EARNINGS AND CASH FLOW PERFORMANCES SURROUNDING IPO
Rahman, A., and Y. Hutagaol
(Faculty of Economics University of Indonesia)
ABSTRACT
Initial public offerings (IPOs) offer a fruitful area to be explored given the existence of asymmetric information among various parties interested in the IPO. This study attempts to examine whether there is significant increase in earnings level prior to the offering to be interpreted as the existence of earnings management. The behaviour of cash flow from operation is also examined.
A sample of 35 Indonesian IPOs that made public during 2002-2005 periods was examined. The t-test for mean difference was performed to test whether earnings differences persist. The findings show that earnings level tends increase in the year closes to the IPO date, but decrease in the next two year after that. The behaviour of cash flow from operating activities is almost similar. However, this study is unable to state that earnings management is strongly evidenced in Indonesian IPO setting.
Keywords: IPOs, prospectus, earnings and cash flow performance.
1. Introduction
This study examines earnings management of Indonesian initial public offerings (IPO). Companies offering shares publicly for listing are required by the securities law to meet certain financial and operating criteria. Because of the major impact of the offering prices on their private wealth and the explicit use of accounting numbers, particularly accounting earnings, the managers and the major stockholders of IPO firms have the incentives to manage earnings numbers to maximize their private wealth.
According to Healy and Wahlen (1999: 368), earnings management occurs "when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers". We interpret this broad definition as including earnings management in IPO.
Levitt (1998), former chairman of United States’ capital market regulator, has asserted that aggressive earnings management has been of concern to regulators for several years and that concern has only intensified following evidence of improper accounting practices by Enron, WorldCom, and some other major corporations. Thus, a better understanding of how earnings management occurs could help (1) regulators and standard setters identify the areas most in need of regulatory change; (2) auditors evaluate and report on their clients' quality of earnings, and train novice auditors about earnings management; (3) CEOs, CFOs, audit committees, and investors focus attention on those areas of the financial statements where they should be most skeptical; (4) managers and audit committees anticipate the transactions that investors will view most skeptically; (5) educators teach students about earnings management; and (6) researchers focus their analyses on areas of high-earnings-management activity.
A number of studies using Indonesia IPOs have been conducted, but the results are still mixed. For example, Gumanti (2001) does not find strong support that issuers of IPO manage accrual in the period prior to offering. Gumanti (2003) also does not find evidence that manufacturing firm making IPO manage earnings prior to the IPO date. However, these studies use accruals base model to predict whether earnings before IPO date are managed. Exception of this study is Gumanti and Swastika (2005) who examine the behaviour of IPO’s performance in the periods before and after the issue.
Before IPO, the operating results for a great proportion of companies demonstrate a bright performance but declined substantially right after the stock offerings, suggesting the existence of earnings management by the IPO firms. The phenomenon is particularly severe for accounting earnings. As a result, accusation that IPO firms manage earnings to inflate offering prices ensues and results in widespread public outcry and demands for government actions. In light with this accusation, this study investigates whether IPO firms manage earnings to raise offering prices.
The remainder of this paper is organized as follows. Section two presents review of literature. Section three describes sample selection and variable measurement. This is followed by findings and discussions. Final section summarises and provides genesis for future study.
2. Review of Literature
A detailed prospectus is required before new securities can be offered to the public in an IPO. It provides information about the offering itself, a brief history of the firm’s business, information related to past financial performance, ownership details, and the risks associated with the investment. The investment community recognizes that the most detailed and precise information about the issuing firm is found in the offering prospectus. In addition, the prospectus is a legal document that protects the issuer and the underwriter because it is written proof that the investor was provided with all the material facts related to the offering. However, very little is known about how useful prospectus information is to investors in their decision to invest in an individual IPO. Because a number of issuers lack a history of past revenues or earnings, investors are likely to be quite skeptical about the value of prospectus information. Teoh et al. (1998) report that earnings management prior to going public is related to long-run underperformance which could further erode the investor’s confidence in the value of the information contained in the prospectus, because it shows that firms could resort to window dressing prior to going public. Nevertheless, information contained in a prospectus is often the first window to a potential investor about the firm’s past and its projected future performance.
