1-1 Research Motivations and Purposes
A strong securities market is the showcase of a healthy national economy, and it provides firms the opportunities of direct financing. Private savings and potential capital can be channeled into the securities market to help the development of national economy and private sectors. There are two major stock markets in Taiwan, Taiwan Securities Exchange (TSE) market and GreTai Securities (GTS) market. A public issuing company applying for listing has to meet the requirements set by these two markets and then gets the final approval of the Securities and Futures Bureau.
Earnings management around large transactions and events is a popular topic in accounting literatures.1 This paper focuses on the earnings management at the process of going listed in the two major markets in Taiwan, due to the incentives and
opportunities for firms to manage earnings during this period.
Once firms decide to be listed in the securities market, they have to qualify the requirements (Table 3.1) set by the trading market and pass the strict examinations conducted by the official bureau. Moreover, firms also try every means to get higher IPO prices to expand the wealth of stockholders. These incentives and motivations may cause firms to manipulate their earnings in the listing process.
For firms already listed in the securities market, the investors can evaluate their business standing and forecast the trend of these firms more accurately through many public channels, like the audited financial statements, released operating performance reports, the characteristics of management, the consulting firms’ analysis reports, and even the media. However Rao (1993) reports that there is almost no news coverage about non-listed firms. The scarcity of information forces the investors to rely heavily on the prospectus, which may include the most recent three years’ financial statements.
Besides, firms can restate their financial statements in accordance with the generally
1 As in the literatures review chapter, Healy (1985), DeAngelo (1986), Jones (1991), Teoh et al.
(1998ab), Ball and Shivakumar (2007).
accepted accounting principles based on the Financial Accounting Standard NO.8 in Taiwan. All of these give managers the opportunities to manipulate earnings.
However, the newly listed firms face a higher reporting standard due to the market demand and regulatory requirements. The investors, lenders, and other users of financial statements demand higher reporting quality due to the information asymmetry between the firms and them. The process of going listed in the securities market also attracts the attention of the stakeholders and the public, independent auditors, boards, corporate lawyers, and the press. Listed firms also face greater regulatory requirements. Ball and Shivakumar (2007) show that the IPO firms report more conservatively instead of inflating earnings because of the demand for higher reporting quality.
Accruals are a popular proxy for earnings management (Healy [1985], DeAngelo [1986], Jones [1991], Dechow et al. [1995], Teoh et al. [1998b]). It plays an important role in these earnings management literatures. Accruals are supposed to reflect the firm’s underlying business standing more accurately because the cash-basis accounting numbers are influenced by the timing of cash receipts and payments.
However, the generally accepted accounting principles give managers the rooms to determine when to recognize revenues and expenses through accruals. It implicitly means the firms have the opportunities to manipulate their earnings by adjusting accruals. It is difficult for investors to distinguish the “real” accruals and “fake”
accruals. Teoh et al. (1998b) indicate that though discretionary long-term accruals also represent earnings management, managers have greater flexibility and control over current versus long-term accruals. And nondiscretionary portion of accruals are considered the responses to the firms’ business standings instead of proxies of earnings management. As a result, this paper uses the discretionary current accruals (DCA) as the main variable representing earnings management.
The main purpose of this study is to see whether newly listed firms manipulate their earnings before they are listed in the TSE and GTS markets. First, this paper uses the cross-sectional modified Jones model (Teoh et al. [1998b]) to estimate the
discretionary current accruals for sample firms in the event year-end. Then, this paper also re-examines the evidence found by using the first methodology and demonstrates
some potential problems related to it. Finally, this paper estimates the discretionary current accruals in event year -1 and -2 to examine whether firms manipulate their earnings before going listed in the two major stock markets in Taiwan. This paper assumes discretionary current accruals in event year -1 and -2 as the proxies of earnings management because those firms want to be listed in the two major stock markets should qualify the profitability requirement in most recent two fiscal years (Table 3.1). This study also tests the conditional conservatism of the newly listed firms in event year -1 and -2.
1-2 Research Contributions
This paper not only shows the fluctuations of discretionary current accruals in the event year for newly listed firms but examines the components of current accruals.
The difference between this study and other Taiwanese literatures is that it examines the fluctuations of individual working capital components in the event year and illustrates some potential problems related to it, such as the discretionary current accruals of firms in the “aggressive” group are too large to be reliable and may not be caused by earnings management.
The sample in this study includes newly listed firms in both TSE and GTS markets. The relevant literatures in Taiwan only examine the earnings management behavior for the TSE firms but no GTS firms.
From table 3.1, the newly listed firms have to qualify the profitability criteria that depend on the most recent two years’ accounting numbers. So this study uses the discretionary current accruals in the two years instead of the event year to examine the earnings management behavior for sample firms.
This paper also illustrates the problems related to the discretionary current accruals in the event year mentioned by Ball & Shivakumar (2007). The results suggest that the future researches in Taiwan should pay attention when using the event year-end discretionary current accruals to test the earnings management hypothesis around large transactions and events.
1-3 Research Structure
This study is organized into five chapters; the content of each chapter is described as follows:
Chapter 1: Introduction
This chapter is to illustrate the motivations, purposes, and contributions of this study and the research structure.
Chapter 2: Literatures Review
This chapter reviews the accruals estimation related literatures first. Then the second section reviews literatures about earnings management at IPO process. Finally, the chapter reviews the literatures about earnings
management of newly listed firms in Taiwan.
Chapter 3: Research Methodology
This chapter shows the development of hypothesis, measurement of variables, analysis methodology, and sample selection and data. The key variable in this study is discretionary current accruals (DCA). The sample includes newly listed firms in the Taiwan Stock Exchange (TSE) market and the GreTai Securities (GTS) market from 1992 to 2006.
Chapter 4: Empirical Results and Analysis
This chapter examines the empirical results and makes the interpretations.
Most importantly, it shows whether firms engage in earnings management before newly listed in the TSE and GTS markets.
Chapter 5: Conclusions and Suggestions The conclusions in this chapter are:
1. The discretionary current accruals are significantly positive in the event
year-end for the newly listed firms, but there are problems related to them and make them unreliable.
2. The discretionary current accruals in event year -1 and -2 for the newly listed firms and the conditional conservatism test suggest that the sample firms do not engage in earnings management and even report more conservatively in the two years before newly listed.
3. There may be potential biases in discretionary current accruals when using the cross-sectional modified Jones model to estimate them due to the out-of-sample estimation problem.
This chapter also makes some suggestions for further study.
The flow chart of this study is as follows:
Figure 1.2: Research Flow Chart Research Motivations
Develop Research Topics
Relevant Earnings Management Literatures Review
Understanding the TSE/GTS Market in Taiwan Relevant IPO
Literatures Review
Develop Hypothesis
Sample Selection and Data Gathering
Examine Discretionary Current Accruals around the Event Year
Out-of-sample Estimation Test
Empirical Results and Analysis
Conclusion and Suggestion Examine
Individual Working Capital Components Changes in Year 0
Conditional Conservatism Test