Earnings management and the performance of UK open offering firms

This study examines the long-run operating and stock price performance of UK open offering firms in the context of the ‘earnings management hypothesis’. The UK stock market differs from that of the US in that UK seasoned equity issues are normally first offered to the existing shareholders in proportion to their current shareholdings, as compared to the US market where seasoned new issues are mostly offered to the general public. An examination of a sample of 181 UK open offers made during 1991?95, reveals that the offering firms experience significant improvements in their operating performance in the pre-offer period and significant declines in the post-offer period both relative to the industry median and performance matched non-offering firms. The time series pattern of pre- and post-offer cash flow performance is opposite to that of the pre- and post-offer net earnings performance. The results also indicate that open offering firms use discretionary current accruals in the pre-offer years to manipulate earnings. Moreover, offering firms that manage their earnings aggressively in the pre-offer period underperform their non-offering matched firms by a median of more than 9% in the asset-scaled growth in net earnings over a period of three years following the offer year. Results on the stock return performance show that offering firms outperform the market and Fama-French three-factor returns in the pre-offer year but underperform both these benchmarks over a period of four years after the offer year. Analysis of the conservative and aggressive offering firms’ four-year post-issue market adjusted returns suggests that the aggressive issuers underperform the conservative issuers by an average of more than 23%. The regression results suggest that one-year pre-offer discretionary current accruals can be used to predict, at least partially, the two-year post-offer stock return underperformance. These findings are more consistent with the earnings management hypothesis than with the ‘timing hypothesis’ and suggest that investors do not fully take advantage of the information available prior to the offer.