Managing Underpricing? The Case of Pre-IPO Discretionary Accruals in China

Abstract

Previous studies have found that companies use income-increasing positive discretionary accruals (DAC) prior to initial public offerings (IPOs) to inflate earnings as a signal to anticipate future income and future dividends. This study, directly explores the role of DAC in prospectus information of 691 A-shares IPOs in China during the period 1995–2002 and its relationship with market-adjusted returns. The results suggest that in China, pre-IPO non-discretionary accruals (NDAC) as well as DAC have informative value in explaining first-day returns as well as first-year adjusted returns. However, in yearly cross-sectional models, I find that firms use income-decreasing accruals (conservative accounting) in prospectus financial statements. This downward manipulation or income “understatement” creates a regulatory setting that could explain initial underpricing and abnormally high IPO returns for A-shares. In addition, the results show that as state ownership (SO) increases, cash flow also increases, exacerbating agency costs and adverse selection problems. These findings may suggest that managers might be using more conservative accounting in Prospectus financial data to offset the agency costs related to high cash flow, and high SO, by “banking income” and possibly therefore “smoothing” the effects of possible future suboptimal earnings.

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