Firm size, timing, and earnings management of seasoned equity offerings

Firm size, timing, and earnings management of seasonedequity offerings Department of Business Administration, Fu Jen Catholic University, Taiwan Article history: Received 28 April 2012 R

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Firm size, timing, and earnings management of seasoned

equity offerings

Department of Business Administration, Fu Jen Catholic University, Taiwan

Article history:

Received 28 April 2012

Received in revised form 18 March 2013

Accepted 8 May 2013

Available online xxxx

Rangan (1998), andTeoh, Wong, and Rao (1998)maintain that the short-term overperformance and long-term underperformance of seasoned equity offerings (SEOs) are due to earnings management, whereasLoughran and Ritter (1997), Baker and Wurgler (2002)andCohen, Papadaki, and Siougle (2007)attribute them to the timing of share placement by issuing firms The present authors propose that large and small firms treat their seasoned equity differently: small firms time the market, whereas large firms use discretionary accruals to increase their proceeds We verify this hypothesis using a sample of 463 firms listed on the Taiwan stock exchange Specifically, for small firms, the timing effect is positively correlated with the firm's short-term wealth and negatively correlated with its long-term wealth For large firms, earnings management (proxied as discretionary accruals gauged by the modified Jone's model) is positively correlated with short-term wealth and negatively correlated with long-term wealth The separating equilibrium is unlikely to be conditioned by the issuing firm's flotation methods

Keywords:

Firm size

Timing

Earnings management

SEOs

1 Introduction

Much academic attention has been attracted to the well-documented short-term overperformance (e.g.,Asquith & Mullins, 1986; Korajczyk, Lucas, & McDonald, 1990) and long-term underperformance (e.g.,Kang, Kim, & Stulz, 1999; Levis, 1995; Loughran & Ritter, 1995, 1997; Mohan & Chen, 2001; Spiess & Affleck-Graves, 1995) of initial public offerings and seasoned equity offerings (SEOs).Brous, Datar, and Kini (2001)andDenis and Sarin (2001)hypothesize that the long-term underperformance arises from and therefore is employed to undo investors' overly optimistic expectations of the future performance of the issuing firms Why would investors have these overly optimistic expectations? Numerous studies based on information asymmetry theory or agency theory suggest that the expectations are attributable to (a) the issuing firm's flotation methods (e.g.,Eckbo & Masulis, 1992; Slovin, Sushka, & Lai, 2000; Wang, Chen, & Huang, 2008), (b) their timing of share issuance, and (c) their degree of earnings management In this study, we focus on (b) and (c), which have been relatively unexplored in the literature

By“timing,” we refer to when shares are offered to the public in the market It has been established that this generally occurs when the market is“hot” or investor sentiment is strongly positive (e.g., Asquith & Mullins, 1986; Baker & Wurgler, 2002; Loughran & Ritter, 1995, 1997; Masulis & Korwar, 1986) For example, Cohen et al (2007)find that firms that place SEOs (hereafter SEO firms) purposely do so when the market is hot, which explains their long-term underperformance Overly optimistic investor sentiment can also result in short-term overvaluation of seasoned shares For example,Brown and Cliff (2004)

find that prices are high when short-term investor sentiment is strongly positive In other words, the stronger the positive sentiment, the lower the long-term performance of the SEO firm is (Baker & Wurgler, 2006; Deng, Hrnjic, & Ong, 2012) This timing argument has become one of the most prominent theoretical explanations for the anomaly associated with SEOs

International Review of Economics and Finance xxx (2013) xxx–xxx

⁎ Corresponding author at: Department of Business Administration, Fu Jen Catholic University, New Taipei City, Taiwan Tel.: +886 2 29053935.

E-mail address: 054399@mail.fju.edu.tw (S.-J Chiang).

