This study examines the operating performance of Chinese IPOs, and the main
research question is to explore the explanations for the change in reported operating performance in the post-IPO period relative to the pre-IPO level. It provides evidence that Chinese IPOs show a significant decline in reported operating performance from before to after the IPO, in terms of Return on Assets (ROA) and Operating Cashflow on Assets (CFQ). Then. I explore the reasons for the decline in reported operating performance and main findings of this research are:
Firstly. I examine the relation between managerial ownership dispersion from before to after the IPO and operating performance change of Chinese IPOs. The regression analysis shows no evidence that managerial ownership change from before to after the IPO is related to operating performance change over the same period, primarily because managerial ownership is very rare in China. Managers in Chinese listed firms hold a very small percentage of ownership (lower than 5%o), which is too small to make any effective impact on corporate operating performance. Moreover, the data further show that there is no significant decrease in the post-IPO managerial ownership relative to the pre-IPO managerial ownership. In this sense, managerial ownership dispersion hypothesis, developed by Jensen and Meckling (1976), is not applicable to Chinese stock market and cannot explain the decline in operating performance of Chinese IPOs from before to after the IPO.
Secondly, I examine discretionary accruals of IPO firms from before to after the IPO to see if managers are manipulating discretionary accruals to boost pre-IPO reported earnings. The finding shows that IPO firms report large positive discretionary accruals in the Y (-1) year and the Y (0) year, and from Y (+3) year onwards, it seems that IPO firms begin to unwind the accruals. The change in discretionary accruals from the pre-IPO period to the post-IPO period will have a significant effect on long-term reported earnings of IPO firms. Further, it is found that IPO firms with large positive discretionary accruals in the pre-IPO period are likely to underperform their industry peers in stock market and/or those IPO firms with smaller positive or negative discretionary accruals, in terms of both long-run BAHRs (Buy-And-Hold Returns) and CARs (Cumulative Abnormal Returns), It implies that investors can not see through this pre-IPO accrual-based earnings management, and they may be overoptimistic about IPO’s prospective profitability. This finding highlights the inefficiency of Chinese stock market, because the stocks involved with pre-IPO accrual-based earnings management are likely to perform poorly in the aftermarket period.
This study also points out that there is no strong evidence of unwinding the discretionary accruals in the post-IPO period. I argue that the reversal of discretionary accruals may be spread over a long period, i.e. longer than 4 years after the IPO. Firstly, the lack of flexibility in accounting choices and/or accounting estimates may be responsible for the insufficient evidence of post-IPO unwinding the discretionary accruals. Secondly, managers may slow down the unwinding process to avoid the negative impact of the unwinding on post-IPO reported earnings. Finally, many firms (28% of the sample) claim that they have recorded a lower provision for asset impairments in pre-IPO financial statements, and therefore they have restated their pre-IPO reported earnings and the provision for impairment losses in the post-IPO period. In this case, pre-IPO reported earnings have been evidently boosted through this specific accrual item of provisions for
impairment losses, and one- pre-IPO earnings are restated, there is no need for a reversal of discretionary accruals in the post-IPO period.
Thirdly, I extend prior literature by focusing on a second source of earnings management, i.e. RPT-based earnings management. The finding shows that related party transactions between IPO firms and controlling shareholders have significant effects on reported operating performance of IPO firms. The abnormally high reported operating performance in the pre-IPO period is positively associated with the size of operating RPTs (non-loan) between controlling shareholders and IPO firms in the pre-IPO period. However, in the post-IPO period, controlling shareholders discontinue these RPT-based manipulative practices, and begin to expropriate IPO subsidiaries by obtaining a large percentage of cash loans from IPO subsidiaries, primarily in return for profits and/or resources transferred into IPO subsidiaries in the pre-IPO period (Cheng et al., 2007). The post-IPO operating performance is negatively associated with the size of such loans by IPO firms to controlling shareholders .in the post-IPO period. It is also found that long-term IPO stock performance is significantly associated with the change in operating RPTs (and/or loan RPTs) from before to after the IPO. It implies that Chinese investors can not fully see through this RPT-based earnings management, and may be overoptimistic about IPO’s prospective profitability. This finding highlights the inefficiency of Chinese stock market, because the stocks involved with pre-IPO RPT-based earnings management are likely to perform poorly in the aftermarket period.
In addition, this study has answered the research question that is left behind in prior literature; Wang et al. (2001), Chen and Shih (2004) conjecture that highly concentrated ownership structure and governance characteristics of IPO companies may impact the long-run IPO operating performance. However, the question 'why concentrated ownership and weak governance affect the IPO
long-term operating performance in China’ has not been explored. I argue that IPO firms with a high level of ownership concentration and a board of directors less independent from the controlling shareholder are more likely to engage in the pre-IPO RPT-based earnings management and get expropriated by controlling shareholders in the post-IPO period via related loans. This finding is applicable to explain why IPO firms with higher ownership concentration and less independent board are likely to report abnormally higher operating performance in the pre-IPO period; and report a larger ROA decline from before to after the IPO than the remaining IPO firms.