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THE ACCOUNTING REVIEW

Vol. 91, No. 2


March 2016
pp. 559586

American Accounting Association


DOI: 10.2308/accr-51153

Managing for the Moment: The Role of Earnings


Management via Real Activities versus Accruals in SEO
Valuation
S. P. Kothari
Massachusetts Institute of Technology
Natalie Mizik
University of Washington
Sugata Roychowdhury
Boston College
ABSTRACT: We assess the role of both accruals manipulation (AM) and real activities manipulation (RAM) in
inducing overvaluation at the time of a seasoned equity offering (SEO). Our results reveal that earnings management
is most consistently and predictably linked with post-SEO stock market underperformance when it is driven by RAM;
in particular, the opportunistic reduction of expenditures on R&D and selling, general, and administrative activities.
Thus, overvaluation at the time of the SEO is more likely when managers actively engage in more opaque channels
to overstate earnings. Our findings are particularly relevant because managers exhibit a greater propensity for RAM
at the time of SEOs, even though RAM is more costly in the long run.
Keywords: earnings management; discretionary accruals; real activity manipulation; seasoned equity offering;
SEO overvaluation; SEO return reversal; earnings management opacity.
JEL Classications: G14; G31; M4; M41.

I. INTRODUCTION

anagement is an important source of financial information to investors. The voluminous earnings management
literature demonstrates that managers misrepresent, typically positively, the firms financial information in the hope
of skewing the firms stock market valuation upward. The extent to which earnings management strategies succeed
in misleading investors depends in part on their relative opacity, i.e., the degree to which external investors can detect and
unravel earnings management. Earnings management can occur through two channels: accruals management (AM) and real
activities management (RAM). Our objective is to assess whether the market is indeed misled by earnings management in a
setting characterized by considerable scrutiny of the firms financial statements and its operationsthe seasoned equity offering
(SEO). Of particular interest is the relative opacity of real earnings management versus accruals management.
Our primary result is that evidence of overvaluation at the time of an SEO is robust among firms overstating earnings
through real activities management, but not accruals management. Accruals management is reliably associated with negative
future returns only when it is simultaneously accompanied by real activities management. Both real and accrual earnings
management strategies, individually and jointly, forecast negative future operating performance. Against this backdrop, our
findings suggest that investors ability to detect earnings management and to assess its consequence for future performance is
impaired more severely when real activities are the basis for earnings management.

The authors are grateful for comments from John Harry Evans III (editor), two anonymous reviewers, Amy Hutton, Robert Jacobson, Shiva Rajgopal, Ewa
Sletten, Susan Shu, seminar participants at Boston College, and conference participants at the 2012 Nick Dopuch Annual Conference at Washington
University in St. Louis.
Editors note: Accepted by John Harry Evans III.

Submitted: January 2013


Accepted: May 2015
Published Online: May 2015

559

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Kothari, Mizik, and Roychowdhury

In accruals-based earnings management, managers intervene in the financial reporting process by exercising
discretion and judgment regarding accounting choices. Importantly, accruals management misrepresents the firms
underlying operating performance, but does not generally involve altering operations themselves. Real activities
manipulation, on the other hand, entails departures from normal operations with the intent to mislead at least some
stakeholders into believing that the reported financial performance has been achieved in the normal course of operations
(Roychowdhury 2006). Real activities manipulation can manifest in many forms, including decreased investment in
research and development (R&D), advertising, and employee training, all for the purpose of meeting short-term goals
(Graham, Harvey, and Rajgopal 2005; Roychowdhury 2006). Marketing strategies, tactics, and budgets are often at the
center of implementing real activity-based earnings management, as well (Moorman, Wies, Mizik, and Spencer 2012;
Chapman and Steenburgh 2009).
A crucial difference between accruals and real earnings management arises because generally accepted accounting
principles (GAAP) provide a framework for acceptable accounting principles enforced by the Securities and Exchange
Commission (SEC), but no such framework for real operations exists. Auditors look for whether firms accounting practices
meet GAAP. Detectable departures from GAAP can impose substantial costs on firms, managers, and auditors via regulatory
investigations, restatements, and personal penalties. Real activities-based management, in contrast, arises from managers
investment and operating decisions. Shareholders delegate to managers the rights to make investment decisions because
managers possess superior information relative to external stakeholders in making those decisions. Thus, the detection of RAM
is conceivably more challenging for investors than that of accruals management.
Existing literature documents that real manipulation is more likely when accounting practices are under greater scrutiny.
For example, Cohen, Dey, and Lys (2008) find greater incidence of real earnings management in the period following the
implementation of the Sarbanes-Oxley Act (SOX) in 2002, which sought to limit questionable accrual choices. Cohen and
Zarowin (2010) and Zang (2012) report that firms whose auditors are likely to be more vigilant with respect to accounting
choices engage more in RAM. While regulators and auditors understandably focus on a firms accounting choices, the larger
financial community includes those who analyze a companys operationsfor example, financial analysts and investors.
Financial analysts spend considerable resources to analyze not just managers accrual choices, but also their operational and
strategic decisions. Further, existing literature suggests that the presence of institutional investors constrains real activities
earnings management (Bushee 1998; Roychowdhury 2006; Zang 2012). Definitive evidence on the markets relative ability to
unravel real versus accruals management conditional on the presence of such manipulation is lacking, however. If equity
investors are indeed misled by overstated earnings, then the firms stock price would be artificially inflated and, in future years,
we would observe return reversals as the market eventually learns that prevailing valuations are unsustainable. Relative opacity
determines the extent to which real earnings management and accruals management are differentially associated with future
return reversals.
In a related study, Cohen and Zarowin (2010; hereafter, CZ), find that earnings manipulation via both accruals and real
activities is associated with poor future earnings performance, although the association is stronger when real activities are
involved. Our study differs from CZ in two respects. First, CZ focus on the costs of real earnings management, in terms of its
association with declines in future operating performance. In contrast, we examine the opacity of earnings management, in
terms of the extent to which the market is unable to detect the earnings management and is resultantly misled into
overvaluing the stock. Our objective requires a stock return-based test: if the market is adept at unraveling earnings
management, then any future earnings decline would be anticipated and factored into current prices, which would have no
further implication for stock returns. However, earnings management that is opaque to market participants will lead to
overvaluation of firms managing earnings, and these firms will exhibit future stock return reversals as the overvaluation is
corrected.
Second, we recognize that the opacity of both accruals and real activities manipulation can depend on whether managers
engage in the two strategies individually or in conjunction. Our research design accommodates these multiple possibilities, and
in doing so, we discover strategies that investors (markets) find most difficult to unravel.
SEOs provide an excellent setting for assessing the capital market consequences of earnings inflation via real activities or
accruals. An SEO is a well-identified event around which there is a significantly increased emphasis on a firms operations and
its stock price. Managers clearly have incentives to inflate earnings, since overvaluation at the time of an SEO results in a
wealth transfer from prospective shareholders to the firm and its current shareholders (see Teoh, Welch, and Wong 1998;
DuCharme, Malatesta, and Sefcik 2004; Rangan 1998; Cohen and Zarowin 2010). On the other hand, financial analysts and the
investment community also subject firms to considerable scrutiny at the time of securities issues (see Ball and Shivakumar
2008). Therefore, only highly opaque earnings management strategies are likely to escape detection. Thus, the SEO provides a
powerful setting to examine the relative opacity of real activities versus accruals manipulation.
Simple frequency analyses reveal that the incidence of firms attempting to overstate earnings via RAM is significantly
higher in SEO years than in non-SEO years. In contrast, the likelihood of firms engaging solely in accruals management to
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inflate earnings (without any RAM) is similar in SEO and non-SEO years. The patterns suggest that managers propensity to
engage in RAM is higher in SEO years than in other years, and it is higher than the propensity for accruals-based earnings
management.
In subsequent analysis, we examine the operating performance of SEO firms in the years following the SEO. We find that
firms that overstate earnings through RAM experience negative operating performance relative to their Barber and Lyon (1997)
matched counterparts in each of the three years following the SEO. Firms relying solely on accruals (but not real activities) to
overstate earnings at the time of the SEO exhibit evidence of negative operating performance in future years as well, although
not as severe as those engaging in RAM. The results on operating performance are largely consistent with Cohen and Zarowin
(2010).
Our returns-based tests underscore the salience of real activities-based earnings management as the driver of future
negative stock price performance. First, future price performance is significantly negative over each of the three post-SEO
years for firms that engage in real activities management, but do not engage in accruals management to overstate earnings.
Second, firms manipulating both real activities and accruals experience consistently negative returns in each of the three
years following the SEO. Third, for firms managing accruals, but not real activities, we do not find consistent evidence of
SEO overvaluation. Overall, the results suggest that SEO overvaluation is primarily driven by managers attempts to
overstate earnings via their real actions; accruals management is successful in misleading investors only when accompanied
by real manipulation.
In additional analyses, we find that post-SEO returns for firms likely to have overstated earnings via real activities
manipulation are more negative for younger firms. This is consistent with the opacity of real earnings management being more
pronounced when the information asymmetry between managers and external parties is more severe, as we would expect for
younger firms. Further tests reveal that the patterns we observe in post-SEO returns cannot be attributed to operating
performance leading up to the SEO year or to survival rates in post-SEO years. Finally, even though the primary method of real
earnings management we examine is the suppression of R&D expenditures, results are robust to examining an alternative
method: the aggressive reduction of selling, general, and administrative (SG&A) expenses.
Existing evidence linking earnings management to mispricing has been questioned, at least in part, based on empirical
research design flaws that induce errors in the risk-adjusted returns and/or the earnings management measures. We address
several empirical concerns. We use refined measures of accruals-based and real activities-based measures of earnings
management, and Barber and Lyon (1997) matched risk-adjusted returns. In addition, our measures of earnings
management incorporate the benefit of hindsight because, in constructing them, we take advantage of data extending
beyond the SEO. Indeed, we find no evidence of return reversals if the construction of earnings management proxies is
restricted to data available at the time of an SEO. Thus, the overvaluation we document can be interpreted as resulting from
managerial decisions at the time of the SEO that are visible to investors (via their consequences) only ex post. To that
extent, the post-SEO return underperformance is not indicative of a trading strategy that can be implemented at the time of
the SEO; rather, it is reflective of overvaluation with respect to managers private information regarding earnings
management.
In summary, the returns-based tests indicate that as a result of the intense scrutiny to which capital markets subject the
SEOs, managers are more likely to engage in real activities management. Such earnings management is more difficult for
investors to unravel than accruals management. The opacity of RAM to the markets is, thus, a potential explanation for the
unconditional preference managers repeatedly voice in anonymous surveys for managing earnings via real activities rather than
accruals (Bruns and Merchant 1990; Graham et al. 2005; Libby and Lindsay 2007).
Next, Section II discusses relevant literature and our hypothesis. Section III describes our research methods and data. Our
primary results are presented in Section IV. In Section V, we discuss additional analysis, and present a summary discussion of
our findings in Section VI. Section VII concludes.
II. RELATED LITERATURE AND HYPOTHESIS DEVELOPMENT
Earnings Inflation at the Time of an SEO and the Response of Financial Markets
While managers are generally expected to have an interest in maintaining high stock price, certain firm-specific events tend
to heighten the emphasis, to the point that they may consider manipulating the information flow to the market in an attempt to
induce high valuations. An SEO is an event around which the firms stock price is of particular interest to managers. It provides
current shareholders an opportunity to transfer wealth from prospective shareholders to themselves. Bar-Gill and Bebchuk
(2003) emphasize the motivation for earnings inflation: to obtain more favorable terms when a firm is raising capital. Firms
undertake an SEO to, among other objectives, collect new capital for funding real growth opportunities, acquire other firms,
retire existing debt obligations, and/or repurchase preferred stock. The amount of capital collected by a firm at the time of an
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SEO depends on its stock price on the day of the offering. To the extent that stock valuations depend, at least in part, on
reported earnings, managers have incentives to inflate earnings in order to maximize SEO proceeds.
The unique characteristics and properties of the SEOs have stimulated considerable research interest. The first stream of
research highlights the SEO pricing anomaly (Loughran and Ritter 1995, 1997; Spiess and Affleck-Graves 1995). These
studies report that SEO firms exhibit below-average risk-adjusted stock returns in the years following an SEO. A second goal
of the literature has been to examine whether managers attempt to inflate reported earnings at the time of the SEO (Teoh at
al. 1998; Rangan 1998; Cohen and Zarowin 2010). Finally, the third objective has been to establish a link between earnings
management at the time of an SEO and the subsequent return underperformance that characterizes SEOs. Research by Teoh
at al. (1998), Rangan (1998), and DuCharme et al. (2004) finds that SEO firms with unusually large discretionary accruals,
which likely result from an attempt to inflate reported earnings, experience the lowest post-SEO abnormal stock returns.
However, a significant number of studies challenge these conclusions, based on concerns related to the estimation of
expected returns; specifically, the bad model problem and the small firm effect (e.g., Fama 1998; Brav, Geczy, and
Gompers 2000; Eckbo, Masulis, and Norli 2000; Shivakumar 2000). These studies argue that post-SEO underperformance is
not anomalous, and instead can be explained by improper modeling of risk. Studies have also questioned the evidence of
earnings management by SEO firms, arguing that the models for explaining accruals in earlier studies are flawed (Collins and
Hribar 2002).
Earnings Inflation via Real Activities
Recent literature suggests that possible earnings management strategies at the time of SEO issuance and in other
settings are not necessarily limited to overstatement of accruals, but can include manipulation of real activities
(Roychowdhury 2006; Mizik and Jacobson 2007; Zang 2012; Gunny 2010; Cohen and Zarowin 2010; Badertscher 2011).
The only study of which we are aware that examines both accruals and real activities manipulation in the context of
seasoned equity offerings is Cohen and Zarowin (2010). They report that both accruals and real activities manipulation at
the time of the SEO are associated negatively with post-SEO industry-adjusted return on assets (ROA), with the
association being more pronounced for RAM. However, they do not examine post-SEO returns, thus leaving the role of
accruals versus real activities in inducing SEO overvaluation unexamined. We believe that this is a crucial gap in the
literature. The goal of earnings management at the time of SEOs is presumably to induce higher stock valuations.
However, equity offerings represent events during which the firm is subject to substantial scrutiny by the capital markets,
including investors, analysts, and even regulators (Ball and Shivakumar 2008). If managers do indeed engage in earnings
management, then they are more likely to achieve their objective of inducing overvaluation with strategies that have a low
probability of detection.
Real operations are more firmly within the domain of expertise of managers rather than investors and/or fiduciary
agents such as auditors. While GAAP provides a framework for establishing acceptable accounting principles that are
enforced by regulatory agencies such as the SEC, no such framework for real operations exists. Managers are expected to
exercise their judgment to determine the best course of action that is appropriate given the economic circumstances. This
provides managers with opportunities to engage in real activities management in lieu of, or in addition to, accruals
manipulation to overstate earnings at the time of an SEO. Further, RAM is potentially costlier for firms in the long run than
accruals management (Cohen and Zarowin 2010). Thus, for the subset of firms that engages in real activities management,
the possible market overvaluation at the time of the SEO and the subsequent correction in mispricing can be particularly
severe.
Our research design identifies whether firms have overstated earnings via accruals and real activities, either exclusively or
simultaneously, and examines the relative economic consequences. We expect any evidence of SEO overvaluation to be the
most pronounced among firms that engage in real activities manipulation, given its greater opacity. Thus, our primary
hypothesis is as follows:
Hypothesis: Firms that overstate earnings via real activity manipulation exhibit negative post-SEO stock return
performance.
III. METHODOLOGY AND DATA
Measuring Real Activities Management
Market participants assess firms health and performance along multiple dimensions, particularly at the time of an SEO.
We focus on real earnings management strategies that positively influence multiple firm indicators and, thus, potentially color
market participants assessment of an SEO firm. Opportunistic reductions in discretionary expenses, particularly R&D, not only
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increase earnings, but can also enable a firm to report higher profit margins and cash flow from operations (CFO). This is not
necessarily true of other strategies, such as price discounting and overproduction to overstate earnings, since these activities can
be detrimental for profit margins and CFO (see Roychowdhury 2006).
The suppression of R&D expenditures to meet short-term earnings goals, in particular, has been termed myopic because
it directly trades off contemporaneous earnings against future competitiveness (see Bushee 1998). Darrough and Rangan (2005)
report results suggesting that firms reduce R&D spending in the year of an initial public offering (IPO), although they do not
examine whether this actually misleads the market into overvaluing the firm. In robustness tests, we also investigate abnormal
reductions in selling, general, and administrative (SG&A) expenses. The real earnings management methods that we focus on
are consistent with the survey by Graham et al. (2005), who report that firm executives point to the reduction of discretionary
expenses such as R&D and SG&A as the most preferred method for overstating earnings.
We estimate abnormal R&D expenditures with a fixed-effect first-order autoregressive model that also includes lagged
sales as an explanatory variable. The basic model for R&D is:
R&Dit ard i Drd t /rd R&Dit1 crd Salesit1 erd it ;