REVECO-00832; No of Pages 18

http://dx.doi.org/10.1016/j.iref.2013.05.011

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International Review of Economics and Finance

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On the other hand, according to the earnings management hypothesis, issuing firms have an incentive to manage earnings upwardly if the market fails to understand that the boosted earnings are only transitory In the following periods, when the earnings become losses, the market revises the valuation of the shares downward This hypothesis, which is widely supported by prior studies (e.g.Rangan, 1998; Teoh et al., 1998), predicts that issuers make unusually high pre-issue, income-increasing accounting adjustments, as a result of which post-issue earnings and stock return performance are unusually poor Nonetheless, whether earnings management actually raises share prices is unclear Shivakumar (2000)argues that investors are rational enough to reduce the inflated values Therefore, firms do not use earnings management to mislead investors but rather to undo their discounting of the shares

Shivakumar's (2000)argument is based on the premise that investors do not discount the inflated numbers equally, because the issuers cannot credibly signal the absence of earnings management However, this premise fails to explain why some firms engage in earnings management more than others when placing their seasoned shares Do issuing firms discount their shares differently depending on how informative they find the firm's reported numbers, that is, how helpful the issuing firms find the numbers for predicting the firm's future prospects? We therefore hypothesize that differences in the degree of earnings management depend on differences in the investor's discounting or the information value of the reported earnings

As the SEO anomaly remains an open issue, we include firm size in our model By doing so, we hope to contrast the mechanisms used by different firms The extensively-studied firm-size effect is found to be negatively correlated with returns for both nonfinancial firms (Fama & French, 1992, 2008; Lin & Wu, 2013; Pontiff & Woodgate, 2008) and financial firms (Barber & Lyon, 1997) in different countries (e.g.,Chan, Hamao, & Lakonishok, 1991) and in different time periods (Davis, 1994) We relate firm size to the SEO anomaly because small issuing firms are found to have much more negative long-term performance than their larger counterparts (e.g.,Brav, Geczy, & Gompers, 2000; Farinós, García, & Ibáñez, 2007; Loughran & Ritter, 1997) This finding inspires us to investigate whether the firm-size effect for SEO firms is attributable to large and small issuing firms placing their seasoned equity differently

Using firm size as a predictor, our empirical results from 463 firms listed in the Taiwan stock market indicate that large issuing firms tended to use earnings management, whereas small issuing firms tended to time the market in placing their seasoned equity shares For large firms, discretionary accruals, which serve as the proxy for earnings management, are positively correlated with the short-term announcement effect and negatively correlated with the ex-post wealth effect For small firms, the timing dummy is positively correlated with the short-term announcement effect and negatively correlated with the ex-post wealth effect These results imply a separating equilibrium for the different approaches adopted by the different firms A further question

is why this is the case and not the reverse We find that the reported earnings predict the ex-post wealth effect for large firms but not for small firms This result provides a plausible explanation for why large firms engage in earnings management more than small firms

In addition to market timing and earnings management, the flotation method an issuing firm uses is commonly referred to as having an impact on the SEO anomaly A question might arise about whether the separating equilibrium found in the present study is in fact conditioned by the flotation method a firm chooses.1For example, the timing argument is not applicable to cases in which the existing shareholders do not renounce their pre-emption rights Under such circumstances, the issuing firm has no incentive to time the market if the existing shareholders subscribe for the new shares in proportion to their ownership stake at the time of issuance This possibility, if true, would jeopardize our interpretation of the findings that large issuing firms employ earnings management and small issuing firms employ market timing

However, we argue that our finding is less likely to be preconditioned by the flotation method adopted by issuing firms Firstly, from the perspective of information asymmetry, the adoption of a rights offer implies that the existing shareholders are willing to subscribe for the new issued shares on a pro rata basis; this sends a positive signal to outside investors that the proceeds collected from the issuance are being channeled to profitable investments (e.g., Eckbo, 1995; Eckbo & Masulis, 1992) Agency theory focuses on whether the flotation method could additionally involve large-block shareholders, as this would improve the management of the issuing firm (Demsetz, 1986; Pound, 1988; Shleifer & Vishny, 1986) Such improvement implies that the announcement effect, when it involves block investors, is positive However, block shareholders are less likely to invest if the offer involves rights than if it involves bookbuilding (e.g.,Aggarwal, Prabhala, & Puri, 2002; Hanley & Wilhelm, 1995; Wang et al.,

2008), private placement (e.g.,Wruck, 1989; Wu, 2004), or public placement (e.g.,Slovin et al., 2000)

