accounting consevatism

Journal of International Accounting, Auditing and Taxation 21 (2012) 127 144

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Journal of International Accounting,Auditing and Taxation

Accounting conservatism and IPO underpricing: China evidence

Z. Jun Lin , Zhimin TianDepartment of Accountancy & Law, Hong Kong Baptist University, Renfrew Road, Kowloon Tong, Kowloon, Hong Kong Special Administrative Region

a b s t r a c t

This study examines how accounting conservatism impacts underpricing of initial public offerings (IPOs) in the Chinese stock market. Inaddition, we investigate how information asymmetry affects the association of accounting conservatism with IPO underpricing. Based onregression analysis of 674 A-shares companies that went public through IPOs at both Shanghai and Shenzhen Stock Exchanges in Chinaduring 20012009, we nd that (1) accounting conservatism is negatively associated with the magnitude of IPO underpricing; and (2)the relationship between accounting conservatism and IPO underpricing is more pronounced when information asymmetry is high. Thendings should shed a light on what drives IPO underpricing and how it could be affected by accounting conservatism in an emergingeconomy.

2012 Elsevier Inc. All rights reserved.

1. Introduction

Going public marks an important watershed in the life of a young company that provides access to public equity capital andlowers the cost of funding for the companys operation and investment. However, many studies nd that when companies gopublic, their share prices jump substantially on the rst day of trading, which is termed as IPO1 underpricing. For instance,Stoll and Curley (1970), Logue (1973), and Ibbotson (1975) document a systematic increase from the offer price to the rst dayclosing price in the U.S. market; Ljungqvist (2007) nds evidence of underpricing in a range of countries including European,Asia-Pacic and Latin American countries and the U.S. However, rms are worse off due to IPO underpricing although insidersmay maximize their wealth in the IPO process (Kennedy, Sivakumar, & Vetzal, 2006). Chi and Padgett (2002) also report thatIPO underpricing is negatively related to long-run performance of the issuing rms. These phenomena motivate a stream ofresearch on IPO underpricing and its determinants and consequences.

Among various theories of IPO underpricing, information asymmetry models play a dominant role (Ljungqvist, 2007).Asymmetric information models assume that one of the parties involved in an IPO knows more about the issuing rm thanthe others. So underpricing is necessary to reach equilibrium on the interests of all participants. As information asymmetrytheory plays an extremely important role in the underpricing of IPO rms, the veriability criteria for the recognition of rmsoperating performance and nancial reporting should matter. Accounting conservatism requires more stringent standardsof verication for economic gains than losses (Basu, 1997). Thus, the earnings and net assets reported under conservatismwill be more reliable and veriable, and accounting conservatism will constrain the managements opportunistic behaviorsfor overstating income and understating potential losses (Bushman & Piotroski, 2006). As a result, information asymmetrybetween issuers and other stakeholders of IPO rms under conservative accounting is relatively lower, which should resultin less IPO underpricing.

The important role of accounting conservatism in reducing information asymmetry and IPO underpricing leads to ourrst hypothesis, i.e., accounting conservatism is negatively associated with IPO underpricing. In addition, a higher degree

Corresponding author. Tel.: +852 3411 7537; fax: +852 3411 5581.E-mail address: [email protected] (Z.J. Lin).

1 An initial public offering (IPO), referred simply as an offering or otation, is when a company (called the issuer) issues its common stocks or sharesto the public for the rst time.

1061-9518/$ see front matter 2012 Elsevier Inc. All rights reserved.http://dx.doi.org/10.1016/j.intaccaudtax.2012.07.003

128 Z.J. Lin, Z. Tian / Journal of International Accounting, Auditing and Taxation 21 (2012) 127 144

of accounting conservatism is needed in a situation with greater information asymmetry in order to reduce the likelihoodof managers manipulation and enhance information quality. Thus, our second hypothesis predicts that the association ofaccounting conservatism with IPO underpricing is more pronounced for rms with high information asymmetry. Using alarge sample of A-share companies2 that went public through initial public offerings on both Shanghai and Shenzhen StockExchanges in China during 20012009, we obtain empirical evidence to support the two hypotheses.

Our study contributes to the extant literature in several ways. First, by revealing the impacts of accounting conservatismon IPO underpricing in the Chinese context, this research supplements a ourishing stream of empirical research on account-ing conservatism showing that conditional conservatism is associated with positive outcomes (Ahmed & Duellman, 2007;Ahmed, Billings, Morton, & Stanford-Harris, 2002; Garca Lara, Garca Osma, & Penalva, 2009; Lafond & Watts, 2008). Ourndings suggest that accounting conservatism can help reduce IPO underpricing, which should have positive implicationson the effective functioning of capital markets. In addition, our within-country study will corroborate that of Boulton, Smart,and Zutter (2011) who document a signicant role of earnings quality in IPO underpricing in their cross-country analyses.

Second, this study provides standard setters with additional insight into the role of accounting conservatism in improvingthe quality of accounting information in corporate nancial reporting. China introduced a new set of Chinese AccountingStandards (CAS) in February 2006, which became mandatory for all listed companies on January 1, 2007. The new CASsubstantially changes the nations old accounting system and covers nearly all topics under the current IFRS.3 However,there is a debate in China on whether the constrictive role of accounting conservatism can be relieved by incorporating thefair value provisions of IFRS. In addition, the institutional structure in China, especially the involvement of governmentalequity holding and the underdeveloped asset appraisal market, gives managers incentives to overstate earnings in nancialreporting (Ball, Robin, & Wu, 2003). Both the new CAS and institutional settings in China led to less conservative accounting,which may have a negative impact on the quality of accounting information (Ahmed, Neel, & Wang, 2010). By exploringthe signicant role of accounting conservatism in the IPO process, the results of this study suggest that the adoption ofconservatism principle in accounting is necessary and important in China where there is a large degree of informationasymmetry.

Third, this study contributes to the literature on the determinants of IPO underpricing by controlling for both deal-specicand rm-specic characteristics of IPO rms in China. As indicated by our study results, IPO underpricing is negativelyrelated to offering size, proportion of tradable shares, integer offer price, location of the exchange listed, rm leverage andprotability, while it is positively associated with government (state) ownership, volume of new issues in the market, lapseperiod of offering and listing, and underwriter reputation in the Chinese market. The ndings should have both theoreticaland practical implications on the development of the IPO mechanism in the Chinese stock market.

Furthermore, this study helps address a void in the nance literature on IPOs, i.e., how can the quality of accountinginformation have a direct impact on IPO underpricing. It is anticipated that this study should stimulate more research onthe interactive effects of accounting conservatism and information asymmetry, which will generate more convincing androbust empirical evidence to explain IPO underpricing in both developed and less developed markets around the world.

The rest of this paper is organized as follows. Section 2 outlines the study background and relevant literature, anddevelops our hypotheses. Section 3 describes the research design and data. Section 4 reports the empirical results, andSection 5 concludes this study.

2. Study background and hypotheses

2.1. IPO market in China

In pace with the progress of wide-scaled economic reforms since the beginning of the 1980s, the share capital system orstock companies were restored in China to restructure the inefcient state-owned enterprises (SOEs). The Chinese govern-ment reopened capital markets by setting up the Shanghai Stock Exchange (SHSE) and Shenzhen Stock Exchange (SZSE) in1990 and 1991, respectively, to facilitate listing and trading of stocks in the country (Lin & Chen, 2005). However, IPOs inChina have the following characteristics of new issuances that are distinct from those in most developed countries.

First, before mid-1999, a quota system for IPOs was implemented by the Chinese authorities. Under the quota system,the State Planning Commission, in conjunction with the Peoples Bank of China (the central bank) and the China SecuritiesRegulatory Commission (CSRC), sets up an annual quota for new stocks to be issued each year, which is then allocated toprovincial governments or ministerial authorities to select IPO rms under their jurisdiction. The quota system was formallyabolished in mid-1999 and investment banks or securities brokerage rms have assumed greater responsibility in identifyingand developing listing candidates.

2 The Chinese stock market was segregated for domestic and overseas investors when the two stock exchanges, i.e., Shanghai Stock Exchange andShenzhen Stock Exchange, were set up in early 1990s. A-shares, denominated in RMB (Chinese currency), are designated only for domestic investors whileB-share, denominated in US$ and HK$ in Shanghai Stock Exchange and Shenzhen Exchange respectively, are issued to overseas investors. A great majorityof Chinese listed rms are A-share rms at present.

3 International Financial Reporting Standards (IFRS) are principles-based standards, interpretations and the conceptual framework adopted by theInternational Accounting Standards Board (IASB).

Z.J. Lin, Z. Tian / Journal of International Accounting, Auditing and Taxation 21 (2012) 127 144 129

Second, the shares of Chinese companies are split into state-owned shares, legal-entity-owned shares, and tradableshares. The state shares are those directly owned by the central or local governments. Legal-entity shares are those held bydomestic entities or nancial institutions (many of them are SOEs as well). Tradable shares were the only class of shares thatcould be traded on stock exchanges before 2006,4 and are further classied as A-, B-, H-, S-, N-, and L-shares.5 Regardless ofthe share type, each share is entitled to the same cash ow and voting right.

