Equity and Debt Issuance by Firms Violating GAAP

Transcription

1 Equiy and Deb Issuance by Firms Violaing GAAP Absrac We examine securiy issuance in resaed periods by firms ha misrepor financial saemens and find ha only a small percen of such firms issues securiies in he resaed period. Invesors are misled by misakes made by firms issuing equiy more so han oher resaing firms a he iniial announcemen of misrepored earnings, bu are no misled by misakes made by deb-issuing firms. Equiy-issuing firms ha manage earnings o bea analys expecaions experience abnormally high reurns in he resaed period prior o securiy issuance. Firms ha resaed more repors and have higher pre-misake reurns are more likely o issue equiy. High leverage, firm size and number of resaed periods are posiively associaed wih he likelihood of deb issuance by resaing firms. 1

2 1. Inroducion We sudy equiy and deb issuance in resaed periods by firms ha violae Generally Acceped Accouning Principals (GAAP). 1 Prior lieraure suggess ha one of he reasons firms violae GAAP is o reduce he cos of securiy issuance (Dechow, Sloan, and Sweeny (1996), Richardson, Tuna and Wu (2003), Burns and Kedia (2006), Efendi, Srivasava and Swanson (2006)). These sudies find ha firms ha resae financial saemens or are subjec o Securiies and Exchange Commission (SEC) enforcemen acions for financial reporing violaions (AAERs) raise more capial han conrol firms during violaion periods. They also find ha securiy issuance in he violaion period increases he likelihood of a resaemen or an AAER. They inerpre hese resuls as evidence ha firms manage earnings o issue securiies a beer prices. However, hese resuls are weak evidence o sugges ha resaing firms violae GAAP in order o issue securiies a inflaed prices. For example, i is plausible ha when equiy and deb issuance is moivaed by oher consideraions, i resuls in higher scruiny of he firm s accouning by managers, audiors, he SEC and oher marke paricipans and hus increases he likelihood of a resaemen or an AAER. Anoher explanaion for high securiy issuance in he resaed period is he successful marke iming by managemen. Above menioned sudies also find ha firms resaing financial saemens experience abnormally high performance prior o he firs resaed year. Therefore, abnormally high firm performance prior o misreporing can be driving boh securiy issuance and he likelihood of misreporing. In fac, Efendi, Srivasava and Swanson (2006) find ha securiy issuance does no explain he likelihood of a resaemen when 1 Resaed period is defined as he period beween he beginning of he firs resaed year or quarer and he dae of resaemen announcemen. 2

3 he pre-missaemen price run up is included as an explanaory variable. This resul is consisen wih Jensen s (2005) heory of overvalued equiy which suggess ha overpricing leads o value desrucive behavior, such as earnings managemen. Furhermore, none of hese papers es wheher erroneous accouning prior o securiy issuance is associaed wih misvaluaion in he resaed period. The main conribuion of his paper is ha i goes beyond he analysis of he frequency of securiy issuance in he resaed period and ess wheher resaing firms experience abnormally high performance in he period afer GAAP violaion bu before securiy issuance, and wheher his performance is relaed o he magniude of accouning misrepresenaion relaive o expecaions. This paper is also he firs o examine which resaing firms are more likely o issue equiy and deb. We analyze 446 US firms ha resaed financial saemens due o violaions of GAAP during he period from January 1, 1996 o June 30, A sample of resaing firms provides a unique seing for sudying he impac of he qualiy of financial informaion on securiy issuance because ex pos one observes he dae and he naure of misakes in financial saemens and he dae of he correcion of hose misakes. We read resaemen announcemens o deermine which financial repors were resaed and he impac of resaemen on ne income. Our research design allows us o direcly es wheher oversaemen of repored earnings is associaed wih invesors over opimism abou firm prospecs prior o equiy and deb issuance. Unlike prior sudies ha examined securiy issuance by resaing firms (Burns and Kedia (2006), Efendi, Srivasava and Swanson (2006)), we focus on acual securiy issuance raher han balance shee proxies. 3

4 We find ha only a small percen of resaing firms issues securiies in he resaed period: 15% of resaing firms issue equiy and 6% issue deb in he resaed period, compared wih 9% of conrol firms issuing equiy and 4% issuing deb. 2 The difference beween he frequencies of securiy issuance is saisically significan. Alhough he percen of resaing firms issuing securiies is higher han he percen of conrol firms issuing securiies, he number of issuances in he resaed period is small o argue ha securiy issuance is he dominan reason for violaing GAAP - only 20% of firms issue eiher equiy or deb. Therefore, 80% of resaing firms were no moivaed by securiy issuance o violae GAAP. Moreover, no all resaing firms ha issue equiy manage earnings upward. Nineeen percen of equiy issuing firms and weny one percen of deb issuing firms undersae ne income prior o he issuance. If he firm undersaes ne income prior o securiy issuance, i will no obain financing a more favorable erms. Therefore, securiy issuance could no be a raional moivaion for downward earnings managemen. Overall, he resuls sugges ha here is no srong connecion beween he ac of resaemen and securiy issuance. If some firms violae GAAP o reduce financing coss, hen we should observe posiive associaion beween abnormal reurn a he announcemen of earnings and he misake, adjused for expeced earnings. We es his proposiion by examining wheher invesors are misled by misakes in repored earnings prior o equiy and deb issuance. Following Bardos, Golec and Harding (2011) we decompose repored earnings ino correcly saed componen and misake and examine abnormal reurns a he iniial 2 Conrol firms are found among all firms ha did no resae heir earnings during he period January 1, 1995 o June 30, 2002 in he same wo digi SIC code as resaing firms ha are he closes in size (marke value) and book-o-marke, measured one fiscal year prior o he announcemen of resaemen, and have sufficien daa o calculae reurns one year prior o misake and one year subsequen o resaemen. 4

