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I examine earnings management around seasoned equity offerings and, consistent with Rangan (J. Financial Econ. 50 (1998) 101) and Teoh et al. (J. Financial Econ. 50 (1998) 63), find evidence of earnings management around the offerings. However, in contrast to their conclusions, I show that investors infer earnings management and rationally undo its effects at equity offering announcements. The investor naı̈veté conclusion of Teoh et al. (J. Financial Econ. 50 (1998) 63) and Rangan (J. Financial Econ. 50 (1998) 101) appears to be due to test misspecification. I conclude that seasoned equity issuers’ earnings management may not be designed to mislead investors, but may merely reflect the issuers’ rational response to anticipated market behavior at offering announcements.

Earnings management around firm-specific events has received considerable attention from researchers in recent years.1 These studies typically examine managers’ reporting behavior around specific corporate events, and conclude that evidence of earnings management is consistent with managerial opportunism. However, relatively little is known about investor response to earnings management, particularly following firm-specific news releases that should alert investors to such earnings management. This paper examines both managerial reporting behavior and investors’ response around public offerings of common stock. The results suggest that earnings management is explained by a rational expectations model at least as well as by managerial opportunism. I hypothesize that managers overstate earnings before announcing seasoned equity offerings, and that an offering announcement reveals this overstatement to market participants. Thus, on the announcement of an equity offering, investors lower their assessments of prior earnings surprises, and rationally discount firm value. The average price drop at the announcements of seasoned equity offerings is consistent with this investor conditioning process. At first glance, the above hypothesis appears paradoxical. Why would issuing firms engage in earnings management if investors undo its effects at offering announcements? I argue that earnings management before equity offerings is not intended to mislead investors, but is instead the issuers’ rational response to anticipated market behavior at offering announcements. Since issuers cannot credibly signal the absence of earnings management, investors treat all firms announcing an offering as having overstated prior earnings, and consequently discount their stock prices. Anticipating such market behavior, issuers rationally overstate earnings prior to offering announcements, at least to the extent expected by the market. Earnings management by issuers and the resulting discounting by investors is a unique Nash equilibrium in a prisoner's dilemma game between issuers and investors. I refer to this argument for earnings management as the ‘Managerial Response’ hypothesis. A secondary objective of this paper is to reexamine the evidence presented in two recent studies by Rangan (1998) and Teoh et al. (1998). Rangan (1998) and Teoh et al. (1998) investigate whether earnings management before seasoned equity offerings causes the poor long-run stock performance following equity offerings, which originally appears in Loughran and Ritter (1995) and Spiess and Affleck-Graves (1995). Both Rangan and Teoh et al. hypothesize that investors fail to recognize earnings management at the time of equity offerings and naively extrapolate pre-offering earnings increases. Consistent with their hypothesis, Rangan and Teoh et al. report a negative relation between pre-offering abnormal accruals and post-offering abnormal stock returns, measured either as market-adjusted returns or as prediction errors from the Fama–French three-factor model. However, statistical tests based on these measures of abnormal returns are severely mis-specified owing to, among other factors, skewness in long-horizon returns data (see Kothari and Warner, 1997; Barber and Lyon, 1997). Further, Kothari et al. (2000) show that such skewness combined with data attrition, either because of firms’ survival or deletion of extreme observations, can induce spurious association between ex ante forecast variables (such as abnormal accruals) and ex post security returns. Hence I reexamine the evidence in Rangan's and Teoh et al. using alternative methodologies that previous research suggests are relatively well specified. My paper is closely linked to a recent study by Erickson and Wang (1999), who investigate earnings management around stock for stock mergers and show that acquiring firms overstate earnings in the pre-merger quarters. Erickson and Wang present several alternative explanations for their findings, including a rational expectations argument that acquirers overstate earnings before merger agreements because the target firms anticipate it and adjust for the anticipated earnings management when negotiating on purchase price. However, Erickson and Wang do not test the hypothesis. I formalize their rational expectations argument and empirically examine the argument, albeit in the context of seasoned equity offerings rather than mergers. The paper's major results are as follows: Consistent with earnings management, accruals are abnormally high before equity offerings, and they predict subsequent declines in net income. Also, consistent with the market learning about this earnings management through offering announcements, investors’ response to unexpected earnings are significantly weaker following offering announcements. Further, the pre-announcement abnormal accruals predict the two-day negative price reaction to an offering announcement, which supports the view that investors rationally correct for earlier earnings management at offering announcements. Finally, the negative relation between pre-offering abnormal accruals and post-offering stock performance, documented by Rangan and Teoh et al., depends crucially on the choice of testing procedures and is not robust to methodologies that research shows are relatively well specified. These findings support the Managerial Response hypothesis for earnings management. This paper makes several contributions to the literature. First, it proposes a non-opportunistic motive for earnings management, and challenges the frequently articulated view that earnings management around corporate events is synonymous with managerial opportunism. Second, by establishing a specific cause for the average price drop observed at offering announcements, it explains investors’ response to such announcements. Third, the paper sheds new light on the debate on long-run stock price performance following equity offering announcements by re-examining the relation between earnings management and post-issue stock price performance. Finally, by showing a weaker price response to earnings following an equity offering announcement, the paper enhances our understanding of the relation between accounting earnings and equity valuation. The next section develops the hypotheses examined in this study. Section 3 discusses the measurement of earnings management. Section 4 presents and interprets the empirical results. Section 5 provides the summary and conclusions.

This paper analyzes whether firms overstate earnings before seasoned equity offerings and whether, at offering announcements, investors recognize and undo the effects of such earnings management. Consistent with earnings management, net income and accruals are abnormally high around equity offerings and pre-offering abnormal accruals predict subsequent declines in net income. However, investors appear to rationally infer this earnings management at equity offerings announcements and, as a result, reduce their price response to unexpected earnings released after offering announcements. Also, at the offering announcement, investors seem to correct the price impact of earlier earnings management, as evidenced by a negative relation between pre-announcement abnormal accruals and the stock price reaction to the offering announcement. In contrast to the above findings, Rangan (1998) and Teoh et al. (1998) document a negative relation between pre-offering abnormal accruals and post-offering abnormal stock returns, which they interpret as suggesting failure on the part of investors to recognize earnings management causing post-offering stock underperformance. However, the statistical tests based on the abnormal return metrics used in these studies have been shown to be biased (Kothari and Warner, 1997; Barber and Lyon, 1997). Hence this paper reexamines the evidence presented in Rangan (1998) and in Teoh et al. (1998) and finds their results to depend crucially on their choice of abnormal return metrics. Their results are not robust to alternative methodologies that are known to be relatively well specified. Overall, the results presented here indicate that investors unravel earnings management well before an equity offering, which at first glance seems to suggest that earnings management by issuers is wasteful on average. However, using a rational expectations framework, this paper shows that earnings management by issuers, rather than being intended to mislead investors, may actually be the rational response of issuers to anticipated market behavior at offering announcements. In a world with managerial discretion over accounting numbers, earnings management by issuers and subsequent price reversal by investors appears to be the unfortunate outcome.