Third, before 2005, the offer price of an IPO rm was set months before market trading started, and in a great majority ofofferings there was no feedback mechanism through market demand that allowed adjustment to the offer price. However,since 2005, the book building mechanism has been adopted to replace the original xed price mechanism. Book buildingmechanism involves underwriters in eliciting indications of interest from informed investors, which are then used in settingthe offer price (Sherman, 2005). Thus, the information asymmetry among investors will be mitigated, which, in turn, reducesthe level of underpricing. The implementation of book building mechanism indicates Chinas adaptation to internationalpractices. However, whether the book building mechanism is efcient depends on the institutional features of China. Forexample, Li (2009) argues that, because of weak market regulation and surveillance in China, book building offers issuersgreater discretion, gives institutional investors more chances to pursue their own benets, and may result in a higher levelof underpricing in China.

Therefore, Chinese IPOs provide an interesting case study for several reasons. First, as stated earlier, the Chinese govern-ment plays a dominant role in IPO processes. The majority of shares of IPO rms are owned by the state or other legal entitiesand are not available to the public. Public investors rush to submit applications whenever there is a new issuing, creatinga huge demand for new issues and pushing up stock returns on the initial trading day. Second, in typical Chinese IPOs,the regulators and many issuers (i.e., SOEs) are controlled by government, and both the managers of issuing rms and IPOunderwriters have close ties with the government. They have an incentive to hide inefciencies and conduct rent-seekingbehaviors, which aggravates information asymmetry between issuers and potential investors and leads to substantial IPOunderpricing. Third, in the Chinese stock market, a dominant portion of investors are individual investors who do not haveaccess to sufcient information or do not have sufcient knowledge or experience of investment. This situation aggravatesinformation asymmetry between issuing rms and investors and contributes to large underpricing of IPO stocks. Fourth,the dominance of government ownership in Chinese rms (even with the privatization of SOEs) has a signicant impacton Chinas transition from a socialist country to a modern market economy (Cheung, Ouyang, & Tan, 2009). Given that thestate-owned rms frequently suffer severe governance problems (Rajan & Zingales, 2003; Shleifer & Vishny, 1993), corporatemanagers and government ofcials have an incentive to cover up governance-related inefciencies and conduct rent-seekingbehaviors. Poor performance resulting from these operating inefciencies and governance conicts will impose a damage topersonal reputation or severe political cost upon the managers and ofcials. This incentive of hiding information or deferringthe disclosure of bad news increases information asymmetry between issuers and investors in China.

Compared with the evidence from other countries, underpricing in China is extremely obvious. Boulton et al. (2011)examine IPOs from 37 countries and show that IPO rms are underpriced in every country, ranging from underpricing of120.7% in China to less than 2% in Argentina. Other markets in the U.S., Japan, and Malaysia have average underpricingof 33.90%, 55.85%, 34.32%, respectively. The rst-day returns of IPOs in the A-share market in China are well above theaverage as similar evidence has been documented by prior research that, on average, very large market-adjusted rst-dayreturns exist in Chinese IPOs: 298% for the period 19921997 (Chen & Hui-Tzu, 2004); 129% for the period 19962000 (Chi& Padgett, 2005); and 133.6% for the period 19922006 (Cheung et al., 2009). A few studies have analyzed IPO underpricingin the Chinese market with respect to the effect of information asymmetry. For example, Mok and Hui (1998) report that theproxies for ex ante uncertainty explain the pattern of A-share IPO returns during the period 19901993. Chan, Wang, and Wei(2004) suggest that the institutional setups in China could also magnify information asymmetry and expand underpricingin the IPO process.

2.2. IPO underpricing and information asymmetry theory

There are three well-known asymmetric information models to explain IPO underpricing in the literature.First, the best-known asymmetric information model is the winners curse initially presented by Rock (1986). Rock (1986)

assumes that some investors are better informed about the true value of the shares on offer than investors in general, theissuing rm, or its underwriting banks. Informed investors bid only for attractively priced IPOs, whereas the uninformedinvestors bid indiscriminately. This situation imposes a winners curse on uninformed investors. Thus, the returns unin-formed investors earned conditional on receiving a share allocation are below the average underpricing returns. However,Rock (1986) argues that the primary market is dependent on continuous participation of uninformed investors, in the sense

4 Before 2006, state shares and legal-entities shares were not permitted to be traded in the secondary market but could be transferred only to anotherinstitution or person through off-counter deals. They are permitted to be traded on stock exchanges after 2006 when the government introduced the socalled circulation of all shares reform.

5 A-shares are designated only for domestic investors and traded on Shanghai and Shenzhen Stock Exchanges. B-, H-, S-, N-, and L-shares are designatedonly for foreign investors to be traded on securities exchanges in China (B-shares), in Hong Kong (H-shares), in Singapore (S-share), on NYSE (N-shares), oron London Stock Exchange (L-shares).


that the informed demand is insufcient to take up all shares on offer even in attractive offerings. This case requires thatconditional expected returns be non-negative so that the uninformed investors can at least break even. In other words, allIPOs must be underpriced in expectation.

Second, some researchers, Loughran and Ritter (2004) as the most prominent ones, stress the dark side of underwritingbanks. Investors may compete for allocation of underpriced stocks by offering underwriters side-payments. Underwritersmay allocate underpriced stocks to investors in order to induce them to reveal their information truthfully in the bookbuilding process for IPOs. Underwriters may also allocate underpriced stocks to the executives at issuing companies inthe hope of winning their future investment banking business (e.g., seasoned equity offering or SEO), a practice known asspinning. In each case, underwriters stand to gain from deliberately underpricing the issuers stocks.

The nal group of asymmetric information models emphasizes information asymmetry between issuing rms and poten-tial investors (Su & Fleisher, 1999). An issuing company has better information about the present value or risk of its future cashows than outside investors and underwriters do, so underpricing is used to signal the companys true value. High-qualityrms have an incentive to credibly signal their higher quality to the market in order to raise capital on more advantageousterms (e.g., better seasoned equity offerings). Low-quality rms will not send a signal by underpricing because they do notexpect to recoup their investment in underpricing through after-market SEOs. The best a low-quality issuer can do is to takethe money and run when its stocks are initially offered. Su and Fleisher (1999) also argue that underpricing is a strategy forrms to signal their value to potential investors.

2.3. Accounting conservatism and IPO underpricing

Since information asymmetry plays an extremely important role in the IPO process, it is natural to ask whether thequality of information matters. Boulton et al. (2011) investigate the relationship between earnings quality and internationalIPO underpricing and nd that IPOs are underpriced less in countries where public rms produce higher quality earningsinformation. However, as Boulton et al. (2011) stated in the limitation of their study, for certain countries, it may be prob-lematic when using earnings quality of existing public rms to proxy for earnings quality in the same country rather thanusing earnings quality of private rms prior to their IPOs.6 In fact, the earnings quality of IPO rms is very different fromthat of the existing public rms due to specic motivations for new issuers such as underpricing incentives and reputationcosts. Besides, there are many studies that investigate the relationship between IPO underpricing and earnings quality fromthe perspective of earnings management (Aharony, Wang, & Yuan, 2010; Ball & Shivakumar, 2008; Teoh & Wong, 2002;Teoh, Welch, & Wong, 1998) and accounting disclosures (Jog & Mcconomy, 2003; Leone, Rock, & Willenborg, 2007; Schrand& Verrecchia, 2005). Few studies have considered the direct effect of accounting conservatism, which is a very importantattribute of earnings quality (Bushman and Piotroski, 2006).

Prior literature on accounting conservatism highlights the benets of conservatism in contracting (Watts, 2003). Condi-tional conservatism acts as a governance mechanism that benets both debt and equity holders and increases rm value. Forexample, Kim and Pevzner (2010) point out that conditional conservatism has informational benets to shareholders andthey nd that higher current conditional conservatism is associated with lower probability of future bad news. In additionto these contracting benets, Lafond and Watts (2008) argue that conservatism is expected to lower information asym-metry between managers and outside investors. According to Lafond and Watts (2008), the managers asymmetric lossfunction provides them incentives to use their private information to transfer wealth from investors to themselves by over-stating nancial performance during their tenure at the rm. Thus, information asymmetry also exists between managersand investors. Conservative accounting could reduce information asymmetry between managers and investors throughtwo potential mechanisms. First, conservatism can provide investors of the best possible non-stock-price hard summaryinformation on current performance (Lafond & Watts, 2008). Hard information here refers to veriable information. Asconservatism requires a higher degree of veriability for gains than losses, the net result of conservative accounting couldbe the provision of more veriable information (Chaney, Faccio, & Parsley, 2011). Second, the hard information provides abenchmark that makes it possible for alternative soft sources (such as management forecasts and voluntary disclosures) togenerate credible information. Investors can compare different-source predictions to the hard numbers that are eventuallyrealized, which could enable them to evaluate the reliability of competing information sources. In this way, outside investorswill know the true value of issuing rms and the information asymmetry between informed and uninformed investors andbetween issuers and underwriters. Thus the information asymmetry between issuers and potential investors can be lessenedand the level of IPO underpricing reduced. We, therefore, set the rst hypothesis as:

H1. Accounting conservatism is negatively associated with IPO underpricing in the Chinese market.

