Earnings management, IPO underpricing, and IPO underperformance

The first purpose of this study is to test whether earnings management can explain the IPO underpricing phenomenon. I hypothesize that IPO firms' initial offer prices are not initially discounted, but instead, are correctly set based on the firms' unmanaged earnings. This assumption is based on the belief that the initial offer prices are set by individuals less likely to suffer from the information asymmetry faced by the secondary market. I hypothesize that the common first day increases in IPO prices are not due to discounted initial offer prices, but are due to first day price inflation. I further hypothesize that this inflation is correlated with pre-IPO earnings management.; The results show that there is a stronger relationship between initial offer prices and unmanaged earnings per share than between initial offer prices and reported earnings per share. The results also show that the relationship between initial after-market prices and reported earnings per share is stronger than the relationship between initial after-market prices and unmanaged earnings per share. These results provide support for my explanation of the IPO "underpricing" phenomenon.; The second purpose of this study is to test the economic profitability of a zero-investment trading strategy based on knowledge of IPO underperformance and on estimates of pre-IPO earnings management. This trading strategy is implemented by forming two-firm portfolios that take short positions in the IPOs and long positions in control firms matched by industry and market capitalization. The economic profitability of trading on the knowledge of IPO underperformance is tested by calculating an average abnormal return over all of the two firm-portfolios. The economic profitability of trading on estimates of pre-IPO earnings management is then tested by separating the two-firm portfolios into four groups based on the estimated levels of pre-IPO earnings management and then calculating an average abnormal return over each group. The first test shows that significant positive abnormal returns can be earned trading on knowledge of IPO underperformance. However, the second test fails to show a link between the level of abnormal returns earned on this trading strategy and the level of pre-IPO earnings management.