Secondly, the two flotation methods adopted in Taiwan are fixed-price offers and bookbuilding offers However, these are not directly relevant to the aforementioned cases With a fixed-price offer, the existing shareholders retain their pre-emption rights (In this respect, it is similar to a rights offer) With a bookbuilding offer, the shareholders renounce their pre-emption rights (In this respect, it is similar to public placing) However, the law in Taiwan stipulates that at least 10% of new shares must be placed with outside investors That is, outside investors are involved whichever flotation method is used Moreover, our statistics show that the proportion of small issuing firms that choose the bookbuilding approach (13%) does not differ significantly from the proportion of large issuing firms that choose it (14%) This result implies that choice of flotation method is not predicted by firm size Therefore, based on both theoretical inference and the kinds of flotation methods adopted in Taiwan, we postulate that our results are less likely to be dictated by the specific flotation method chosen by an issuing firm

Using three valuation models,Jindra (2000)finds that overvaluation is commonly found in SEOs Insiders who know that seasoned shares are overvalued tend to engage in arbitrage Moreover,Jindra (2000)finds earnings management to be positively

1 Using data from Hong Kong SEOs, Ching, Firth, and Rui (2006) ﬁnd that the average announcement effect is positive for private placements and negative for rights offers Firms that adopt either method suffer inferior long-term performance.

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associated with overvaluation2of seasoned shares, although he does not address the long-term performance of seasoned shares Using Taiwanese SEO data from 1996 to 2008,Wang et al (2008)find that the positive announcement effect of bookbuilding offers is due to the introduction of block shareholders, who enhance the governance quality of the issuing firms; in contrast, they find the announcement effect for fixed-price offers to be negative Again, these authors cover only the short-term announcement, not the long-term performance of the issuing firms

The potential contribution of this study is our identification of the separating equilibrium for large and small issuing firms when they place their seasoned shares Even though earnings management and timing effects have been widely documented in prior studies, to the best of our knowledge none of them has explored the coupling between large firms and earnings management and between small firms and timing We suggest that the information value of the reported earnings might offer a clue to explaining the differences in the use of these mechanisms

The rest of this paper is organized as follows InSection 2we discuss the SEO’s underwriting methods in Taiwan InSection 3

we review the literature and develop our hypotheses InSection 4we describe our data sources and define the variables In

Section 5we report the empirical results InSection 6we present our conclusions

2 Underwriting methods used by SEOﬁrms in Taiwan

Until March 1995, fixed-price offering was the only underwriting method used in Taiwan for seasoned offerings Since then, firms have been able to choose between bookbuilding offers and fixed-price offers, depending on whether the existing shareholders retain their pre-emption rights; these rights are preserved with fixed-price offers but not bookbuilding offers Taiwan's Company Law stipulates that at least 10% of the new shares in an SEO have to be publicly sold to outside investors, and another 10–15% are reserved for employee subscriptions; the latter are intended to align employees' incentives with shareholders' interest of the SEO firm Therefore, with a fixed-price offer, the existing shareholders can purchase at most 75–80%

of the newly issued shares, the exact percentage depending on their ownership stake at the time of issuance The offer price is negotiated between the issuing firm and the lead underwriter In case of oversubscription, the excess shares are distributed to the public by means of a lottery using computer-generated random numbers In each round of the lottery in Taiwan, each qualified individual investor can submit purchase orders and is allowed to buy up to 1000 shares In the case of a fixed-price offer, this placement via public lottery is supposed to be fair to all participants However, the price discrepancy between the offered price and the last secondary market price provides arbitrage opportunities3that encourage sophisticated investors to borrow token accounts to increase their odds of winning the lottery In 1997, the government imposed several changes in the regulations to mitigate this token investor problem.4

The fixed-price offer in Taiwan is similar but not directly parallel to the rights offer in the U.K First, as noted above, Taiwanese regulations require that at least 10% of the newly issued shares must be sold to outside investors and another 10–15% made available for employee subscription We therefore consider the fixed-price offer to be a partial rights offer, because at least 10% of the new shares are purchased by outside investors This is not the case for the rights offer, which is used by most countries except the U.S In the U.K., for example, the rights offer allows existing shareholders to buy up to 100% of the newly issued shares depending on their ownership stake These pre-emption rights are renounceable, so outside investors can purchase them from the market and then use them to buy new shares at the subscription price Therefore, the total cost of one new share for an outside investor is the sum of the subscription price per share and the market price of the pre-emption right In Taiwan, when a fixed-price offer is adopted, the pre-emption right owned by the existing shareholders is non-renounceable: the investor can either take up the right or let it lapse Once a right has elapsed, it no longer exists

