Earnings management in initial public offerings (IPOs) of u s REITs

EARNINGS MANAGEMENT IN INITIAL PUBLIC OFFERINGS (IPOS) OF U.S REITS SHEN HUAISHENG (BACHELOR OF MANAGEMENT, ZHEJIANG UNIVERSITY) A THESIS SUBMITTED FOR THE DEGREE OF MASTER OF SCIENCE DEPARTMENT OF REAL ESTATE NATIONAL UNIVERSITY OF SINGAPORE 2008 Acknowledgements I would like to express my deepest gratitude to all those who make this thesis possible, and help me through out the whole master program First, I am deeply grateful to my advisor and friend — A/P Sing Tien Foo His insightful ideas, patience and support has been a great fortune for me Next, I wish to express my sincere thanks to A/P Fu Yuming, Prof Ong Seow Eng, and A/P Tu Yong who helped my throughout my course work and research in various ways I am really appreciated for members of SDE family who provided favorable environment for me And my thanks goes to Mr Zhu Yuanwei, Mr Zhou Sheng, Mr Wu Jianfeng, Mr Wang Jinliang, Mr Sun Liang, Mr Chen Zhiwei, Ms Xu Yiqin, Ms Liu Bo, Ms Tan Yan Fen, Ms Xie Yajun, and Ms Li Mu My thanks also goes out to the Department of Real Estate, National University of ii Acknowledgements iii Singapore Above all, I am gratitude for support of my parents and my brother And for whom I dedicate this thesis Shen Huaisheng Aug 2008 Contents Acknowledgements ii List of Tables v List of Figures vi Introduction 1.1 Research Questions 1.2 Motivation 1.3 Significance of the Study 1.4 Hypothesis Development 1.5 Organization of the Study Literature Review 2.1 IPO Underpricing 2.1.1 Information Asymmetry iv Contents 2.1.2 v Behavioral Theories 15 2.2 Earnings management 18 2.3 Economies of Scale 20 2.4 REIT IPOs 24 Empirical Methodology 3.1 3.2 28 Measurement of Earnings Management 28 3.1.1 30 Economies of Scale Measures 33 3.2.1 Translog Model 35 3.2.2 Simple Quadratic Model 35 3.2.3 Quadratic Semi-Log Model 36 Earnings Management Measurement Model Empirical Findings 37 4.1 Data Source 37 4.2 Earnings Management 38 4.2.1 Earnings Performance 38 4.2.2 Accrual 48 4.2.3 Regression analyses of Explanatory power of Discretionary Current Accrual 58 4.2.4 Potential Sources of Earnings Management 59 4.2.5 Robustness Test 70 Conclusion 80 5.1 Major Findings 80 5.2 Limitations of the Study 82 Contents 5.3 Future Studies Bibliography vi 83 84 List of Tables 3.1 Definition of Variables Used in the Modified Jones Model 31 4.1 Summary of Property Type 40 4.2 Characteristics of IPO firms ($ millions) 41 4.3 Industrial Adjusted Return On Asset (ROA) 44 4.4 Industrial Adjusted Operational Cash Flow to Total Asset Ratio 45 4.5 Modified Jones’ Model 51 4.6 Discretionary Current Accrual with Modified Jones Model on Revenue 55 4.7 Discretionary Current Accrual with Modified Jones Model on Cost 56 4.8 Characteristics of Aggressive and Conservative REITs 57 4.9 Explanatory Power of Discretionary Current Accrual on Earning Performance Changes 60 4.10 Explanatory Power of Discretionary Current Accrual on Price Changes 61 4.11 Unexpected Account Receivables 64 4.12 Unexpected Account Payables 65 vii List of Tables viii 4.13 Explanatory Power of Discretionary on Change on Depreciation 69 4.14 Discretionary Current Accrual of Pure-REITs 71 4.15 Earnings Management Before and After Sarbanes-Oxley Act 72 4.16 Translog Model 74 4.17 Simple Quadratic Model 75 4.18 Quadratic Semi-Log Model 76 4.19 Average Economies of Scale Estimate (SCE) 79 List of Figures 4.1 Number of IPOs 39 4.2 Net Income and FFO Scale on Total Asset 43 4.3 Total Asset by year 47 4.4 Total Asset by years after IPO 48 4.5 Marginal Effect of FFO over years after IPO 49 4.6 Yearly Average Age of REITs in the Market 50 4.7 Depreciation proxy by (F F O − N I) 68 ix Chapter Introduction 1.1 Research Questions This thesis focuses on earnings management in REIT IPOs We attempt to test whether REIT IPOs involve in the earnings management If they do, what is the impact of the earnings management on the post-IPO period performance of the stocks 1.2 Motivation Ritter and Welch (2002) documented that from 1980 to 2001 Initial Public Offerings (IPOs) industrial firms reported an average 18.8% abnormal initial return at the end of the first day of trading However, Ritter (1991), in a separate study, found that the cumulative adjusted returns (CAR) of a sample of 1526 industrial company IPOs in 1975–84 fell by 29.13% after 36 months For REITs, the empirical evidence is mixed Wang, Chan, and Gau (1992) found that REIT IPOs had a negative 4.2 Earnings Management in managing interest expenses, but they show better scale efficiency in operating expenses On dividends, both aggressive and conservative REITs not have economies of scale effects In summary, the economies of scale effects on interest expenses, operating expenses, and dividends vary by the models we employ To be specific, SCE for interest expenses is not significantly different from one The SCE of conservative REITs is significantly different from that in aggressive REITs The SCE on operating expenses indicate that economies of scale exists, except for aggressive REITs in the simple quadratic model SCE on operating expenses for aggressive REITs is not better than that of the conservative REITs Conservative REITs have more desirable economies of scale effects on dividends in the translog model The results did not rule out the hypothesis that earnings management through reducing operating expenses could be more significant for larger REITs, which are found some form of scale efficiency However, the scale effects on dividends are not likely to vary by REIT sizes We could thus argue that earnings management through income manipulations, if adopted, could be independent on scale economies effect of REITs In other words, smaller REITs could also manipulate income equally effective, if not better that large-cap REIT 79 4.2 Earnings Management 80 Table 4.19: Average Economies of Scale Estimate (SCE) Panel A: Translog Model ln(Int Exp) (0) Conservative 0.9694853*** (1) Aggressive 0.9607733*** ttest((0) − (1) ≤ 0) 0.0032 ln(Opr Exp) 1.083*** 1.064363*** 0.0041 ln(Dividend) 1.009626*** 1.014335*** 0.9976 Panel B: Simple Quadratic Model Int Exp Opr Exp (0) Conservative 0.9111032*** 1.220661*** (1) Aggressive 1.027855 1.057763 ttest((0) − (1) ≤ 0) 0.9999 0.0047 Dividend 2.061959 0.985658 0.1095 Panel C: Quadratic Semi-Log Model ln(Int Exp) ln(Opr Exp) (0) Conservative 6.897153*** 5.067012*** (1) Aggressive 6.572289*** 3.684435*** ttest((0) − (1) ≤ 0) 0.2298 0.0001 ln(Dividend) 5.556332 1.734869 0.1313 Conservative or Aggressive SCE = 1: *** p