The valuation of IPOs and the setting of IPO offer prices represent a challenging crossroads between valuation theory and practice. Theory dictates the use of discounted cash flow as the conceptual foundation of valuation. Unfortunately, estimates of future cash flows and discount rates for IPOs are imprecise (See Kim and Ritter, 1999). In addition, it seems that stereotypical industry practice emphasizes the use of accounting numbers as cash flow surrogates and comparable firm multiples such as P/E ratios as proxies for discount factors.
Of course, even casual inspection of the data reveals that offer prices and initial market prices do not conform rigidly to simple multiples of accounting numbers, implying that underwriters and market participants incorporate additional information into the valuation equation. An important question raised within the IPO literature, therefore, is just how much variation in IPO prices remains to be explained by factors other than accounting numbers and comparable firm multiples. However, the findings reported by Kim and Ritter (1999) suggest that IPO pricing is largely unrelated to historical accounting information. One interpretation of their results is that underwriters and investors build their cash flow and discount rate estimates with vastly different information.
Theoretically, cash flows are impossible to manipulate through accounting choices. Given that earnings management can be achieved through accrual items, the difference between earnings and cash flows can be an inference basis for the behaviour of earnings management.
Empirical evidence seems to indicate that the evidence is identified in certain economic settings, but not in others, and even conflicting results occur in studies using similar context, which indicate that the motive and incentive for earnings management among preparers of financial reports are different. Dechow and Skinner (2000) assert that share offerings (IPO) provide direct incentive for managing earnings. In the same spirit, Healy and Wahlen (1999) contend that the capital market provides specific incentive for earnings management and in particular in the case of an IPO in which managers “overstate” reported earnings in periods prior to equity offers.
Despite the widely accepted view that information contained in a prospectus is valuable in assessing the risk of the offering, very little attention has been devoted in the finance literature to studying the usefulness of the information contained in the prospectus vis-à-vis the subsequent performance of the issuer. Hensler et al. (1997) and Jain and Kini (2000) examine the survival of IPOs in the aftermarket using some information from the offering prospectus.
Hensler et al. (1997) find that the issuer’s size, age at the time of the IPO, level of underpricing, insider ownership, industry membership, and the level of IPO activity in the market are significantly positively related to the probability of survival whereas the number of risk factors listed in the offering prospectus is significantly negatively related to the likelihood of survival. Jain and Kini (2000) show that venture capitalist backed IPOs are more likely to survive compared to others because they attract prestigious investment bankers, influence managers in strategic resource allocation decisions, influence institutional investors, and help attract analyst following of the firm sooner.
Platt (1995) also uses prospectus data to predict the survival of an IPO firm beyond the first three years of its public life and finds that predicting bankruptcies is difficult at best. Only 31% of bankrupt IPOs are correctly classified, whereas the corresponding rate for surviving IPOs is more than 90%. The results are, however, based on a small sample of 32 bankrupt and 76 surviving IPOs. These studies provide the first evidence that information contained in the prospectus can be gainfully employed to assess the risk of an individual IPO.
The literature has paid considerable attention on the long-run underperformance of IPOs. Ritter (1991) and Loughran and Ritter (1995) present evidence that IPOs significantly underperform their matched-firm benchmarks in the five years after their offering. Researchers have reported long-run underperformance of IPOs in several other financial markets in such countries as Latin America (Aggarwal et al., 1993), Japan (Hwang and Jayaraman, 1995; Howe et al., 1996), the United Kingdom (Espenlaub et al., 2000), Finland (Keloharju, 1993), Singapore (Lee et al., 1996), Korea (Kim et al., 1994), Germany (Stehle et al., 2000), China (Mok and Hui, 1998), South Africa (Page and Reyneke, 1997), and Malaysia (Paudyal et al., 1998).