With a bookbuilding offer, the existing shareholders renounce their pre-emption rights at the shareholders' meeting The proportion of new shares sold to new investors can be 85–90% Because numerous shares are sold to the market, the target investors of a bookbuilding offer are usually qualified institutional investors, each of which is allowed to buy up to 10% of the newly issued shares

A feature shared by U.K private placement, U.S commitment offers, and Taiwan bookbuilding is that the issuing firm must obtain the approval of shareholders at a general meeting to avoid a violation of the pre-emption requirements However, there are several noteworthy differences among the three First, with bookbuilding offers in Taiwan, the underwriters and issuing firms negotiate a possible price range within which outside investors can buy interest The final offer price is set after review by the lead underwriter and the issuing firm Because the shares are sold mainly to institutional investors, the bookbuilding offer usually attracts external block investors Unlike their counterparts in the U.S., where the lead underwriters purchase new shares from issuing firms at a specified price and then sell them mainly to institutional investors to earn their placement fee, underwriters in Taiwan do not purchase the new shares from the issuing firm in advance Rather, they bridge the sale of the new shares from the issuing firm to the outside block investors Second, in Taiwan, the lead underwriters of bookbuilding offers create an order book, gather information about the market demand for the offering, and negotiate the final offer price with the issuing firm In contrast, in the U.S., lead

2

Elliott, Koeter, and Warr (2007) indicate that overvaluation of shares by matching ﬁrms implies high growth potential for these ﬁrms.

3

SEO shares tend to be greatly underpriced because the underwriting period, the time between the offer-price-settlement day and the last payment day for successful share allocation, averages 80 days ( Chen, Shu, & Chiang, 2011 ).

4 First, each individual investor can subscribe SEO shares at only one brokerage house Either duplicate subscription or an insufﬁcient deposit in the brokerage house's bank account disqualiﬁes the subscription Moreover, the lottery processing fee paid to underwriters for each subscription is reduced from NT$30 to NT

$17.5.

3 P.-G Shu, S.-J Chiang / International Review of Economics and Finance xxx (2013) xxx–xxx

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underwriters have no specific information about the market demand for the newly issued shares Thus, they cannot subsequently change the value of the proceeds received by the issuing firm (e.g.,Barnes & Walker, 2006; Ho, 2005; Slovin et al., 2000) To protect the existing shareholders' rights, the new shares cannot be discounted by more than 10% of the prevailing market price

Both the bookbuilding and fixed-price offering approaches provide positive and negative information to outside investors If a firm adopts a fixed-price offer, the existing shareholders retain their pre-emption rights when subscribing the new shares, which send a positive signal to outside investors (e.g.,Eckbo, 1995; Eckbo & Masulis, 1992) However, it could be case that existing shareholders are overly optimistic when subscribing the new shares (e.g.,Andrikopoulos, 2009) A bookbuilding offer, on the other hand, sends a negative signal to existing shareholders, making them reluctant to buy the new shares, which are placed mainly with block institutional investors The introduction of these new block shareholders, who, as a result of the change in ownership structure play an active monitoring role, is deemed a positive signal (Wruck, 1989) Therefore, the short-term and long-term effects associated with SEO firms are not necessarily dictated by their flotation approaches, because both approaches send positive or negative signals to outside investors

3 Literature and hypotheses

3.1 Earnings management, SEO anomalies, andﬁrm size

Most managers use accounting accruals to conceal poor performance, postpone a portion of unusually good earnings to future years (DeAngelo, 1988; DeAngelo, DeAngelo, & Skinner, 1994; Perry & Williams, 1994; Warfield, Wild, & Wild, 1995), and release value-relevant information (Francis, Maydew, & Sparks, 1999; Healy & Palepu, 1993)

It seems intuitively desirable to relate the use of discretionary accounting choices to SEOs, because a firm's profitability influences the success of its issues Prior studies indicate that firms tend to opportunistically manipulate earnings upward before placing their SEOs However, the accruals used to boost these earnings tend to reverse in latter reporting periods (Dechow, Sloan, & Hutton, 1996; Rangan, 1998; Teoh et al., 1998) Furthermore,Marquardt and Wiedman (2004)show that when such SEO firms engage in earnings management, they prefer to accelerate the recognition of their revenues or to defer the recognition of their expenses

