Earnings management around reverse stock splits

• Published date: 01 January 2024
• Author: Shrikant P. Jategaonkar,Yuan Shi,Xiaoxiao Song
• Date: 01 January 2024
• DOI: http://doi.org/10.1002/jcaf.22660

Received:  June   Accepted:  September 

DOI: ./jcaf.

RESEARCH ARTICLE

Earnings management around reverse stock splits

Shrikant P. Jategaonkar1Yuan Shi2Xiaoxiao Song3

Department of Economics and Finance,

Southern Illinois University Edwardsville,

Edwardsville, Illinois, USA

Assistant Professor of Accounting, Penn

State Great Valley, Malvern,

Pennsylvania, USA

Department of Accounting, Southern

Illinois University Edwardsville,

Edwardsville, Illinois, USA

Correspondence

Shrikant P.Jategaonkar, Department of

Economics and Finance, Southern Illinois

University Edwardsville, Edwardsville, IL,

USA.

Email: sjatega@siue.edu

Abstract

Utilizing a sample of  reverse stock splits from  to , we contrast

earnings management by firms that initiate reverse splits for diverse reasons. Lit-

erature suggests that the incentives for reverse splits vary based on firms’ stock

price ranges. As such, we use the pre-split and target-price ranges to separate

the sample into three groups. Wefind a stark difference in discretionary accruals

across these groups. While previous studies have treated earnings management

and reverse splits as substitutes, we hypothesize that firms at risk of delisting may

employ these two mechanisms as complements. Consistent with the hypothesis,

we document a strong positive association between reverse splits and post-split

discretionary accruals for firms with pre-split prices below $. This relationship,

however, is non-existent among the remaining two groups. Our findings have

two important implications for investors: (i) firms with different motives behind

reverse splits exhibit different earnings management behavior and (ii) firms that

are likely facing exchange delisting use discretionary accruals in complement

with reverse stock splits.

KEYWORDS

discretionary accruals, delisting, earnings management, reverse stock splits

JEL CLASSIFICATION

M,G,M

1 INTRODUCTION

In this study, we examine whether firms with different

underlying incentives for reverse stock splits exhibit

different earnings management behavior. While it is

generally believed that firms split their stocks to achieve

an optimal trading price or to increase liquidity, recent

studies have documented other motives. For instance,

some firms reverse split stocks to attract institutional

investors (Chung & Yang ), while others leverage it

as a strategic move to avert delisting from an exchange

(Frost et al., ;Yang). Given the diverse moti-

vations driving different firms to initiate reverse stock

splits, analyzing them all in one group can hide the true

picture.

To address this issue, our study draws from a sample of

 reverse stock splits spanning the period  to ,

where we partition the sample into three groups based on

pre-reverse split prices: LH, LH, and HH.We arg ue

that the rationale for reverse splits varies substantially

among these groups. For instance, firms in LH group

are likely to reverse split their stocks to avoid delisting. In

December , when Heat Biologics Inc. announced a

reverse split of their stock, Jeff Wolf, CEOof the company,

stated: “Our sole purpose in conducting this reverse-split

was to address market concerns related to the Nasdaq

minimum bid price requirement”.In contrast, Chung

and Yang () propose that firms in LH are likely to

reverse split their stocks to attract institutional investors

by bringing the stock price over $. On the other hand, the

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