Different lies to different audiences: Tax avoidance versus earnings inflation

Abstract

Using a proprietary dataset collected by the National Bureau of Statistics of the People's Republic of China (NBS), we are able to compare earnings reported to the NBS in the pre-IPO (initial public offerings) period with earnings for the same firm and the same year reported in firms' IPO prospectus. While Ball and Shivakumar (2008) find that in the U.K., financials reported at IPOs tend to be more conservative than the original reports, we find the opposite: income reported by Chinese firms in their IPO prospectus tend to be higher than those reported to the NBS. In the year immediately preceding the IPO, the discrepancy is mostly driven by firms inflating earnings in the IPO prospectus to increase issue prices. In earlier years, firms in provinces with weak law enforcement report lower earnings to the NBS to avoid taxes, which also contributes to the discrepancy between the IPO and NBS data. These findings suggest that firms tell different lies to different audiences. The discrepancy between the IPO and NBS earnings is positively correlated with the IPO issue price, indicating that firms are able to increase their IPO proceeds by raising earnings in the IPO prospectus from the original NBS reports. Furthermore, firms with the highest discrepancies experience the most significant declines in return on assets (ROA) and the most negative abnormal returns after the IPOs. Our paper complements the existent literature on earnings quality at IPOs, sheds light on firms' tax avoidance behaviors, and is of practical value to regulators.