2.4. Accounting conservatism and information asymmetry

Our second hypothesis addresses the association of the magnitude of information asymmetry with the impact of account-ing conservatism on IPO underpricing. Information asymmetry aggravates agency problems between two contractual parties

6 This problem exists in Boulton et al. (2011) because they could not obtain the data on pre-IPO disclosures of private rms for some countries.


(Haw, Lee, & Lee, 2010). Informed parties have more incentives and opportunities to transfer wealth to themselves. Thistendency is greater for pre-IPO rms owned by a small number of large controlling shareholders (Burkart, Gromb, & Panunzi,1997; Mueller & Inderst, 2001). Therefore, managers in these rms have a greater latitude to indulge their own preferences,even at the expense of shareholders interests (Francis & Martin, 2010). Lafond and Watts (2008) argue that informationasymmetry between insiders and outside investors lowers the rms stock price by increasing the required rate of return onthe stock and generating agency costs that reduce the rms expected cash ows. The more the relatively private informa-tion, the larger the bid-ask spread and the lower the returns to investors without private information (Amihud & Mendelson,1986). The equilibrium return effect provides managers and other insiders incentives to apply governance mechanisms thatincrease public information, so reducing private information and increasing stock price (Lafond & Watts, 2008). However,managers have a motivation to use their private information to maximize their own utilities, which may generate deadweightlosses to shareholders and reduce the rms cash ows and its stock price. Thus investors prefer rms to use veriable infor-mation to restrict managements manipulation. As a result, information asymmetry between insiders and outside investorsgenerates incentives and demands for accounting conservatism. There are, however, differences in corporate governancesystems and managements control over accounting and reporting processes among rms at varied development stages.Thus the level of information asymmetry varies at different rms (Kennedy et al., 2006; Rock, 1986). In rms with highinformation asymmetry, conservative accounting can play a more signicant role in curbing management manipulation ofaccounting information and improving the credibility of nancial statements (Garca Lara et al., 2009), which should con-tribute more substantially to the reduction of information asymmetry between issuing rms and potential outside investors(Ahmed et al., 2002). Therefore, for rms with greater information asymmetry, accounting conservatism is likely to play aneven more signicant role in reducing issuing rms incentives to intentionally underprice their stocks. These argumentslead to the second hypothesis as follows:

H2. The negative association between accounting conservatism and IPO underpricing is more pronounced for rms withhigh information asymmetry than for rms with low information asymmetry.

3. Research design and data

3.1. Measurement of accounting conservatism

Based on Givoly and Hayn (2000), we use the total accrual-based measure of conservatism (CONS TA), which is the totalaccruals deated by average total assets at the beginning of year, and averaged over a 3-year period centered on the yearbefore the IPO, multiplied by negative one. According to Givoly and Hayn (2000), total accruals are dened as:

total accruals = (net income + depreciation) cash ow from operations (1)

3.2. Measurement of IPO underpricing

Consistent with previous studies, we employ the methodology used by Aggarwal, Leal, and Hernandez (1993) to mea-sure IPO underpricing, i.e., we measure the market-adjusted abnormal returns for the rst trading day to proxy for IPOunderpricing. The measurement is described as follows.

The return of stock i at the end of the rst trading day is calculated as:

Ri1 =(

Pi1Pi0

) 1 (2)

where Pi1 is the closing price of stock i on the rst trading day, and Pi0 is the offering price and Ri1 is the total rst-dayreturn on the issuing stock.

The return on market index for the corresponding time period is:

Rm1 =(

Pm1Pm0

) 1 (3)

where Pm1 is the closing value of the corresponding Shanghai or Shenzhen A-share market index on the rst trading dayand Pm0 is the closing value of the corresponding Shanghai or Shenzhen A-share market index on the offering day of thecorresponding stock, while Rm1 is the rst-days comparable market return.

Using these two returns, the market-adjusted abnormal return for each IPO on the rst trading day which we use tomeasure IPO underpricing is computed as:

MAARi1 = 100 {[

(1 + Ri1)(1 + Rm1)

] 1

}(4)

In addition, we use the difference of market-to-book ratio between that on the listing day and pre-offering (DMB) toalternatively measure IPO underpricing (Chan et al., 2004). The pre-offering MB ratio is calculated using the offering priceand net assets per share one year before IPO. We assume that MB is higher on the listing day than that in the pre-offeringperiod if IPO underpricing exists, which will yield a positive DMB as its magnitude denotes the level of underpricing.


3.3. Empirical model

We construct the following regression model to test our hypotheses. IPO underpricing is the dependent vari-able and the proxy of accounting conservatism is the key explanatory variable. In addition, we incorporate severaldeal-specic and rm-specic factors contextual to the distinct features in the Chinese IPO market as controlvariables:

UPi = 0 + 1CONSi + 2BOOKi + 3CONSi BOOKi + 4LDAYi + 5OFF SIZEi + 6OWN Si + 7OWN Li + 8TSi+ 9VOLi + 10INTEGi + 11EXCHi + 12UWREPi + 13LEVi + 14ROAi + i (5)

where

UP (MAAR) measure of underpricing with market-adjusted initial returns on the rst trading day of the IPO stockUP (DMB) measure of underpricing with difference of market-to-book ratio between the listing day and pre-offeringCONS (TA) proxy for accounting conservatism with total accruals approach, which is measured by income before extra-ordinary items

less cash ows from operations plus depreciation expense deated by average total assets at the beginning of year, andaveraged over a 3-year period centered on the year before IPO, multiplied by negative one

BOOK dummy variable, equals to 1 if the rm goes public through book building mechanism and 0 otherwiseCONS*BOOK the interaction term of CONS and BOOKLDAY number of days between offering and listing of an IPO stockOFF SIZE natural logarithm of the number of offering shares multiplied by offering price, indicating the offering size of individual IPO

stocksOWN S percentage of shares held by government and state-owned legal entities after IPO, representing the proportion of government

ownership in the equity of an issuing rmOWN L percentage of shares held by non-state-owned legal entities after IPOTS percentage of publicly tradable shares of each IPOVOL Number of IPOs in each yearINTEG dummy variable, equals to 1 if the offer price is an integer and 0 otherwiseEXCH dummy variable, equals to 1 if the new issue is listed on Shenzhen Stock Exchange and 0 if it is listed on Shanghai Stock

ExchangeUWREP dummy variable, equals to 1 if the underwriter belongs to Top 5 underwriters nationwide7 and 0 otherwiseLEV a rms total debt divided by its total assets of the year before IPOROA after-tax net income divided by total assets of the year before IPO

Regarding the effect of accounting conservatism on IPO underpricing, 1 is predicted to be negative for H1, thus con-servative accounting should be able to reduce IPO underpricing. In order to test H2, we partition all issuers into twosubgroups by the extent of information asymmetry in pre-IPO period and analyze whether the association betweenaccounting conservatism and IPO underpricing is more pronounced when information asymmetry is high. We mea-sure the magnitude of information asymmetry between issuers and potential investors by four proxies that have beenused in prior studies: sales growth, rm age, rm size, and corporate governance. First, as stated by Khan and Watts(2009), information asymmetry between managers and investors increases with growth options because future cash owsfrom growth options are typically unveriable and may produce more agency costs. Second, younger rms tend to havemore growth options and less standardized accounting and reporting systems relative to old rms and have a greaterscale of information asymmetry (Stoll & Curley, 1970). Third, large rms are more mature and have richer informationenvironments (e.g., more analyst following), which contributes to less overall uncertainty and information asymme-try associated with the realizability of projected gains. Fourth, strong corporate governance rms will better align theinterests of all stakeholders, which will mitigate agency problems and result in relatively less information asymmetry(Watts, 2003).

Sales growth is measured as the change in sales revenue divided by one-year lagged sales revenue. Firm age is measured asthe number of years passed since a rms establishment date before its IPO. Firm size is measured as the total assets beforeIPO. Corporate governance is measured by taking the unweighed average of standardized composing variables includingownership concentration, ratio of the number of independent directors in the Board, separation of CEO/Chair positions, liti-gation risk, and leverage risk (Burkart et al., 1997; Jog & Mcconomy, 2003). We use the sample median of each partitioningproxy to divide the total sample into high information asymmetry sample and low information asymmetry sample. Firmswith high sales growth, young age, small rm size and weak corporate governance are classied as high information asym-metry rms, respectively. We run regressions (Eq. (5)) separately for the high- and low information asymmetry subsamplesto test whether accounting conservatism has a varied impact on IPO underpricing under different information asymmetryenvironments.