5 earnings as a funcion of hese numbers relaive o expecaions. Expecaions are measured as consensus analys forecass. We find ha invesors aach he same valuaion coefficien o he erroneous componen of earnings as hey do o he rue earnings. Invesors are more misled by misakes made by equiy issuing firms prior o he issuance, bu are no misled by misakes prior o deb issuance. For equiy-issuing firms ha manage earnings o bea analys expecaions abnormal reurns persis beyond announcemen window such firms experience abnormally high reurns in he resaed period prior o securiy issuance. Ineresingly, for equiy issuing firms here is lile evidence of abnormal performance before he misakes are made, which suggess ha he abnormal performance prior o equiy issuance is caused by earnings managemen. Overall our resuls sugges ha a small number of firms ha violae GAAP and subsequenly issue equiy mislead invesors. We also examine which ypes of firms in he cross-secion are mos likely o use earnings managemen o issue equiy and deb. We find ha resaing firms ha issue equiy are larger in marke value erms han non-issuing firms, have higher pre-misake reurn, make smaller downward revisions of ne income and resae more repors. Resaing firms ha issue deb are considerably larger, more highly levered, and make smaller downward revisions of ne income han non-issuing firms and firms issuing equiy. Resaing firms ha issue deb resae more repors han non-issuing firms, bu no firms issuing equiy. This paper conribues o he lieraure in several ways. Firs, i is he firs paper o examine wheher firm performance is abnormal subsequen o GAAP violaions before equiy and deb issuances and wheher such performance is associaed wih he magniude 5

6 of he resaemen. Prior lieraure assumed ha if he firm issues securiies in he resaed period, he issuance follows he period of abnormal performance induced by earnings managemen (Burns and Kedia (2006), Efendi, Srivasava and Swanson (2006), Dechow, Sloan and Sweeney (1996)). This paper provides a direc es of his claim. Because he adverse impac of resaemens on shareholder wealh a resaemen announcemen has been used o moivae a number of regulaions, including some provisions in he Sarbanes Oxley Ac of 2002 (Palmrose, Richardson and Scholz (2004)), Agrawal and Chadha (2005)), i is imporan o undersand he full impac of resaemens on financial markes. Second, his is he firs paper o documen he frequency of equiy and deb issuance in he resaed period and examine characerisics of resaing firms issuing securiies. The resuls of his paper complemen he growing sream of lieraure sudying he causes and consequences of financial misreporing, and show ha conrary o prior beliefs, securiy issuance a inflaed prices by resaing firms is no prevalen. Moreover, his paper provides a es of he earnings managemen hypohesis posed by Teoh, Welch and Wong (1998b) for firms violaing GAAP. The earnings managemen hypohesis suggess ha firms pursue aggressive accouning pracices prior o equiy issuance. Such pracices mislead invesors and cause hem o overvalue securiy issuance. However, as he rue value of earnings is revealed, invesors devalue firms ha manage earnings. To es he earnings managemen hypohesis, Teoh, Welch and Wong (1998b) used abnormal accruals prior o equiy issuance as a proxy for earnings managemen. 3 However, Dechow, Sloan and Sweeney (1995), Shivakumar (2000), and 3 A finding ha is common o sudies ha examine earnings managemen prior o seasoned equiy offerings (SEOs), converible deb issuance, iniial public offerings (IPOs) or sock-financed acquisiions is ha firms ha engage in such aciviies on average conain posiive abnormal accrual componens prior o he even, ha he accruals are negaively relaed o pos-even sock reurns, and ha accruals end o reverse during 6

7 Kohari, Leone and Wasley (2005) among ohers show ha abnormal accruals is a poor measure of earnings managemen prior o securiy issuance. 4 The advanage of esing he earnings managemen hypohesis using a sample of resaemens is ha ex pos one observes he deails of accouning misreporing. However, accrual managemen is a more common pracice, which does no impose he large coss of financial misrepresenaion ha are associaed wih resaemens. Therefore, while his sudy exends he prior lieraure ha esed he earnings managemen hypohesis using accruals, is resuls are no direcly comparable o ha sream of lieraure. The paper proceeds as follows. Secion 2 discusses he relaed lieraure and oulines hypoheses esed in his paper. Secion 3 describes he daa. Secion 4 presens resuls and Secion 5 concludes. 2. Relaed lieraure and hypoheses A firm is required o file a prior period adjusmen of financial saemens whenever i discovers maerial discrepancies in previously filed financial saemens. Resaemens resul in significan negaive marke reacion (Akhigbe, Kudla and Madura (2005) and Palmrose, Richardson and Scholz (2004)) ha is spilled over o firms in he same indusry (Akhigbe and Madura (2008)). Markes anicipae financial saemen he pos-even period (Teoh, Welch, and Wong (1998a, b) and Rangan (1998), Friedlan (1994), DuCharme, Malaesa, and Sefcik (2001)), Erickson and Wang (1998), Chrisie and Zimmerman (1994), and Urcan and Kieschnick (2006)). 4 Shivakumar (2000) poins ou four problems wih using discreionary accruals as a proxy for earnings managemen around large evens such as SEOs, IPOs, and mergers. Firs, such evens are frequenly associaed wih unusually large changes o working capial, independen of any earnings managemen. Second, many sudies esimae accruals from balance shee changes in working capial, no by aking hem from cash flow saemens. Third, accrual models commonly used o esimae earnings managemen are mis-specified. Fourh, such evens frequenly involve subsanial expenses ha migh be unpaid prior o he even and hence are accrued a he balance dae, resembling income increasing discreionary accruals. 7

