporate governance practice concerning the board of directors, remuneration,

shareholders, audit, accountability, etc.

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