| Abstract:
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Pre-IPO earnings management is prevalent in global capital markets, but emerging markets, particularly China, demonstrate more aggressive practices, intensifying the information asymmetry between IPO companies and external investors, and has become a bottleneck restricting investor protection. This paper posits that pre-listing earnings management is an unintended consequence of China's compromised IPO pricing mechanism, as the China Securities Regulatory Commission imposed a 23x P/E cap on IPOs in June 2014, following a failed market-oriented reform between 2009 and 2012. Since the pricing cap forced the companies to issue new shares at below-fair-market prices, they were motivated to inflate earnings per share to recover the losses. Using mainland Chinese companies listed on the Hong Kong stock market as the control group, we measure the level of firms' earnings management in the year before the IPO and provide causal evidence for our proposition in a cohort DID model. We further find that such opportunistic accounting practice is concentrated among privately controlled IPO companies with high valuations, which potentially suffer more from the pricing cap. The pricing cap has also led to adverse capital market consequences as it significantly increases the probability of financial performance reversals and stock price crashes after companies go public, and also largely reduces investors' long-term returns. These findings suggest that the Chinese government's paternalistic investor protection has not achieved the desired results, and IPO pricing should be deregulated, with important implications for emerging capital markets and guidance for international investors.
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