7 We rank underwriters according to the number of their IPO deals annually. In general Top-5 underwriters represent high-quality ones nationwide.


Table 1Sample selection.

Sample selection process Observations dropped Observations remaining

Initial sample from 2001 to 2009 available from CSMAR 695After eliminating rms in nancial industries 19 676After eliminating rms that began their initial public offerings but have not been listed on

stock exchanges2 674

6468

66

98

15

68

110

78

109

05

01

00

Nu

mb

er

of IP

Os b

y Y

ea

r

200920082007200620052004200320022001

Fig. 1. Number of IPOs in China by year (the nal sample includes 65 IPOs for 2003 and 77 IPOs for 2008. Two IPOs (each in 2003 and 2008 respectively)are eliminated from the sample because they have not been listed on stock exchanges in the year although they began their initial public offerings).

3.4. Data

Our sample includes all A-share companies that went public through initial public offerings on both the Shanghai StockExchange and Shenzhen Stock Exchange in China during 20012009.8 IPOs of B-share companies are excluded because theirIPO behaviors and performance are substantially different from those of A-share companies due to varied regulatory require-ments (Chan et al., 2004). We exclude companies in the nancial industry because the nancial reporting environment fornancial institutions signicantly differs from that of other industrial companies. Basic data about IPOs, nancial perfor-mance, stock returns, and ownership information are obtained from the database of Chinese Stock Market and AccountingResearch (CSMAR). Following Chan et al. (2004), we also exclude rms that have a lapsed time between offering date andlisting date that exceeds 360 days.

Our initial sample extracted from the CSMAR database includes 695 IPOs. After excluding 19 companies in the nancialindustry and two rms that began their initial public offerings but have not been listed on stock exchanges, we have 674IPOs for the nal sample.9 Table 1 reports the rm-level sample selection process. The number of new issues in each year isplotted in Fig. 1, which demonstrates a considerable time-series volatility in the Chinese market. For example, IPO activitypeaked in 2007 with a record of 110 rms going public, but only 15 IPOs took place in 2005.

3.5. Descriptive statistics

Table 2 presents the descriptive statistics for the variables by year. All variables are winsorized at the extreme 1% and 99%both to mitigate the possible effect of outliers. The average magnitude of IPO underpricing is 110.9% for the entire period,which is obviously at a substantially high level. A breakdown of the IPOs by year shows that IPO underpricing in the Chinesemarket undergoes two stages. There is a decreasing trend in terms of IPO underpricing from 145.0% in 2001 to 86.6% in 2006and from 192.7% in 2007 to 69.4% in 2009, respectively. In our sample, 54.7% of IPOs (369 of 674) went public through bookbuilding mechanism. The number of days between offering and listing (LDAY) is 26.078 in 2001 and declines to 13.982 in2009, indicating that the time lag between offering and listing has become shorter and the Chinese IPO market has becomemore efcient in recent years. The average offer size (OFF SIZE) is RMB 831.465 million in 2001 (US$1 = RMB 6.5) andincreases to RMB 1652.478 million in 2009, which indicates a negative relationship with the level of underpricing. Thepercentage of state shares (OWN S) or government ownership shows a steady decrease from 48.5% in 2001 to 12.0% in 2009.

8 In October 2000, Shenzhen Stock Exchange was temporarily closed to IPOs, leaving Shanghai Stock Exchange as the only IPO market from 2001 to 2003in China. Our sample starts from 2001 in order to mitigate the effects arising from the suspension of IPO activities on the Shenzhen that Stock Exchange.

9 All rms in the sample period have a lapsed time between offering date and listing date of less than 360 days.

134Z.J.

Lin, Z.

Tian /

Journal of

International Accounting,

Auditing

and Taxation

21 (2012) 127 144Table 2Descriptive statistics for A-share IPOs in China by year.

Year MAAR CONS BOOK LDAY OFF SIZE OWN S OWN L TS VOL INTEG EXCH UWREP LEV ROA

2001

Mean 1.450 0.019 0.172 26.080 831.500 0.485 0.171 0.331 64 0.141 0.000 0.438 0.555 0.076Median 1.261 0.015 0 23.500 482.600 0.587 0.033 0.321 64 0.000 0.000 0.000 0.580 0.059SD 0.896 0.086 0.380 9.030 1494.000 0.243 0.234 0.064 0 0.350 0.000 0.500 0.112 0.045Obs. 64 64 64 64 64 64 64 64 64 64 64 64 64 64

2002


2003


2004

Mean 0.744 0.012 0 16.460 360.700 0.256 0.267 0.328 98 0.122 0.398 0.133 0.527 0.097Median 0.629 0.008 0 15.000 282.100 0.124 0.180 0.321 98 0.000 0.000 0.000 0.526 0.093SD 0.559 0.079 0 2.781 297.900 0.273 0.248 0.061 0 0.329 0.492 0.341 0.128 0.039Obs. 98 98 98 98 98 98 98 98 98 98 98 98 98 98

2005


2006


2007

Mean 1.927 0.014 0.909 13.440 2285.000 0.197 0.343 0.213 110 0.064 0.864 0.409 0.553 0.091Median 1.708 0.005 1 14.000 277.300 0 0.265 0.202 110 0.000 1.000 0.000 0.573 0.081SD 0.997 0.067 0.289 3.473 9329.000 0.273 0.286 0.061 0 0.245 0.345 0.494 0.135 0.040Obs. 110 110 110 110 110 110 110 110 110 110 110 110 110 110

2008

Mean 1.220 0.027 0.753 12.130 1382.000 0.158 0.326 0.201 78 0.013 0.922 0.416 0.569 0.100Median 0.901 0.027 1 12.000 321.600 0 0.264 0.201 78 0.000 1.000 0.000 0.579 0.086SD 0.904 0.070 0.434 3.254 4066.000 0.264 0.280 0.039 0 0.114 0.270 0.496 0.158 0.061Obs. 77 77 77 77 77 77 77 77 77 77 77 77 77 77

2009

Mean 0.694 0.054 1 13.980 1652.000 0.120 0.286 0.192 109 0.385 0.927 0.193 0.486 0.129Median 0.629 0.040 1 12.000 628.300 0 0.197 0.201 109 0.000 1.000 0.000 0.477 0.119SD 0.393 0.098 0 7.322 5364.000 0.230 0.256 0.033 0 0.489 0.262 0.396 0.155 0.069Obs. 109 109 109 109 109 109 109 109 109 109 109 109 109 109

Total

Mean 1.109 0.019 0.547 15.670 1166.000 0.265 0.278 0.264 85.240 0.138 0.556 0.280 0.543 0.095Median 0.858 0.011 1 15.000 349.100 0.110 0.171 0.235 78 0.000 1.000 0.000 0.561 0.086SD 0.854 0.083 0.498 6.075 4703.000 0.289 0.269 0.085 21.680 0.345 0.497 0.450 0.138 0.053Obs. 674 674 674 674 674 674 674 674 674 674 674 674 674 674

Note: Variables are dened as: MAAR, measure of underpricing with market-adjusted initial returns on the rst trading day of IPO stock; CONS, proxy for accounting conservatism, which is measured by incomebefore extra-ordinary items less cash ows from operations plus depreciation expense deated by average total assets at the beginning of year, and averaged over a 3-year period centered on the year before IPO,multiplied by negative one; BOOK, a dummy variable, equals to 1 if the rm goes public through book building mechanism and 0 otherwise; LDAY, number of days between offering and listing of an IPO stock;OFF SIZE, natural logarithm of the number of offering shares multiplied by offering price, indicating the offering size of individual IPO stocks; OWN S, percentage of shares held by government and state-ownedlegal entities after IPO, representing the proportion of government ownership in the equity of an issuing rm; OWN L, percentage of shares held by non-state-owned legal entities after IPO; TS, percentage ofpublicly tradable shares of each IPO; VOL, number of IPOs in each year; INTEG, a dummy variable, equals to 1 if the offer price is an integer and 0 otherwise; EXCH, a dummy variable, equals to 1 if the new issueis listed on Shenzhen Stock Exchange and 0 if it is listed on Shanghai Stock Exchange; UWREP, a dummy variable, equals to 1 if the underwriter belongs to Top 5 underwriters nationwide and 0 otherwise; LEV, arms total debt divided by its total assets of the year before IPO; ROA, after-tax net income divided by total assets of the year before IPO.This table presents the description of variables for the entire sample of 674 IPOs by year. All variables are winsorized at the extreme 1% and 99%.


It should be noted that the shares owned by the state and legal entities account for more than 50% of the total shares forthe listed companies in the 20012009 period. This situation may contribute to operational inefciencies and informationasymmetry that aggravate IPO underpricing. Analysis of INTEG, EXCH and UWREP shows that 13.8% of IPOs (93 of 674) havean integer offer price, 55.6% of IPOs (375 of 674) are listed on the Shenzhen Stock Exchange during the sample period, and28.0% of IPOs (189 of 674) are underwritten by the Top 5 underwriters in China.

