Chapter 01-Introduction

1.1 Earnings management and accrual accounting

Financial reporting processed governed by accounting rule and standards, managerial
incentives, and enforcement and monitoring mechanism have caused to rise of
earnings management and accrual accounting. It is important for analysts to
understand the financial reporting environment along with the objectives and concepts
underlying the accounting information presented in financial statements. It is
questionable whether the accounting information reliably reflects the financial
performance and position of a firm in accordance with the limitations of the
accounting information. The primary factors affect the nature and content of financial
reports to appreciate the financial accounting information reported in them are
accounting rules (GAAP- Generally Accepted Accounting Principles), manager
motivations, and monitoring and enforcement mechanisms. Other factors are users,
regulators, industry practices and other information sources.

Statutory financial reports

In the financial reporting process, statutory financial reports are the significant part. In
addition to annual reports which are more familiar with the analysts, there are other
important statutory financial reports that an analyst needs to review. These are the
financial statements, earnings announcements, and other statutory reports.

Factors affecting statutory financial reports

The main component of financial statements is financial accounting information.

Much of financial accounting information is determined by GAAP while other
determinants are managers (preparers) and the monitoring and enforcement
mechanisms that ensure its quality and integrity.

Generally accepted accounting principles (GAAP)

“GAAP are a collection of standards, pronouncements, opinions, interpretations, and

practice guidelines.” Wild, Bernstein and Subramanyam. (2001, p.83)

Financial statements are prepared in accordance with GAAP, which are the rules and
guidelines of financial accounting. These rules determine measurement and
recognition policies such as how assets are measured, when liabilities are incurred.
And also what information must be provided in those notes also dictated by them.
Various professional and quasistatutory bodies such as the Financial Accounting
Standards Board (FASB), the Securities and Exchange Commission and the Institutes
of Chartered Accountants set GAAP. In the Sri Lankan context, the Sri Lanka
Accounting Standards are set by the institute of Chartered Accountants, Sri Lanka.

1.2 Need and important of the study

It is generally accepted that the main responsibility for financial statements rests with
management. Managers have ultimate control over the integrity of the accounting
system and the financial records that make up financial statements. As a common
phenomenon it is known that judgment is necessary in determining financial
statement numbers. While accounting standards reduce subjectivity and arbitrariness
in these judgments, they do not eliminate it. The implement of managerial judgment
arises both due to the accounting standards often allow managers to choose among
alternative accounting methods and because of the estimation involved in arriving at
accounting numbers.

Judgment in financial accounting involves managerial discretion. This discretion

improves the economic content of accounting numbers by allowing managers to
implement their judgment and to communicate their private information through their
accounting choices and estimates. As an example managers could decrease the
allowance for bad debts based on inside information such as the improved financial
status of a major customer. In practice, many managers tend to do this discretion to
manage earnings and window-dress financial statements.

Monitoring and enforcement mechanisms

The reliability and integrity of financial reports is ensured by monitoring and

enforcement mechanisms. All public companies must file audited financial statements
with the Securities and Exchange Commission. External auditing is an important
mechanism to help ensure the quality and reliability of financial statements. All public
companies‟ financial statements must be audited by an independent certified public
accountant.

Teoh, Welch and, Wong (1998) said that earnings are managed only if there are
opportunities to do so. Further , they have said that the requirement of accounting
reports presented in the offering prospectus be audited by an external accounting firm
to verify compliance with generally accepted accounting principles (GAAP) is a
major limit on managerial discretion. According to their statements, the auditor is
responsible only for ensuring that the financial statements are in accordance with
GAAP and not those they are the most accurate representation of the firm‟s condition.
The accrual accounting system mandated by GAAP allows firms to make adjustments
when reporting earnings. Managers are afforded discretion in recognizing both the
timing and amounts of revenues and expenses.

Accrual accounting

Modern business transactions are mostly done on credit basis. Therefore accounting
adopts the accrual basis over the more primitive cash flow basis. Under accrual
accounting, revenues and expenses are recognized based on realization rather than on
cash inflows and outflows. Though accrual basis increases the relevance of
accounting information, it causes for certain limitations. When it considers the
complexity of modern businesses, cash flows are not enough to evaluate financial
performance and condition in a realistic manner. Accrual accounting intends to inform
users about the consequences of business activities for a company‟s future cash flows
with a reasonable level of certainty. This is achieved by recognizing revenue earned
and expenses incurred, regardless of whether or not cash flows occur
contemporaneously. Accrual adjustments, which adjust cash flows and cash outflows
to yield revenues and expenses facilitates the separation of this revenue and expense
recognition from cash flows. Accrual adjustments are recorded after making
reasonable assumptions and estimates, without materially sacrificing the reliability of
accounting information.