8 resaemens as early as half way hrough he resaed period (Bardos, Golec, Harding (2011)). Resaemens lead o an increase in a firm s cos of capial (Hribar and Jenkins (2004), Bardos, Cline and Koumos (2011), and Graham, Li, and Qiu (2008), Bardos (2011)), and increase he likelihood of liigaions (Palmrose and Scholz (2004), Bradley, Cline and Lian (2010)). Richardson, Tuna and Wu (2003) find ha 452 firms resaing during he period araced more exernal capial han non-resaing firms in he period of alleged manipulaion. They compare he sandardized sum of addiional cash raised from common and preferred sock and long-erm deb for resaing versus non-resaing firms mached by indusry and size during he period of alleged manipulaion. Burns and Kedia (2007) analyze a sample of 215 firms resaing over a period from 1995 hrough They find some evidence ha resaing firms raise more funds in misrepored years han non-resaing S&P 1,500 firms in univariae, bu no in mulivariae seings. Efendi, Srivasava and Swanson (2006) find ha firms making resaemens in 2001 and 2002 raise more funds in he firs missaed year han conrol firms mached on size and booko-marke. 5 The paper does no examine securiy issuance beyond he firs missaed year. These sudies inerpreed he resul ha resaing firms issue more exernal funds han conrol samples as evidence in favor of he earnings managemen hypohesis, i.e., firms manage earnings o issue securiies a more favorable prices. There are several problems wih such inference. Firs, here are oher poenial explanaions for he 5 In a relaed paper, Dechow, Sloan and Sweeney (1996) sudied 92 firms ha were subjec o SEC enforcemen acions for financial reporing violaions (AAERs) beween 1978 and They repor ha he main moivaion as cied by he SEC for earnings managemen was o issue securiies a inflaed prices. They also find ha he AAER sample raises more exernal funds han conrol sample. The paper did no invesigae wheher or no funds were issued a a lower cos han hey would have been in he absence of earnings managemen. 8

9 observed resul. I has been shown by he same sudies ha missaemens follow periods of sock price run-up. Therefore, a higher number of issuances by resaing firms in a resaed period can simply be he resul of a manager s abiliy o ime he marke. Indeed many sudies find ha firms issue equiy when heir shares are overpriced (Jung, Kim and Sulz (1996), Hovakimian, Opler, and Timan (2001), (Dimar and Thakor (2007), Asquih and Mullins (1986), Baker and Wurgler (2002), and Burch, Chrisie, and Nanda (2004)). Anoher plausible explanaion for his resul is ha firms ha issue securiies are more likely o resae as hey face greaer scruiny by he SEC, audiors and invesors han non-issuing firms. Third, hese papers did no es wheher erroneous reporing ha leads o resaemens inflaes securiy prices prior o securiy issuance and herefore allows managemen o issue securiies a more favorable prices. This paper conribues o he lieraure by analyzing wheher maerial misakes in financial saemens allow resaing firms o reduce financing coss. We sudy a sample of firms ha resaed financial saemens during For hese firms we can ex pos idenify financial repors which conained misakes as well as he size of he misakes (see Figure 1). We can also deermine if he firms issued securiies in he resaed period. Equiy or Deb issuance dae Beginning of he 1 s resaed period Resaemen Announcemen dae Time -b Misake Issuance Resaemen +a Pre-misake period Resaed period Pos-resaemen period Figure 1: Misake is he beginning of he firs resaed period, Issuance is he dae of equiy or deb issuance, Resaemen is he dae of he resaemen announcemen, -b and +a are ime periods of ineres. 9

10 If securiy issuance a favorable prices is one of he main moivaions for misreporing earnings as suggesed by prior sudies, hen one should observe a higher frequency of securiy issuance by resaing firms relaive o conrol firms in he resaed period. This leads o our firs hypohesis: H1: Resaing firms issue more equiy and deb han conrol firms. We examine he number of equiy and deb issuances in he resaed period relaive o a sample of conrol firms. Unlike prior sudies ha use he sum of funds raised hrough equiy and deb obained from Compusa, we use securiy issuance daa from Securiies Daa Corporaion, which allows us o deermine he precise iming of he issuance. As noed earlier, even if hypohesis 1 is suppored, his would no imply ha maerial misakes in financial saemens reduced financing coss of resaing firms. The likelihood of securiy issuance and he likelihood of resaemen can be driven by he same variable, such as overvaluaion in he pre-misake period. Securiy issuance in he resaed period can increase he likelihood of resaemen due o addiional scruiny of financial saemens by managemen, audiors, regulaors and oher marke paricipans. To es wheher misreporing allows resaing firms o issue securiies a more favorable prices, we examine wheher maerial misakes of issuing firms resul in misvaluaion. If invesors are misled by maerial misakes in repored earnings hen hey would price he error componen of earnings he same way as hey price he rue earnings. For example, if he error pus he firm in line wih expecaions, hen here should be no abnormal performance a he announcemen of earnings. Similarly, if oversaed earnings 10

11 cause he firm o bea expecaions ha may generae posiive abnormal performance. Mos of he acion will ake place a he announcemen of earnings. A well esablished resul in he lieraure is ha earnings announcemen reurns are posiively relaed o unexpeced earnings (Ball and Brown (1968), Collins and Kohari (1989)). Abnormal reurn R a he earnings announcemen a ime is a funcion of he difference beween repored earnings I and expeced earnings E (I ). The -1 difference beween repored and expeced earnings I E (I ) has been ermed -1 sandardized earnings surprise SUE: R + = α + b1(i E -1(I )) + ε = α + b1sue ε, (1) The coefficien b 1 is called he earnings response coefficien (ERC). Bardos, Golec and Harding (2011) sudy wheher invesors are misled by missaed earnings by esimaing wheher invesors aach he same earnings response coefficien o he missaed earnings as hey do o he rue componen of earnings. Specifically, hey esimae he following equaion: R = α + b (I MISTAKE + E- (I )) + b M + ε = α + b SUE b2 ε, (2) where M (MISTAKE) is he amoun by which earnings are missaed, R is marke adjused reurn for a 3 day window (-1; +1) relaive o he earnings announcemen on day zero. They find ha coefficien is posiive and equal o b, suggesing ha invesors b2 1 are fooled by misakes in financial saemens and rea missaed componen of earnings he same way ha hey rea he correcly saed componen. 11