If investors cannot see through these accounting practices, they will be induced to buy the seasoned stocks at higher prices However,Shivakumar (2000)argues that because issuers cannot credibly signal the absence of earnings management, investors treat all firms as having overstated prior earnings when they announce an offering As a result, they discount their stock prices This average price drop at the time SEOs are announced is consistent with this investor-conditioning process

If the processes described above actually occur, why would issuing firms engage in earning management when investors undo its effects at the time the offer is announced?Shivakumar (2000)suggests that earnings management prior to equity offerings is not used to mislead investors, but instead it is a rational response to anticipated market behavior at the time the offering is announced; the issuers overstate the earnings, at least to the extent expected by the market

However, Shivakumar's argument fails to explain why some firms engage more in earnings management than others We argue that the motive for SEO firms to engage in earnings management is based on whether the boosted earnings provide sufficient information to predict the firm's growth If they are, it is more likely that investors will take the reported numbers at face value, which in turns motivates the firms to engage in a large degree of earnings management If the issuing firm does so, investors are in a better position to evaluate whether the firm's earnings report has reference value

We postulate that the earnings reported by large issuing firms have higher reference value than those reported by small issuing firms This argument is based on the following rationale First, large firms tend to be associated with more prestigious accounting firms and/or underwriters than small firms Because of the good reputations of these financial intermediaries, the firms' reported earnings are more credible and informative Second, large firms are more likely than small firms to have a stable stream of earnings This stability implies that the reported earnings are good predictors of the issuing firm's growth prospects Third, large firms are more likely than small firms to keep records of their SEOs, which gives investors greater confidence in the reported earnings Because these reported earnings have reference value, large SEO issuing firms are motivated to engage in earnings management practices aimed at increasing their proceeds from the equity issues

Hypothesis 1 When placing their seasoned shares, large firms are more likely than small firms to engage in a large degree of earnings management

3.2 Timing, SEO anomalies, andﬁrm size

Loughran and Ritter (1995, 1997),Spiess and Affleck-Graves (1995), andBaker and Wurgler (2002)argue that firms tend to issue equity and take advantage of the opportunistic time window to improve their poor financial performance when their equity

is substantially overvalued.Graham and Harvey (2001)suggest that managers are concerned about the appropriate timing of issuing equity.Eckbo, Masulis, and Norli (2007)indicate that the facts concerning SEOs' stock price dynamics prove that firms engage in managerial timing of these issues during the brief periods when they are overvalued

This market timing hypothesis suggests that managers have an incentive to time the market so they can sell newly issued shares at the highest price possible Research byCohen et al (2007)supports the timing hypothesis These authors find that the market trend prior to the issuance of SEOs is the only variable that significantly explains post-SEO returns There is no significant

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relationship between discretionary accruals and post-issue stock returns.Greenwood and Hanson (2012)show that firms tend to issue equity prior to periods when other stocks with similar characteristics are performing poorly

We assume that issuing firms prefer earnings management to timing This assumption is based on the following First, if the accounting numbers are assumed by the market to be credit-worthy, issuing firms can reap larger proceeds by selling the new shares at a higher price Second, issuing firms that use earnings management are not constrained by time, meaning that they can place their SEOs whenever they wish This is not the case for firms that don't use earnings management

If earnings management is considered preferable by issuing firms, why don't they all employ it? Specifically, why does earnings management tend to be eschewed by small firms? The reason is that, unlike large firms, small firms lack the traceable records that would make their reported earnings informative Moreover, because small firms tend to be in the growth stage of their lifecycle, their earnings tend to be volatile, which further reduces the reference value of their reported earnings Alternatively, from the perspective of market demand, earnings management by small issuing firms is less likely to be accepted by the market than earnings management by large issuing firms; this means that in the small firm case, investors are relatively unable to predict the short-term and long-term performance of SEO firms We therefore postulate that small firms tend to time the market if earnings management is not accessible to them

Hypothesis 2 When placing their seasoned shares, small firms are more likely than large firms to time the market

4 Sample and variables

4.1 The sample

We collect our sample of SEO firms in the 1996–2010 period from the Taiwan Economic Journal (TEJ), published by a data company in Taiwan To accurately gauge earnings management by discretionary accruals, we require that there be at least 5 years

of accounting data in the quarterly TEJ database for each firm in the sample We exclude utilities and financial companies, owing

Table 1

Sample distribution The sample of 463 non-financial SEOs in 1996–2010 is jointly collected from company prospectus, Taiwan Securities Association, Market Observation Post System, and Taiwan Economic Journal (a database company in Taiwan) Panel A summarizes the sample distribution by yearly breakdown Panel

B summarizes the distribution by industry breakdown.

