Largest Shareholder Ownership and Downward Real‐activity Earnings Management in Korean Seasoned Equity Offerings Firms

• Author: Hye‐Jeong Shin,Su‐In Kim,Jin‐Ho Byun
• Date: 01 August 2018
• DOI: http://doi.org/10.1111/ajfs.12224
• Published date: 01 August 2018

Largest Shareholder Ownership and

Downward Real-activity Earnings

Management in Korean Seasoned Equity

Offerings Firms*

Su-In Kim

Department of Tax and Accounting, Hanyang Women’s University, Republic of Korea

Jin-Ho Byun

College of Business Administration, Ewha Womans University, Republic of Korea

Hye-Jeong Shin**

Department of Business Administration, Kyonggi University, Republic of Korea

Received 20 May 2016; Accepted 13 April 2018

Abstract

We investigate whether firms’ real-activity earnings management (REM) around seasoned

equity offerings (SEOs) and stock return performance after SEOs are different for the largest

shareholders’ participation in SEOs. Using Korean firms, we find that an increase in the lar-

gest shareholders’ ownership is negatively related to REM in the quarters preceding an SEO.

Additionally, positive market responses to SEO with the largest shareholders’ ownership

increases are mitigated by the level of REM. We conclude that firms manage earnings in

favor of the largest shareholders rather than other existing shareholders.

Keywords Seasoned equity offering; Real-activity earnings management; Largest shareholders

JEL Classification: G18, G32, M41, M48

1. Introduction

We examine whether earnings management before a seasoned equity offering (SEO)

is affected by an increase in the largest shareholders’ ownership

1

around the SEO.

*The authors are grateful for helpful comments from the editor, Professor Hee-Joon Ahn,

and two anonymous reviewers.

**Corresponding author: Department of Business Administration, Kyonggi University,

Gwanggyosan-Ro, Yeongtong-Gu, Suwon, Kyonggi-do, 16227, Republic of Korea. Tel: +82-

31-249-1376, Fax: +82-31-249-9401, email: hj_shin@kyonggi.ac.kr

1

We define the largest shareholders as the shareholders who have actual control over the firm.

The shares of the largest shareholders are the sum of the shares of the largest shareholders

and related parties (Kim and Byun, 2016).

Asia-Pacific Journal of Financial Studies (2018) 47, 546–570 doi:10.1111/ajfs.12224

546 ©2018 Korean Securities Association

Extant studies insist that firms try to inflate offering prices by managing earnings

upward prior to an SEO to protect current shareholders’ wealth and then experi-

ence lower abnormal returns after the SEO (Rangan, 1998; Teoh et al., 1998).

Some studies examine whether firms’ decisions on earnings management and

post-SEO stock returns differ based on the participation of existing shareholders.

They use SEO types to capture the participation of existing shareholders. Under

regulation, the right offering provides incumbent shareholders with primacy, which

is attractive for existing shareholders to avoid the costs incurred when the shares

are sold to outsiders (Shin, 1995; Berk et al., 2012; Brealey et al., 2014). Therefore,

there would be fewer incentives to manage earnings to inflate offering prices in case

of the right offering compared to other types (Kim and Hwang, 2009; Ahn et al.,

2015). Research about post-performance by SEO type has been conducted in the

past, but the results are inconsistent (Hertzel and Smith, 1993; Slovin et al., 2000;

Ching et al., 2006).

We conjecture that the conflicting results are the result of the fact that SEO

types do not actually capture the existing shareholders’ participation in the SEO.

Although it is assumed that a majority of existing shareholders participate when the

SEO is conducted in the right type of offering, the participation ratio actually turns

out not to be as high as expected (Holderness and Pontiff, 2016). Considering that

the actual take-up by existing shareholders is a key determinant of firms’ decisions

regarding SEO pricing (Eckbo and Masulis, 1992), we directly use the changes in

the largest shareholders’ ownership around an SEO and investigate the firms’ earn-

ings management.

Korea is a good setting to test the effect of the largest shareholders’ participation

in SEOs for several reasons. First, diverse types of SEOs exist in Korea, whereas one

type of SEO is dominant in other countries. In North America, most SEO firms

adopt the public placement method (Ching et al., 2006), and private offerings are

common in other countries such as Italy and Australia. In the Korean market, the

right offering, public offering, and third-party placement coexist, which represents

an ideal setting or investigation in that it is possible to test firms’ incentives to

manage earnings in favor of the largest shareholders regardless of the differences in

the regulation details. This is why several studies have been conducted on post-SEO

stock returns and earnings management (Shin, 1995; Dhatt et al., 1996; Kim and

Hwang, 2009; Jang et al., 2010; Ahn et al., 2015).

Second, firms utilize SEOs for several purposes in Korea. SEOs are a vehicle to

raise capital from potential investors, but Korean firms often use SEOs to pass

down management rights or control subsidiaries (Jang et al., 2010; Kim et al.,

2012). When the largest shareholders want to participate in new equity issuance, a

lower offering price is the most advantageous to the largest shareholders because

they want to invest the least amount of money to increase their ownership. Given

that Korean firms with concentrated ownership (chaebol) and diverse financing

decisions are motivated by the tunneling incentives of the largest shareholders (Paek

and Cho, 2006; Black et al., 2015), offering prices for SEOs are likely to be lower

Largest Shareholder Ownership, REM, SEO

©2018 Korean Securities Association 547