Earnings management and ownership retention for initial public offering firms: Theory and evidence

This paper investigates, both theoretically and empirically, how earnings management and ownership retention interact, and how these two jointly affect the equilibrium market valuation of IPO firms in the presence of information asymmetry. Analytically, this paper extends the univariate signaling framework of Leland and Pyle (1977) and derives an efficient signaling equilibrium in which both reported earnings and ownership retention are endogenously chosen to convey the IPO issuer's private information. It is shown that even though either ownership retention or reported earnings communicates the issuer's type to the market unambiguously, the issuer will strategically employ both signals to achieve separation from potential lower quality imitators at minimal cost. Comparative statics analysis shows that the trade-off between the two signals depends critically on the uncertainty over future earnings. The theoretical analysis generates several empirical implications regarding market efficiency, IPO pricing, and the strategic choice of earnings management. Through systematic econometric analysis, I confirm the major predictions of the model.