Panel A: Yearly breakdown

Panel B: Industry breakdown

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to the high degree of regulation imposed on these firms, which could limit their ability to engage in earnings management Delisted firms and firms suspended from trading are also excluded The final sample comprises 463 SEOs

The sample distribution summarized in Table 1 is not balanced, because there are more fixed-price offers (400) than bookbuilding offers (63).5The yearly breakdown in Panel A indicates no obvious clustering pattern in the sampling years The industry breakdown in Panel B shows that the top three SEO industries are iron (54; 11.68%), construction (45; 9.72%), and optoelectronics (44; 9.5%)

4.2 Hot markets and earnings management

The first variable of interest we call the“hot-market period” defined byIbbotson and Jaffe (1975)andRitter (1984)as a period

of high new-issue volume and high initial returns The results inTable 2show that 1996–1999, 2007, 2009, and 2010 are the hot-market periods and 2000–2006 and 2008 are the cold-market periods.6

Following previous research, we use abnormal accruals in the quarters surrounding an equity offering announcement as our measure of managerial discretion in reported earnings (DeAngelo, 1986; DeFond & Jiambalvo, 1994; Healy, 1985; Jones, 1991; Rangan, 1998; Teoh et al., 1998) For our model, we define the estimates of total accruals (AC) as the reciprocals of firm size (1/TA) and change in sales (△Sales/TA) as well as plant property and equipment (PPE)

ACi;t

TAi;t−1¼ αi

1

TAi;t−1

!

þ β1i

ΔSalesi;t

TAi;t−1

!

þ β2i

PPEi;t

TAi;t−1

!

Nondiscretionary accruals are gauged by estimated coefficients as follows:

NDACi;p

TAi;p−1 ¼ ^αi

1

TAi;p−1

!

þ ^β1i

ΔSalesi;p

TAi;p−1 −ΔRECTA i;p

i ;p−1

!

þ ^β2i

PPEi;p

TAi;p−1

!

where NDAC represents nondiscretionary accruals and ΔREC is the change in receivables Discretionary accruals (DAC) are estimated by subtracting nondiscretionary accruals from total accruals

DACi;p

TAi;p−1¼ TAACi;p

i ;p−1

!

− NDACTA i;p

i ;p−1

!

4.3 Short-term and long-term performance of SEOﬁrms

4.3.1 Announcement effect of SEOs

For announcement effects, we use the two-stage residual technique proposed byFama, Fisher, Jensen, and Roll (1969)to measure the change in shareholders' wealth from the day the certificate of the right to place new shares is issued to the payout day of the stocks The event day is defined as the day the board meets to announce an SEO We begin by estimating the coefficients

α and β for the capital assets pricing model (CAPM) from 31 to 120 days before the announcement date:

where Ri,tis the return of SEO equity i on day t Rm,tis the return of the value-weighted TSEC index, a proxy for market return Next, an abnormal return is calculated as the difference between the raw return and the expected return derived from the market model, with the parameters α and β estimated by regressing the underlying firm's raw returns on the market returns

5

As bookbuilding has become the dominant underwriting method in IPOs, why ﬁxed-price offers are more popular than bookbuilding offers in the Taiwan stock market is puzzling Chen et al (2011) extend the wealth-loss measure proposed by Barry (1989) and ﬁnd that after considering the preemption rights held

by the existing shareholders, the average loss of value of ﬁxed-price offerings is less than that of the bookbuilding offerings.

6 Prior studies utilize different variables besides the combination of issue volume and initial returns to deﬁne hot versus cold markets (e.g., Baker, Stein, & Wurgler, 2003; Baker and Wurgler, 2002; Huang & Ritter, 2009; Loughran & Ritter, 1995 ) Our results are qualitatively similar regardless of which deﬁnition we use.

