Abstract
We analyze how REITs managers use real earnin gs management to address issues of liquidity risk and increased cost of capital they face during seasoned equity offerings. We show that REITs managers engage in real earnings management instead of accrual earnings management to attract more uninformed trading in order to provide the liquidity service at a lower cost during seasoned equity offerings. We find REITs with higher liquidity risk are more likely to manipulate earnings prior to equity offerings and uninformed trading is higher following real earnings management. Firms set the offer price at a smaller discount after engaging in real earnings management and stock returns decline in the long run. The findings are consistent with real option and liquidity risk explanations for equity offerings.
Similar content being viewed by others
Notes
Accrual based earnings management is defined as a way to generate a desired level of reported earnings in the umbrella of GAAP.
Given that Sarbanes-Oxley Act (SOX) imposed more stringent reporting standards, firms started to switch from accrual-based earnings management to real earnings management.
There are other alternative real earnings management tools such as changing discretionary expenses including advertising, R&D, and SG&A expenses. However, they are not available to real estate firms.
Given sales levels, REITs that manage earnings upwards are likely to have unusually low cash flow from operations, unusually high property operating expenses, and/or unusually low gain (even loss) from assets sales and income from assets sales/disposition (Cohen and Zarowin 2010).
Considering that repeated SEO of REITs are often observed, 36 month instead of 60 month returns are used to circumvent the overlapping of event period that may contaminate the study.
In robustness test, we find a weaker result for REITs during non-SEO years, as reported in the Appendix 3. The coefficients of liquidity risk are of smaller magnitude compared with SEO years, suggesting that SEO firms are more aggressive in real earnings management in all periods.
In robustness test, we measure abnormal trading volume using 22 days (one month), 44 days (two months) prior to SEO as the event period.
A difference-in-difference analysis is performed based on REITs pre-SEO liquidity in robustness check.
See the Appendix 1.
The 1st model includes book value and the 2nd model includes net income in addition to book value. Our results remain robust to either of these models. RKRV provides a detailed discussion of the rationale behind these models.
References
Acharya, V. V., & Pedersen, L. H. (2005). Asset pricing with liquidity risk. Journal of Financial Economics, 77, 375–410. https://doi.org/10.1016/j.jfineco.2004.06.007.
Altinkilic, O., & Hansen, R. (2003). Discounting and underpricing in seasoned equity offers. Journal of Financial Economics, 69(2), 285–323.
Ambrose, B., & Bian, X. (2010). Stock market information and REIT earnings management. Journal of Real Estate Research, 32(1), 101–137.
Amihud, Y. (2002). Illiquidity and stock returns: Cross-section and time-series effects. Journal of Financial Markets, 5, 31–56. https://doi.org/10.1016/S1386-4181(01)00024-6.
Anglin, P., Edelstein, R. H., Gao, Y., and Tsang, D. (2013). What is the relationship between REIT governance and earnings management? Journal of Real Estate Finance and Economics, 47, 538–563. https://doi.org/10.1007/s11146-012-9367-y.
Bartov, E. (1993). The timing of asset sales and earnings manipulation. The Accounting Review, 68, 840–855.
Blau, B., Hill, M., & Wang, H. (2011). REIT short sales and return predictability. The Journal of Real Estate Finance and Economics, 42, 481–503. https://doi.org/10.1007/s11146-009-9196-9.
Boudry, W. I., Kallberg, J. G., & Liu, C. H. (2010). An analysis of REIT security issuance decisions. Real Estate Economics, 38, 91–120. https://doi.org/10.1111/j.1540-6229.2009.00255.x.
Brown, D. T., & Riddiough, T. J. (2003). Financing choice and liability structure of real estate investment trusts. Real Estate Economics, 31(3), 313–346.
Carter, R., & Manaster, S. (1990). Initial public offerings and underwriter reputation. Journal of Finance, 45(4), 1045–1067. https://doi.org/10.1111/j.1540-6261.1990.tb02426.x.
Cohen, D. A., & Zarowin, P. (2010). Accrual-based and real earnings management activities around seasoned equity offerings. Journal of Accounting and Economics, 50, 2–19. https://doi.org/10.1016/j.jacceco.2010.01.002.
Cohen, D. A., Dey, A., & Lys, T. Z. (2008). Real and accrual-based earnings management in the pre- and post-sarbanes-oxley periods. Accounting Review, 83, 757–787. https://doi.org/10.2308/accr.2008.83.3.757.
