Earnings management around reverse stock splits

Abstract

Utilizing a sample of 1258 reverse stock splits from 1988 to 2019, we contrast earnings management by firms that initiate reverse splits for diverse reasons. Literature suggests that the incentives for reverse splits vary based on firms' stock price ranges. As such, we use the pre-split and target-price ranges to separate the sample into three groups. We find a stark difference in discretionary accruals across these groups. While previous studies have treated earnings management and reverse splits as substitutes, we hypothesize that firms at risk of delisting may employ these two mechanisms as complements. Consistent with the hypothesis, we document a strong positive association between reverse splits and post-split discretionary accruals for firms with pre-split prices below $1. This relationship, however, is non-existent among the remaining two groups. Our findings have two important implications for investors: (i) firms with different motives behind reverse splits exhibit different earnings management behavior and (ii) firms that are likely facing exchange delisting use discretionary accruals in complement with reverse stock splits.