where R&Dit is the value of the size-adjusted R&D series to be modeled for firm i at time period t; R&Dit1 is its lagged value;
and Salesit1 is the value of size-adjusted Sales series for firm i at time period t1. Typically, models ignoring fixed effects
suffer from misspecificationcertain firms would be habitually misclassified as exhibiting unusually high (or low) R&D due to
growth (or lack thereof ) and/or their operating and business decisions. This issue persists when the model is estimated by
industry-year, because firms can often systematically deviate from industry-year norms in their attempts to differentiate
themselves from the rest of the industry (Owens, Wu, and Zimmerman 2013).
To control for year-specific and firm-specific effects that induce model misspecification, we employ the following steps.
First, every firms annual R&D expenditure is differenced from the cross-sectional mean for that year. Second, for every
firm, the annual deviation of R&D from the cross-sectional mean is differenced from the corresponding deviation in the
previous year. The explanatory variable Sales in the model for R&D is also differenced twice in the same manner. The model
is then estimated using panel data.1 The estimation yields a time-series of residuals for every firm. We subtract from every
firm-year residual the mean value of the residual across all years for the corresponding firm to obtain abnormal R&D.
Importantly, our estimation technique allows for data from years beyond the SEO to be incorporated in the measurement of
earnings management at the time of the SEO, which offers two distinct advantages. First, by taking advantage of the full
time-series available for every firm, our method addresses the possibility that there may not be enough data available at the
time of the SEO to detect real activities that are significant departures from the firms normal operations. Second, our
technique has the intuitively appealing feature that it yields measures of earnings management that cannot necessarily be
constructed at the time of the SEO and, thus, would be opaque to investors.
Measuring Accruals Management
Total accruals are defined as the change in non-cash current assets minus the change in current liabilities net of the current
portion of long-term debt, minus depreciation and amortization, divided by lagged total assets. Our estimation of abnormal
accruals is based on the modified Jones model augmented for net income (Kothari, Leone, and Wasley 2005). Thus, the model
for total accruals is:
TAit bi Dta t /ta TAit1 b1 1=Assetsit1 b2 DSalesit  DARit b3 PPEit b4 NetIncomeit tit ;

where TAit is total accruals scaled by lagged total assets; TAit1 is its lagged value; Assetsit1 is lagged total assets; DSalesit is
change in sales net of accounts receivable scaled by lagged total assets; PPEit is net property, plant, and equipment scaled by
lagged total assets; and NetIncomeit is net income scaled by lagged total assets. Unlike Kothari et al. (2005), the estimation of
the above model includes firm and year fixed effects, and a correction for serial correlation following the procedure for
abnormal R&D described earlier. The results of all our subsequent analyses are not sensitive to alternative abnormal accrual
measures, such as the Jones or the modified Jones models (Dechow, Sloan, and Sweeney 1995).2

1
2

We use the fixed effects instrumental variable estimation (Arellano 2003) to recover autoregressive coefficient /rd and lagged sales coefficient cSales.
Our primary results are qualitatively similar without instrumentation.
Certain accruals models include contemporaneous, future, and past cash flow from operations (CFO) as explanatory variables, based on Dechow and
Dichev (2002). Note that we allow for the possibility that managers manipulate R&D. Since R&D manipulation can influence CFO as well, we refrain
from including CFO as an explanatory variable in the accruals model.

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Measuring Abnormal Earnings


We model annual earnings scaled by assets or return on assets (ROA) as a first-order autoregressive process adjusted for
year-specific and firm-specific effects (Arellano 2003).3 We use the following time-series model:
ROAit aroa i Droa t /roa ROAit1 eroa it ;

where ROAit is the value of the ROA series to be modeled for firm i at time period t; and ROAit1 is its lagged value. We use a
panel data time-series specification to model ROA, and adjust for year-specific and firm-specific effects as described in the
construction of abnormal R&D. The difference between the actual and predicted ROA yields abnormal ROA; we use positive
abnormal ROA to identify earnings overstatement attempts.
More complex models for ROA, such as fixed effects panel AR(2) or VAR(2), do not improve over the fixed effects
AR(1) specification of Model (3) in identifying RAM. Therefore, we use the more parsimonious Model (3). To avoid
imposing further data requirements, we refrain from using analyst forecasts as proxies for the markets expectations of
earnings. Analyst forecasts are particularly sparse in the early part of our sample, which spans 19702012. Moreover, our
goal is to detect departures from what would be considered normal earnings for the firm, not necessarily the extent to which
reported earnings exceed analysts ex ante expectations. Analysts forecasts at the beginning of the year are not well suited
to our purpose as, by construction, they are dated. Analysts final forecasts issued toward the end of the year, on the other
hand, reflect management guidance throughout the year (Matsumoto 2002; Richardson, Teoh, and Wysocki 2004).
Analysts final forecasts, therefore, can reflect managers attempts to guide analysts toward the earnings they expect to
report inclusive of any manipulation they expect to undertake, or have already undertaken during the year, making forecasts
an unsuitable proxy for unmanaged earnings. In addition, analysts forecasts do not enjoy the advantage intrinsic to the
time-series estimation of normal earnings, which allows us to incorporate both ex ante and ex post earnings data to assess
departures from normality.
Measuring Abnormal Stock Returns
A major concern in the literature is that all expected return models exhibit problems in depicting long-term average returns.
For example, past research highlights that (1) SEO risk characteristics differ from non-SEO firms (e.g., Eckbo et al. 2000), and
(2) existing asset-pricing models have systematic problems explaining the average returns on categories of small stocks
(Fama 1998). Analysis seeking to correct for these considerations has suggested that the new issues puzzle, e.g., the apparent
mispricing of SEOs reported in previous studies, can be explained by lack of proper controls for risk (Brav et al. 2000; Eckbo et
al. 2000; Shivakumar 2000).
Our analysis addresses a number of issues associated with the bad model problem. Following arguments made in
Shivakumar (2000), we control for differences in expected returns among firms by using the Barber and Lyon (1997) approach,
which involves matching sample firms to control firms of similar sizes and book-to-market ratios. However, our approach
differs from that employed in previous research, in that we match based on post-issuance rather than pre-issuance
characteristics. This further reduces the complications associated with the SEO potentially changing the risk characteristics of
the firm (Carlson, Fisher, and Giammarino 2006). Following Barber and Lyon (1997), the control firm is chosen among all
firms in the same two-digit SIC group not issuing SEOs with a market value of equity between 70 percent and 130 percent of
that of the sample firm, and whose book-to-market ratio is closest to that of the sample firm.4 We then calculate abnormal
returns as the difference in one-, two-, and three-year-ahead stock returns for a firm undertaking an SEO versus the returns for
the matched benchmark firm.5
Research Design
The extent of overvaluation conditional on the type of earnings management is a primary focus of our exercise. That is, we
are not interested in the decision process underlying the observed exercise of choice to manage earnings via real activities
versus accruals; rather, we are interested in the influences of the choices themselves. Therefore, we sort independently on the
signs of (1) abnormal R&D, (2) abnormal accruals, and (3) abnormal earnings in the form of abnormal ROA in the year of the
3

For computing ROA, we use operating income before depreciation. We also undertook analysis using alternative accounting return measures, e.g., Net
Income over Assets and Income before Extraordinary Items over Assets. The results we document are not sensitive to these alternative definitions.
In the few cases where we were unable to identify a matching firm at the two-digit SIC level, we searched for a match at the one-digit SIC level. In the
cases where no match was found at the one-digit SIC level, we searched for a matching firm with no SIC constraint.
We have also tested our hypothesis using raw returns, market-adjusted returns, and a measure of abnormal returns calculated as the stock return not
explained by industry- and market-wide effects or by firm size and book-to-market (Daniel and Titman 1997). We found results very similar to those
we report.