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We average the abnormal returns of the sample firms for each day in the event window to obtain the daily-average abnormal return (AAR) and the cumulative average abnormal return (CAR)

AAR tð Þ ¼

Xn

i ¼1

ARi;t

CAR tð1; t2Þ ¼X

t2

t¼t 1

We alternatively use the one-week average excess return (CAR(-5, 0)) and the one-day average excess return (CAR(0, 0)) as the announcement effect measure

4.3.2 Discounting, initial returns, and overvaluation of SEOs

Discounting (DI), a procedure used to attract investors to subscribe to the issued shares (seeMola & Loughran, 2004), is defined as follows:

where PTdenotes the offer price and PT0denotes the close price of issued shares on the price-setting day

The initial return (IR) is defined as follows:

where PIdenotes the first close price on the day that the certificates of payment are publicly traded, and PTdenotes the offer price Further, we define overvaluation (OV) as the difference between the initial return and discounting

OV¼PI−PT0

PT ¼PI−PT

PT −PT0−PT

We also investigate the long-term performance of post-seasoned equity offerings Based onRitter (1991), we calculate a wealth ratio as the investor's buy-and-hold returns 1–5 years post SEO divided by the corresponding market measures

WR12n¼

1þ ∏12n

t ¼1 1þ rSEOs;t

−1

1þ ∏12n

t¼1 1þ rm;t

−1

where rm, tdenotes the return from the market index

Table 2

Hot versus cold issues According to Ibbotson and Jaffe (1975) and Ritter (1984) , hot issue is defined as markets at periods of high new issue volume and high level of initial returns (IR) In Table 2 we list the years that are characterized as hot issues versus cold issues based on number of issues and initial returns The result shows that the issues in 1996–1999, 2007, 2009, and 2010 are hot issues, and the issues in 2000–2006 and 2008 are cold issues.

Hot issues

Cold issues

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4.4 Other control variables

The underwriter's reputation has been found to correlate positively with the market return and performance indicators of IPO firms (e.g.,Carter, Dark, & Singh, 1998; Carter & Manaster, 1990) This variable is represented by a dummy, coded 1 if the lead underwriter is among the top six underwriters in Taiwan and 0 otherwise In a similar vein, we include the auditor's reputation (Michaely & Shaw, 1995), which again is a dummy coded 1 if the auditor is one of the top four accounting firms in Taiwan and 0 otherwise Finally, the flotation method is represented by a dummy coded 1 for bookbuilding and 0 otherwise

Ritter (1991) notes that proceeds have been found to be negatively related to initial returns and positively related to long-term performance The larger the issuing firm's size, the smaller the information asymmetry between that firm and outside investors We therefore include the natural logarithm of firm size and the natural logarithm of proceeds in the model Moreover,

we use board shareholdings as a proxy for the agency cost This can also be construed as a proxy for the interest alignment effect,

in the sense that the greater the board's shareholdings, the lower the agency cost associated with this structure

5 Empirical results

5.1 Descriptive statistics

The summary statistics reported inTable 3indicate that 78% of the issues in our sampling period are recognized as placed during a hot market The value of the average discretionary accrual is only 0.11% of the value of the total assets The average announcement effect of an SEO firm is defined as the market-adjusted abnormal return for one day or one week The mean (median) one-week return of 0.27% (−0.28%) and the mean (median) one-day return of 0.08% (−0.09%) do not differ significantly from 0 The mean (median) underpricing of 18.25% (18.21%) is significantly different from 0, indicating that the offer price tended to be set significantly lower than the close price on the price-setting day The average initial return of 29.56% indicates that SEO investors earned handsome profits by subscribing the newly issued shares The average overvaluation of the stock is 11.31%, indicating that the price increased from the offer price-setting day to the SEO firm's share-listing day This increase can be interpreted as investor overreaction (or over-optimism) leading to short-term overperformance We note that the tests of discounting, initial return, and overvaluation against the null hypothesis of 0 are all significant The tests of the wealth ratios (WR12, WR24, WR36, WR48, WR60) against the null of 1 are also all significant, indicating that the SEO firms experienced prolonged performance deterioration

The results indicate that 49% (79%) of the SEO firms are associated with the top underwriters (auditors), which the reader will recall are used as proxies for institutional reputation On average, the board shareholdings were 24.84% and the EPS was 1.71