The correlations between all variables are presented in Table 3. These estimates do not reveal correlations that aresufciently high. So the multicollinearity problem is moderate in our model and will not have a signicant impact on therelationship between the dependent and independent variables used in Eq. (3).

4. Empirical results

4.1. The association of accounting conservatism with IPO underpricing

Table 4 shows the results of cross-sectional analyses for the impact of accounting conservatism on IPO underpricing inthe Chinese market based on Eq. (3). We use total accruals (TA) to proxy for accounting conservatism10 and use both market-adjusted abnormal return (MAAR) and difference of market-to-book ratios (DMB) to measure IPO underpricing. In Model1, the dependent variable is the market-adjusted abnormal returns (MAAR) on the rst trading day. The main independentvariable is accounting conservatism measured by total accruals (CONS TA). The model is reasonably well specied withadjusted R2 of 17.9% at the signicance level of 1% (F = 11.45). As we predict, the coefcient on CONS TA is 1.045 at the 10%signicance level, suggesting that accounting conservatism is negatively and signicantly related to IPO underpricing in theChinese market. This nding supports H1.

Results in Model 1 also reveal that the offering mechanism does affect underpricing. The book building mechanism(BOOK) is found to be positively related to underpricing (MAAR) at the 5% signicance level (2 = 0.196, t = 2.35), which isconsistent with Ljungqvist, Jenkinson, and Wilhelm (2003) and Li (2009). Li (2009) explains the positive relationship betweenthe book building mechanism and the level of underpricing by stating that book building offers issuers greater discretionsand gives institutional investors more chances to pursue their own benets. Book building mechanism allows shares to beallocated preferentially and enables investors to call for changes in offer price that will give everyone a fair chance (Sherman,2005). Besides, we include an interaction term for book building mechanism and accounting conservatism. Model 1 showsa positive relationship between the interaction (BOOK*CONS) and the level of underpricing (MAAR) at the 10% signicancelevel (3 = 1.378, t = 1.85), indicating that the relationship between accounting conservatism and IPO underpricing is lesspronounced after the implementation of book building mechanism. This result further conrms the substitute relationshipbetween BOOK and CONS as shown in the correlation matrix.

Other results in Model 1 are broadly consistent with the extant IPO underpricing literature. For example, LDAY has a pos-itive relationship to the level of underpricing, although its coefcient is not signicant at the conventional level (4 = 0.002,t = 0.30). This result can be explained by the specic sample period. Our regression uses IPOs that took place in 20012009,and as shown in Table 2, the average lapsed time between offering and listing during the test period is 15.67 days. The timegap is not as unreasonably long as in previous periods. It can be interpreted that the level of underpricing will not be signi-cantly affected by the time elapsed between offering and listing if issuers can list their offerings within a reasonable durationperiod. Regarding the offering size of IPOs (OFF SIZE), we nd a signicantly negative relationship to the level of underpricingat the 1% signicance level (5 = 0.402, t = 10.41), which is in line with prior studies stating that smaller offer size makesit easier for institutional investors to control the issuing process and have more money left on the table for themselves. Withrespect to the impact of shareholders structure, the results show a positive relationship between the proportion of stateshares (OWN S) and IPO underpricing at the 5% signicance level (6 = 0.360, t = 2.23)11 and a negative relationship betweenthe proportion of publicly tradable shares (TS) and IPO underpricing at the 5% signicance level (8 = 1.258, t = 2.45),suggesting that a high proportion of state-owned shares give managers more opportunities to cover up inefciencies, whichaggravates information asymmetry and IPO underpricing. This result is consistent with Chaney et al. (2011) who argue thatpolitically connected rms have incentives to hide inefciencies and end up with a large degree of information asymmetry.With a high state ownership, managers are subject to less monitoring and discipline of public investors and they are eagerto cover up inefciencies because they tend to pursue their personal interests such as their bureaucratic careers. However,a high proportion of tradable shares may reduce the demand for new issues and push down the stock returns on the initialtrading day.

We nd a signicantly positive relationship between IPO volume (VOL) and initial IPO returns (MAAR) at the 1% level(9 = 0.008, t = 4.72), which is in line with the hot issues market phenomenon. Consistent with Banerjee, Dai, and Shrestha(2009) and Boulton et al. (2011), integer offer price (INTEG) is negatively related to IPO underpricing (MAAR) at the 5% signif-icance level (10 = 0.210, t = 2.37). Harris (1991) argues that the use of integer offer price intends to reduce uncertainty instock pricing and the frequency of integer offer prices should increase in offerings. In this respect, integer offer price nega-

10 We also use discretionary accruals to proxy for accounting conservatism in robustness tests with reduced sample size owing to missing data of somerms and the result is qualitatively the same (see Section 4.4.).11 Cheung et al. (2009) also nd similar evidence on the relationship between state ownership and IPO underpricing in the Chinese market.

136Z.J.

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21 (2012) 127 144

Table 3Correlation matrix among variables.

MAAR CONS BOOK LDAY OFF SIZE OWN S OWN L TS VOL INTEG EXCH UWREP LEV ROA

MAAR 1TA 0.0116 1BOOK 0.0542 0.0622 1LDAY 0.0102 0.0368 0.311*** 1OFF SIZE 0.316*** 0.0353 0.156*** 0.0475 1OWN S 0.0128 0.19*** 0.232*** 0.169*** 0.288*** 1OWN L 0.0359 0.0538 0.159*** 0.116*** 0.124*** 0.613*** 1TS 0.0393 0.101*** 0.578*** 0.27*** 0.125*** 0.304*** 0.263*** 1VOL 0.111*** 0.125*** 0.362*** 0.241*** 0.0913** 0.268*** 0.0637* 0.354*** 1INTEG 0.0869** 0.0628 0.0785** 0.0503 0.0455 0.0367 0.0373 0.0858** 0.147*** 1EXCH 0.0782** 0.158*** 0.556*** 0.303*** 0.243*** 0.559*** 0.311*** 0.617*** 0.401*** 0.0888** 1UWREP 0.0836** 0.0235 0.0433 0.0234 0.122*** 0.0593 0.012 0.0575 0.0137 0.0486 0.0322 1LEV 0.0235 0.085** 0.0349 0.0101 0.0592 0.0405 0.0656* 0.03 0.118*** 0.0973** 0.084** 0.0522 1ROA 0.0889** 0.248*** 0.0881** 0.0095 0.0161 0.283*** 0.114*** 0.251*** 0.195*** 0.127*** 0.25*** 0.0048 0.591*** 1

Note: This table reports the correlation of variables used. Variables are dened as in Table 2. All variables are winsorized at the extreme 1% and 99%.* Statistical signicance at the 10% level.

** Statistical signicance at the 5% level.*** Statistical signicance at the 1% level.


Table 4Results for the impact of accounting conservatism on IPO underpricing in 20012009.

Predictions MAAR DMB

Intercept 3.537*** 0.940(8.44) (0.29)

CONS TA 1.045* 7.676*(1.86) (1.77)

BOOK ? 0.196** 2.338***

(2.35) (3.64)TA*BOOK ? 1.378* 1.917

(1.85) (0.33)LDAY + 0.002 0.165***

(0.30) (4.00)OFF SIZE 0.402*** 1.115***

(10.41) (3.74)OWN S + 0.360** 1.766

(2.23) (1.42)OWN L + 0.068 1.130

(0.46) (1.00)TS 1.258** 2.660

(2.45) (0.67)VOL + 0.008*** 0.070***

(4.72) (5.68)INTEG ? 0.210** 0.495

(2.37) (0.72)EXCH ? 0.234** 1.498*

(2.28) (1.89)UWREP ? 0.232*** 1.057**

(3.44) (2.03)LEV 0.416 8.577***

(1.49) (3.98)ROA 1.936** 44.985***

(2.45) (7.39)N 674 674R2 0.196 0.247Adj. R2 0.179 0.231F 11.45 15.48

Note: This table reports the cross-sectional analyses for the impact of accounting conservatism on IPO underpricing based on Eq. (3). Denition of variablesis as specied in Table 2. All variables are winsorized at the extreme 1% and 99%. t-Statistics are reported in parentheses.

* Statistical signicance at the 10% level.** Statistical signicance at the 5% level.

*** Statistical signicance at the 1% level.

tively affects the magnitude of underpricing. The coefcient on EXCH reveals that the IPO underpricing in the Shenzhen StockExchange is signicantly lower than that in the Shanghai Stock Exchange at the 5% signicance level (11 = 0.234, t = 2.28),which is consistent with Yu and Tse (2006). The regulations and investors behaviors in the Shenzhen Stock Exchange aremuch closer to those in neighboring Hong Kong where international standards and practices prevail, which may result inless information asymmetry between issuers and potential investors for the Shenzhen Stock Exchange. Besides, it is notedthat some rms on the Shenzhen Stock Exchange are joint ventures with foreign capitals, while those listed on the ShanghaiStock Exchange are mostly SOEs (Yu & Tse, 2006). There are more disclosures and less uncertainty in joint venture rmswith foreign partners, so the IPO rms listed on the Shenzhen Stock Exchange are relatively less underpriced.

