THE INFLUENCE OF PUBLIC EQUITY OWNERSHIP ON EARNINGS MANAGEMENT THROUGH THE MANIPULATION OF OPERATIONAL ACTIVITIES

Abstract

This paper examines whether public equity firms and private equity firms with public debt exhibit different degrees of real earnings management, defined as the manipulation of operational activities in order to influence reported earnings. Public equity firms face intense capital market scrutiny that their private equity counterparts do not. Therefore, this study's comparison of the two types of firms provides insight on the impact of capital market pressure on real earnings management behaviors. The impact of capital market pressure is not clear ex ante. On the one hand, the scrutiny associated with the public equity markets may play a disciplining role that leads firms to refrain from activities that distort reported earnings. On the other hand, the penalties faced by public equity firms that fail to meet earnings benchmarks may put additional pressure on top managers to report positive and improved earnings and hence, may lead to greater distortion of reported earnings through the manipulation of operational activities. Consistent with the latter possibility, I find that public equity firms are more likely than private equity firms to opportunistically alter normal operations to improve earnings by cutting R&D spending, by pushing sales through discounts and promotions, and by lowering costs of sales through overproduction. I find no difference in abnormal discretionary expenses between public equity and private equity firms.

Although private equity firms with public debt do not face the same capital market pressure that public equity firms face, they are not immune from incentives to engage in real earnings management. Specifically, I find that private equity firms with public debt engage in a greater degree of real earnings management as their debt moves closer to default. Given that debt claims become more like equity claims as a firm's debt moves closer to default, this finding suggests that public debtholders exert similar pressure to public equity holders when their claims become more equity-like. Moreover, private equity firms with public debt that do engage in real earnings management appear to emphasize the zero earnings benchmark, consistent with prior research, suggesting that this benchmark is of primary importance to creditors.

In addition, I assess the performance implications of capital market-induced real earnings management, by examining its association with one-year ahead industry-adjusted return on assets (ROA). I find that public equity firms that just meet earnings benchmarks while altering real operating activities suffer from lower future industry-adjusted ROA than private equity firms that just meet earnings benchmarks while altering real operating activities. The finding for the public equity firms validates concerns that operating decisions made in response to capital market pressure may negatively impact future firm performance. On the other hand, the results for private equity firms indicate that alterations of operating activities made in the absence of capital market pressure are more likely to be strategically sound.