Industry-Level Earnings Management and IPO Pricing

Abstract

We examine the information spillover effects related to industry-average earnings management on the pricing of IPOs, both before and after IPOs begin trading in the secondary market. We posit that a systematic component of the variation in the firms’ earnings management is related to industry-average earnings management, and therefore, the current level of industry-average earnings management provides useful information regarding the earnings quality and valuation of the IPO firm. Results provide evidence consistent with our proposition and indicate higher industry-average discretionary accruals negatively affect the pre-issuance price update and also the first day return of IPOs. Our findings are robust to the inclusion of discretionary accruals of the IPO firm as well as an estimate of IPO firm audit quality. Our findings lend support to the partial adjustment phenomenon of IPO pricing which suggests information that influences valuation is only partially incorporated in the initial offer price and more fully incorporated in the share price during the first day of secondary market trading. Most importantly, our results are consistent with the interpretation that information contained in the average earnings quality of peer industry firms is utilized to help establish the market value of the new IPO firm.