The magnitude of underpricing is positively related to the reputation of underwriters (UWREP) at the 1% signicance level(12 = 0.232, t = 3.44), which is consistent with Boulton et al. (2011) and Ritter and Welch (2002). This result further shows thatunderwriters in China still play a major role in underpricing in the process of initial public offerings. Large underwriters willdemand high underpricing to pursue their own benets. The coefcient on rm leverage (LEV) is 0.416, which supports themonitoring role of leverage in reducing managements opportunistic behaviors and information asymmetry between issuersand potential investors. However, the t-statistic of this variable is not signicant at the conventional level, indicating thatthe role of leverage in reducing information asymmetry and IPO underpricing is rather weak in China. Consistent with Rock(1986) who argues that the degree of information asymmetry is a decreasing function of rm protability, ROA is negativelyrelated to the level of underpricing at the 5% signicance level (14 = 1.936, t = 2.45), suggesting that protability helpsreduce IPO underpricing in the Chinese market.

Similar results are obtained when IPO underpricing is measured alternatively as the difference of market-to-book ratiosbetween pre-IPO and listing date (DMB). In Model 2, the coefcient on CONS TA is 7.676 at the 10% signicance level, thusour empirical results are robust in respect of the association of accounting conservatism with IPO underpricing in the Chinesemarket.


Table 5Differences between high- and low information asymmetry groups.

Partition proxy High information asymmetry Low information asymmetry Mean variances

N Mean Std. dev. N Mean Std. dev. Variance t-Statistics

Growth 336 0.424 0.274 338 0.023 0.106 0.4003 25.01***

Firm age 337 2.412 0.859 337 7.400 2.814 4.989 31.13***Firm size 337 2.44e+08 8.54e+07 337 6.04e+09 1.92e+09 5.79e+09 5.55***Corp. gove 337 1.696 1.399 337 1.696 1.295 3.393 32.66***

Note: Subgroups are divided based on the median value of the four partition proxies respectively, so rms with high growth, young age, small size and weakcorporate governance are dened as high information asymmetry. Sales growth is measured as the change in sales revenue divided by the one-year laggedsales revenue. Firm age is measured as the number of years passed since a rms establishment date. Firm size is measured as the total assets before IPO.Corporate governance is measured by taking the unweighed average of the standardized composing variables including separation of CEO/Chair positions,the ratio of the number of independent directors to the number of all directors, litigation risk, ownership concentration, and leverage.*** Signicance of 1%.

4.2. Effect of information asymmetry on the association between accounting conservatism and IPO underpricing

We examine the second hypothesis regarding the impact of pre-IPO information asymmetry on the relationship betweenaccounting conservatism and IPO underpricing in this section. As explained in Section 3, we divide our sample into highvs. low information asymmetry sub-groups based on four partition factors, i.e., growth, rm age, rm size, and corporategovernance.12 Table 5 lists the group means and between-group mean variances under the four partitions. All show asignicant difference between the high and low information asymmetry sub-groups at the signicance level of 1%. Forinstance, the average age of the high information asymmetry group is 2.41 years while for the low asymmetry group itis 7.4 years. The average total assets are RMB 244 million and RMB 6040 million, respectively. Table 6 presents theanalyses for the second hypothesis based on the partitioned sub-samples (e.g., high vs. low information asymmetry). In eachcolumn, the left (right) sub-sample represents high (low) information asymmetry rms. In the regression, the coefcient onCONS TA is 1.115 for high growth sub-group (t = 1.58), which is more pronounced than the coefcient 0.525 for the lowgrowth sub-group (t = 0.53). The coefcient on CONS TA for the young rm sub-group is 1.113 at the 10% signicance level(t = 1.67), which is more pronounced than the coefcient 1.001 for the old rm sub-group (t = 0.85). The coefcient onCONS TA for the small rm sub-group is 1.568 at the 5% signicance level (t = 1.98), which is more pronounced than thecoefcient 0.206 for the large rm sub-group (t = 0.26). The coefcient on CONS TA for the weak corporate governancesub-group is 2.419 at the 1% signicance level (t = 2.85), which is more pronounced than the coefcient of 0.278 for thestrong corporate governance sub-group (t = 0.36). The results reveal that the relationship between accounting conservatismand IPO underpricing is more pronounced for high information asymmetry rms. Furthermore, we evaluate the differencesin the coefcients between high and low information asymmetry sub-samples. We nd that the coefcient on CONS TA issignicantly more negative in rms with high sales growth, young age, small size, and weak corporate governance than intheir counterparts with low information asymmetry, thus conrming that accounting conservatism has a greater impact onIPO underpricing under a high information asymmetry environment.

4.3. Reverse causality test

Until now, we have not addressed the potential endogeneity problem of accounting conservatism. An alternative expla-nation of the negative relationship between accounting conservatism and IPO underpricing is that rms with higher levelsof underpricing are more likely to employ less conservative accounting. This reverse causality explanation is difcult to ruleout since it is hard to specify ex ante which rms are more underpriced and which are not. We deal with this reverse causalityissue in the following ways. First, we use the average of a three-year lagged accounting conservatism measure to addressthe causality ow from accounting conservatism to IPO underpricing. Second, we apply the two-step Heckmans procedureto purge the endogenous component of accounting conservatism. In the rst stage, we estimate a selection model (probitmodel) to explain rms overall decisions to choose conservative accounting or not. The dependent variable is an indicatorvariable that gets the value of one if a rms accounting conservatism measure at one year before the IPO is above thesample median and zero otherwise. The explanatory variables include leverage, return on assets, sales growth, total assets,the ratio of independent directors to all directors, and board size. We use two-year lagged data for explanatory variables asthe determinants for accounting conservatism one year before IPO. Conditional on this rst stage analysis, we analyze in thesecond stage the relationship between accounting conservatism and IPO underpricing by including other control variables.We construct an inverse Mills ratio (IMR) based on the coefcient estimates from the rst step probit model, and includeIMR as an additional explanatory variable in the second-step model. Table 7 shows that IMR has a signicantly negativecoefcient (0.992; t = 1.93) and the coefcient on CONS is still signicantly negative (3.828; t = 3.31), consistent with

12 The partition is based on the group media for each factor individually. Thus the high- and low information asymmetry sub-groups have the samenumber of sample rms.


Table 6Results for the impact of information asymmetry on the relationship between accounting conservatism and IPO underpricing.

Sales growth Firm age Firm size Corporate governance

High Low Young Old Small Large Weak Strong

Intercept 3.823*** 3.334*** 4.677*** 2.121*** 6.101*** 2.012*** 3.447*** 3.405***

(6.26) (5.30) (7.67) (3.47) (7.96) (3.74) (5.59) (5.54)CONS TA 1.115 0.525 1.113* 1.001 1.568** 0.206 2.419*** 0.278

(1.58) (0.53) (1.67) (0.85) (1.98) (0.26) (2.85) (0.36)BOOK 0.000 0.366*** 0.180 0.137 0.348*** 0.033 0.363*** 0.054

(0.00) (2.88) (1.48) (1.12) (2.61) (0.31) (3.01) (0.45)TA*BOOK 0.612 1.826 0.198 2.149 1.919* 0.089 2.913*** 0.230

(0.66) (1.33) (0.18) (1.63) (1.74) (0.09) (2.72) (0.21)LDAY 0.002 0.003 0.001 0.006 0.009 0.003 0.000 0.002

(0.22) (0.38) (0.12) (0.70) (1.12) (0.46) (0.01) (0.27)OFF SIZE 0.368*** 0.460*** 0.494*** 0.272*** 0.880*** 0.206*** 0.452*** 0.328***

(5.66) (7.89) (8.40) (4.26) (7.36) (4.10) (7.84) (6.09)OWN S 0.473** 0.204 0.512** 0.199 0.245 0.559** 0.409* 0.337

(2.19) (0.84) (2.03) (0.90) (0.98) (2.58) (1.74) (1.47)OWN L 0.085 0.247 0.004 0.170 0.145 0.113 0.046 0.053

(0.44) (1.09) (0.02) (0.85) (0.72) (0.53) (0.23) (0.24)TS 2.106*** 0.402 2.078*** 0.338 2.622** 0.568 0.208 1.733**

(2.81) (0.55) (2.74) (0.45) (2.59) (0.98) (0.26) (2.53)VOL 0.004** 0.011*** 0.005** 0.011*** 0.008*** 0.008*** 0.007*** 0.009***