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SEO. Abnormal R&D and abnormal accruals are our proxies for earnings management via real activities and accruals,
respectively. Abnormal earnings are incorporated in our research design to capture whether firms report earnings in the SEO
year that exceed the normal level relative to their time-series record. We expect that unusually high earnings accompanied by
abnormally low R&D and/or abnormally high accruals allow for more accurate identification of firm-years in which managers
attempt to overstate earnings.6
Studies have examined earnings management in both the year of and the year prior to the SEO, with similar results (Teoh
et al. 1998; Rangan 1998; Cohen and Zarowin 2010). We focus on the SEO year, consistent with Cohen and Zarowin (2010),
who examine real activities manipulation in the context of SEOs. We form the following eight groups based on the signs of
abnormal R&D, abnormal accruals, and abnormal ROA:
Abnormal Accrualsis . 0
Abnormal ROAis . 0

Abnormal
Abnormal
Abnormal
Abnormal

Abnormal ROAis , 0

R&Dis
R&Dis
R&Dis
R&Dis

.
,
.
,

0
0
0
0

Group
Group
Group
Group

1
3
5
7

Abnormal Accrualsis , 0
Group
Group
Group
Group

2
4
6
8

Partitioning firms into the eight groups enables us to segregate firms by the means they might have used to overstate
earnings performance. Firms in Groups 1 through 4 exhibit unusually high earnings in the SEO year, making them of primary
interest to us because they include firms that may have used accruals and/or real activities to overstate earnings (with the
exception of Group 2, discussed in the next paragraph). Group 1 includes firms that generate positive abnormal earnings and
report unusually high accruals, without exhibiting unusually low R&D. Firms in Groups 3 and 4 report positive abnormal
earnings, along with unusually low R&D; firms in Group 3 also exhibit unusually high accruals, while those in Group 4 do not.
Thus, Group 1 firms are more likely to have overstated earnings solely via accruals management; Group 4 firms are likely to
have done so by suppressing R&D expenditures. Group 3 firms are likely to have engaged in both types of earnings
management simultaneously. Alternatively, it is also possible that real activities management by some firms in Group 3 have
accrual consequences, as well. For example, R&D reduction can lead to a reduction in accounts payable, and a corresponding
increase in accruals.
Firms in Group 2 also reported positive abnormal earnings, but are unlikely to have done so with any earnings
management because they exhibit unusually high R&D and unusually low accruals. For completeness, we also report results for
firms in Groups 5 through 8, which do not exhibit positive abnormal earnings. In particular, these groups include firms with
non-positive abnormal ROA that nevertheless exhibit positive abnormal accruals (Group 5), negative abnormal R&D (Group
8), or both (Group 7). However, among these groups, our proxies are less likely to capture attempts to overstate earnings, or
they capture unsuccessful attempts to overstate earnings.
In preliminary analysis, we examine whether the frequency of firms in any one group is significantly different in SEO years
relative to non-SEO years. For example, if managers have incentives to inflate earnings prior to an SEO and they perceive
RAM as being more opaque to the market, then we should observe a higher frequency of firms in Groups 3 and 4 in an SEO
year than in the non-SEO years. In subsequent analysis, we test whether SEO overvaluation is indeed associated with earnings
management and its type by estimating annual abnormal stock returns up to three years following the SEO and studying when
the returns are significantly negative.
To examine risk-adjusted abnormal returns for our eight groups, we estimate the following model for years 1 through 3
after the SEO:
abnStkRiskjs

8 
X


kg kIg gisk for k 1; 2; 3;

g1

where abnStkRiskjs is the k-period ahead (i.e., future multi-period) risk-adjusted cumulative stock return for firm i, with an SEO
occurring at time s; and I(g) is an indicator function that takes on the value 1 if the firm is in group g, and 0 otherwise. Under
the null of proper valuation at the time of the SEO, the future-term abnormal returns for all groups should not differ from zero,
and no differences in the post-SEO stock returns should exist for any group of firms (k g(k) 0 for g 1 to 8). To examine
whether firms generating abnormally positive earnings via both accruals and real activities manipulation underperform in the
post-SEO periods, we would test whether k3(k) , 0. Similar tests can be performed for each group.
6

The role of ROA in our analysis is distinct from that in Cohen and Zarowin (2010). We exploit abnormal ROA to increase the power of our tests to
detect situations in which overvaluation is more likely, while testing for the overvaluation itself via future stock return patterns. Cohen and Zarowin
(2010) examine future patterns in ROA relative to SEO year to measure the costs of earnings management, but do not address overvaluation per se.

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Data
We use three different sources to compile the dataset for testing our hypothesis. First, we access the Thomson Financial
Securities database to obtain the sample of seasoned equity offerings conducted between January 1970 and December 2012.
The SEO sample data contains company name and the SEO issue date. Next, we access the Compustat database to obtain
annual accounting data, and The University of Chicagos Center for Research in Security Prices (CRSP) to obtain stock returns
data. Merging the SEO and the Compustat data samples yields an unbalanced pooled cross-sectional time-series panel
involving 2,107 firms with data available to conduct all our tests.7 These firms conducted a total of 3,353 SEOs between 1970
and 2012. In order to minimize any potential survivorship bias and to preserve degrees of freedom, we do not require that all
accounting and stock return data be available for a firms inclusion in the sample. The actual sample size varies across the
estimating models depending on the test procedure and the variables used in the analysis.
As shown in Table 1, Panel A, firms undertook SEOs throughout the period, but with significant year-to-year variation in
the number of SEOs. Further, SEOs were issued across a broad range of industries: Table 1, Panel B presents the distribution of
SEOs in the final sample by industry. We do not exclude firms based on industry membership. Later, we reestimate our tests
excluding utilities and financial companies, and find results corresponding closely to those we report. Table 1, Panel C provides
summary statistics for the 3,353 SEO firm-years with data available for all our tests. As Panel C indicates, mean and median
R&D in SEO years are 11 percent and 4.6 percent of assets, respectively, while mean and median accruals in SEO years are 4
percent and 1.9 percent of assets, respectively.
IV. EMPIRICAL ANALYSIS
The first step in our analysis involves estimating models for R&D intensity, accruals, and ROA to predict expected levels,
from which we obtain the unexpected components from the models as abnormal values of the corresponding variables. Table
2, Panel A reports the results for R&D intensity and ROA, which are modeled using similar specifications. We find that the
^ ROA 0:43. The models
^ RD 0:30 and u
R&D and ROA series exhibit considerable and similar amounts of persistence: u
imply that deviations of R&D and ROA from the respective firm-specific means do not last indefinitely (we test for and find no
unit roots), nor do they dissipate immediately. Rather, these deviations decay over a number of periods. As such, deviations that
occur in a given year contain information about the future term, as well. Consistent with the R&D and ROA models, the
accruals model incorporates an autoregressive term; the coefficient reveals that accruals exhibit mean reversion with
/ TA 0:034.
Table 2, Panels C and D present the mean values of abnormal ROA, abnormal R&D, and abnormal accruals for the firms in
our eight groups in the year of an SEO issuance. Firms issuing an SEO, on average, tend to have positive abnormal ROA (0.4
percent), negative abnormal R&D (0.4 percent of assets), and positive discretionary accruals (0.1 percent of assets). Median
values of abnormal ROA, R&D, and accruals reveal similar patterns.
Groups 3 and 4, most likely to have engaged in the opportunistic reduction of R&D to overstate earnings, include 66
percent of all SEO firm-years with negative abnormal R&D. Table 2, Panels C and D also provide the magnitude of abnormal
R&D and abnormal ROA. Median abnormal R&D (as a percentage of assets) in Groups 3 and 4 is approximately 2.4 percent
and 2.5 percent, respectively; median abnormal ROA for these same groups is approximately 4.7 percent and 6.0 percent,
respectively. Thus, median abnormal R&D (by construction, scaled by assets) represents about 51 percent and 42 percent of
median abnormal ROA for Groups 3 and 4, respectively.8
The Prevalence of Earnings Inflation Strategies at the Time of an SEO
Table 3 reports the relative proportion of firm-years in each of our eight groups that encompass SEOs and firm-years that
do not. Thus, firms across periods other than the years when an SEO is issued serve as our typical benchmark.9 In SEO years,
19.3 percent of our sample firms fall into Group 3, that is, the group of firms exhibiting positive abnormal ROA, abnormally
low R&D expenditures, and abnormally high accruals. This proportion is significantly greater (p , 0.0001) than in non-SEO
7

A greater number of firms report earnings than R&D. In our analysis for relevant tests, we use this larger sample. For R&D-based tests, we use only
those firms that reported their R&D expenditures.
It is possible to estimate the effect of abnormal R&D on earnings per share (EPS). Multiplying abnormal R&D by total assets and dividing it by
common shares outstanding yields an estimate of the effect of R&D manipulation on EPS. By this calculation, median EPS overstatements because of
unusually low R&D in Groups 3 and 4 equal approximately $0.18 and $0.16, respectively. These seem to be economically significant amounts, since
total median EPS for Groups 3 and 4 are around $0.47 and $0.52, respectively.
We make use of a typical benchmark rather than a naive benchmark of equal proportions in each group to allow for a non-symmetric distribution
of forecast errors across groups. We have also used an alternative typical benchmark comprised of all Compustat firms not issuing SEOs (as opposed
to just our sample firms), and found the results in near-exact correspondence with those we report.

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TABLE 1
Descriptive Statistics
Panel A: Distribution of the Seasoned Equity Offerings by Year
Year

Number of
SEO Issues

Frequency
%

1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991

5
29
56
23
10
26
45
27
36
30
68
75
73
177
42
49
57
40
23
35
32
88

0.15
0.86
1.67
0.69
0.30
0.78
1.34
0.81
1.07
0.89
2.03
2.24
2.18
5.28
1.25
1.46
1.70
1.19
0.69
1.04
0.95
2.62

Year

Number of
SEO Issues

1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012

78
100
93
126
127
96
81
111
121
91
80
107
125
98
109
118
46
193
190
186
31

Total:

3,353

Frequency
%
2.33
2.98
2.77
3.76
3.79
2.86
2.42
3.31
3.61
2.71
2.39
3.19
3.73
2.92
3.25
3.52
1.37
5.76
5.67
5.55
0.92
100%

The sample includes all SEO issues reported in the Thomson Financial Securities database for the period January 1970December 2012 by firms that were
also listed in the Compustat (December 2012) database, with data available to conduct all our tests.

