Earnings management and the performance of UK rights issuers

This study tests the ‘earnings management hypothesis’ in a market that differs significantly from the US market in that UK seasoned equity issuers rely mostly on rights issues to existing shareholders rather than public offerings to new investors as in the US. The study examines a sample of 424 rights issues by UK industrial companies during the period 1991–95. The results indicate that the operating performance of rights issuers, relative to industry median and performance-matched non-issuing firms, improves significantly before the issue but deteriorates thereafter. This increase in net earnings prior to the issue is not mirrored in cash flows. Decomposing total accruals into four categories, we find that firms actively use discretionary current accruals to manipulate earnings. Pre-issue stock return performance, using various returns measures, suggests that rights issuers significantly outperform the market in the year before the issue, but significantly underperform in the four years after the issue. Comparing the four-year post-issue market adjusted returns of conservative and aggressive earnings management issuers suggests that aggressive issuers underperform their conservative counterparts by more than 20%. The results from a regression analysis suggest that discretionary current accruals in the pre-issue year help to predict the return underperformance in the two years after the issue year. The fact that these results are found for rights issues where new equity is offered pro rata to existing shareholders suggests that managerial motives drive the incentive to manage earnings.