Corwin, S. A. (2003). The determinants of underpricing for seasoned equity offers. The Journal of Finance, 58(5), 2249–2279.
DeAngelo, H., DeAngelo, L., & Stulz, R. M. (2010). Seasoned equity offerings, market timing, and the corporate lifecycle. Journal of Financial Economics, 95, 275–295. https://doi.org/10.1016/j.jfineco.2009.11.002.
Denis, D. J., & Kadlec, G. B. (1994). Corporate events, trading activity, and the estimation of systematic risk: Evidence from equity offerings and share repurchases. The Journal of Finance, 49, 1787–1811. https://doi.org/10.1111/j.1540-6261.1994.tb04781.x.
DuCharme, L. L., Malatesta, P. H., & Sefcik, S. E. (2004). Earnings management, stock issues, and shareholder lawsuits. Journal of Financial Economics, 71(1), 27–49.
Eckbo, B. E., & Norli, Ø. (2005). Liquidity risk, leverage and long-run IPO returns. Journal of Corporate Finance, 11, 1–35. https://doi.org/10.1016/j.jcorpfin.2004.02.002.
Edelstein, R., Liu, P., & Tsang, D. (2011). REIT dividend regulation and real earnings management: the impact of external financing, capital investment and financial distress, Working Paper.
Fu, F., Lin, L., & Officer, M. S. (2013). Acquisitions driven by stock overvaluation: Are they good deals. Journal of Financial Economics, 109(1), 24–39. https://doi.org/10.1016/j.jfineco.2013.02.013.
Ghosh, C., Nag, R., & Sirmans, C. F. (1999). An analysis of seasoned equity offerings by equity REITs, 1991 to 1995. The Journal of Real Estate Finance and Economics, 19, 175–192. https://doi.org/10.1023/A:1007852309497.
Ghosh, C., Nag, R., & Sirmans, C. F. (2000). The pricing of seasoned equity offerings: Evidence from REITs. Real Estate Economics, 28, 363–384. https://doi.org/10.1111/1540-6229.00805.
Ghosh, C., Roark, S., & Sirmans, C. F. (2011). On the operating performance of REITs following seasoned equity offerings: anomaly revisited. The Journal of Real Estate Finance and Economics, 46, 633–663. https://doi.org/10.1007/s11146-011-9344-x.
Goodwin, K. (2013). Discounting and underpricing of REIT seasoned equity offers. Journal of Real Estate Research, 35(2), 153–172.
Graham, J. R., Harvey, C. R., & Rajgopal, S. (2005). The economic implications of corporate financial reporting. Journal of Accounting and Economics, 40, 3–73. https://doi.org/10.1016/j.jacceco.2005.01.002.
Gunny, K. A. (2010). The relation between earnings management using real activities manipulation and future performance: Evidence from meeting earnings benchmarks. Contemporary Accounting Research, 27, 855–888. https://doi.org/10.1111/j.1911-3846.2010.01029.x.
Hertzel, M. G., & Li, Z. (2010). Behavioral and rational explanations of stock price performance around SEOs: Evidence from a decomposition of market-to-book ratios. Journal of Financial and Quantitative Analysis, 45, 935–958. https://doi.org/10.1017/S002210901000030X.
Hoberg, G., & Phillips, G. (2010). Real and financial industry booms and busts. The Journal of Finance, 65, 45–86. https://doi.org/10.1111/j.1540-6261.2009.01523.x.
Howe, J. S., & Shilling, J. D. (1988). Capital structure theory and REIT security offerings. The Journal of Finance, 43, 983–993. https://doi.org/10.1111/j.1540-6261.1988.tb02616.x.
Jones, J. (1991). Earnings management during import relief investigations. Journal of Accounting Research, 29, 193–228. https://doi.org/10.2307/2491047.
Kim, B. H., Lisic, L. L., Myers, L. A., & Pevzner, M. (2011). Debt Contracting and Real Earnings Management, Working paper Available at SSRN: http://ssrn.com/abstract=1701218.
Korajczyk, R. A., & Sadka, R. (2008). Pricing the commonality across alternative measures of liquidity. Journal of Financial Economics, 87, 45–72. https://doi.org/10.1016/j.jfineco.2006.12.003.
Lambert, R., Leuz, C., & Verrecchia, R. E. (2007). Accounting information, disclosure, and the cost of capital. Journal of Accounting Research, 45, 385–420. https://doi.org/10.1111/j.1475-679X.2007.00238.x.
