Do Firms Mislead Investors by Overstating Earnings Before Seasoned Equity Offerings?

Abstract

Rangan (1998) and Teoh, et al. (1998) argue the failure on part of investors to identify pre-offering earnings management as a cause for the post-offering stock underperformance. This paper re-examines their hypothesis. Like Rangan and Teoh et al., I find evidence of earnings overstatements by issuers, but show their conclusions on investor naivete to be influenced by skewness in long-run returns data. Far from being naive, investors appear to infer earnings management and rationally undo its effects at offering announcements. The paper shows this to be consistent with an extension of the Myers-Majluf model, which endogenizes asymmetric information between managers and investors around equity offerings. I conclude that earnings management by issuers may not be intended to mislead investors, but may merely reflect their rational response to anticipated market behavior at offering announcements.