Discretionary financial reporting: Items manipulated by IPO firms, and investors' increased awareness

This paper examines discretionary financial reporting of three major accounting items, earnings, sales, and research and development expense, for a sample of 2,975 initial public offering (IPO) firms in the period 1988--2000. Four distinct groups of firms are analyzed: science-based firms, technology-based firms, assets-in-place firms, and Internet firms. I document significant variation in discretionary reporting across the groups in accordance with the importance that investors in each group attach to the items. I find that discretionary sales for the technology-based group and discretionary accruals for the assets-in-place group predict long-term stock returns; this result would seem to support opportunistic reporting behavior by firms and suggest that investors are unaware that some reporting is discretionary, I demonstrate that the unique research design that examines manipulation of different accounting items by distinct groups of firms and their association with long-term stock returns is essential for research on discretionary reporting by IPO firms; a more general model that only examines discretionary accruals by the entire sample generates much weaker results.; Over time, it seems that investors in the technology-based firms learn about the use of discretion in reporting and for the most part do not price the discretionary components; in contrast, investors in the assets-in-place firms seem to remain fixated on the reported data. Companies do not seem to be aware of the reduced benefit of data manipulation over time, as its magnitude is virtually unchanged over the periods studied. Alternatively, it is possible that firms are aware, but that the cost of discretionary reporting is too small to cause them to change their behavior.