Lease, R. C., Masulis, R. W., & Page, J. R. (1991). An investigation of market microstructure impacts on event study returns. The Journal of Finance, 46(4), 1523–1536. https://doi.org/10.1111/j.1540-6261.1991.tb04629.x.
Lemmon, M., & Portniaguina, E. (2006). Consumer confidence and asset prices: some empirical evidence. Review of Financial Studies, 19(4), 1499–1529.
Lin, J.-C., & Wu, Y. L. (2013). SEO timing and liquidity risk. Journal of Corporate Finance, 19, 95–118. https://doi.org/10.1016/j.jcorpfin.2012.09.005.
Liu, W. (2006). A liquidity-augmented capital asset pricing model. Journal of Financial Economics, 82, 631–671. https://doi.org/10.1016/j.jfineco.2005.10.001.
Lobo, G. J., Zhang, W., & Zhou, J. (2008). The impact of corporate governance on discretionary accrual changes around the sarbanes-oxley act. Working Paper: University of Houston, SUNY at Albany and SUNY at Binghamton.
Loderer, C. F., Sheehan, D. P., & Kadlec, G. B. (1991). The pricing of equity offerings. Journal of Financial Economics, 29(1), 35–57.
Loughran, T., & Ritter, J. R. (1995). The new issues puzzle. Journal of Finance, 50, 23–51. https://doi.org/10.1111/j.1540-6261.1995.tb05166.x.
Lowry, M. (2003). Why does IPO volume fluctuate so much?. Journal of Financial Economics, 67(1), 3–40.
Mizik, N., & Jacobson, R. (2007). Myopic marketing management: Evidence of the phenomenon and its long-term performance consequences in the SEO context. Marketing Science, 26, 361–379. https://doi.org/10.1287/mksc.1060.0261.
Ng, J. (2011). The effect of information quality on liquidity risk. Journal of Accounting and Economics, 52, 126–143. https://doi.org/10.1016/j.jacceco.2011.03.004.
Ooi, J., Ong, S.-E., & Li, L. (2010). An analysis of the financing decisions of REITs: The role of market timing and target leverage. The Journal of Real Estate Finance and Economics, 40, 130–160. https://doi.org/10.1007/s11146-008-9127-1.
Pástor, Ľ., & Stambaugh, R. F. (2003). Liquidity risk and expected stock returns. Journal of Political Economy, 111, 642–685. https://doi.org/10.1086/374184.
Pastor, L., & Veronesi, P. (2005). Rational IPO waves. Journal of Finance, 60, 1713–1757. https://doi.org/10.1111/j.1540-6261.2005.00778.x.
Petersen, M. (2009). Estimating standard errors in finance panel data sets: Comparing approaches. Review of Financial Studies, 22, 435–480. https://doi.org/10.1093/rfs/hhn053.
Rangan, S. (1998). Earnings management and the performance of seasoned equity offerings. Journal of Financial Economics, 50, 101–122. https://doi.org/10.1016/S0304-405X(98)00033-6.
Rhodes-Kropf, M., Robinson, D. T., & Viswanathan, S. (2005). Valuation waves and merger activity: The empirical evidence. Journal of Financial Economics, 77, 561–603. https://doi.org/10.1016/j.jfineco.2004.06.015.
Roychowdhury, S. (2006). Earnings management through real activities manipulation. Journal of Accounting and Economics, 42, 335–370. https://doi.org/10.1016/j.jacceco.2006.01.002.
Sadka, R. (2006). Momentum and post-earnings-announcement drift anomalies: The role of liquidity risk. Journal of Financial Economics, 80, 309–349. https://doi.org/10.1016/j.jfineco.2005.04.005.
Sadka, R. (2011). Liquidity risk and accounting information. Journal of Accounting and Economics, 52, 144–152. https://doi.org/10.1016/j.jacceco.2011.08.007.
Safieddine, A., & Wilhelm Jr., W. J. (1996). An empirical investigation of short-selling activity prior to seasoned equity offerings. Journal of Finance, 51, 729–749. https://doi.org/10.1111/j.1540-6261.1996.tb02701.x.
Teoh, S. H., Welch, I., & Wong, T. J. (1998). Earnings management and the underperformance of seasoned equity offerings. Journal of Financial Economics, 50, 63–99.
Wang, S., and J. M. D'Souza, 2006. Earnings management: the effect of accounting flexibility on R&D investment choices. Johnson School Research Paper Series No. 33–06. Available at SSRN: http://ssrn.com/abstract=878345 .