Recent studies have examined some of the factors that affect this long-run underperformance. Brav and Gompers (1997) show that underperformance is concentrated in small non-VC-backed IPOs, and Teoh et al., (1998) attribute the long-run underperformance to earnings management prior to the IPO. Houge et al. (2001) find that IPOs with greater uncertainty exhibit poor stock return performance in the long run. Klein (1996) reports earnings management through accruals in the periods before the offering on US IPOs. That is, IPO firms tend to use income increasing discretionary accruals in the periods prior to the offering.
Gumanti (2003) examine the incidence of earnings management of IPO firms in manufacturing industry that went public over the period of 1991-1994 at the Jakarta Stock exchange. Using the total accrual approach that is similar to the one developed by Friedlan (1994), Gumanti study finds that the issuers of Indonesian IPOs do not make income increasing discretionary accruals in the periods prior to the offering. The positive changes in earnings in these periods do not contribute to positive discretionary accruals. The second test examining the behavior of discretionary accruals in the year after the offering, that is the first year as a public firm, shows evidence of earnings management. However, Rahman and Hutagaol (2007) find evidence that manager manage earnings through accruals in the periods before the offering on a sample of 149 IPOs that went public during 1994-2003. This conflicting result demands further examination whether earnings management in Indonesia IPO setting is pervasive.
Previous studies largely use accruals approach in testing earnings management in IPO setting either using a simple accruals model developed in Healy (1985), DeAngelo (1986) and Friedland (1994) or Jones and modified Jones (1991) model including the industrial adjusted model. In this study a difference approach is used, that is an earnings benchmark model. The spirit in doing so is based on Holland and Ramsay (2003) who examine whether Australian firms manage earnings to meet earnings benchmark. They assert that Australian companies manage earnings to ensure reporting of positive profits and to sustain the previous year’s profit performance.
3. Sample and Research Method
The sample in this study includes 35 firms making IPO at the Indonesian Stock Exchange during 2001-2005 periods. All the firms have December 31 as their fiscal year end. Financial statement data for these firms include three years before and two years after the IPO year. Note that the complete financial report in terms of the latest year available in the prospectus is treated as the year zero and consequently be used as the benchmark.
This study examine the behaviour of two mostly target variables in assessing the performance of IPO, namely the level of earnings and cash flow from operating activities. These two variables and their derivative have been used and extensively examined in previous studies examining earnings management of earnings manipulation of the firms, in various economic setting not limited to IPO per se. Holland and Ramsay (2003) use the level and change of earnings and cash flow from operation to detect whether firms manage earnings to meet simple earnings benchmark.
In line with Holland and Ramsay (2003), this study also examines the behaviour of earnings and cash flow from operation in the periods before and after the IPO year. The comparison of the level of earnings and cash flow follows Jain and Kini (1994) who use the latest year of IPO complete financial year as the benchmark in examining the performance of IPO firms.
4. Findings and Discussions
A sample of 35 IPO firms meets the selection criteria. Of the 35 sample firms, 14 firms went public in 2002, three were in 2003, ten firms went public in 2004, and eight firms made an IPO in 2005.
Two firms are from agriculture sector, four are from basic industry and chemical, 13 are from finance sector, six firms are from trade and services sector, followed by utility which is represented by four firms. Three firms are from miscellaneous industry, two are from mining sector and only one is from real estate.
5. Summary and Conclusion
Because the wealth of the managers is linked to the IPO prices, the requirement provides incentives for the managers of an IPO firm to manage earnings. Using a sample of Indonesia 35 IPOs during the 2002-2005 periods, this study investigates whether managers of the IPO firms exercise income-increasing discretionary accruals before IPO to maximize the offering prices and private wealth. Evidence suggests that companies use different discretionary components for earnings management in the most current year prior to the offering.
Further study may compare the figures for IPO long before the economic crisis and those after the crisis, for instance five years after the crisis.
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