Credit Ratings and Earnings Management around IPOs

• Published date: 01 January 2017
• Author: Dimitrios Gounopoulos,Hang Pham
• DOI: http://doi.org/10.1111/jbfa.12228
• Date: 01 January 2017

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 44(1) & (2), 154–195, January/February 2017, 0306-686X

doi: 10.1111/jbfa.12228

Credit Ratings and Earnings Management

around IPOs

Dimitrios Gounopoulos and Hang Pham∗

Abstract: This study examines the impact of having a credit rating on earnings management

(EM) through accruals and real activities manipulation by initial public offering (IPO) firms. We

find that firms going public with a credit rating are less likely to engage in income-enhancing

accrual-based and real EM in the offering year. The monitoring by a credit rating agency (CRA)

and the reduced information asymmetry due to the provision of a credit rating disincentivise

rated issuers from managing earnings. We also suggest that the participation of a reputable

auditing firm is crucial for CRAs to effectively restrain EM. Moreover, we document that for

unrated issuers, at-issue income-increasing EM is not linked to future earnings and is negatively

related to post-issue long-run stock performance. However, for rated issuers, at-issue income-

increasing EM is positively associated with subsequent accounting performance and is unrelated

to long-run stock performance following the offering. The evidence indicates that managers in

unrated firms generally manipulate earnings to mislead investors, while managers in rated firms

tend to exercise their accounting and operating discretion for informative purposes.

Keywords: IPOs, credit ratings, earnings management

1. INTRODUCTION

Earnings are a crucial indicator of firm performance, as investors commonly rely

on them to value stocks. Consequently, managers have strong motives to manipulate

earnings to influence short-term stock prices. The incentives of managers are stronger

around IPOs due to the high level of information asymmetry between inside managers

and outside investors. Various studies investigating EM in the IPO markets find

evidence of income-increasing EM around IPOs and a negative association between

at-issue EM and post-issue long-run stock performance, suggesting that managers

∗Dimitrios Gounopoulos is at the Newcastle University Business School, Newcastle University, UK. Hang

Pham is at the School of Business, Management and Economics, University of Sussex, UK. The authors

are grateful to Mohammad Alhadab, Ozlem Arikan, Kevin Chan, Francois Derrien, Quintao Fan, Michael

Firth, John Forker, Guanming He, Trevor Hopper, Bikki Jaggi, Arthur Kraft, David Marginson, Paul

McGuinness, Patricia O’Brien, Zulfiqar Shah, Douglas Skinner, Martin Walker (The Editor), Georgios

Voulgaris„ conference participants at the American Accounting Association Annual Meeting 2015, the

European Accounting Association 2015, the FMA Meeting 2015, and seminar participants at the University

of Leeds and the University of Sussex and the University of Warwick for valuable comments and suggestions.

This study is based on a chapter of Hang Pham’s thesis submitted to the University of Sussex in July 2016.

Address for correspondence: Dimitrios Gounopoulos, Newcastle University Business School, Newcastle

University, UK.

e-mail: Dimitrios.Gounopoulos@newcastle.ac.uk

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CREDIT RATINGS AND EARNINGS MANAGEMENT 155

can mislead investors to opportunistically manage earnings (Aharony et al., 1993;

Friedlan, 1994; Teoh et al., 1998a, 1998b; Roosenbloom and Van De Goot, 2003;

DuCharme et al., 2004; and Gramlich and Sorensen, 2004). The accounting research

also demonstrates that certain parties, such as audit committees, boards of directors,

external auditors, venture capitalists and underwriters, can restrain EM (Becker et al.,

1998; Klein, 2002; Morsfield and Tan, 2006; and Lee and Masulis, 2011). However, to

our knowledge, the influence of CRAs on EM by IPO firms has not been explored.

We hypothesise that CRAs disincentivise IPO issuers from engaging in EM through

their two main economic functions as an information intermediary and a monitor. By

acting as an information intermediary, CRAs provide an independent assessment of

the creditworthiness of a borrowing entity or a debt issue. In evaluating the firm, credit

analysts thoroughly review both public sources of information and relevant private

information provided by managers. Particularly, after the enactment of the Regulation

Fair Disclosure (FD), credit analysts can have access to confidential information which

is not made available to other investment professionals such as equity analysts (Jorion

et al., 2005). Therefore, CRAs provide the market with information beyond publicly

available sources, contributing to alleviating information asymmetries in the IPO

markets (An and Chan, 2008; Chan and Lo, 2011). Besides their informational role,

CRAs also serve an important function as monitors (Arnoud et al., 2006; Bannier and

Hirsch, 2010; and Bonsall et al., 2015). CRAs conduct due diligence on the issuer

in the initial rating. They subsequently keep track of the developments that may

affect the issuer’s risk profiles to adjust their rating accordingly.Reputational concerns

and heightened regulatory oversight also strengthen CRAs’ incentives to thoroughly

monitor the firm (Cheng and Neamtiu, 2009). The monitoring by CRAs and the

reduced information asymmetry due to the provision of a credit rating make financial

reporting misbehaviours more likely to be detected, thereby disincentivising rated

IPO firms from opportunistically managing earnings. Moreover, the lower information

asymmetries may encourage high-quality rated issuers to signal their future prospects

by employing accounting discretion to convey private information to less-informed

investors because investors will be more likely to accurately interpret that information.