Panel B: Distribution of the Seasoned Equity Offerings by Industry


Number of
Seasoned Equity
Issues

Frequency

Agriculture, forestry, fishing


Mining, oil, gas
Construction
Nondurable manufacturing
Durable manufacturing
Transport, utilities, communication
Wholesale and retail trade
Finance, insurance, real estate
Services
Miscellaneous, unclassifiable

16
67
3
857
1,483
48
394
24
447
14

0.48
2.00
0.09
25.56
44.23
1.43
11.75
0.72
13.33
0.42

Total:

3,353

Industry

100%

Firms are grouped according to their one-digit Compustat SIC code.

(continued on next page)

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568

TABLE 1 (continued)
Panel C: Descriptive Statistics in the Year of Issuing an SEO (3,353 Firm-Years)

ROA
R&D Intensity
Total Accruals
Total Assets ($M)
Sales Level ($M)
Market Cap ($M)
Market-to-Book Equity

Mean

Standard
Error of
the Mean

10%

Median

90%

0.003
0.110
0.040
939.891
833.166
1105.780
3.908

0.005
0.003
0.002
52.394
41.072
52.815
0.080

0.382
0.000
0.090
18.606
4.163
30.262
1.028

0.109
0.046
0.019
143.457
102.419
282.548
2.755

0.238
0.318
0.220
1821.640
2040.290
2168.820
8.454

Variable Definitions (in terms of Compustat Variables):


ROA OIBDP/AT;
R&D XRD/AT;
Total Assets AT;
Sales Level SALE;
Total Accruals (DACT  DCHE  DLCT DDLC  DP)/lag(AT);
Market Cap CSHO  PRCC_C; and
Market-to-Book Equity Market Cap/CEQ

years, when only 14.8 percent of firms are categorized in Group 3. This 4.5 percent-point difference in the proportion of Group
3 firms represents an approximately 30 percent higher relative frequency in SEO years than in non-SEO years. This difference
is consistent with a significant number of firms inflating earnings at the time of an SEO through a simultaneous reduction in
discretionary expenditures and an increase in abnormal accruals. Group 4, characterized by positive abnormal ROA,
abnormally low R&D, but not abnormally high accruals, also exhibits significant differences in the relative frequency of firms
across the SEO and non-SEO years. The proportion of firms in Group 4, i.e., firms with a higher likelihood of having engaged
in real activity management, but not accruals-based earnings management, is 19.8 percent in SEO years compared to 16.8
percent in non-SEO years.
Group 1 includes firms reporting positive abnormal earnings, along with positive abnormal accruals, but also positive
abnormal R&D. Their incidence is relatively lower in SEO years relative to non-SEO years at 8 percent and 8.9 percent,
respectively, in Table 3, and the difference is marginally statistically significant at the p , 0.10 level. Group 2 includes firms
that experience positive abnormal earnings, but are not likely to have either curbed their R&D expenditures or reported higher
accruals. They constitute 10.4 percent of the sample in SEO years, significantly lower than the 12.1 percent in non-SEO years.
Groups 58 represent firms that did not generate positive abnormal earnings at the time of their SEOs. Such firms generally
appear less frequently during SEO years than during non-SEO years, with the exception of Group 7. Firms in Group 7
constitute similar percentages of the sample in SEO and non-SEO years, at 11.4 percent and 11.2 percent, respectively.
In general, the evidence is consistent with a greater propensity of firms to overstate earnings via real activities manipulation
in SEO years (Groups 3 and 4) relative to non-SEO years.
Post-SEO Operating Performance
To assess the operating consequences of earnings inflation strategies, we examine the post-SEO ROA, adjusted for the
ROA of their Barber and Lyon (1997) matched counterparts. Table 4, Panels A and B report average adjusted ROA and tests of
significance for firms in all eight groups. Firms in Groups 3 and 4 exhibit significantly negative ROA relative to their matches
in each of the three post-SEO years.10 Interestingly, Groups 5, 6, and 7 also exhibit significant underperformance following the
SEO, and the relative performance across all groups is generally negative; this indicates that operating underperformance
(relative to matched firms) may be endemic for SEO firms.

10

We have also examined other operating performance metrics and find that firms engaging in real earnings management also tend to have lower sales,
net income, income before extraordinary items, and cash flow than their matched-firm counterparts.

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TABLE 2
Abnormal ROA, R&D, and Accruals
Panel A: Models for Normal R&D and ROA
R&D
Equation
/
(Std.)
c
(Std.)
# of observations
F-statistic

ROA
Equation

0.301***
(0.015)
0.027***
(0.004)
34,937
222.51

0.425***
(0.010)

72,812
1710.51

***, **, * Denote p , 0.01, p , 0.05, and p , 0.10, respectively.


Results of estimating models for normal R&D expenditures and for normal ROA. Standard errors are in parentheses. The models are estimated with firm
and year fixed effects.
R&D Equation: R&Dit ard i Drd t /rd  R&Dit1 crd  Salesit1 erd it.
ROA Equation: ROAit aroa i Droa t /roa  ROAit1 eroa it.
(Firm and Year fixed effects included.)

Panel B: Models for Normal Accruals


Accruals
Equation
/
(Std.)
b1
(Std.)
b2
(Std.)
b3
(Std.)
b4
(Std.)
# of observations
F-statistic

0.034***
(0.003)
0.147***
(0.029)
0.229***
(0.012)
0.225***
(0.032)
0.115***
(0.026)
180,451
96.04

***, **, * Denote p , 0.01, p , 0.05, and p , 0.10, respectively.


Results of estimating models for normal total accruals (TA). Standard errors are in parentheses. The models are estimated with firm and year fixed effects.
TAit bi Dta t /ta  TAit1 b1  (1/Assetsit1) b2(DSalesit  DARit) b3PPEit b4NetIncomeit tit.
(Firm and Year fixed effects included.)
Variable Definitions (in terms of Compustat Variables):
ROA OIBDP/AT;
R&D XRD/AT;
Total Assets AT; and
Sales Level SALE.

(continued on next page)

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TABLE 2 (continued)
Panel C: Characteristics of the Groups in the Year of SEOMeans
Groups Based on Earnings Surprise,
R&D Surprise, and Abnormal Accruals
Group 1:
aROAis
Group 2:
aROAis
Group 3:
aROAis
Group 4:
aROAis
Group 5:
aROAis
Group 6:
aROAis
Group 7:
aROAis
Group 8:
aROAis

Mean
aROAis

Mean
aR&Dis

Mean
aAccis

. 0, aR&Dis . 0, aAccis . 0,

268

0.049

0.026

0.078

. 0, aR&Dis . 0, aAccis , 0,

348

0.067

0.022

0.093

. 0, aR&Dis , 0, aAccis . 0,

647

0.106

0.064

0.144

. 0, aR&Dis , 0, aAccis , 0,

665

0.141

0.056

0.129

, 0, aR&Dis . 0, aAccis . 0,

412

0.154

0.095

0.092

, 0, aR&Dis . 0, aAccis , 0,

344

0.228

0.092

0.105

, 0, aR&Dis , 0, aAccis . 0,

383

0.066

0.032

0.163

, 0, aR&Dis , 0, aAccis , 0.

286

0.058

0.032

0.096

3,353

0.004

0.004

0.010

Median
aROAis

Median
aR&Dis

Median
aAccis

All groups:

Panel D: Characteristics of the Groups in the Year of SEOMedians


Groups Based on Earnings Surprise,
R&D Surprise, and Abnormal Accruals
Group 1:
aROAis
Group 2:
aROAis
Group 3:
aROAis
Group 4:
aROAis
Group 5:
aROAis
Group 6:
aROAis
Group 7:
aROAis
Group 8:
aROAis

. 0, aR&Dis . 0, aAccis . 0,

268

0.026

0.010

0.059

. 0, aR&Dis . 0, aAccis , 0,

348

0.037

0.011

0.061

. 0, aR&Dis , 0, aAccis . 0,

647

0.047

0.024

0.061

. 0, aR&Dis , 0, aAccis , 0,

665

0.060

0.025

0.059

, 0, aR&Dis . 0, aAccis . 0,

412

0.045

0.021

0.057

, 0, aR&Dis . 0, aAccis , 0,

344

0.042

0.023

0.048

, 0, aR&Dis , 0, aAccis . 0,

383

0.035

0.019

0.072

, 0, aR&Dis , 0, aAccis , 0.

286

0.026

0.017

0.051

3,353

0.009

0.005

0.001

All groups:

This table presents the mean and median values of abnormal ROA, abnormal R&D, and abnormal accruals for the firms in our eight groups in the year of
an SEO issuance. See Panels A and B for the models that yield the predicted values.
Variable Definitions:
aROAis abnormal ROA ROAis  predicted ROAis;
aR&Dis abnormal R&D R&Dis  predicted R&Dis; and
aAccis abnormal Accruals TAis  predicted TAis.

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TABLE 3
The Prevalence of Earnings Inflation at the Time of an SEO
Manipulation of Accruals and Manipulation of Real Activities
Proportion of Firms by
Earnings Surprise, R&D Surprise, and
Abnormal Accruals
Group 1:
aROAis
Group 2:
aROAis
Group 3:
aROAis
Group 4:
aROAis
Group 5:
aROAis
Group 6:
aROAis
Group 7:
aROAis
Group 8:
aROAis

% in the Year
When an SEO
was Issued
n 3,353

% in Years
When an SEO
was Not Issued
n 31,881

Change in %
(% points)
0.9*

. 0, aR&Dis . 0, aAccis . 0,

8.0%

8.9%

. 0, aR&Dis . 0, aAccis , 0,

10.4%

12.1%

1.7***

. 0, aR&Dis , 0, aAccis . 0,

19.3%

14.8%

4.5***

. 0, aR&Dis , 0, aAccis , 0,

19.8%

16.8%

3.0***

, 0, aR&Dis . 0, aAccis . 0,

12.3%

14.3%

2.0***

, 0, aR&Dis . 0, aAccis , 0,

10.3%

13.1%

2.8***

, 0, aR&Dis , 0, aAccis . 0,

11.4%

11.2%

0.2

, 0, aR&Dis , 0, aAccis , 0.

8.5%

8.8%

0.3

Total:

100%

100%

***, **, * Denote p , 0.01, p , 0.05, and p , 0.10, respectively.


The table depicts proportion of SEO firms falling in each of the eight aROA, aR&D, and aAcc groupings during the year when an SEO was issued and
during the period when no SEO was issued. The number of SEO firm-years in each group is reported in Table 2, Panels C and D.
Variable Definitions:
aROAis abnormal ROA ROAis  predicted ROAis;
aR&Dis abnormal R&D R&Dis  predicted R&Dis; and
aAccis abnormal Accruals TAis  predicted TAis.