12 If firms violae GAAP o reduce financing coss, hen we should observe posiive associaion beween abnormal reurn a he announcemen of earnings and he misake, adjused for expeced earnings. H2: There is a posiive associaion beween abnormal earnings announcemen reurns and misake in repored earnings for firms issuing equiy and deb. To es hypohesis 2, we esimae he following wo models: R = α + b SUE + b Equiy b MISTAKE + b Equiy 4 2 *SUE + b Equiy 5 * MISTAKE + ε, (3) R = α + b SUE + b Deb b MISTAKE + b Deb 4 2 *SUE + b Deb 5 * MISTAKE + ε, (4) Equiy (Deb) is a dummy ha equals one for quarers in he resaed period preceding equiy (deb) issuance. For example, if a firm resaed financial saemens for 1999 and 2000 fiscal years and issued equiy in November of 1999, hen Equiy will equal one for he firs hree quarers of 1999 (provided ha he 3 rd quarer is announced prior o equiy issuance announcemen). If invesors are misled by misakes in financial repors of equiy and deb issuing firms, hen b2 + b5 > 0 and b 2 + b5 = b1 + b4. If invesors are only parly fooled, hen b 2 + b 5 < b 1 + b 4. We esimae equaions (3) and (4) using OLS regression. For each firm, we include all quarers in he resaed period in his period MISTAKE is non zero. To provide a benchmark for he esimaion in he resaed period, for each firm we include quarers for wo years preceding he resaed period and cluser errors by firm. As a resul, usual performance of he firm in pre-resaemen period is used as is own conrol. Clusering sandard errors by firm also correcs for cross-secional and imeseries dependence (Peersen (2009)). 12

13 If he issuing firms manage earnings o bea expecaions (MISTAKE>SUE) and if invesors are fooled by he misakes (hypohesis 2 holds) he misvaluaion migh persis over he longer ime period. Firms ha bea expecaions by a greaer amoun should experience greaer misvaluaion. Issuing firms, whose earnings managemen merely pus hem in line wih expecaions, will simply experience normal performance over an exended period. H3: If SUE<0 and MISTAKE>SUE, issuing firms will experience abnormal performance in he resaed period before securiy issuance. To es hypohesis 3 we examine abnormal reurns in he resaed period unil securiy issuance (period (Misake, Issuance)) relaive o several benchmarks: usual performance of he firm iself, conrol firm and he marke. 6 Lasly, we examine which ypes of firms in he cross-secion are mos likely o use earnings managemen o issue equiy and deb. We also sudy wheher here is a difference in earnings managemen beween deb versus equiy issuance. As discussed in he inroducion and he resul secion, only a small percen of resaing firms issue equiy and deb. Because of he small sample size, we focus only on a few key characerisics o preserve he degrees of freedom in mulivariae analysis. An esablished resul in he lieraure is ha firms issue equiy afer periods of run-up in sock prices (Baker and Wurgler (2002)). Prior lieraure has also shown ha resaing firms make misakes in financial saemens following periods of abnormally high performance (Burns and Kedia (2007), Efendi, Srivasava and Swanson (2006)). Therefore, we should expec firms wih beer pre-misake performance o be more likely o issue equiy han deb. 6 Calculaion of abnormal reurns is discussed in deail in secion

14 H4: Firms wih beer pre-misake performance are more likely o issue equiy. Several sudies find ha firms close o violaing lending covenans manage earnings (Sweeney (1994), DeFond and Jiambalvo (1994)), and Dechow e al. (1996)). These sudies sugges ha avoidance of penalies associaed wih he violaions of deb covenans is a moivaion o manage earnings. A firm would manage earnings o issue new deb if earnings managemen allows he firm o obain deb a more favorable erms. A firm ha mees resricive covenans can obain more favorable financing. Prior sudies use leverage as a proxy for he pressure firms feel o manage earnings (Richardson e al (2002), Burns and Kedia (2007)). H5: Firms wih higher leverage are more likely o issue deb. We examine wheher firms ha issue equiy and deb differ from non issuing firms in erms of resaemen characerisics. If issuing firms make larger misakes, his would sugges ha hey have a longer disance o heir earnings hreshold. Issuing firms are more likely o have longer resaed period because he likelihood of any even is greaer during a longer ime period. We also conrol for firm size in mulivariae analysis. 3. Daa We colleced a sample of US firms ha announced resaemens of financial saemens beween January 1997 and June We searched Lexis-Nexis daabase using key words resaemen, resa, revis, adjus, error and responding o guidance from he SEC. We crossed checked search resuls wih he sample released by he Governmen Accounabiliy Office (GAO). Unlike he GAO sample, we excluded resaemens ha were caused by an adopion of new accouning rules, and reained only resaemens due o a misake or an improper inerpreaion of GAAP rules. Afer 14

15 idenifying he sample of companies announcing resaemens, we searched for he originally filed and resaed financial saemens on Lexis-Nexis (Forms 10-K/A(s) and Forms 10-Q/A(s)). The following daa was colleced from resaemen announcemens and original and resaed financial saemens: dae of he announcemen of resaemen, years and quarers resaed, original and resaed ne income. The search resuled in 536 resaemens made by 496 firms. We imposed several oher filers. Some firms resaed more han once during he sample period. In several cases resaed periods of muliple resaemens by he same firm overlapped. To avoid double couning securiy issuance, we deleed 29 resaemens ha had overlapping resaed periods. The laer of he wo resaemens wih overlapping resaed periods was deleed. Second, we deleed 20 resaemens for which he impac on ne income was zero or could no be idenified. Third, we deleed 6 Real Esae Invesmen Truss (REITs). Because REITs are required o pay ou 90% of heir repored ne income in dividends, hey may have differen consideraions when deciding wheher o issue equiy or deb. Fourh, 35 observaions were los because hese firms did no have daa in Compusa o find a maching firm. The final sample consiss of 446 resaemens by 436 firms. Ten firms resaed financial saemens wice during he resaed period (Table 1, Panel A). Reurn daa is from CRSP. Financial daa was obained from Compusa. Informaion on equiy and deb issuance is aken from he Securiies Daa Corporaion daabase (SDC Plainum). [Inser Table 1 abou here] 15

