Earnings Management and the Reputation of Nomads Around IPOs: The Experience of the UK Alternative Investment Market

Abstract

Synopsis The research problem We examined whether the reputation of the nominated advisor (Nomad) impacts the accrual and real earnings management of initial public offering (IPO) firms on the Alternative Investment Market (AIM) of the London Stock Exchange in the UK. Motivation and theoretical reasoning While the role of Nomads on the AIM is a significant determinant in ensuring the integrity of the financial reporting quality of their advisee firms, to date, there has been no analysis of the impact of Nomads on such reporting activities. The test hypothesis The main hypothesis of this study tested whether IPO firms that appoint a more reputable Nomad exhibit a lower level of accrual-based and real-based earnings management during the IPO. Target population The initial sample of this study consisted of all IPO firms that went public on the AIM between January 1998 and December 2008. After restricting the sample to non-financial IPO firms with the necessary data available to estimate accrual and real earnings management and Nomad reputation, the final sample consisted of 432 IPO firms that are backed by 80 Nomads over the sample period. Adopted methodology Two real earnings management activities were examined: sales-based manipulation and discretionary expenses–based manipulation. Discretionary accruals were estimated as a proxy of accrual earnings management. To construct the unweighted index of Nomad reputation (NOMAD), data were manually collected for the number of IPOs backed by a Nomad, proceeds of IPOs backed by the Nomad, the Nomad’s age, and the Nomad’s credit score. Analyses Following prior research, several techniques and regressions were employed to test the hypothetical relation between Nomad reputation and accrual and real earnings management. As for robustness, both Heckman and instrumental variable (IV) regressions were used to control for sample selection bias, and a three-stage least squares (3SLS) estimation approach was used to test for the two-way interaction between Nomad reputation and earnings management. Findings This paper found evidence that more reputable Nomads on the AIM play a significant role in constraining the use of accrual-based and real-based earnings management during the IPO year by their advisee IPO firms. This is also the first evidence on the significant role of reputable financial institutions and intermediaries in monitoring the financial reporting quality in less regulated markets such as the AIM in the UK.