Table 3

Summary statistics This table reports the summary statistics of variables Hot issue is a dummy variable that is assigned the value 1 as the markets at periods of high new issue volume and high level of initial return and 0 otherwise Earnings management is gauged by the nondiscretionary accruals of the modified Jone's model proposed by Dechow, Sloan and Sweeney (1995) Announcement effect is alternatively gauged by one-week and one-day market adjusted abnormal returns on the announcement date, i.e CAR (−5, 0) and CAR (0, 0), respectively Discounting is defined as (P T0 -P T )/P T , Initial return is defined as (P I -P T )/P T , Overvaluation is defined as (P I -P T0 )/P T , where P T , P T0 and P I denote offer price, the close price of issued shares on price setting date and the first close price on the day that the certificates of payment are publicly traded Underwriter (auditor) reputation is a dummy that is assigned 1 if the lead underwriter (associated auditor) is one of the top six underwriters (top four auditors) in Taiwan and 0 otherwise Underwriter method is 1 if SEO firms adopt bookbuilding and 0 otherwise WR 12n denotes n-year market adjusted performance and is defined as: WR 12n ¼ 1 þ ∏12n

t¼1 1 þ r SEOs;t

−1

1 þ ∏12n

t¼1 1 þ r m;t

−1

Both means and medians of one-week return, one-day return, discounting, initial return, and overvaluation are tested against with the null hypothesis of 0 and WRs are tested against with the null hypothesis of 1 ***, **, and * denote the significance levels of 1%, 5%, and 10%, respectively.

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Table 4

Test in differences The table reports the tests in differences of variables In Panel A, the sample is divided based on previous-yearend firm size: large versus small.

In panel B, the sample is divided based on underwriting methods: fixed price versus bookbuilding In Panel C, the sample is divided based on earnings management: high versus low EM In Panel D, the sample is divided based on market condition: cold versus hot market All variables are defined in Table 3 In each panel, we report the test in means and in medians against the null of 0 for one-week return, one-day return, discounting, initial return, and overvaluation, the test in means and medians against the null of 1 for WRs, and the test in differences of means and medians for all variables ***, **, and * denote the significance levels of 1%, 5%, and 10%, respectively.

Panel A: Large vs small firms

Panel B: Fixed-price offer vs bookbuilding offer

Panel C: High vs low earnings management

(continued on next page)

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5.2 Univariate analyses

5.2.1 SEOﬁrm size and performance

In Panel A ofTable 4we report difference tests comparing large-issuing and small-issuing SEO firms on the variables We divide the sample into halves at the median of the firm's assets one year prior to SEO issuance The results show that the large firms had higher discretionary accruals (0.13%) than the small firms (0.08%) Over the short-term, the mean (median) one-week return 0.97% (0.05%) for the large firms is significantly higher than that of−0.43% (−0.87%) for the small firms The other indicators, namely, discounting, initial return, and overvaluation, are all significantly different from 0 However, these variables do not differ significantly for the large and small firms Over the long term, both the large and small firms suffered ex-post wealth losses, and the losses became larger with the passage of time Moreover, the large firms lost less wealth than the small firms The median 3-year (4-year) wealth ratio of 0.74 (0.72) for large firms is significantly greater than ratio of 0.57 (0.55) for small firms These results are consistent with those ofLoughran and Ritter (1997), who find that both their large- and small-issuing firms underperformed in the long term and the underperformance was greater for the small firms

The results from the other control variables show that large firms had a higher average EPS (2.39) than small firms (1.05) It comes as no surprise that large firms had greater assets and proceeds than median and small firms The overall statistics basically portray the differences in how large and small firms issue seasoned equity

5.2.2 Underwriting methods and SEOﬁrm's performance

In Panel B ofTable 4, we divide the sample by flotation method Because the existing shareholders retain their preemption rights in a fixed-price offer, they get a higher discount than they would get with a bookbuilding offer This positive signal, accompanied by the high discount, made the initial returns significantly higher with fixed-price offers than with bookbuilding offers However, there is no significant difference between the two kinds of offer in the long-term wealth they generated We note that the pattern illustrated in Panel A is different from that in Panel B, implying that the flotation method is less likely to predict the results related to firm size

5.2.3 Earnings management and SEOﬁrm's performance

In Panel C ofTable 4, we divide the sample at the median of the discretionary accruals (EM) The results indicate that issuing firms in the high EM group were more overvalued and had a higher three-year wealth ratio (WR36) than firms in the low EM group

Table 4 (continued)

Panel C: High vs low earnings management

Panel D: Cold vs hot market

Table 4 (continued)

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