Due to the distinct roles of CRAs in the capital markets and the gap in the literature

on the influence of CRAs on EM around IPOs, we seek to answer the following

research questions: (1) whether rated IPO firms are less likely to engage in EM in the

offering year, and (2) whether rated IPO firms employ their accounting and operating

discretion to better inform the market. Toaddress these questions, we analyse a sample

of US common share IPOs over the period 1991–2011. In order to establish a complete

view of EM, we investigate two EM methods: (1) accrual-based EM, which involves

exploiting the accounting discretion over the recognition of accruals, and (2) real EM,

which entails altering the timing or structuring of real economic activities. Moreover,

we account for the self-selection bias, which occurs due to the firm’s choice to obtain

a credit rating, and the endogeneity problem, which happens due to the potential

correlation between EM determinants and factors influencing the firm’s decision to

solicit a credit rating. We employ alternative econometric techniques to address the

endogenous selection issue including Heckman’s (1979) two-step treatment effect

model, the maximum likelihood treatment effect model, and the instrumental variable

model.

We find that rating existence is negatively associated with income-enhancing

accrual-based and real EM in the offering year. Credit rating levels, however, do

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not appear to explain the variation in EM around IPOs. Controlling for the inter-

action effects between CRAs and venture capitalists, top-tier underwriters and big

six auditors, we document that the impact of CRAs on reducing EM remains, but is

less pronounced, in the presence of these financial intermediaries. Particularly, the

participation of a prestigious underwriter is crucial for a CRA to significantly exert

its influence on real EM. Having a reputable auditor also enables CRAs to effectively

restrain both accrual-based and real EM by IPO issuers. Furthermore, rating existence

influences income-increasing EM in the offering year and also affects managers’

intentions of exercising their accounting and operating discretion to report higher

earnings. We reveal that for unrated firms, at-issue income-increasing EM is unrelated

to subsequent earnings and negatively linked to long-run stock performance following

the offering. However, for rated firms, at-issue income-increasing EM is positively

related to future accounting performance and not associated with post-issue long-

run stock performance. The evidence suggests that unrated issuers tend to manage

earnings upward to mislead investors, while rated issuers are more likely to employ

discretion in accounting and operating decisions to better inform the market. It

also supports the role of a credit rating in mitigating the information asymmetry

around IPOs. Lower information asymmetry alleviates information uncertainty and

allows investors to more immediately recognise EM and adjust for it in their stock

valuation; therefore, the post-issue long-run stock returns are insignificantly related to

at-issue EM.

Our study makes several contributions to the IPO, EM and credit rating literature.

Prior studies document opportunistic accrual-based EM around IPOs (Aharony et al.,

1993; Friedlan, 1994; Teoh et al., 1998a, 1998b; Roosenbloom and Van De Goot, 2003;

DuCharme et al., 2004) and highlight the roles of financial intermediaries including

auditors, venture capitalists and investment banks in restraining EM (Morsfield and

Tan, 2006; Venkataraman et al., 2008; Lee and Masulis, 2011; Hochberg, 2012;

Wongsunwai, 2013). Our findings provide new empirical evidence to support the

impact of another important intermediary in the capital markets – CRAs on EM

around IPOs. Moreover, we examine both accrual-based and real EM to gain more

complete insight into EM activities of IPO firms. In addition, Chen et al. (2013)

argue that the extent of information uncertainty around IPOs affects issuers’ motives

to engage in EM. Specifically, high-information-uncertainty firms opportunistically

manipulate earnings, while low-information-uncertainty firms manage earnings for

informative purposes. Prior research on CRAs in the IPO markets (e.g., An and

Chan, 2008; and Chan and Lo, 2011) suggests that credit ratings convey useful

information that can reduce the information asymmetry around IPOs. We present

further empirical evidence of the significance of information environment in influ-

encing managerial incentives to manage earnings. Specifically, we show that lower

information uncertainty due to the existence of a credit rating allows investors to more

correctly interpret managers’ messages. Therefore, rated issuers are more motivated

to employ accounting and operating discretion to signal firm value. Additionally, our

findings are applicable to an international context as the issue of EM is prevalent in

international IPOs (e.g., Roosenboom et al., 2003; Ahmad-Zaluki et al., 2011; Alhadab

et al., 2014; Kouwenberg and Thontirawong, 2015; and Alhadab et al., 2016) and CRAs

are globally recognised as a crucial information intermediary and a gatekeeper of

the capital markets. The paper also provides important implications for practitioners

and regulators in evaluating the financial reporting quality of firms going public

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