16 4. Resuls 4.1. Descripive Saisics Table 1, Panel B shows he disribuion of resaemens by year, which is similar o ha of prior sudies. There was an increase in resaemens in 1999 and Noe ha 2002 resaemens were colleced only hrough July. As a resul, all resaemens in he sample precede he enacmen of he Sarbanes Oxley Ac and are made in a common regulaory environmen. Table 1, Panel C shows disribuion of resaemen characerisics. An average firm resaes 1.34 annual repors. Table 1, Panel C also shows he disribuion of he magniude of he misake, which is measured as he difference beween resaed ne income and originally repored ne income, sandardized by he absolue value of he originally repored ne income (ΔNI/abs(OriginalNI)). This measure is heavily skewed, wih he mean falling below he firs quarile. The median reducion of previously repored ne income is -23% for he full sample. Table 1, Panel C also shows he disribuion of he ΔNI/Asses, which is he difference beween resaed ne income and originally repored ne income, sandardized by book value of oal asses measured one year prior o resaemen announcemen. This measure of misake shows similar paern as does ΔNI/abs(OriginalNI). However, ΔNI/Asses is considerably less skewed. Therefore, we rely more on he ess using ΔNI/Asses. Table 1, Panel D shows ha he majoriy of resaing firms revise ne income downward a resaemen announcemen (downward resaemens). Only 13.7% of our sample revises ne income upward a resaemen announcemen (upward resaemens). Panel E shows ha downward resaemens are of greaer magniude han upward resaemens. 16

17 Table 2, Panel A shows seleced characerisics of resaing firms one fiscal year prior o he announcemen of resaemen. The mean (median) marke value of resaing firms is $2,259 million ($183 million). The mean (median) book value of resaing firms is $2,375 million ($223 million). The mean leverage is 18.45% and he mean book-omarke raio is Table 2, Panel B shows he characerisics of conrol firms in he year in which he maching is performed (one year prior o he resaemen announcemen). Conrol firms are found among all firms ha did no resae heir earnings during he period January 1, 1996 o June 30, 2002 in he same wo digi SIC code as resaing firm, ha are he closes in size and book-o-marke and have sufficien daa o calculae reurns one year prior o misake and one year subsequen o resaemen. Marke value and book-omarke raios of resaing firms are measured one fiscal year prior o he announcemen of resaemen. Table 2, Panel C compares characerisics of resaing and conrol firms using 2- ailed Wilcoxon signed ranks es. The samples do no differ in erms of size and book-omarke, which indicaes a successful mach. They also do no differ in erms of he book value of asses. Resaing firms are more highly levered han conrol firms. On average, resaing firms have a capial srucure ha has 2% more deb. [Inser Table 2 abou here] 4.2. Equiy and deb issuance Resuls presened in Table 3 and Table 4 show ha resaing firms issue more equiy and deb in he resaed period han non-resaing firms. Table 3, Panel A shows frequency of equiy issuance by resaing and conrol firms in he resaed period. 17

18 Resaed period is defined as he period beween he beginning of he period of he firs misake (year or quarer) and he resaemen announcemen. There are 85 equiy issuances made by 68 resaing firms. The number of equiy issuances by resaing firms is surprisingly low. Only fifeen percen of resaemens have equiy issuance in resaed period. Conrol firms issue less equiy. Fory one conrol firms issue equiy in 48 mached resaed periods. This suppors hypohesis 1 and suggess ha equiy issuance serves as a moivaion for some resaing firms. The majoriy of resaing and conrol firms issue equiy only once (78% of resaing firms and 85% of he conrol firms). Thireen of resaing firms and five of conrol firms issue equiy wice, wo of resaing firms issue equiy hree imes and one of conrol firms issues equiy four imes (Table 3, Panel B). Resaing firms raise more equiy per issuance: $110 million versus $82 million per conrol firm, however he difference is no saisically significan. Boh resaing and conrol firms raise non-rivial amouns of equiy as a percen of oal asses: 33.74% and 40.67% for resaing firms and conrol firms, respecively. [Inser Table 3 abou here] Table 4 shows he same saisics for deb issuance in he resaed period. 7 We find ha while fewer resaing firms issue deb han equiy in he resaed period (6.28%), many firms raise deb more han once in resaed period and raise more funds per issuance. Similar paern is seen for conrol firms. There are more deb issuances in resaed period by resaing firms han conrol firms. However, he difference in he 7 Number of deb issuances figures in Table 4 combine sraigh and converible deb issuance. Saisics for he wo ypes of issuances are combined because of very small number of converible deb issuances. There are four converible deb issuances by resaing firms and hree by conrol firms. Small number of observaions does no allow furher saisics analysis of converible deb issuance. All resuls are unaffeced by exclusion of converible deb issuances. 18

19 number of firms raising deb beween resaing and conrol sub-samples is no saisically significan (28 resaing firms versus 18 conrol firms). Therefore, hypohesis 1 is no suppored for deb issuance. Moreover, conrol firms raise more per issuance: he mean issuance size is $ million (1.91% of oal asses) for resaing firms and $ million (2.88% of oal asses) for conrol firms. This difference is saisically significan. [Inser Table 4 abou here] Ineresingly, no all resaing firms ha issue equiy manage earnings upward. We find ha 13 ou of 68 resaing firms ha issued equiy in he resaed period undersaed ne income; and 6 ou of 28 deb issuing firms undersaed ne income. We call firms ha undersaed ne income and as a resul had o revise ne income upward as upward resaemens. If he firm undersaes ne income prior o securiy issuance, i will no obain financing a more favorable erms. Therefore, securiy issuance could no be a raional reason for downward earnings managemen. We focus our analysis on 55 equiy issuing and 22 deb issuing firms ha resae ne income downward (downward resaemens) Marke reacion o iniial announcemen of missaed earnings In his secion we es hypohesis 2 by analyzing marke reacion o he iniial announcemen of missaed earnings. We calculae SUE as sandardized earnings surprise based on Sree earnings repored in I/B/E/S because Bradshaw and Sloan (2002) find ha Sree earnings are more direcly comparable wih analyss forecass. As a resul, earnings surprise is more precisely measured using Sree earnings. We follow Bardos, Golec and Harding (2011) in calculaing correcly saed earnings. SUE is he difference 19

