Earnings management in IPOs: Post-engagement third-party mitigation or issuer signaling?

Initial public offering (IPO) firms typically hire auditors, underwriters, and attorneys to assist in the IPO process. Many firms that take the IPO route are also backed by venture capitalists. In the extant literature, these four specialists (auditors, underwriters, attorneys, and venture capitalists) are termed third-party certifiers. In this study, we examine 3900 IPOs from 1985 to 2005 and document a significant negative and robust correlation between IPO firm earnings management and the presence of prestigious third-party certifiers. Next, we test if this correlation is driven by (1) IPO firms attempting to signal firm quality or (2) third-party certifiers mitigating earnings management in the issuing firm. Using a two-stage multivariate model, we find empirical support for the signaling hypothesis - IPO firms self-select prestigious certifiers for IPOs. We do not find support for post-engagement mitigation hypothesis - after engagement, third-party certifiers do not significantly impact earnings management in IPOs.