To examine the relation between accruals and cash flows, it is important to recognize
different types of cash flows. Operating cash flows refers to cash from a company‟s
ongoing operating activities. Free cash flow reflects the added effects of investments
and disinvestments in operating assets. Bottom line cash flow is net cash flow, which
also is the change in the cash account balance. Strictly defined, accruals are the sum
of accounting adjustments that make net income different from net cash flow. What is
included in accruals depends on the definition of cash flow. The most common
meaning of accruals is accounting adjustments that convert operating cash flow to net
income. This can be interpreted as following:

Net income = Operating cash flow + Accruals

Under this definition, accruals are of two types: short-term accruals, which are related
to working capital items, and long-term accruals, such as depreciation and
amortization.

Short- and long-term accruals

Short- term accruals refer to short-term timing differences between income and cash
flow. The working capital items in the balance sheet are generated by these accruals
and are also called working capital accruals. Short-term accruals arise primarily from
inventories and credit transactions that give rise to all types of receivables and
payables such as trade debtors and creditors, prepaid expenses, and advances
received. Long-term accruals arise from capitalization. Asset capitalization is the
process of deferring costs incurred in the current period whose benefits are expected
in future periods. Long-term assets are generated by this process such as plant,
machinery and goodwill. Accounting for long-term accruals is more complex and
subjective than that for short-term accruals. Cash flow implications of short-term
accruals are direct and readily determinable.

Earnings management

Earnings management can be defined as the “purposeful intervention by management

in the earnings determination process, usually to satisfy selfish objectives” (Schipper,
1989). The window dressing financial statements are often included in it. Earnings
management can be cosmetic, where managers manipulate accruals without any cash
flow consequences. It also can be real, where managers take actions with cash flow
consequences for purpose of managing earnings. Cosmetic earnings management is a
potential outcome of the latitude in applying accrual accounting. Though accounting
standards and monitoring mechanism reduce this latitude, it is impossible to eliminate
it completely due to the complexity and variation in business activities. Nevertheless,
accrual accounting requires estimates and judgments. This yields some managerial
discretion in determining accounting numbers. Managers can use this to widow-dress
financial statements and manage earnings.
Motivations for earnings management

These are the reasons for managing earnings. Increasing manager compensation tied
to reported earnings, increasing stock price, and lobbying for government subsidies
can be mentioned as the motivations for earnings management. Stock price effect is a
main reason for earnings management. Managers may increase earnings to
temporarily boost company stock price for events such as a forthcoming merger or
security offering, or plans to sell stock or exercise options. This is the underlying
problematic area for my research; manage earnings in Initial Public Offering to show
a better picture about the company by the managers.

1.3 Research Problem

Evaluate the extent to which managed accruals have an influence on the long-run
performance of IPO firms is the key objective of this research.

In order to accomplish the said objective, I am using current discretionary accruals

and earnings management as the independent variable and the dependent variable
respectively. I will use formulas and statistical techniques to compute discretionary
current accruals and measure earnings management. The control variables in my
research will be the net income, cash flows from operating activities, book-to-market
ratio and the EPS of IPO firms. I will be able to experiment the impact of earnings
management on the long-run performance by using statistical tests. At the end, it is
expected to get a conclusion whether the IPO managers manage earnings in their
financial information in order to depict a sound picture of the firm.

1.4 Objective of the Research

Generally a company is planning Initial Public Offering event before 2 to 3 years back
as it requires a lot of planning. If one is trying to do it suddenly in hurry, it might lead
to various issues including dilute the value of the ownership of existing shareholders.
While adhering to the relevant regulations, the companies perform various activities
before issuing shares to the public. Studies of short run and long run behavior of
returns on IPOs reveal that IPOs are underpriced in the short run, whereas
underperformance in the long run. IPO firms can enhance their earnings by adopting
discretionary accounting accrual adjustments that raise reported earnings. Over time,
investors may recognize that the firms‟ earnings are not maintaining momentum, and
hence, investors may lose their optimism, resulting in poor long run performance.
Teoh et al., (1998) revealed that the offering firms report significant improvements in
their operating performance in the pre-offer period, which are not due to their cash
flow performance. They have also recorded that an aggressive earnings management
pre-offer leads to worse operating and return performance post-offer. Most of the
prior studies on earnings management have focused on why firms manage earnings.

