Source of IPOs’ Underperformance – Evidence on the Implication of Accrual Reversal

Abstract

IPOs' long-run underperformance has been well documented in prior studies. This paper examines earnings management and the implication of accrual reversals as the source of IPOs' underperformance. I decompose earnings reported at the time of IPOs into accrual and cash components. I find that for US IPOs, only the cash component of earnings (not the accrual component) has significant predictive power for future stock performance; suggesting the level of accruals that makes up IPO earnings fails to sustain its performance in the post-issue period. For ADR IPOs, both the accrual and the cash components have significant predictive power for future stock performance. I further investigate whether the level of accrual reversal is associated with stock return in the post-issue period after controlling for earnings change. In the period subsequent to IPOs, after controlling for earnings change, I find that for US IPOs the larger the accrual reversal, the lower the stock performance. This result suggests that IPOs with inflated earnings are over-valued at the time of first going public. In the subsequent periods when accrual reversed against earnings, market penalizes firms with accrual reversal by revising their price valuation. For ADR firms, there is no significant association between accrual reversal and stock returns after controlling for earnings change, suggesting any change in accruals is due to changes in firm performance.