Post-SEO Stock Price Performance


Under the null hypothesis stemming from the efficient markets, if earnings inflation strategies are transparent to investors
and stocks are priced efficiently at the time of the SEO, then future abnormal returns should not be statistically distinguishable
from zero for Groups 1, 3, and 4, and, indeed, for any of the eight groups. However, if the financial markets do not fully
impound the effect of earnings inflation at the time of an SEO, but do so only after its effects are realized over subsequent
periods, then we expect firms engaging in earnings inflation to exhibit negative abnormal stock returns in the future.
The results for Groups 1 through 4 are presented in Table 5, Panel A. Only two groups exhibit significantly negative mean
cumulative abnormal returns in each year following the SEO. Group 3 includes firms that likely overstate earnings via both
R&D and accruals. Firms in Group 3 experience, on average, an abnormal return of 11.4 percent one year subsequent to an
SEO. The mean cumulative stock returns become more negative in the second year after the SEO, at 20.7 percent. Thereafter,
cumulative abnormal returns decline in magnitude in the third year after the SEO, but are still significantly negative at 16.3
percent. The first post-SEO year accounts for 55 percent of the two-year post-SEO cumulative abnormal returns and almost 70
percent of the three-year post-SEO cumulative abnormal returns.
Group 4 includes firms attempting to overstate earnings via unusually low R&D expenses, but not via unusually high
accruals. Firms in Group 4 in Table 5, Panel A have significantly negative mean cumulative abnormal returns of 10.6 percent,
17.0 percent, and 22.9 percent in the successive three years following an SEO. While the negative cumulative returns are
monotonically increasing in magnitude across the three years, returns in the first year after the SEO account for 62 percent and
46 percent of the two-year and three-year post-SEO cumulative returns, respectively. We do not observe significant negative
returns in any of the three years following an SEO for firms in Group 1; these firms are likely to have relied on accruals alone to
inflate earnings. We also document median returns in Table 5 with patterns very similar to those for the mean returns.
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TABLE 4
Post-SEO Operating Performance by Firm Groups Based on Abnormal ROA, Abnormal R&D, and Abnormal
Accruals at the Time of an SEO
Panel A: Groups 14 (aROA . 0)

Group 1(n 268):


aROAis . 0, aR&Dis . 0, aAccis . 0
Group 2 (n 348):
aROAis . 0, aR&Dis . 0, aAccis , 0
Group 3 (n 647):
aROAis . 0, aR&Dis , 0, aAccis . 0
Group 4 (n 665):
aROAis . 0, aR&Dis , 0, aAccis , 0

One Year
after SEO

Two Years
after SEO

Three Years
after SEO

0.006
(0.038)

0.027
(0.033)

0.051
(0.049)

0.017
(0.017)

0.005
(0.013)

0.013
(0.048)

0.042***
(0.015)

0.032*
(0.019)

0.053***
(0.017)

0.034***
(0.013)

0.049***
(0.018)

0.050***
(0.015)

One Year
after SEO

Two Years
after SEO

Three Years
after SEO

0.048***
(0.017)

0.045**
(0.010)

0.030*
(0.017)

0.078***
(0.023)

0.052**
(0.023)

0.012
(0.028)

0.056***
(0.014)

0.037**
(0.015)

0.031*
(0.018)

0.027
(0.019)

0.016
(0.027)

0.004
(0.026)

Panel B: Groups 58 (aROA , 0)

Group 5 (n 412):
aROAis , 0, aR&Dis . 0, aAccis . 0
Group 6 (n 344):
aROAis , 0, aR&Dis . 0, aAccis , 0
Group 7 (n 383):
aROAis , 0, aR&Dis , 0, aAccis . 0
Group 8 (286):
aROAis , 0, aR&Dis , 0, aAccis , 0

***, **, * Denote p , 0.01, p , 0.05, and p , 0.10, respectively.


This table presents differences in profitability (computed as deviation of the sample firms ROA from the ROA of their Barber and Lyon [1997] matched
counterparts) in the three years following an SEO. n represents the number of SEO firm-years in each group. Cluster-robust standard errors are in
parentheses. See Table 2, Panels A and B for the models that yield the predicted values.
Variable Definitions:
aROAis abnormal ROA ROAis  predicted ROAis;
aR&Dis abnormal R&D R&Dis  predicted R&Dis; and
aAccis abnormal Accruals TAis  predicted TAis.

For completeness, Table 5, Panel B reports results for Groups 5 through 8. We expect the power of our empirical proxies to
capture real and accruals manipulation undertaken to overstate earnings to be weaker among these groups, as they consist of
firms that do not report positive abnormal earnings. Largely, our returns-based tests confirm this intuition, because of the 12
group and post-SEO-year combinations that we report, none exhibit significantly negative mean returns. Median returns are
marginally significantly negative at the p , 0.10 level for Group 7. Firms in Group 7 exhibit evidence of unusually low R&D
and unusually high accruals, without abnormally high earnings. These firms possibly engaged in earnings manipulation
strategies, but were still unsuccessful in their attempts to overstate earnings; future negative returns could, thus, represent the
market discovering these unsuccessful earnings management attempts.
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TABLE 5
Post-SEO Cumulative Stock Returns by Firm Groups Based on Abnormal ROA, Abnormal R&D, and Abnormal
Accruals at the Time of an SEO
Panel A: Groups 14 (aROA . 0)

Means (with standard errors)


Group 1 (n 268):
aROAis . 0, aR&Dis . 0, aAccis . 0
Group 2 (n 348):
aROAis . 0, aR&Dis . 0, aAccis , 0
Group 3 (n 647):
aROAis . 0, aR&Dis , 0, aAccis . 0
Group 4 (n 665):
aROAis . 0, aR&Dis , 0, aAccis , 0
Medians (with p-values)
Group 1 (n 268):
aROAis . 0, aR&Dis . 0, aAccis . 0
Group 2 (n 348):
aROAis . 0, aR&Dis . 0, aAccis , 0
Group 3 (n 647):
aROAis . 0, aR&Dis , 0, aAccis . 0
Group 4 (n 665):
aROAis . 0, aR&Dis , 0, aAccis , 0

One Year
after SEO

Two Years
after SEO

Three Years
after SEO

0.052
(0.052)

0.080
(0.080)

0.137
(0.110)

0.003
(0.046)

0.014
(0.074)

0.128
(0.106)

0.114***
(0.036)

0.207***
(0.059)

0.163**
(0.082)

0.106**
(0.033)

0.170***
(0.056)

0.229***
(0.075)

0.079
(0.132)

0.074
(0.253)

0.072
(0.212)

0.031
(0.606)

0.000
(0.927)

0.104
(0.229)

0.118***
(,0.001)

0.305***
(,0.001)

0.243***
(0.003)

0.088***
(0.001)

0.109***
(0.002)

0.266***
(0.001)
(continued on next page)

Figure 1 represents the post-SEO returns graphically. As discussed above, firms in Groups 3 and 4 (with negative abnormal
R&D and positive abnormal ROA) exhibit the most pronounced negative returns in the three years following the SEO. The
graph also reveals that the Group 1 firms with positive abnormal accruals, as well as ROA, also exhibit negative post-SEO
returns, even though these returns are not statistically significant. Thus, there is some weak evidence of abnormal accruals
possibly also influencing overvaluation, but not to the same extent as R&D manipulation.
Table 6 presents similar results to those in Table 5, using annual returns (instead of cumulative returns) for every event
year relative to SEO year. The results confirm that Groups 3 and 4 exhibit significantly negative returns both in Year 1 and Year
2 after the SEO. In Year 3, the returns for Group 3 and 4 are still negative, but statistically insignificant. Table 6 also reports
negative returns for Group 7 in the third year after the SEO. However, as Table 5 indicates, Group 7 firms experience only a
statistically insignificant 6.8 percent cumulative return, on average, over the three-year period following an SEO, as compared
to 16.3 percent for Group 3 and 22.9 percent or Group 4.
V. ADDITIONAL ANALYSES
Post-SEO Returns and Firm Age
The opacity of earnings management arises from the information asymmetry between managers and shareholders. Lang
(1991) argues that external investors of younger firms are more heavily dependent on current earnings surprises in assessing
firm performance, reflecting the relative lack of availability of time-series data on earnings to develop a better understanding of
the firm. Studies such as Zhang (2006) argue that younger firms experience greater information asymmetry between managers
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574

TABLE 5 (continued)
Panel B: Groups 58 (aROA , 0)

Means (with standard errors)


Group 5 (n 412):
aROAis , 0, aR&Dis . 0, aAccis . 0
Group 6 (n 344):
aROAis , 0, aR&Dis . 0, aAccis , 0
Group 7 (n 383):
aROAis , 0, aR&Dis , 0, aAccis . 0
Group 8 (286):
aROAis , 0, aR&Dis , 0, aAccis , 0
Medians (with p-values)
Group 5 (n 412):
aROAis , 0, aR&Dis . 0, aAccis . 0
Group 6 (n 344):
aROAis , 0, aR&Dis . 0, aAccis , 0
Group 7 (n 383):
aROAis , 0, aR&Dis , 0, aAccis . 0
Group 8 (286):
aROAis , 0, aR&Dis , 0, aAccis , 0

One Year
after SEO

Two Years
after SEO

Three Years
after SEO

0.050
(0.047)

0.032
(0.070)

0.010
(0.088)

0.044
(0.060)

0.033
(0.085)

0.082
(0.112)

0.053
(0.051)

0.005
(0.070)

0.068
(0.095)

0.077
(0.058)

0.118
(0.092)

0.069
(0.121)

0.071
(0.434)

0.042
(0.755)

0.042
(0.640)

0.029
(0.543)

0.032
(0.711)

0.005
(0.870)

0.083*
(0.100)

0.074
(0.675)

0.142
(0.370)

0.033
(0.116)

0.238
(0.279)

0.026
(0.826)

***, **, * Denote p , 0.01, p , 0.05, and p , 0.10, respectively.


8
X
kg kIg gisk , where: abnStkRiskjs is the k-period ahead (i.e., future multi-period) risk-adjusted
Each cell in the table presents: abnStkRiskjs
g1

cumulative stock return for firm i, with an SEO occurring at time s; and I(g) is an indicator function that takes on the value 1 if the firm is in Group g, and 0
otherwise. We use the Barber and Lyon (1997) matched-firm approach to compute abnormal stock return. n represents the number of SEO firm-years in
each group. Mean returns for each group are presented, along with cluster-robust standard errors in parentheses. Median returns for each group are
presented, along with p-values from non-parametric tests in parentheses. See Table 2, Panels A and B for the models that yield the predicted values.
Variable Definitions:
aROAis abnormal ROA ROAis  predicted ROAis;
aR&Dis abnormal R&D R&Dis  predicted R&Dis; and
aAccis abnormal Accruals TAis  predicted TAis.

and shareholders. If managers do indeed possess a more pronounced information advantage over external stakeholders in
younger firms, then we expect that earnings management in such firms, particularly via real activities, will be more highly
associated with negative post-SEO returns.
Our proxy for firm age is the number of years between the first Compustat listing of the firm and the date of the SEO.
Median firm age in the sample is nine years. Table 7 reports mean returns after splitting the sample into two groups based on
median age. As Table 7 indicates, the post-SEO returns are most consistently negative for Groups 3 and 4 when firms are below
median age. In other words, when managers overstate earnings by suppressing R&D expenditures, investors of younger firms
are misled more severely.
The Performance of Firms in the Year Prior to the SEO
It is conceivable that Groups 3 and 4, which most consistently exhibit negative future returns in the year following the
SEO, are underperforming firms leading up to the equity issue. In other words, they possibly have low or negative cash flows
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Managing for the Moment: Earnings Management via Real Activities versus Accruals in SEO Valuation

575

FIGURE 1
Post-SEO Cumulative Stock Returns by Firm Groups Based on Abnormal ROA, Abnormal R&D, and Abnormal
Accruals at the Time of an SEO

