This study investigates how investors in the market react to earnings management (hereafter, EM) and whether analysts provide added value to the market in interpreting EM information. We consider whether evidence of EM in financial statements influences market prices and returns, and whether analysts provide investors with incremental information that may help them assess the integrity of reported earnings.
Following Balsam et al. (2002), we focus on market reaction to the release of the full set of financial statements, and not to earnings announcements, as the latter may not include sufficient information (e.g., balance sheet and/or cash flow information) that can be used to disentangle the consequences of EM (see also, e.g., Baber et al., 2006; Balsam et al., 2002). Balsam et al. (2002) show that sophisticated investors as well as unsophisticated investors (proxied by the level of institutional ownership) are unable to recognize earnings management around earnings announcement date.
International capital flows have become an indispensable part of global economies of the 21st century. Economic growth used to be constrained by the boundaries of domestic markets since countries had to rely on their own saving and investment capabilities. However, the presence of international capital flows proposes a remedy to this problem by providing the countries with the opportunity to make use of the global resources and share the risks associated with investment. Thus, it would seem that the limits of domestic markets for economic growth cease to be a constraint for the global economies of the 21st century. This line of thinking encourages the countries with closed capital accounts to engage in financial integration by liberating their capital accounts. Nonetheless, many emerging economies experienced financial crises after capital account liberalization which casts a doubt on the prospects of fered by the presence of a global financial market. Thus, the arguments raised in favor of financial integration started to lose ground leading to a reevaluation of the benefits and costs of international capital flows. In that sense, much of the questioning is directed towards the validity of capital account liberalization and whether it exerts a positive influence on economic growth for the country in question, or not. (Akgül, 2009)
Within the framework of an open economy Ramsey model, this study will examine the impact of international capital mobility on the economy by focusing on the domestic allocation of resources across multiple sectors. The focus on multiple sectors provides a more informative and detailed analysis on the growth effects of financial openness. As is discussed in Aykut and Sayek (2007), in models of real economy, not only the presence of free international capital flows, but also the sectoral composition of them are decisive in economic growth. In fact, they suggest that if international capital flows are channeled towards manufacturing sector, economic growth will be improved. On the other hand, if they are channeled towards primary goods or services sectors, then economic growth might be affected negatively. Therefore, if financial liberalization is considered in the context of multiple sectors, the analysis will include the sector specific factors of international capital flows and present more grounded conclusions. Based on this perspective, in this study production will take place in three sectors. One of the sectors is the tradable goods sector which produces all the internationally tradable goods in the economy at world prices. The domestic production in this sector is for international markets. The other sectors are the home services and the non tradable goods sectors which produce for the domestic market. The prices in these sectors are endogenously determined within each respective domestic market. In all these sectors output is produced using three inputs: raw labor, physical capital and human capital. Production sectors are different from each other on the basis of their relative factor intensities and the nature of their output. Moreover, the accumulation of physical and human capital takes place in different sectors as the economy allows for international capital mobility.
The role of venture capital backing in initial public offerings has been the subject of considerable debate in the finance literature. Two seminal papers in this literature are Megginson and Weiss (1991) and Barry, Muscarella, Peavy, and Vetsuypens (1990). Megginson and Weiss (1991) document that venture capital (VC) backed IPOs were less underpriced than non-VC backed IPOs during 1983-1987, attributing this difference to venture capital “certification.” Venture capital certification (the “certification hypothesis” from now on) reflects the notion that venture capitalists, being repeat players in the IPO market, are concerned about their reputation in that market, so that they price the equity of the IPOs of firms backed by them closer to intrinsic value (and credibly convey this fact to the IPO market). Similarly, Barry et al (1990) document that VC backed IPOs were less underpriced than non-VC backed IPOs between 1978 and 1987. They, however, attribute this difference in underpricing to the capital market’s recognition of “IPOs with better monitors.” In broader terms, the idea here is that since venture capitalists fund only a small minority of firms, these firms are of better quality than non-VC backed firms (“screening”). Further, since venture capitalists devote considerable time to monitoring firm management (in the pre-IPO stage), the quality of firms brought public with VC backing is likely to be higher than that of non-VC backed firms, even if their quality at the time the VC got involved with them was similar to that of non-VC backed firms (“monitoring”). Since both screening and monitoring by VCs will lead to similar results, namely, higher firm quality for VC backed firms compared to non-VC backed firms at the time of IPO, we will refer to this role of venture backing as the “screening and monitoring hypothesis” or simply “screening” from now on.
More recent papers have, however, called the above early evidence into question. Lee and Wahal (2002) document that, between 1980 and 2000, IPOs of VC backed firms were, in fact, more underpriced than those of non-VC backed firms. A number of other papers have also presented similar results: see, e.g., Loughran and Ritter (2003). This, in turn, has reopened the debate about the role of venture backing in IPOs. The main objective of this paper is to attempt a resolution of the above debate by approaching it from a new perspective and using a new methodology. We propose to distinguish between the two roles of venture backing in IPOs discussed above, and a third possible role that we refer to as “market power”. The market power hypothesis captures the notion that venture capitalists are able to develop long-term relationships with various participants in the IPO market (underwriters, institutional investors, and analysts) due to their role as powerful repeated players in that market. These relationships enable them to attract greater participation by these market players in the IPOs of firms backed by them, thus obtaining a higher price for the equity of these firms (both in the IPO and in the secondary market). The market power and certification hypotheses have dramatically different implications for the pricing of IPOs: while the certification hypothesis implies that venture capitalists price IPOs of firms backed by them closer to intrinsic value due to their concern for preserving reputation in the IPO market, the market power hypothesis implies that venture capitalists’ objective is to obtain the highest price possible for these IPOs (by taking advantage of their relationships with various market participants).