Watanabe, A., & Watanabe, M. (2008). Time-varying liquidity risk and the cross section of stock returns. Review of Financial Studies, 21(6), 2449–2486. https://doi.org/10.1093/rfs/hhm054.
Zang, A. (2012). Evidence on the Tradeoff between Real Manipulation and Accrual Manipulation. The Accounting Review, 87(2), 675–703. https://doi.org/10.2308/accr-10196.
Zhu, Y. W., Ong, S. E., & Yeo, W. Y. (2010). Do REITs Manipulate Their Financial Results Around Seasoned Equity Offerings? Evidence from US Equity REITs, The Journal of Real Estate Finance and Economics, 40, 412. https://doi.org/10.1007/s11146-009-9227-6.
Acknowledgements
The paper has been presented at FMA Annual Meeting 2013 (Chicago, IL), 6th IREBS Conference on Real Estate Economics and Finance 2013, AREUEA-ASSA 2014 and Asia Pacific Real Estate Research Symposium 2014. We thank conference participants and referees for valuable comments. As this paper is built on a part of Xiaoying’s PhD thesis, she specially thanks the thesis committee members and examiners: Yongheng Deng, Brent Ambrose, and Masaki Mori for the valuable feedback. Xiaoying Deng acknowledges the financial support of the National Science Foundation of China (71703095) and the Fundamental Research Funds for the Central Universities.
Author information
Authors and Affiliations
Corresponding author
Appendices
Appendix 1 Rhodes-Kropf et al. (2005) (RKRV) methodology
Rhodes-Kropf et al. (2005) (RKRV) methodology estimates the firm value v by estimating both industry level accounting multiples and long run firm accounting multiples using the following equation.
The first component m it − v(θ it ; α jt ) measures the difference between market value and fundamental value estimated using firm-specific accounting data and the contemporaneous industry accounting multiples. This component is the mispricing proxy we use in this paper. The third component v(θ it ; α j ) − b it captures the growth opportunities.
To empirically separate mispricing component, RKRV (2005) adopt three different models to estimate firm value. We adopt RKRV’s 3rd model to estimate the market value as followsFootnote 12:
Where m is market value of equity, b is a book value of equity, \( \ln {(NI)}_{it}^{+} \) is the natural logarithm of positive net income, I is an indicator function for negative net income observations, and LEV is leverage ratio.
To calculate the REITs industry wide accounting multiples, we run cross-sectional regressions for the REITs industry to obtain the estimated REITs industry accounting multiples \( {\widehat{\alpha}}_{jt} \) for each year t.
Hence, the estimated firm value is obtained in the following equation.
If investors overestimate the future cash flows or underestimate risks, market-to-value will capture the mispricing component of the market-to-book ratio. The difference between market value m it prior to SEO issuance and the estimated firm value \( v\left({b}_{it},{NI}_{it},{LEV}_{it};{\widehat{\alpha}}_{0 jt},{\widehat{\alpha}}_{1 jt},{\widehat{\alpha}}_{2 jt},{\widehat{\alpha}}_{3 jt}\right) \) is our proxy for stock mispricing.
Appendix 2 Variable Definition
Variable name | Definition | Data Sources |
---|---|---|
Panel A: Variables of interests | ||
Abnormal Trading Prior to SEO(AV) | Abnormal trading volume prior to SEO using the standard event study method. | CRSP |
SEO discounting | The (negative of) percentage difference between the offer price and the closing price on the prior trading day | COMPUSTAT |
SEO Offering at the market price | Equals to 1, if the firm sets the offer price at the market price. | SDC |
Panel B: Real earnings management | ||
ABCFO | The actual CFO minus the normal level of CFO, which is estimated as a linear function of sales in the last period and change in revenue in the last period. | COMPUSTAT |
ABEXP | The actual property operating expenses minus the normal level of property operating expenses, which is estimated as a linear function of contemporaneous revenue. | COMPUSTAT |
