Earnings management around secondary equity offerings by insiders

Accruals-based earnings management is becoming a more common practice. Firms have strong incentives to manage earnings around secondary equity offerings by insiders (insider offerings) to raise offer prices. However, the literature on earnings management around insider offerings is limited and provides mixed evidence of earnings management. In this study, I investigate the motivations and the extent of earnings management around insider offerings. This study examines a sample of 490 secondary equity offerings made by insiders over the period 1989 to 2005. Inconsistent with the managerial opportunism hypothesis, I find negative adjusted discretionary total accruals before insider offerings. While discretionary accruals drop during the pre-offer year, operating performance improves during the pre-offer year, keeps improving during the offer year, and deteriorates only afterwards. These results suggest that downward earnings management before insider offerings may be manager response to an expectation of a decline in operating performance after the offerings. In the offer year I find positive adjusted discretionary total accruals, which may be driven by litigation concerns. Furthermore, pre-offer discretionary accruals are positively related to the post-offer changes in operating performance but not related to post-offer stock performance. The findings suggest that earnings management before the offerings is not driven by managerial opportunism; instead, it reflects superior information about future opportunities, consistent with the earnings smoothing hypothesis. The deterioration in operating performance immediately after insider offerings can induce securities fraud lawsuits filed against offering firms. Thus, managers have motives to inflate earnings to avoid operating performance deterioration, thereby lowering litigation risk. I find that offering firms do not show a higher incidence of restatements and lawsuits during the post-offer period. This is opposite of the prediction of the managerial opportunism hypothesis. Moreover, I investigate whether firms engage in real earnings management (i.e., management of R&D expenses) before insider offerings. I find that firms slightly increase R&D expenses before and during the offer year, inconsistent with the hypothesis that firms manipulate R&D expenses to increase pre-offer earnings. Overall, the study suggests that discretionary accruals management before insider offerings is to achieve smoother earnings. Earnings management during the pre-offer and offer years is consistent with the litigation avoidance hypothesis