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“Earnings Management and Initial Public Offerings: The Case of the Depository Industry”

“Earnings Management and Initial Public Offerings: The Case of the Depository Industry”. Adams, Carow and Perry CFR Workshop October 25, 2006 Discussant Timothy J. Curry, FDIC . Story Line. Accounting story!

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“Earnings Management and Initial Public Offerings: The Case of the Depository Industry”

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  1. “Earnings Management and Initial Public Offerings: The Case of the Depository Industry” Adams, Carow and Perry CFR Workshop October 25, 2006 Discussant Timothy J. Curry, FDIC

  2. Story Line • Accounting story! • Conclusion: Insiders of mutual thrift organizations (legally) shade the books in IPO offerings to extract rents!

  3. Story Line • Tale of two incentives (Banks vs.Mutuals): -Maximin vs. Minimax strategies for IPO offerings! -banks max. gains; min. losses (best foot forward) to increase value and IPO price (“net sellers”) -Mutual thrifts min. gains; max. losses (worse foot forward) to reduce value and limit the IPO price (“net buyers”)

  4. Story Line • How do they do this? • Through discretionary accounting adjustments to loss provisions and loan loss reserve accounts! • Results: insiders make excess rents with demutualization's! First day trading returns 21.2 % for sample thrifts

  5. General Comments! • Results are plausible; many historical examples of insider abuse and windfall rents at the expense of depositor/(owners) during mutual conversions; (Unal, 1997); this is a new twist; • All investors in thrift conversions earn rents to some extent because depositors/owners get nothing for accumulated book equity! supervisors do not permit the issuance of shares to depositors! (e.g. P/B 66.6% vs. 119.5% Table II) • Be circumspect using the words like “equity claim”, “equity claimants” etc.

  6. General Comments! • Data suggests that something is going on w/accounting data before thrift conversions! • Story is consistent with literature involving in management buyouts (Jones, 1991);(Perry and Williams (1994); develop more sources along these lines if available • Good start: well presented; important subject; no problem w/the modeling; straight forward approach -

  7. Specific Comments/Concerns! • Story needs more development -Describe how conversion process works! • How are deals structured? How much do insiders get (10%)? depositors/owners? outsiders? • Role of stock options? • Role of the underwriter? • Tell us about the appraisal process? • What is the role of the supervisor? Gets to bless the deal?

  8. Thrift mutual conversions: -Incentives are to keep offering prices relatively low! All parties benefit; (insiders /depositors /investors) -results may not necessarily be associated with accounting adjustments! -underwriters often low ball IPO price especially for small/unknown firms to assure successful subscription offering and capture rents during subsequent trading for insiders /investors -Stock options to insiders: keep strike price low -Fighting a “head wind” in the model

  9. Other issues -Cyclical effects: sample period (1992-2003) was good period for financial institutions; 74 percent of the sample banks went public after 1994; 66 percent for mutuals. Accounting adjustments may reflect improving economy -Segment the samples (1991-1994)- (1995-2003) to test for cyclicality of results and to see if trends hold up; time dummies may not be enough to account for changing economic conditions

  10. Variable ((NPAt-1)/Loans))non-performing assets or loans? How defined? Differs from section to section • Robustness checks: What happens to IPO price during the first year? Do rents persist? • Where are the examiners/regulators during all of this? OTS/SEC? Learning curves? • How widespread is the problem? Comment

  11. Conclusionary statements unclear: “…detecting earning management in highly regulated industries is important because it demonstrates that to the extent earnings management is a problem, regulatory solutions may not be the answer” Explain. • “We believe our results shed light on whether regulators “see through” earnings management…” Explain.

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