ABDISP | Gain/Loss from the Sale of Property, Plant and Equipment and Investments minus the Gain/Loss, which is estimated as a linear function of market capitalization, fixed asset sales and capital expenditure. | COMPUSTAT |
Panel C: Control variables | ||
Mkt_beta | The market beta estimated from the liquidity-augmented CAPM model. | CRSP |
Liq_beta | The liquidity beta estimated from the liquidity-augmented CAPM model, in which the liquidity factor is developed by Pástor and Stambaugh (2003). | CRSP |
Liquidity | The Amihud illiquidity measure | CRSP |
Cash | Cash and short-term investment over total assets | COMPUSTAT |
Size | The nature logarithm of firm’s market capitalization | COMPUSTAT |
logMB | The logarithm of firms’ market value divided by its book value in the most recent quarter | COMPUSTAT |
Growth | percentage change of total assets from last period | COMPUSTAT |
ROA | Net income over total assets | COMPUSTAT |
SeqREIT | The current SEO sequence regarding the REIT itself to account for the clustering and frequency of SEO | SNL |
Uranking | The underwriter reputation | SDC |
InfoAs | The abnormal return around earning announcement releases as a proxy for information asymmetry | CRSP, COMPUSTAT |
Sentiment | Investors’ sentiment index constructed from University of Michigan’s Consumer Sentiment Index, using the methodology described in Lemmon and Portniaguina (2006) | University of Michigan |
Accrual | Aggregate accruals estimated by modified Jones Model (1991) | COMPUSTAT |
Appendix 3 Determinants of real earnings management for REITs during non SEO years
This table presents the result of determinants of real earnings management for REITs during non SEO years. Dependent variables are measures for real earnings management ABCFO, ABEXP and ABDISP, respectively. The variables of interest are Liq_beta. The independent variables are Mkt_beta, Cash, Size, LogMB, Growth, ROA, InfoAs, and Sentiment as defined in Appendix 1. Coefficients for the variables of interest are presented, and T-statistics are included in parentheses.*, ** and *** represent the 10%, 5% and 1% significance levels, respectively.
Abnormal CFO(ABCFO) | Abnormal Operating Expense(ABEXP) | Abnormal Asset Disposition(ABDISP) | ||||
---|---|---|---|---|---|---|
Model 1 | Model 2 | Model 3 | Model 4 | Model 5 | Model 6 | |
Liq_beta | −0.315** | 0.238*** | −0.055* | |||
(−2.06) | (2.75) | (−1.68) | ||||
Mkt_beta | −0.008 | −0.077 | 0.207*** | 0.249*** | 0.003 | −0.006 |
(−0.17) | (−1.50) | (8.28) | (8.52) | (0.36) | (−0.55) | |
Cash | −1.307** | −1.275** | 1.445*** | 1.371*** | 0.491*** | 0.508*** |
(−2.17) | (−2.12) | (4.53) | (4.29) | (4.03) | (4.16) | |
Size | −0.045** | −0.045** | −0.065*** | −0.063*** | −0.043*** | −0.043*** |
(−2.51) | (−2.50) | (−6.80) | (−6.59) | (−11.66) | (−11.76) | |
LogMB | −0.122** | −0.117* | 0.015 | 0.018 | 0.032** | 0.031** |
(−1.97) | (−1.90) | (0.47) | (0.55) | (2.53) | (2.48) | |
Growth | 0.291*** | 0.292*** | −0.098*** | −0.097*** | −0.008 | −0.008 |
(10.00) | (10.07) | (−6.36) | (−6.25) | (−1.35) | (−1.42) | |
ROA | −0.025 | −0.023 | −0.112*** | −0.111*** | −0.007** | −0.007** |
(−1.56) | (−1.50) | (−13.45) | (−13.35) | (−2.12) | (−2.18) | |
InfoAs | 0.493 | 0.375 | −0.381* | −0.302 | 0.234*** | 0.216*** |
(1.24) | (0.94) | (−1.81) | (−1.42) | (2.90) | (2.65) | |
Sentiment | 0.002 | 0.002 | −0.004*** | −0.004** | 0.002*** | 0.002*** |
(0.81) | (0.81) | (−2.59) | (−2.57) | (3.92) | (3.91) | |
Constant | Yes | Yes | Yes | Yes | Yes | Yes |
Time effect | Yes | Yes | Yes | Yes | Yes | Yes |
Property Type | Yes | Yes | Yes | Yes | Yes | Yes |
No. of Obs | 4442 | 4442 | 4442 | 4442 | 4442 | 4442 |
Adjusted R 2 | 0.047 | 0.047 | 0.197 | 0.198 | 0.044 | 0.044 |
F Stat | 13.90 | 13.91 | 64.94 | 61.84 | 13.00 | 12.44 |
Rights and permissions
About this article
Cite this article
Deng, X., Ong, S.E. Real Earnings Management, Liquidity Risk and REITs SEO Dynamics. J Real Estate Finan Econ 56, 410–442 (2018). https://doi.org/10.1007/s11146-017-9649-5
Published:
Issue Date:
DOI: https://doi.org/10.1007/s11146-017-9649-5