(2.03) (4.70) (2.10) (4.84) (3.21) (3.85) (2.93) (4.03)INTEG 0.257** 0.119 0.224 0.249** 0.139 0.201* 0.125 0.257*

(2.28) (0.82) (1.53) (2.15) (1.03) (1.75) (1.06) (1.91)EXCH 0.196 0.164 0.280* 0.008 0.642*** 0.220* 0.422*** 0.004

(1.40) (1.07) (1.94) (0.05) (4.01) (1.73) (2.73) (0.03)UWREP 0.009 0.255** 0.166 0.024 0.139 0.021 0.236** 0.150

(0.08) (2.00) (1.35) (0.20) (0.95) (0.22) (2.53) (1.47)LEV 0.492 0.278 0.548 0.276 0.504 0.702** 0.161 0.807*

(1.20) (0.68) (1.31) (0.70) (1.05) (2.11) (0.41) (1.77)ROA 1.209 2.921** 2.315* 2.251* 0.324 2.370** 1.505 2.148

(1.17) (2.23) (1.94) (1.94) (0.25) (2.12) (1.51) (1.56)N 336 338 337 337 337 337 337 337R2 0.164 0.245 0.224 0.184 0.259 0.166 0.232 0.216Adj. R2 0.127 0.212 0.190 0.149 0.227 0.130 0.199 0.182F 4.487 7.471 6.636 5.187 8.045 4.573 6.965 6.351

Note: This table reports the regression results for test of second hypothesis. Subgroups are divided based on the median value of the four partition proxiesrespectively, so rms with high growth, young age, small size and weak corporate governance are dened as high information asymmetry. Sales Growthsis measured as the change in sales revenue divided by the one-year lagged sales revenue. Firm age is measured as the natural logarithm of the number ofyears passed since a rms establishment date. Firm size is measured as the natural logarithm of total assets. Corporate governance is measured by takingthe unweighed average of the standardized composing variables including ownership concentration, ratio of the number of independent directors in theBoard, separation of CEO/Chair positions, litigation risk, and leverage. Other variables are dened as in Table 2. t-Statistics are reported in parentheses.



the interpretation that rms with more conservative accounting tend to have lower underpricing. Therefore, we concludethat our results are robust to the correction of potential self-selection bias that higher underpricing rms are more likely toemploy less conservative accounting.

4.4. Results of robustness tests

We run several robustness tests to check the validity of our study results. First, we use C SCORE developed by Khan andWatts (2009) as an alternative conservatism measure because the cash-based conditional measure of conservatism mayhave a better governance role in reducing information asymmetry. We also partition the full sample into two sub-samplesaccording to whether or not the rm goes public through book building mechanism. As stock returns are not available forrms before the IPO, C SCORE in this study is based on the Ball and Shivakumar (2005) accruals model13 rather than the Basu(1997) model. The accruals model is specied as:

ACCi = 0 + 1DCFOi + 2CFOi + 3DCFOi CFOi + i (6)

13 This approach presents the advantage of not relying on market measures, thereby reducing the risk of drawing incorrect inferences due to marketinefciencies (Garca Lara et al., 2009).


Table 7Results of reverse causality test using Heckman (1978) two-step procedure.

Panel A: rst-stage probit regression Panel B: second-stage regression

MAARIntercept 2.230** Intercept 6.006***

(2.22) (7.51)LEV 0.772* CONS TA 3.828***

(1.71) (3.31)ROA 4.423*** IMR 0.992*

(3.63) (1.93)GROWTH 0.028 BOOK 0.048

(0.20) (0.38)FIRM SIZE 0.139*** TA BOOK 6.787***

(2.92) (4.17)RINDE 0.417 LDAY 0.01

(0.90) (1.19)BOARD SIZE 0.047* OFF SIZE 0.599***

(1.66) (7.22)N 566 OWN S 0.178Pseudo-R2 0.057 (0.69)

OWN L 0.298(1.22)

TS 2.642***(3.43)

VOL 0.008***

(3.81)INTEG 0.200

(1.29)EXCH 0.453***

(2.82)UWREP 0.349***

(3.25)LEV 0.248

(0.50)ROA 0.355

(0.16)N 566

Note: This table reports the results for correcting the self-selection bias using the Heckman (1978) two-step procedure. Panel A presents the rst-stageprobit analysis of rms decision to use conservative accounting or not. The dependent variable equals to one if a rms accounting conservatism at oneyear before IPO is above the sample median and zero otherwise. The explanatory variables include leverage (LEV), return on assets (ROA), sales growth(GROWTH), total assets (TA), the ratio of independent directors to all directors (RINDE), and board size (BOARD SIZE). We use two-year lagged data forexplanatory variables as the determinants for accounting conservatism one year before IPO. Board size is the number of directors. Panel B presents theresults of the second-stage regression. The dependent variable is market-adjusted abnormal returns. IMR is the inverse Mills ratio constructed based onthe coefcients of the probit model in Panel A. Other variables are as dened in Table 2. All variables are winsorized at the extreme 1% and 99%. t-Statisticsare reported in parentheses.



where i indexes the rm; ACC is the income before extra-ordinary items less cash ows from operation plus depreciationexpenses deated by average total assets at the beginning of the year before IPO; CFO is cash ows from operations deatedby average total assets at the beginning of the year before IPO, DCFO is a dummy variable and equals to 1 if CFO < 0 and 0otherwise; and is the residual. In this model, 2 is expected to be signicantly negative, showing the negative correlationbetween accruals and cash ows. 3 is expected to be positive in the presence of accounting conservatism showing a positiveassociation between contemporaneous cash ows and accruals in the bad news periods, suggesting that accrued losses aremore likely to be reported in the periods of negative cash ows (Ball & Shivakumar, 2005).

We refer to the timeliness of good news 2 as G SCORE and the incremental timeliness of bad news 3 as C SCORE,which we use to alternatively measure accounting conservatism. G SCORE and C SCORE are linear functions of rm-speciccharacteristics (Watts, 2003):

G SCORE = 2 = 0 + 1SIZEi + 2MBi + 3LEVi (7)C SCORE = 3 = 0 + 1SIZEi + 2MBi + 3LEVi (8)

We substitute them into regression Eq. (6) to obtain Eq. (9) below and get C SCORE as a rm-year measure of accountingconservatism using 0, 1, 2 and 3:

ACCi = 0 + 1DCFOi + CFOi(0 + 1SIZEi + 2MBi + 3LEVi) + DCFOi CFOi(0 + 1SIZEi + 2MBi + 3LEVi)+ (0SIZEi + 1MBi + 2LEVi + 3DCFOi SIZEi + 4DCFOi MBi + 5DCFOi LEVi) + i (9)


Table 8Regression results for robustness tests.

Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Model 7 Model 8

OTHERS BOOK 20012005 20062009

Intercept 5.802*** 2.584*** 4.285*** 3.995*** 3.902*** 3.541*** 3.456*** 3.350*** 3.285*** 3.475***

(8.45) (4.08) (7.29) (6.04) (8.93) (8.29) (8.20) (8.96) (7.64) (8.56)CONS TA 0.753* 0.521 1.064* 1.099* 1.046* 1.181** 1.049*

(1.73) (0.97) (1.87) (1.94) (1.86) (2.07) (1.87)CONS DA 1.569*

(1.80)C SCORE 0.126** 0.068

(2.01) (1.61)BOOK 0.306*** 0.927*** 0.185** 0.191** 0.199** 0.192** 0.267*** 0.183**

(2.64) (5.91) (2.18) (2.28) (2.37) (2.31) (3.23) (2.19)TA*BOOK 1.386* 1.436* 1.362* 1.543** 1.361*

(1.85) (1.92) (1.83) (2.07) (1.83)DA*BOOK 1.723

(1.45)LDAY 0.001 0.005 0.017*** 0.008 0.002 0.002 0.002 0.001 0.002 0.001

(0.07) (0.63) (2.95) (0.88) (0.35) (0.43) (0.40) (0.27) (0.46) (0.27)OFF SIZE 0.313*** 0.566*** 0.538*** 0.479*** 0.434*** 0.407*** 0.392*** 0.388*** 0.426*** 0.398***

(3.46) (9.72) (9.79) (7.25) (10.58) (9.67) (10.08) (9.64) (10.83) (10.28)OWN S 0.106 0.407* 0.427* 0.435** 0.398** 0.391** 0.390** 0.358** 0.354** 0.385**

(0.40) (1.94) (1.76) (2.04) (2.42) (2.41) (2.40) (2.22) (2.18) (2.41)OWN L 0.200 0.034 0.155 0.044 0.048 0.048 0.054 0.071 0.094 0.059

(0.75) (0.20) (0.62) (0.25) (0.33) (0.32) (0.37) (0.49) (0.64) (0.40)TS 2.486*** 0.566 0.180 0.168 1.737*** 1.256** 1.195** 1.313** 1.156** 1.186**