Researchers found it difficult and challenging to detect or measure earnings

management. It is not possible to observe earnings management directly. Therefore,
researchers have investigated two mechanisms for earnings management, the choice
of accounting methods and the management of accruals. In this research I have chosen
discretionary accrual model by Jones (1991) to test the earnings management. Jones
(1991), Dechow, Sloan and Sweeney (1995), Rangan (1998), Teoh et al. (1998a) and
Teoh et al. (1998b) used discretionary accruals as a measure of earnings management.
The rationale behind excluding non-discretionary accruals is that non-discretionary
accruals are used to reflect business condition; subject to firms condition and sales
growth and thus it cannot be controlled by managers. The most popular discretionary
model is the standard Jones (1991) model. This model is able to decompose accruals
into discretionary and non-discretionary accruals. When changes in sales are adjusted
for the change in receivables, standard Jones model becomes a modified Jones model,
which is proposed by Dechow et al. (1995).

Several studies have found that IPOs underperform after the issue. Those findings
reveal that though the managers manage the earnings with regard to the IPO; the same
earnings could not be continued for the proceeding periods. My study for identifying
earnings management of IPO firms listed in the Colombo Stock market will help
policy makers in formulating appropriate policies to tackle misreporting of earnings
and will confirm whether IPOs getting underperformance in the long-run.

1.5 Limitations
The study depends on available data and information in company‟s annual reports.
Colombo Stock Exchange is relatively small capital market with compared to other
stock exchanges in the world. Hence the data source used in the research is too small.

1.6 Contribution
This research and its findings will contribute to investors, investment and financial
statement analysts, policy makers and researchers who are keen on the area of
earnings management and long-run performance of IPOs. Investors who invest in
IPOs may get the benefit of knowing the actual scenario of information presented in
the IPO prospectus. Policy makers will identify the loopholes in rules, regulations and
the standards. Financial analysts can deploy far better methods to evaluate earnings
management which they have not implemented yet. Finally, the researchers keen on
this area shall come up with new approach to study the earnings management and
IPOs.

1.7 Chapter Organization

Chapter 01: This chapter is to give understanding about the study. It includes the
need, important, research problem, objectives and limitations of this study

Chapter 02: This chapter is to a review of theoretical and empirical literature on

previous findings of earnings management of IPO firms.
Chapter 03: This chapter is describes the relevant background information of the
methodology. It describes the population, sample, data collection methods, data
analysis methods and conceptual framework.

Chapter 04: This chapter describes the collection of data, data analysis and also
presents the findings. Discuss the findings with available literature, both globally and
locally, and discuss possible managerial implications and solutions that are relevant
and related to the research problem and context.

Chapter 05: This chapter summarized the major findings, conclusions, limitations
and further research of the study.
 Chapter 02- Literature review

2.1 Chapter Introduction

This chapter is committed to a review of the theoretical and empirical literature on
earnings management and the long-run performance of IPO firms.

2.2 Theoretical Framework

Earnings Management
A considerable amount of literature review has been contributed in the area of
earnings management. Potential earnings management has become a concern
throughout the world. Earnings management occurs when managers use judgment in
financial reporting and in structuring transactions to alter financial reports. The
objective is to either mislead some stakeholders about the underlying economic
performance of the company or to influence contractual outcomes that depend on
reported accounting numbers (Healy and Wahlen, 1999). Many studies have
examined management‟s choice of accounting methods, while other research has
studied accrual management. Managers may choose among various accounting
policies that affect reported income differently as stipulated under Generally Accepted
Accounting Principles (GAAP). Neill, Pourciau and Schaefer (1995) report that,
proceeds from the initial offering of IPO using income-increasing, for example
borrowing aggressively from future earnings, are relatively higher than those using
income-decreasing (conservative) methods when analyzing accounting method
choice. Thus, there is incentive for issuing firms to manage earnings to raise enough
capital when the investors foresee the share price to increase. In addition, managers
personally can earn abnormal profits when they sell their shares. Managers attempt to
manipulate earnings in order to influence short-term stock price performance.