This figure represents cumulative risk-adjusted returns in years one, two, and three after the SEO. The groups are defined as follows:
Group 1: aROAis . 0, aR&Dis . 0, aAccis . 0,
Group 2: aROAis . 0, aR&Dis . 0, aAccis , 0,
Group 3: aROAis . 0, aR&Dis , 0, aAccis . 0,
Group 4: aROAis . 0, aR&Dis , 0, aAccis , 0,
Group 5: aROAis , 0, aR&Dis . 0, aAccis . 0,
Group 6: aROAis , 0, aR&Dis . 0, aAccis , 0,
Group 7: aROAis , 0, aR&Dis , 0, aAccis . 0,
Group 8: aROAis , 0, aR&Dis , 0, aAccis , 0.
See Table 2, Panels A and B for the models that yield the predicted values.
Variable Definitions:
aROAis abnormal ROA ROAis  predicted ROAis;
aR&Dis abnormal R&D R&Dis  predicted R&Dis; and
aAccis abnormal accruals TAis  predicted TAis.

from operations (CFO), as well as low or negative ROA in the year preceding the SEO. This would potentially explain their
need to access equity markets for cash and their aggressive reduction of R&D. Although this alone is insufficient to explain
why they underperform in post-SEO years, it raises the possibility that their unusually low R&D in SEO years is driven by
managers responding to poor performance via cost controls, rather than earnings management.
Table 8 presents data on ROA and CFO in the year prior to the SEO for all groups of firms over the years 19702012.
Panel A of Table 8 reveals that firms in Groups 3 and 4 (that exhibit unusually low R&D) are unlikely to be underperforming in
the years prior to the SEO. Median abnormal ROA for firms in Groups 3 and 4 in the year before the SEO are positive at 4.9
percent and 4.8 percent, respectively. For comparison, consider firms in Groups 1 and 2. Group 1 firms are likely to have
overstated earnings via accruals alone, while Group 2 firms have abnormally high earnings, but do not exhibit any evidence of
R&D or accruals manipulation. Similar to firms in Groups 3 and 4, those in Groups 1 and 2 report positive abnormal ROA in
the SEO year, but have lower median abnormal ROA in the year preceding the SEO (3.4 percent and 4.0 percent, respectively).
Firms in Groups 58, which do not exhibit unusually high ROA in the SEO year, report generally negative mean and
median abnormal ROA in the year preceding the SEO. Table 8, Panel A additionally reports firm-year ROA in excess of mean
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Kothari, Mizik, and Roychowdhury

576

TABLE 6
Post-SEO Annual Stock Returns by Firm Groups Based on Abnormal ROA, Abnormal R&D, and Abnormal Accruals
at the Time of an SEO
Panel A: Groups 14 (aROA . 0)

Means (with standard errors)


Group 1 (n 268):
aROAis . 0, aR&Dis . 0, aAccis . 0
Group 2 (n 348):
aROAis . 0, aR&Dis . 0, aAccis , 0
Group 3 (n 647):
aROAis . 0, aR&Dis , 0, aAccis . 0
Group 4 (n 665):
aROAis . 0, aR&Dis , 0, aAccis , 0
Medians (with p-values)
Group 1 (n 268):
aROAis . 0, aR&Dis . 0, aAccis . 0
Group 2 (n 348):
aROAis . 0, aR&Dis . 0, aAccis , 0
Group 3 (n 647):
aROAis . 0, aR&Dis , 0, aAccis . 0
Group 4 (n 665):
aROAis . 0, aR&Dis , 0, aAccis , 0

Year One
after SEO

Year Two
after SEO

0.052
(0.052)

0.055
(0.055)

0.044
(0.064)

0.003
(0.046)

0.051
(0.054)

0.045
(0.053)

0.114***
(0.036)

0.119***
(0.043)

0.021
(0.045)

0.106***
(0.033)

0.066*
(0.040)

0.030
(0.044)

0.079
(0.132)

0.045
(0.269)

0.012
(0.867)

0.031
(0.606)

0.035
(0.392)

0.049
(0.326)

0.126***
(0.005)

0.015
(0.660)

0.068*
(0.081)

0.060
(0.186)

0.118***
(,0.001)
0.088**
(0.001)

Year Three
after SEO

(continued on next page)

ROA across all firms in that corresponding fiscal year. Median year-adjusted ROA for Groups 3 and 4 are also positive, at 6.9
percent and 8.2 percent, respectively. For comparison, firms in Groups 1 and 2 have median year-adjusted ROAs of 7.6 percent
and 6.9 percent, respectively. Further, median raw ROA (i.e., without any adjustment) are as high as 13.8 percent and 14.6
percent, respectively, for Groups 3 and 4, making it highly unlikely that they are poorly performing firms.
In Table 8, Panel B we report data on pre-SEO-year CFO (scaled by total assets) for all groups. The estimation procedure
for abnormal CFO closely follows the procedure for abnormal ROA. Median abnormal CFO is 0.9 percent for Group 3 and 5.0
percent for Group 4. For comparison, firms in Groups 1 and 2 have median abnormal CFO of 15.8 percent and 4.3 percent,
respectively, in the year prior to the SEO. Median year-adjusted CFO for firms in Groups 3 and 4 is 0.3 percent and 6.5 percent,
respectively, while that of Groups 1 and 2 is 0.4 percent and 4.7 percent, respectively. Median raw CFO for firms in Groups 3
and 4 is 3.4 percent and 10.1 percent, respectively, while that of Groups 1 and 2 is 3.4 percent and 7.4 percent, respectively.
Thus, it seems unlikely that firms in Groups 3 and 4 experienced negative CFO shocks or had low unadjusted CFO in the year
prior to the SEO.
In summary, the data suggest that firms in Groups 3 and 4 are unlikely to be performing poorly or to be facing cash
constraints in the year leading up to the SEO, yet they exhibit the most negative cumulative returns in the three years following
the SEO. This is consistent with the negative returns for Groups 3 and 4 reflecting reversals of overvaluation driven by opaque
earnings management via the suppression of R&D during the SEO year.
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577

TABLE 6 (continued)
Panel B: Groups 58 (aROA , 0)

Means (with standard errors)


Group 5 (n 412):
aROAis , 0, aR&Dis . 0, aAccis . 0
Group 6 (n 344):
aROAis , 0, aR&Dis . 0, aAccis , 0
Group 7 (n 383):
aROAis , 0, aR&Dis , 0, aAccis . 0
Group 8 (286):
aROAis , 0, aR&Dis , 0, aAccis , 0
Medians (with p-values)
Group 5 (n 412):
aROAis , 0, aR&Dis . 0, aAccis . 0
Group 6 (n 344):
aROAis , 0, aR&Dis . 0, aAccis , 0
Group 7 (n 383):
aROAis , 0, aR&Dis , 0, aAccis . 0
Group 8 (286):
aROAis , 0, aR&Dis , 0, aAccis , 0

Year One
after SEO

Year Two
after SEO

Year Three
after SEO

0.050
(0.047)

0.043
(0.055)

0.002
(0.053)

0.044
(0.060)

0.007
(0.062)

0.034
(0.063)

0.053
(0.051)

0.055
(0.050)

0.083*
(0.050)

0.077
(0.058)

0.067
(0.058)

0.016
(0.070)

0.071
(0.434)

0.083
(0.192)

0.066
(0.560)

0.029
(0.543)

0.003
(0.930)

0.115
(0.399)

0.083*
(0.100)

0.028
(0.329)

0.100**
(0.046)

0.033
(0.116)

0.000
(0.521)

0.013
(0.811)

***, **, * Denote p , 0.01, p , 0.05, and p , 0.10, respectively.


We use the Barber and Lyon (1997) matched-firm approach to compute abnormal stock return. n represents the number of SEO firm-years in each group.
Mean returns for each group are presented, along with cluster-robust standard errors in parentheses. Median returns for each group are presented, along
with p-values from non-parametric tests in parentheses. See Table 2, Panels A and B for the models that yield the predicted values.
Variable Definitions:
aROAis abnormal ROA ROAis  predicted ROAis;
aR&Dis abnormal R&D R&Dis  predicted R&Dis; and
aAccis abnormal Accruals TAis  predicted TAis.

Survival Rates
In the returns-based tests in Tables 5 and 6, we observe significantly negative post-SEO returns for Groups 3 and 4, and
insignificant returns for firms in Groups 1 and 2. This leads us to infer that SEO overvaluation is more rampant when firms
overstate earnings via real activities (as is likely the case for firms in Groups 3 and 4) rather than via accruals alone (as is likely
the case for firms in Group 1). However, if the survival rates of SEO firms in Groups 1 and 2 are lower than those in Groups 3
and 4, then the inference possible from the returns-based tests would be weaker.
Table 9 presents group survival rates in the three years subsequent to an SEO. Survival is identified in two ways. In Panel
A, survival in any year is defined as being listed on CRSP at the end of the year. In Panel B, survival in any year is defined as
not being assigned a delisting code that reflects cessation of operations and/or delisting by the exchange due to liquidations,
bankruptcy, etc.11 In either panel, we fail to detect statistically significant differences in survival rates across any of the groups;
11

CRSP delisting codes in the 400s and 500s refer to the cessation of operations and delisting by the exchange, respectively. Transfers to other exchanges,
including international ones, and/or delisting because of mergers are assigned distinct codes and, strictly speaking, do not count as failures.

The Accounting Review


Volume 91, Number 2, 2016

Kothari, Mizik, and Roychowdhury

578

TABLE 7
Post-SEO Annual Stock Returns by Firm Groups Based on Abnormal ROA, Abnormal R&D, and Abnormal Accruals
at the Time of an SEO, Partitioned on Median Firm Age
Panel A: Groups 14 (aROA . 0)
Year One
after SEO
Old Firms: AGE  9 YEARS*** Means (with cluster-robust standard errors)
Group 1 (n 130):
aROAis . 0, aR&Dis . 0, aAccis . 0
0.070
(0.083)
Group 2 (n 161):
aROAis . 0, aR&Dis . 0, aAccis , 0
0.030
(0.066)
Group 3 (n 341):
aROAis . 0, aR&Dis , 0, aAccis . 0
0.087*
(0.049)
Group 4 (n 363):
aROAis . 0, aR&Dis , 0, aAccis , 0
0.056
(0.042)
Young Firms: AGE , 9 YEARS*** Means (with cluster-robust standard errors)
Group 1 (n 138):
aROAis . 0, aR&Dis . 0, aAccis . 0
0.040
(0.067)
Group 2 (n 187):
aROAis . 0, aR&Dis . 0, aAccis , 0
0.023
(0.062)
Group 3 (n 306):
aROAis . 0, aR&Dis , 0, aAccis . 0
0.136**
(0.053)
Group 4 (n 302):
aROAis . 0, aR&Dis , 0, aAccis , 0
0.154***
(0.051)

Year Two
after SEO

Year Three
after SEO

0.111
(0.118)

0.140
(0.158)

0.084
(0.103)

0.094
(0.137)

0.123
(0.087)

0.062
(0.117)

0.155**
(0.072)

0.100
(0.095)

0.058
(0.108)

0.134
(0.153)

0.075
(0.102)

0.281*
(0.151)

0.279***
(0.080)

0.262**
(0.115)

0.185**
(0.085)

0.346***
(0.115)
(continued on next page)

however, some patterns emerge. As expected, firms in Groups 58, which have negative abnormal ROA in the SEO year,
generally exhibit lower survival rates in post-SEO years. Turning to groups with abnormally positive ROA in the SEO year,
Groups 3 and 4 have slightly lower survival rates than Groups 1 and 2. This is true in both panels, that is, irrespective of the
definition of survival. The patterns indicate that the lower post-SEO returns for firms in Groups 3 and 4 relative to those in
Groups 1 and 2 cannot be attributed to lower survival rates for the latter two groups.
The Manipulation of Selling, General, and Administrative Expenses
The suppression of R&D expenditures provides the most intuitive setting for managers potentially sacrificing future
competitiveness for the sake of current short-term earnings goals. However, the requirement for our tests that firms report nonzero R&D expenses restricts our sample size. Fortunately for our purpose, the reduction of discretionary expenditures to
temporarily overstate earnings can influence earnings components other than just R&D. Motivated by prior studies, such as
Roychowdhury (2006), Cohen and Zarowin (2010), and Zang (2012), we examine whether the suppression of selling, general,
and administrative (SG&A) expenses misleads the market and, therefore, is associated with post-SEO negative returns. The
analysis of SG&A expenses yields a larger sample of 5,182 SEO firm-years, as opposed to the 3,353 SEO firm-years included
in the R&D analysis. Analogous to R&D, the model for normal level of SG&A is as follows:
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579

