How Do Financial Constraints Relate to Financial Reporting Quality? Evidence from Seasoned Equity Offerings

Abstract

This paper examines the relation between firms’ financial constraints and their financial reporting during periods when they attempt to raise equity capital. I document that constrained issuers, which cannot credibly signal the absence of aggressive earnings management, report higher income-increasing accruals around SEOs than unconstrained issuers. This result is robust to controlling for several variables that may affect the level of earnings management such as growth opportunities, analyst following, and CEO equity holdings, as well as using the instrumental variable approach. I also find that investors correctly conjecture this greater earnings inflation and adjust issuers’ stock prices accordingly at the time of the offering. The evidence suggests that the aggressive earnings management by constrained issuers is not simply the result of managerial opportunism but rather a rational response to anticipated market behavior at offering announcements.