20 beween correcly saed earnings and consensus analys forecass. The consensus analys forecas is calculaed as he median of forecass repored o I/B/E/S in he 90 days prior o he earnings announcemen, considering only he mos recen forecas for each analys. SUE and Misake are sandardized by he sock price. Earnings announcemen daes are obained from I/B/E/S. We are able o idenify sufficien daa for esimaing equaions (1)-(4) for 1,843 quarers corresponding o 226 firms. Of hese firms, only 22 issued equiy and 13 issued deb in he resaed period. R is calculaed as marke adjused reurn using equally weighed CRSP marke index as a proxy for he marke reurn. 8 Table 5, Panels A and D show descripive saisics for R, SUE and Misake for various sub-samples. For he full sample, boh he mean and he median R is posiive and equals.12% and.45%, respecively. SUE is negaive, wih he mean of and Misake is posiive wih he mean of We show separae able for he resaed period sample, during which Misake is no equal zero. Ineresingly, for his sub-sample boh mean and median R is negaive and equals -1.02% and -.13%, respecively. The median Misake almos exacly offses he negaive median SUE, suggesing ha firms manage earnings o simply mee (raher han bea) expecaions. Panels C and D show descripive saisics for equiy issuing and deb issuing firms for he resaed period quarers. Boh Misake and SUE are larger for equiy sub-sample. For deb issuing firms mean and median misake does no pu he firms in line wih expecaion since SUE is negaive and in absolue erms larger han Misake. [Inser Table 5 abou here] 8 Resuls are robus o using equally weighed index. 20

21 Table 5 Panel E shows regression resuls for he full sample. Model 1 esimaes equaion (1) and is consisen wih prior lieraure. I finds ha abnormal reurns a earnings announcemen are a posiive funcion of earnings surprise. Model (2) esimaes equaion (2) and confirms resuls in Bardos, Golec and Harding (2011) ha invesors aach posiive valuaion o he erroneous componen of earnings and value hem he same way as correcly saed earnings (as suggesed by posiive b2 which equals b1). We es hypohesis 2 by esimaing Models 3 and 4 (Table 5, Panel E). Model 3 esimaes equaion (3), which shifs all coefficiens for equiy issuing firms. We find ha he dummy coefficien Equiy is negaive and significan, suggesing ha overall R is lower han for he res of he sample. This resul is consisen wih univariae saisics - R is lower in Panel C han in Panels A and B. For equiy issuing firms, he oal coefficien on SUE ( b ) 1 + b4 and Misake b + ) are posiive and significan. As for he ( 2 b5 full sample, hese wo coefficiens are equal each oher for equiy issuing firms. Significance of he coefficien on Misake for equiy issuing firms indicaes ha invesors are misled by misakes of such firms. Ineresingly, we find ha coefficien b 4 on he ineracion of SUE and Equiy dummy is posiive and significan. This shows ha invesors reac more srongly o surprises in correcly saed componen of earnings of equiy issuing firms. This resul suggess ha equiy issuing firms are overvalued. Similarly, we find ha he coefficien b 5 on he ineracion of Misake and Equiy dummy is posiive and significan, suggesing ha invesors are more misled by misakes made by equiy issuing firms hen oher resaing firms. Model 4 shows similar analysis for deb issuing firms. We find ha invesors are no misled by misakes made by deb issuing firms ( b + ) is no significan). We also ( 2 b5 21

22 find ha he coefficien on SUE for deb issuing firms is no significan, suggesing ha our sample migh be oo small o es predicions for deb issuing firms. Table 5 Panel F shows regression resuls for he downward resaemens. All resuls are similar o hose for he full sample (Panel E). Overall, we find suppor for hypohesis 2 for equiy bu no for deb issuing firms Abnormal reurns in he resaed period before equiy and deb issuance To es hypohesis 3 we examine abnormal reurns in he resaed period unil securiy issuance (period (Misake, Issuance)). This period begins afer he resaed earnings have been repored o he marke (day +2) and end wo days prior o he announcemen of he securiy offer. For firms ha are missing earnings announcemen dae, he sar dae is calculaed as he end of he quarer plus 29 days, which is he average lag beween he end of he quarer and he reporing dae for our sample. To ensure robusness of he resuls, we calculae several measures of abnormal performance. Firs, we calculae cumulaive abnormal reurns prior o equiy and deb issuance in resaed period ( CAR (Misake, Issuance) esimae marke model parameers as follows. ). To calculae marke model CAR, we firs R i = α + β R + ε (5) i i m i where R is he reurn on firm i on day, R is he reurn on he marke index on day i (value-weighed CRSP marke index), and ε i is a random error erm. The abnormal sock reurn for securiy i on day is defined as m Marke Model AR i ^ ^ = R ( α + β R ) (6) i i i m 22