TABLE 7 (continued)
Panel B: Groups 58 (aROA , 0)
Year One
after SEO
Old Firms: AGE  9 YEARS*** Means (with cluster-robust standard errors)
Group 5 (n 232):
aROAis , 0, aR&Dis . 0, aAccis . 0
0.004
(0.070)
Group 6 (n 191):
aROAis , 0, aR&Dis . 0, aAccis , 0
0.061
(0.099)
Group 7 (n 203):
aROAis , 0, aR&Dis , 0, aAccis . 0
0.055
(0.069)
Group 8 (n 131):
aROAis , 0, aR&Dis , 0, aAccis , 0
0.103
(0.076)
Young Firms: AGE , 9 YEARS*** Means (with cluster-robust standard errors)
Group 5 (n 180):
aROAis , 0, aR&Dis . 0, aAccis . 0
0.085
(0.063)
Group 6 (n 153):
aROAis , 0, aR&Dis . 0, aAccis , 0
0.031
(0.074)
Group 7 (n 180):
aROAis , 0, aR&Dis , 0, aAccis . 0
0.052
(0.073)
Group 8 (n 155):
aROAis , 0, aR&Dis , 0, aAccis , 0
0.063
(0.080)

Year Two
after SEO

Year Three
after SEO

0.051
(0.099)

0.158
(0.142)

0.119
(0.136)

0.191
(0.166)

0.100
(0.092)

0.004
(0.124)

0.108
(0.135)

0.053
(0.191)

0.097
(0.097)

0.109
(0.112)

0.035
(0.108)

0.001
(0.152)

0.086
(0.105)

0.130
(0.140)

0.124
(0.123)

0.143
(0.156)

***, **, * Denote p , 0.01, p , 0.05, and p , 0.10, respectively.


8
X
kg kIg gisk , where: abnStkRiskjs is the k-period ahead (i.e., future multi-period) risk-adjusted
Each cell in the table presents: abnStkRiskjs
g1

cumulative stock return for firm i, with an SEO occurring at time s; and I(g) is an indicator function that takes on the value 1 if the firm is in Group g, and 0
otherwise. We use the Barber and Lyon (1997) matched-firm approach to compute abnormal stock return. n represents the number of SEO firm-years in
each group. Mean returns for each group are presented, along with cluster-robust standard errors in parentheses. Median returns for each group are
presented, along with p-values from non-parametric tests in parentheses. See Table 2, Panels A and B for the models that yield the predicted values. In
arriving at abnormal values, the residuals from the models are corrected for systematic firm-specific estimation error.
Variable Definitions:
aROAis abnormal ROA ROAis  predicted ROAis;
aR&Dis abnormal R&D R&Dis  predicted R&Dis; and
aAccis abnormal Accruals TAis  predicted TAis.

SG&Ait asga i Dsga t /sga SG&Ait1 csga Salesit1 esga it ;

where SG&Ait is the value of the SG&A series to be modeled for firm i at time period t, and SG&Ait1 is its lagged value.
The above model is estimated using exactly the same procedure as the model for R&D and adjusts for year-specific and
firm-specific effects. We assign SEO firm-years to groups based on the sign of abnormal SG&A, abnormal accruals, and
abnormal earnings. Table 10, Panels A and B report the returns for each group over the three years following the SEO. Groups
3 and 4 are most likely to have overstated earnings by reducing SG&A expenses, respectively, with and without abnormally
positive accruals. Table 10, Panel A reveals that firms in Groups 3 and 4 exhibit significantly negative cumulative returns for all
three years following the SEO. Group 3 cumulative abnormal returns are 11.0 percent, 16.5 percent, and 24.1 percent in
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Kothari, Mizik, and Roychowdhury

580

TABLE 8
ROA and CFO in the Year Prior to the SEO
Panel A: ROA in the Year Prior to the SEO
Mean
Abnormal
ROAt1
Group 1 (n 268):
aROAis . 0, aR&Dis
Group 2 (n 348):
aROAis . 0, aR&Dis
Group 3 (n 647):
aROAis . 0, aR&Dis
Group 4 (n 665):
aROAis . 0, aR&Dis
Group 5 (n 412):
aROAis , 0, aR&Dis
Group 6 (n 344):
aROAis , 0, aR&Dis
Group 7 (n 383):
aROAis , 0, aR&Dis
Group 8 (286):
aROAis , 0, aR&Dis

Median
Abnormal
ROAt1

Mean
YearAdjusted
ROAt1

Median
YearAdjusted
ROAt1

Mean
ROAt1

Median
ROAt1

. 0, aAccis . 0

0.069

0.034

0.056

0.076

0.132

0.160

. 0, aAccis , 0

0.070

0.040

0.045

0.069

0.129

0.156

, 0, aAccis . 0

0.091

0.049

0.087

0.069

0.076

0.138

, 0, aAccis , 0

0.127

0.048

0.053

0.082

0.120

0.146

. 0, aAccis . 0

0.231

0.063

0.371

0.099

0.222

0.037

. 0, aAccis , 0

0.331

0.076

0.516

0.251

0.275

0.168

, 0, aAccis . 0

0.061

0.030

0.048

0.012

0.025

0.087

, 0, aAccis , 0

0.052

0.029

0.085

0.002

0.021

0.072

ROA and abnormal ROA are defined as in Tables 1 and 2, respectively. Year-adjusted ROA is defined as the deviation of a firms ROA from that years
mean ROA. n represents the number of SEO firm-years in each group.

(continued on next page)

the three successive years after the SEO. Group 4 cumulative abnormal returns are 11.3 percent, 12.3 percent, and 20.5
percent in the three successive years after the SEO. While the negative cumulative returns monotonically increase in magnitude
over the three years, returns in the year immediately following the SEO tend to be disproportionately more negative for both
groups. Mean Year 1 returns after the SEO represent 67 percent and 46 percent, respectively, of the two-year and three-year
post-SEO cumulative returns for Group 3; the corresponding percentages for Group 4 are 92 percent and 55 percent. Table 10,
Panel B reveals that Group 7 firms also exhibit significantly negative future returns, but only beginning the second year after the
SEO. Median returns generally confirm the evidence we observe with mean returns for every group.
Figure 2 represents the post-SEO returns graphically. Firms in Groups 3 and 4 with negative abnormal R&D and positive
abnormal ROA exhibit the most pronounced negative returns in the three years following the SEO, similar to the evidence we
observe with abnormal R&D. The graph also reveals that firms with positive abnormal accruals and negative abnormal R&D,
but with unusually low ROA (Group 7), exhibit economically significant negative post-SEO returns, as well. Recall that these
may be firms engaging in earnings manipulation via both accruals and SG&A, but still failing to report unusually high earnings.
The results suggest the possibility that these firms are also overvalued at the time of the SEO.
In additional untabulated analysis, we partition firms with unusually high ROA based on the sign of abnormal SG&A and
abnormal R&D. We find that post-SEO returns are significantly negative only when firms reduce both SG&A and R&D to
overstate earnings. We do not consistently detect significantly negative returns in the three years following the SEO among
firms with unusually high ROA when either abnormal R&D or abnormal SG&A is non-negative. This is partially an issue of
power, because firms with both unusually low R&D and unusually low SG&A form the largest group within the set of SEO
firms with positive abnormal ROA, accounting for around 49 percent of the sample. Nevertheless, the results suggest the
possibility that the market is misled the most when firms reduce both their R&D and SG&A expenditures to overstate earnings.
VI. DISCUSSION OF FINDINGS
Our primary result, robust to various specifications, is that SEO firms exhibit future negative abnormal returns when they
report positive abnormal earnings that are also accompanied by real activities management. Interestingly, we observe the most
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TABLE 8 (continued)
Panel B: CFO in the Year Prior to the SEO

Group 1 (n 268):
aROAis . 0, aR&Dis
Group 2 (n 348):
aROAis . 0, aR&Dis
Group 3 (n 647):
aROAis . 0, aR&Dis
Group 4 (n 665):
aROAis . 0, aR&Dis
Group 5 (n 412):
aROAis , 0, aR&Dis
Group 6 (n 344):
aROAis , 0, aR&Dis
Group 7 (n 383):
aROAis , 0, aR&Dis
Group 8 (286):
aROAis , 0, aR&Dis

Mean
Abnormal
CFOt1

Median
Abnormal
CFOt1

Mean
YearAdjusted
CFOt1

Median
YearAdjusted
CFOt1

0.137

0.158

0.021

0.073

0.043

0.058

Mean
CFOt1

Median
CFOt1

0.004

0.108

0.034

0.058

0.047

0.162

0.073

0.009

0.003

0.003

0.039

0.034

0.090

0.050

0.057

0.065

0.163

0.101

0.190

0.094

0.295

0.113

0.133

0.081

0.270

0.048

0.397

0.121

0.219

0.141

0.051

0.026

0.052

0.004

0.060

0.036

0.190

0.001

0.178

0.026

0.011

0.052

. 0, aAccis . 0
. 0, aAccis , 0
, 0, aAccis . 0
, 0, aAccis , 0
. 0, aAccis . 0
. 0, aAccis , 0
, 0, aAccis . 0
, 0, aAccis , 0

See variable description below for computation of abnormal CFO. Year-adjusted CFO is defined as the deviation of a firms CFO from that years mean
CFO. n represents the number of SEO firm-years in each group. Because the Compustat Net Cash Flow data (OANCF) are only available starting in 1987,
we compute the size-adjusted cash flow in the pre-1987 period as Cash Flows Funds from Operations  Current Accruals (FOPT  ((ACTt 
lag(ACT))  (CHE-lag(CHE))  (LCT  lag(LCT)) (DD1  lag(DD1))))/AT (e.g., Teoh at al. 1998). Post-1987, we use OANCF from Compustat. We
estimate the following time-series panel data model to estimate abnormal cash flow: CFOit ai /  CFOit1 eit, where CFOit is the amount of sizeadjusted cash flow for firm i at time period t; CFOit1 is its lagged value. Firm and year fixed effects are included in the regression, and the residuals for
every firm-year are differenced from their firm-specific mean. The estimation procedure follows that of normal ROA. See Table 2, Panels A and B for the
models that yield the predicted values.
Variable Definitions:
aROAis abnormal ROA ROAis  predicted ROAis;
aR&Dis abnormal R&D R&Dis  predicted R&Dis; and
aAccis abnormal Accruals TAis  predicted TAis.

