Earnings Management, Underpricing and Underperformance of Chinese IPOs

We examine the underpricing and long-term performance of Chinese initial public offerings (IPOs) issued during the 1998-2003 period in the accrual context. While issuers use income-increasing discretionary accruals to inflate earnings prior to IPOs, sentiment investors do not price discretionary accruals correctly but extrapolate past histories of managed earnings too far into the future. Consistent with the hypothesis that investors ’ incorrect beliefs about unusual accruals lead to initial overpricing of the new issue and thereby seemingly underpricing from the issuer perspective, we find that discretionary accruals in the IPO year are positively related to underpricing but negatively related to long-term stock performance. These relations are statistically and economically significant and robust to alternative benchmarks, models, variable specifications, and robust standard errors