23 Cumulaive abnormal reurn is he sum of abnormal reurns over period τ. We repor daily CARs, since some of he periods of ineres are firm specific. Daily CARs are calculaed as CARs divided by he number of days over which accumulaion occurred. We esimae marke model parameers for 250 rading days saring on day -250 relaive o he beginning of he resaed period. This window is chosen so ha he same marke model parameer esimaes can be used o es wheher CARs are abnormal one year before he beginning of resaed period ( CAR (1 year, Misake) ). Unforunaely, only 32 of 68 equiy issuing firms have enough daa o esimae marke model parameers for his period. To recover some of he observaions and o ensure he robusness of he resuls, we also esimae marke model parameers for 250 days saring on day -5 relaive o misake. Table 6 shows ha he resuls depend on he esimaion period for marke model parameers. Therefore, we esimaed wo more measures of abnormal performance: marke adjused abnormal reurns and buy-and-hold abnormal reurns. Marke adjused abnormal reurn is calculaed as Marke Adjused AR i = R R (7) i m The advanage of using his reurn is ha i does no require he esimaion of he marke model parameers and herefore leads o fewer los observaions. The drawback is ha marke adjused reurn does no accoun for he marke risk. Buy-and-hold reurn ( BHR i,τ ) over period τ for firm i is calculaed as he geomeric reurn. BHR i,τ represens he acual experience of an invesor who passively holds a sample firm for period τ. T BHR = i, τ (1 + R i ), (8) 23

24 where R i is he i h firm reurn on he h day, and T is he number of rading days in period τ. Buy and hold abnormal reurn ( BHARi, τ ) is calculaed as: BHAR BHR E BHR i i, τ = i, τ (, τ), (9) where E( BHRi, τ ) is he τ period expeced reurn for securiy i. We use wo esimaes of expeced earnings. The firs proxy is he performance of resaing firm iself one year before he sar of he resaed period. The second proxy is he reurn on a size and book-o-marke mached peer firm in he same indusry (wo digi SIC code) as he resaing firm. 9 We follow Lyon, Barber and Tsai s (1999) approach o selecing among possible conrol firms. They showed ha conrol firm approach yields well specified resuls when conrol firms are mached on size and book o marke. 10 Size is measured by he marke value of equiy. Book-o-marke raio is calculaed as he raio of equiy book value o equiy marke value. Boh size and book o marke are calculaed one year prior o resaemen. We eliminae all resaing firms from he pool of poenial conrol firms. We also require conrol firms o have CRSP daa a leas one year prior o misake and one year subsequen o resaemen. Firs, we calculae reurns in he period (Misake, Issuance) for all firms issuing equiy and deb (Table 6, Panels A and B). Table 7, Panel A shows resaed period abnormal reurns prior o equiy issuance. We find ha BHARs boh relaive o conrol firm and relaive o pre-misake period are posiive and significan and equal 0.45% and 0.31%, respecively. 11 Marke adjused CAR is also posiive and significan. However, 9 Conrol firms for hree companies had o be found wihin one digi SIC code o saisfy daa requiremens. 10 They also show ha when using his approach regular saisics are well specified. 11 The period beween misake and securiy issuance and beween securiy issuance and resaemen are firm specific. Therefore, we presen daily abnormal reurns in Table 6. 24

25 marke model adjused abnormal reurns are no saisically differen from zero for his period. Since BHARs are considered o be beer measures of abnormal performance during longer periods, we conclude ha equiy issuing firms experience abnormally posiive performance afer misake before securiy issuance. Nex, we es hypohesis 3 by consraining he sample o only hose firms for which MISTAKE>SUE before equiy issuance. We calculae oal SUE and oal Misake for he period (Misake, Issuance) by adding SUE and Misake for all quarers announced in his period. Of he 22 firms issuing equiy wih available daa for SUE, 16 (73%) make misakes ha allow hem o bea expecaions (MISTAKE>SUE). For all of his firms SUE<0, which means ha in he absence of earnings managemen such firms would no have me analys expecaions. Unforunaely, he daa is available only for 11 of hese firms for calculaion of abnormal reurns. Despie small sample, we find ha for hese firms all measures of abnormal reurns are posiive and saisically significan. 12 This suppors hypohesis 3 for equiy issuing firms firms ha manage earnings o bea analys expecaions experience abnormally high reurns in he resaed period prior o securiy issuance. Table 6 Panel C shows abnormal reurns one year before resaed period for firms issuing equiy in he resaed period (1 Year, Misake). Only marke adjused CAR is posiive and significan, suggesing ha mos of he overvaluaion sars afer he firm repors erroneous earnings. 12 Resuls are no abulaed for breviy. 25

26 Table 6 Panels B and D show ha for deb issuing firms all reurns are saisically insignifican from zero for he period (Misake, Issuance) and (1 Year, Misake). 13 We do no repor marke model CARs, for which marke model parameers are esimaed during period (-254,-5), because esimaion period for model parameers coincides wih CAR period. Only marke model CAR, wih marke model parameers esimaed during he period (-501, -250) relaive o misake, is esimaed for his window. This resul is no surprising in ligh of he finding ha misakes made by deb issuing firms do no cause misvaluaion even during a hree day window a he announcemen of missaed earnings Characerisics of issuing firms Table 7 examines characerisics of resaing firms condiional on securiy issuance for he full sample of resaing firms. 14 Panels A and B show characerisics of resaing firms ha do no issue securiies in resaed period and hose ha issue equiy, respecively. Panel C compares hese sub-samples using wo-ailed Wilcoxon signed ranks es. We find ha resaing firms ha issue equiy in resaed period have higher marke value and reurn one year before he sar of he resaed period. They have he same book value, leverage and book-o-marke raio compared o firms ha do no issue securiies in resaed period. We find ha firms ha issue equiy in resaed period inflae ne income less hrough erroneous accouning han non-issuing firms. This suggess ha resaing firms has shorer disance o he benchmark hey are rying o mee. Despie his, as we showed in secion 4.3, marke reacs more srongly o surprises and misakes made by resaing 13 For 10 ou of 12 firms issuing deb wih available daa for calculaing SUE, SUE is negaive. For 9 firms wih negaive SUE Misake is greaer han SUE. 14 The resuls are robus o consraining he sample o downward resaemens. 26

