Understanding earnings quality - MIT Sloan School of Management

5.5.1 Incentives when firms raise capital
The premise of this literature is that the cost/benefit trade-offs of accounting choices change
during periods when a firm raises capital. Greater litigation risk, for example, may increase the costs
of opportunistic accounting choices. Greater utility associated with the availability or price of
capital may increase the benefits of opportunistic accounting choices. Hence, the firm’s accounting
choices, and thus its earnings quality, may differ when a firm is raising capital.
A firm’s initial public offering (IPO) is a commonly examined setting. Friedlan (1994) and
Teoh, Wong, and Rao (1998) find that firms have income increasing discretionary accruals prior to
setting the offer price in an IPO. Aharony, Lin, and Loeb (1993) find little evidence that accruals
are abnormally high prior to a firm’s IPO. To the extent there is evidence suggesting earnings
management, they find it more prevalent among smaller and more levered firms and those that use
lower quality underwriters and brokers. Teoh, Wong, and Rao (1998), however, find unusually high
abnormal accruals in the IPO issue-year and lower allowances for doubtful receivables. Similar to
Aharony et al. (1993), Morsfield and Tan (2006) find that monitoring is a mitigating factor; IPO-year
abnormal accruals are lower for IPO firms with venture capitalists than for other IPO firms.
We also observe evidence outside the IPO setting that firms’ accruals choices are affected by
capital market incentives. Haw, Qi, Wu, and Wu (2005) find that Chinese firms that meet or just
miss the 10% ROE requirements to qualify to make a stock rights offering in China between 1996
and 1998 have higher accruals. Erickson and Wang (1999) find evidence of income increasing
earnings management via accruals prior to stock-for-stock merger agreements. In a management
buyout (MBO), when the incentive is to understate performance to justify lower offer prices to
existing shareholders, DeAngelo (1986) finds no evidence of income-decreasing discretionary
accruals in the MBO year for 64 deals prior to 1982 using the year-over-year change in working
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