(3.60) (0.71) (0.30) (0.20) (3.22) (2.43) (2.30) (2.55) (2.23) (2.34)VOL 0.001 0.019*** 0.002 0.016*** 0.007*** 0.007*** 0.008*** 0.008*** 0.008*** 0.008***

(0.62) (8.36) (0.90) (6.43) (4.56) (4.63) (4.65) (4.67) (5.03) (4.71)INTEG 0.012 0.313*** 0.032 0.320*** 0.209** 0.231*** 0.224** 0.218** 0.192** 0.210**

(0.08) (2.72) (0.28) (2.66) (2.32) (2.59) (2.51) (2.45) (2.11) (2.37)EXCH 0.073 0.628*** 0.434*** 0.601*** 0.315*** 0.198* 0.205** 0.228** 0.265** 0.226**

(0.57) (3.65) (3.98) (2.60) (2.91) (1.92) (1.99) (2.22) (2.58) (2.21)UWREP 0.348*** 0.068 0.097 0.079 0.226*** 0.236*** 0.198*** 0.227***

(3.30) (0.78) (1.08) (0.86) (3.28) (3.49) (2.93) (3.36)LEV 2.775*** 1.119* 0.668** 0.169 0.392 0.363 0.391 0.373

(3.17) (1.93) (2.01) (0.41) (1.36) (1.29) (1.39) (1.43)ROA 5.374*** 1.019 1.989** 0.197 1.949** 1.857** 1.914** 1.986*** 1.160*

(3.47) (0.87) (2.01) (0.17) (2.44) (2.33) (2.41) (2.66) (1.86)UWREP1 0.105

(1.24)UWREP2 0.097

(1.24)LEV1 0.064*

(1.89)SD 0.012

(0.06)OIA 1.650***

(2.68)N 299 358 310 364 653 674 674 673 656 674R2 0.204 0.326 0.337 0.314 0.203 0.183 0.183 0.198 0.207 0.197Adj. R2 0.171 0.303 0.308 0.289 0.185 0.166 0.166 0.180 0.189 0.180F 11.62 11.96 11.56 12.34 11.58 10.55 10.55 11.57 11.94 11.55

Note: This table reports the regression results for robustness tests Model 1 use C SCORE as an alternative conservatism measure and partitions the fullsample into two subsamples according to whether a rm goes public through book building mechanism. Model 2 partitions the sample into two test periods(20012005 vs. 20062009) to test the effect of circulation of non-tradable shares since 2006 on the association between accounting conservatism andIPO underpricing. Model 3 use discretionary accruals as an alternative measure of conservatism. Models 4 to 8 use alternative measures of underwriterreputation, leverage and protability for robustness tests. UWREP1 is a dummy variable and equals to 1 if the underwriter belongs to Top 5 underwritersin China and 0 otherwise as the underwriters are ranked according to their total underwriting amounts. UWREP2 is a dummy variable and equals to 1 ifunderwriter belongs to Top 5 underwriters in China and 0 otherwise, as underwriters are ranked according to their rm size. LEV1 refers to a rms totaldebt divided by its net assets of the year before IPO. SD refers to a rms short-term debt divided by its book value of total assets of the year before IPO. OIAis operating income divided by total assets of the year before IPO. Other variables are as dened in Table 2. All variables are winsorized at the extreme 1%and 99%. t-Statistics are reported in parentheses.




Table 8 (Model 1) reports the regression results using C SCORE as the independent variable to measure accounting con-servatism and test H1. The coefcient on C SCORE is 0.126 (t = 2.01) at the 5% signicance level for rms that go publicthrough other mechanisms than book building mechanism, while the coefcient on C SCORE is insignicant for rms that gopublic through book building mechanism. This result is consistent with H1 and conrms the negative relationship betweenaccounting conservatism and IPO underpricing and the substitutive relationship between accounting conservatism and bookbuilding mechanism.

As described earlier, the original non-tradable shares have been permitted to be traded on stock exchanges in China since2006. Increased volume of publicly tradable shares offers potential investors more choices and reduces the high demand ofinvestors for new issues. This fact may mitigate the demand for accounting conservatism and lower the level of underpricing.We partition the sample into two periods (20012005 vs. 20062009) to test the effect of the circulation of originally non-tradable shares since 2006 on the relationship between accounting conservatism and IPO underpricing in the Chinese market.Results of Model 2 in Table 8 show that the coefcient on CONS TA in the 20012005 period is 0.753 (t = 1.73) at the10% signicance level but insignicant in the 20062009 period, indicating the negative relationship between accountingconservatism and IPO underpricing is mitigated after the circulation of non-tradable shares in 2006.

We also consider discretionary accruals (DA) as the measure of accounting conservatism,14 because discretionary accrualsmay be more directly affected by managers choice of accounting standards or practices that may result in varied degrees ofaccounting conservatism. We employ the modied Jones model (Dechow, Sloan, & Sweeney, 1995) to measure discretionaryaccruals. The modied Jones model is specied as follows;

TAitAit1

= 0 + 1(

REVit RECitAit1

)+ 2

GPPEitAit1

+ it (10)

where TAit is total accruals for rm i in year t, REVit is the change in is total revenue from t 1 to t, and RECit is thechange in accounts receivables for rm i from the previous year. GPPEit is the gross acquisition cost of property, plants andequipments for rm i in year t, and Ait1 is the value of total assets for rm i in year t 1.

The OLS residuals from Eq. (10) are the estimates of discretionary accruals. The alternative proxy for accounting conser-vatism (CONS DA) in this study is measured as discretionary accruals multiplied by negative one. The regression results forH1 are similar when accounting conservatism is proxied by discretionary accruals (CONS DA). In Model 3, the coefcient onCONS DA is 1.569 at the 10% signicance level while coefcients on other variables are generally the same as that shownin Table 4 when discretionary accruals are used to measure accounting conservatism.

Finally, besides ranking underwriters according to the number of their IPO deals in the main test, we also rank under-writers in terms of total underwriting amounts and their rm size for robustness tests. In addition, we use a rms totaldebt divided by its net assets at the year before IPO and a rms short-term debt divided by its book value of total assets ofthe year before IPO to alternatively proxy for leverage risk. We also use operating income divided by total assets at the yearbefore IPO to proxy for rm protability. Models 48 in Table 8 report the regression results of the robustness tests and ourhypotheses are generally supported after adopting alternative measures of those control variables.

5. Conclusion

The purpose of this study is to investigate whether and how accounting conservatism impacts IPO underpricing in theChinese stock market. We utilize the unique data from Chinese IPO rms contextual to their inherent uncertainty andinformation asymmetry to test two hypotheses. The results of our regression analyses reveal that IPO underpricing in Chinais inversely associated with accounting conservatism, after controlling for deal-specic and rm-specic characteristics. Thisevidence is consistent with asymmetric information theory underlying IPO underpricing in the literature. Thus, accountingconservatism will help to reduce information asymmetry facing IPO rms and mitigate IPO underpricing. In addition, we ndthat the negative impact of accounting conservatism on IPO underpricing is more pronounced for rms with high informationasymmetry than for rms with low information asymmetry, indicating that higher information asymmetry creates moreincentives for conservative accounting by IPO rms. Our ndings should have positive implications for the improvement ofaccounting and reporting practices and the effective operation of capital market in the emerging economies like China andother developing countries.

Generalization of our study ndings must be made with caution as there are some distinct characteristics for the develop-ing Chinese stock market at present. A potential limitation is that this study focuses mainly on the perspective of informationasymmetry to investigate the impact of accounting conservatism on IPO underpricing. However, there are other theoriesregarding the causes of IPO underpricing in the literature. Factors other than information asymmetry could be explored toinvestigate the association of IPO underpricing with accounting conservatism in future research. In addition, the validityof the corporate governance variables (e.g., ownership concentration, proportion of outside directors, duality of CEO/Boardchairman positions and litigation risk) being used in our study may be further tested as the Chinese stock market is oper-ating in a context with dominant government ownership and weak rule of law. The environmental differences should be

14 Our main test is based on the total accruals approach because discretionary accruals data are not available for some rms, so the proxy for accountingconservatism measured by discretionary accruals is based on a smaller sample size.


taken into account, if data are available, if similar studies with data from other capital markets are carried out. Finally, morerigorous empirical models based on multivariate data analysis may be developed to generate more powerful evidence onthe relationship between accounting conservatism and IPO underpricing.

Acknowledgements

The authors are thankful to two anonymous reviewers and Professor Kathleen Sinning (the Journal Editor) for theirinsightful comments and editorial support to the previous drafts of this paper.

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Accounting conservatism and IPO underpricing: China evidence1 Introduction2 Study background and hypotheses2.1 IPO market in China2.2 IPO underpricing and information asymmetry theory2.3 Accounting conservatism and IPO underpricing2.4 Accounting conservatism and information asymmetry

3 Research design and data3.1 Measurement of accounting conservatism3.2 Measurement of IPO underpricing3.3 Empirical model3.4 Data3.5 Descriptive statistics

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