27 firms ha issue equiy han by non-issuing firms. Resaing firms ha issue equiy in resaed period have longer resaed periods han firms ha do no issue equiy. This resul can be due o he increase in he likelihood of any even happening during longer period of ime. Table 7, Panels D shows characerisics of firms ha issue deb in resaed period and Table 7, Panel E compares his sub-sample o ha of resaing firms ha do no issue securiies. Resaing firms ha issue deb are much larger, more highly levered, make smaller misakes and have longer resaed periods han non-issuing sub-sample. As in he case of equiy issuing firms, he magniude of he misake is smaller for deb-issuing firms han for non-issuing sub-sample. Unlike equiy issuing firms, deb issuing firms do no exhibi posiive sock reurns in pre-misake period. Table 7, Panel F compares resaing firms ha issue deb in resaed period o resaing firms ha issue equiy in resaed period. We find ha firms ha issue deb are much larger and have higher leverage han resaing firms ha issue equiy in resaed period. Firms ha issue equiy make larger misakes in ne income han firms ha issue deb. Since higher ne income is more likely o have a greaer posiive impac on equiy price han on deb price, his resul is consisen wih managers inflaing earnings o obain beer financing. Overall we find suppor for hypohesis 4: equiy issuing firms have beer premisake performance han non-issuing firms and deb-issuing firms. We also find suppor for hypohesis 5: deb issuing firms have higher leverage han boh equiy-issuing and non-issuing firms. [Inser Table 7 abou here] 27

28 Table 8 ess hypoheses 4 and 5 in a mulivariae seing. Specifically, we examine he likelihood of equiy and deb issuance as a funcion of firm and resaemen characerisics by running a logi model. The dependen variable in Model 1 (Model 2), Equiy (Deb), is equal o 1 if he firm issued equiy (deb) and zero oherwise. Please see legend o Table 7 for precise definiions of oher variables. Model 1: Equiy = a + β 1 Buy-and-hold reurn before misake + β 2 Leverage + β 3 ΔNI/Asses + β 4 Number of periods resaed + β 5 log(marke value) Model 2: Deb = a + β 1 Buy-and-hold reurn before misake + β 2 Leverage + β 3 ΔNI/Asses + β 4 Number of periods resaed + β 5 log(marke value) Hypohesis 4 predics ha β 1 >0 in Model 1 and insignifican coefficien β 1 in Model 2. Hypohesis 5 predics ha β 2 >0 in Model 2 and is insignifican in Model 1. We also conrol for resaemen characerisics: is magniude (ΔNI/Asses) and number of periods resaed (Number of periods resaed). We also conrol for firm size by including logarihm of marke capializaion log(marke value). We expec ha larger firms are more likely o issue equiy and securiy. We esimae Models 1 and 2 only for downward resaemens for which firms managed heir earnings upward. As discussed earlier, downward earnings managemen prior o securiy issuance canno lead o more favorable financing and herefore mus be moivaed by oher consideraions. We find suppor for hypohesis 4 and 5. Firms ha issue equiy have higher reurn before misake han non-issuing firms (β 1 >0 in Model 1). Coefficien β 1 is saisically insignifican in Model 2 suggesing ha deb issuing firms do no exhibi high reurns prior o he sar of he resaed period. We also find suppor for hypohesis 2: coefficien 28

29 β 2 on leverage is posiive and saisically significan in Model 2 and is indifferen from zero in Model 1. The only oher significan coefficien in Model 1 is he coefficien β 4 on he Number of periods resaed. This coefficien is also significan in Model 4, which is consisen wih univariae analysis. We also find ha resaing firms are more likely o issue deb when hey make smaller misakes as suggesed by β 3 >0. Deb is issued by larger firms. In resuls no abulaed we consider oher firm and resaemen characerisics and add hem o models 1 and 2 one a a ime. To conrol for growh opporuniies we include book-o-marke and sales growh. Firms wih higher growh prospecs should be more likely o issue securiies. However, we find ha he coefficiens on book-o-marke and sales growh are no saisically significan in eiher model. In alernaive specificaion, we conrol for profiabiliy by including reurn on asses bu find he coefficien o be insignificanly differen from zero. 5. Conclusion Increasing number of firms resae financial saemens (GAO (2002), Huron (2005)). Large shareholder losses associaed wih resaemens moivaed several legislaions, including Sarbanes Oxley Ac of 2002 (Palmrose, Richardson and Scholz (2004)). I has been suggesed ha firms manage earnings, boh wihin GAAP and ouside of GAAP, o issue securiies a favorable prices. Such pracices mislead invesors and cause hem o overvalue securiy issuance. However, as invesors learn he rue value of earnings, hey revalue firms ha manage earnings downwards. This conjecure was called he earnings managemen hypohesis by Teoh, Welch and Wong (1998b). 29

30 This paper ess earnings managemen hypohesis using a sample of firms resaing financial saemens during he period of January June We find ha while resaing firms issue more equiy and deb han conrol firms, he number of issuances is small. Moreover, abou 20% of equiy and den issuing firms manage ne income downward prior o securiy issuance, which is inconsisen wih he earnings managemen hypohesis. This resul implies ha securiy issuance is no he dominan reason for violaing GAAP for more han 80% of resaing firms. Resaing firms ha issue equiy ouperform he marke and he conrol firms subsequen o GAAP violaion and prior o equiy issuance and perform beer one year prior o GAAP violaion. Earnings managemen hypohesis is no suppored for firms ha issue deb in resaed period. They do no exhibi any abnormal performance prior o deb issuance in resaed period and one year before misake. In conclusion, overall resuls sugges limied suppor for earnings managemen hypohesis for a sample of firms violaing GAAP. Resaing firms ha issue equiy are larger in marke value erms han non-issuing firms, have higher pre-misake reurn, make smaller downward revisions of ne income and resae more repors. Resaing firms ha issue deb are considerably larger, more highly levered, and make smaller downward revisions of ne income han non-issuing firms and firms issuing equiy. Resaing firms ha issue deb resae more repors han non-issuing firms, bu no firms issuing equiy. Overall our resuls indicae ha only a few resaing firms ha issue equiy obain financing a beer erms. 30