Earnings management before IPOs: Are institutional investors misled?

Leveraging the unique detailed bid data of institutional investors during the IPO process in China, we investigate how investors, especially institutional investors, react to the issuing firm's pre-IPO earnings management (EM). Our findings suggest that institutional investors' bid prices are negatively correlated with pre-IPO EM. The results are more pronounced for accrual-based EM than real EM. The findings are robust to a battery of different bid prices. We also document that retail investor oversubscription ratio is negatively or not associated with pre-IPO accrual-based EM. However, such oversubscription ratio is positively correlated with pre-IPO real EM. Additional results show that IPO offer prices (relative to the proposed IPO price range) are negatively correlated with pre-IPO EM, suggesting that institutional investors' ability to recognize EM pressures IPO issuing firms into setting a lower offer price. Lastly, we find that, the long-run IPO performance is mostly unrelated to EM, which is different from what the literature depicts.