consistently negative post-SEO returns when we combine measures of real earnings management with those of unusually high
earnings, suggesting that this provides a powerful method for identifying opaque earnings overstatement via real activities.
Our primary measure of real earnings management is unusual reductions in R&D expenditures, but we obtain very similar
results with the unusual reductions in SG&A expenses, as well. Results with respect to accruals management are more mixed.
We observe significantly negative future returns only when accruals management is also accompanied by R&D reductions to
generate unusually high earnings. This could possibly reflect the markets inability to comprehend the implications of accruals
when manipulation of real activities is an obfuscating factor. Note that abnormal accruals accompanying RAM might arise as a
result of real activities, such as R&D reductions, that also lead to unusually low payables. Importantly, in Group 4, we observe
negative future returns for firms that are likely to have inflated earnings via real activities, but do not exhibit any evidence of
accruals management. Thus, accruals management per se does not appear to be driving SEO overvaluation. Collectively, the
results suggest that investors and other market participants do not necessarily fixate on earnings; rather, their ability to process
earnings information and detect any manipulation is weaker when managers engage in more opaque strategies to inflate
earnings.
VII. CONCLUSION
An SEO is an event where the firms stock price is of particular interest to managers. The amount of capital collected by a
firm at the time of an SEO depends on its stock price on the day of the offering. To the extent that stock valuations depend, at
least in part, on reported earnings, managers and current shareholders have incentives to inflate earnings in order to maximize
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TABLE 9
Post-SEO Survival Rates
Panel A: Survival Rates Based on Delisting from CRSP

Group 1 (n 268):
aROAis . 0, aR&Dis
Group 2 (n 348):
aROAis . 0, aR&Dis
Group 3 (n 647):
aROAis . 0, aR&Dis
Group 4 (n 665):
aROAis . 0, aR&Dis
Group 5 (n 412):
aROAis , 0, aR&Dis
Group 6 (n 344):
aROAis , 0, aR&Dis
Group 7 (n 383):
aROAis , 0, aR&Dis
Group 8 (286):
aROAis , 0, aR&Dis

Year of
SEO

One Year
after SEO

Two Years
after SEO

Three Years
after SEO

. 0, aAccis . 0

1.000

0.919

0.783

0.697

. 0, aAccis , 0

1.000

0.917

0.795

0.680

, 0, aAccis . 0

1.000

0.906

0.770

0.637

, 0, aAccis , 0

1.000

0.906

0.771

0.658

. 0, aAccis . 0

1.000

0.890

0.786

0.657

. 0, aAccis , 0

1.000

0.807

0.689

0.548

, 0, aAccis . 0

1.000

0.898

0.759

0.650

, 0, aAccis , 0

1.000

0.860

0.728

0.600

Panel B: Survival Rates Based on Involuntary Delisting from CRSP

Group 1 (n 268):
aROAis . 0, aR&Dis
Group 2 (n 348):
aROAis . 0, aR&Dis
Group 3 (n 647):
aROAis . 0, aR&Dis
Group 4 (n 665):
aROAis . 0, aR&Dis
Group 5 (n 412):
aROAis , 0, aR&Dis
Group 6 (n 344):
aROAis , 0, aR&Dis
Group 7 (n 383):
aROAis , 0, aR&Dis
Group 8 (286):
aROAis , 0, aR&Dis

Year of
SEO

One Year
after SEO

Two Years
after SEO

Three Years
after SEO

. 0, aAccis . 0

1.000

0.996

0.977

0.959

. 0, aAccis , 0

1.000

0.993

0.975

0.957

, 0, aAccis . 0

1.000

0.985

0.965

0.956

, 0, aAccis , 0

1.000

0.991

0.965

0.946

. 0, aAccis . 0

1.000

0.974

0.948

0.932

. 0, aAccis , 0

1.000

0.959

0.919

0.896

, 0, aAccis . 0

1.000

0.985

0.963

0.935

, 0, aAccis , 0

1.000

0.987

0.957

0.932

This table presents the fraction of firms within each group that survive at the end of each year relative to the SEO year. A firm is counted as surviving in
a given year if it is listed in the CRSP database at the end of that year. A firm-year is counted as surviving in a given year if it is not assigned a delisting
code between 400 and 600 (600 excluded). These codes capture involuntary delistings, i.e., delistings because of cessation of operations, or delistings by
the respective exchange due to liquidations, bankruptcies, etc. n represents the number of SEO firm-years in each group. See Table 2, Panels A and B for
the models that yield the predicted values.
Variable Definitions:
aROAis abnormal ROA ROAis  predicted ROAis;
aR&Dis abnormal R&D R&Dis  predicted R&Dis; and
aAccis abnormal Accruals TAis  predicted TAis.

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TABLE 10
Post-SEO Cumulative Stock Returns by Firm Groups Based on Abnormal ROA, Abnormal SG&A, and Abnormal
Accruals at the Time of an SEO
Panel A: Groups 14 (aROA . 0)

Means (with standard errors)


Group 1 (n 465):
aROAis . 0, aSG&Ais . 0, aAccis . 0
Group 2 (n 723):
aROAis . 0, aSG&Ais . 0, aAccis , 0
Group 3 (n 949):
aROAis . 0, aSG&Ais , 0, aAccis . 0
Group 4 (n 902):
aROAis . 0, aSG&Ais , 0, aAccis , 0
Medians (with p-values)
Group 1 (n 465):
aROAis . 0, aSG&Ais . 0, aAccis . 0
Group 2 (n 723):
aROAis . 0, aSG&Ais . 0, aAccis , 0
Group 3 (n 949):
aROAis . 0, aSG&Ais , 0, aAccis . 0
Group 4 (n 902):
aROAis . 0, aSG&Ais , 0, aAccis , 0

One Year
after SEO

Two Years
after SEO

Three Years
after SEO

0.029
(0.040)

0.079
(0.062)

0.224**
(0.090)

0.075
(0.033)

0.050
(0.051)

0.055
(0.072)

0.110***
(0.028)

0.165***
(0.045)

0.241***
(0.059)

0.113***
(0.030)

0.123***
(0.046)

0.205***
(0.058)

0.009
(0.823)

0.028
(0.356)

0.110**
(0.034)

0.020*
(0.079)

0.014
(0.669)

0.113***
(,0.001)

0.199***
(,0.001)

0.225***
(,0.001)

0.058***
(,0.001)

0.123***
(0.009)

0.116***
(0.002)

0.053
(0.931)

Panel B: Groups 58 (aROA , 0)

Means (with standard errors)


Group 5 (n 426):
aROAis , 0, aSG&Ais . 0, aAccis . 0
Group 6 (n 408):
aROAis , 0, aSG&Ais . 0, aAccis , 0
Group 7 (798):
aROAis , 0, aSG&Ais , 0, aAccis . 0
Group 8 (n 511):
aROAis , 0, aSG&Ais , 0, aAccis , 0
Medians (with p-values)
Group 5 (n 426):
aROAis , 0, aSG&Ais . 0, aAccis . 0

One Year
after SEO

Two Years
after SEO

Three Years
after SEO

0.065
(0.046)

0.182**
(0.084)

0.261**
(0.109)

0.143**
(0.054)

0.073
(0.076)

0.157
(0.111)

0.040
(0.03)

0.100**
(0.042)

0.028
(0.041)

0.077
(0.069)

0.072
(0.085)

0.183**
(0.012)

0.205**
(0.012)

0.011
(0.278)

0.192***
(0.057)

(continued on next page)

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TABLE 10 (continued)

Group 6 (n 408):
aROAis , 0, aSG&Ais . 0, aAccis , 0
Group 7 (798):
aROAis , 0, aSG&Ais , 0, aAccis . 0
Group 8 (n 511):
aROAis , 0, aSG&Ais , 0, aAccis , 0

One Year
after SEO

Two Years
after SEO

0.077*
(0.051)

0.033
(0.391)

0.000
(0.271)

0.101**
(0.030)

0.276
(0.163)

0.006
(0.327)

Three Years
after SEO
0.137
(0.227)
0.139***
(0.002)
0.022
(0.625)

***, **, * Denote p , 0.01, p , 0.05, and p , 0.10, respectively.


8
X
kg kIg gisk , where: abnStkRiskjs is the k-period ahead (i.e., future multi-period) risk-adjusted
Each cell in the table presents: abnStkRiskjs
g1

cumulative stock return for firm i, with an SEO occurring at time s; and I(g) is an indicator function that takes on the value 1 if the firm is in Group g, and 0
otherwise. We use the Barber and Lyon (1997) matched-firm approach to compute abnormal stock return. n represents the number of SEO firm-years in
each group. Mean returns for each group are presented, along with cluster-robust standard errors in parentheses. Median returns for each group are
presented, along with p-values from non-parametric tests in parentheses. See Table 2, Panels A and B for the models that yield the predicted values.
Variable Definitions:
aROAis abnormal ROA ROAis  predicted ROAis;
aSG&Ais abnormal SG&A SG&Ais  predicted SG&Ais; and
aAccis abnormal Accruals TAis  predicted TAis.

SEO proceeds, and thereby transfer wealth from future shareholders. However, an SEO also signifies a period of enhanced
scrutiny of the firm and its financial statements, which possibly dissuades managers from attempts to inflate earnings.
Reflecting these conflicting circumstances, the literature reports mixed evidence on overvaluation at the time of an SEO and its
link to earnings management.
Managers can choose from a range of methods to inflate earnings. Following recent literature, we recognize that earnings
management can occur through two channels, accruals manipulation and real activities manipulation. Only those methods that
are relatively more opaque are likely to escape detection under the scrutiny characterizing SEOs. We reason that earnings
management is more opaque to investors when achieved via real activities rather than via accruals.
In identifying real activities manipulation, we focus on managers incentives to reduce R&D expenditures, since such
reductions can be detrimental for future competitiveness and profitability, but can improve current earnings, profit margins, and
cash flow from operations. We observe that firms with abnormally high earnings and abnormally low R&D exhibit significantly
negative post-SEO returns, consistent with these firms being overvalued at the time of the SEO. We obtain similar results with
an alternative measure of real earnings management, unusual reductions in selling, general, and administrative (SG&A)
expenses. Our analysis of discretionary expenditures such as R&D and SG&A is consistent with the survey evidence in
Graham et al. (2005) that the suppression of discretionary expenditures is managers preferred method to overstate earnings.
While our research design incorporates the possibility that managers may engage in accruals management, our results suggest
that unusually high accruals are unlikely to be a dominant source of overvaluation at the time of an SEO.
Since real activities management is expected to be costlier for the firm, it may be natural to expect that managers attempt to
accomplish earnings management via accruals before they engage in opportunistic real activities. The evidence in studies such
as Badertscher (2011) is generally consistent with managers first exhausting or depleting their flexibility to maintain
overvaluation via accruals management before switching to real activities management. Our paper suggests that at times of
heightened scrutiny, managers can exhibit a preference for real activities manipulation strategies if they wish to inflate earnings,
because such strategies have a higher probability of escaping detection.
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585

FIGURE 2
Post-SEO Cumulative Stock Returns by Firm Groups Based on Abnormal ROA, Abnormal SG&A, and Abnormal
Accruals at the Time of an SEO

This figure represents cumulative risk-adjusted returns in years one, two, and three after the SEO. The groups are defined as follows:
Group 1: aROAis . 0, aSG&Ais . 0, aAccis . 0
Group 2: aROAis . 0, aSG&Ais . 0, aAccis , 0
Group 3: aROAis . 0, aSG&Ais , 0, aAccis . 0
Group 4: aROAis . 0, aSG&Ais , 0, aAccis , 0
Group 5: aROAis , 0, aSG&Ais . 0, aAccis . 0
Group 6: aROAis , 0, aSG&Ais . 0, aAccis , 0
Group 7: aROAis , 0, aSG&Ais , 0, aAccis . 0
Group 8: aROAis , 0, aSG&Ais , 0, aAccis , 0
See Table 2, Panels A and B for the models that yield the predicted values.
The functional form of the model yielding predicted values for SG&A is identical to that for R&D.
Variable Definitions:
aROAis abnormal ROA ROAis  predicted ROAis;
aSG&Ais abnormal SG&A SG&Ais  predicted SG&Ais; and
aAccis abnormal accruals TAis  predicted TAis.

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