Most past researches were carried out in the field and some of them are described in
the following sections According to Cormier and Magnan (1996), research supports
the economic and financial theory assumption that managers make accounting choices
to maximize their personal interests and well-being. An accounting choice that is
economically beneficial for managers will be preferred to manage earnings because
they generally do not require disclosure and often will not be questioned by an
auditor. Schipper (1989) defines earnings management as „a purposeful intervention
in the external financial reporting process with the intention of obtaining some private
gains‟. As DuCharme et al. (2000) point out, pure earnings management techniques
available to managers tend to fall within three broad categories: choice of accounting
methods, revision of estimates and acceleration of deferral of revenues and expenses.
At any point of time, some of the firm‟s future revenues and costs are genuinely
uncertain and while no set of hard and fast rules can help to solve it and inevitably,
there are instances where firm exercise judgment and thus opens room for firms to
manage earnings. It is not surprising that managers, in their judgment, believe that
they are acting in the firm‟s best interest. In particular, without violating accounting
rules, firms can accelerate the recognition of revenues and defer the recognition of
certain expenses under business environment.

Long-run performance of IPOs

Ritter (1991) first documented the long-run underperformance of initial public

offerings. He found that IPO firms underperformed non-issuing firms, matched by
size and industry, by an average of 27 percent over the three years following the issue.
Loughran and Ritter (1995) found similar underperformance for both IPO and SEO
firms. This underperformance following IPOs and SEOs has become known as the
new issues in the study area. Rangan (1998), Teoh, Welch, and Wong (1998a and
1998b), and Teoh, Wong, and Rao (1998) suggest that some firms may manage
earnings upwards to induce mispricing. The incentive for doing so is clear. Higher
earnings produce higher stock prices, and higher stock prices produce greater
proceeds from the stock issue with less dilution of earnings and control. Poor
subsequent performance for IPOs was found by Stoll and Curley (1970), Stern and
Borstein (1985), Ritter (1991), and Lough-ran and Ritter (1995). Jbbotson (1975)
reports statistically insignificant negative performance in the second through fourth
post-issue years and positive performance in the first and fifth years. In contrast,
Buser and Chan (1987) report positive performance in the first two post-issue years;
Ritter (1991) discusses possible reasons for the differences in the findings. Jain and
Kini (1994), Mikkelson, Partch, and Shah (1997), and Teoh, Wong, and Rao (1998)
examine the accounting performance of issuers in detail.
Discretionary accruals

To test this hypothesis for IPO firms, Teoh, Welch and Wong (1998a) divide their
IPO sample into quartiles based on discretionary accruals (their proxy for earnings
management) and examine the abnormal returns across the quartiles. Consistent with
this hypothesis, they find firms in the lowest quartile (those with the lowest levels of
earnings management as proxy by discretionary accruals) significantly outperform
those firms in the highest quartile (high earnings management firms) by about 20
percent over the three years following the issue. Supporting this finding, Teoh, Wong,
and Rao (1998) find that IPO firms also have poor earnings performance following
their IPOs and that the poor earnings performance is explained by discretionary
accruals. In addition, they too find that the abnormal stock returns of low earnings
management firms are significantly higher than those of high earnings management
firms. Thus, each of these studies finds evidence supporting the earnings management
hypothesis.

According to the research by Robert M. Bowen, David Burgstahler, and Lane A.

Daley, ”Content of Accrual Verses Cash Flows”, Current financial reporting practices
have traditionally emphasized measures of accrual earnings. On the other hand, the
link between future cash flows and firm value is well accepted by financial
economists, and recently there has been increased interest in measures of cash flow.
Patell and Kaplan [1977] examine the incremental information content of cash flow
data using percentage changes in working capital from operations as a measure of
unexpected cash flow. Patell and Kaplan define abnormal returns using the market
model, and then apply a procedure for testing incremental information content similar
to that used by Gonedes [1975, 1978].

This research contributes to this literature in several respects. Here, it follows the
research by Teoh, Welch, and Wong (1998) conducted on earnings management and
the long-run underperformance in IPO firms. Basically, It extends on two areas, first
is to analyze earnings management by the IPO firms using accrual accounting and
second is to evaluate long-run underperformance of those firms. It has conducted
conduct regression analysis in line with current accruals and change in sales to
measure the proxy of earnings management, the current accruals.
2.3 Chapter summery
In summary, the literature review points out to the fact that IPO firms manage the
earnings using discretionary accruals supportive to show a good picture through their
financial reports. An arrangement of theories and empirical research presented in the
literature review point out that there is a consensus amongst the academia that there is
no single universal explanation that can shed light on the accruals and the earnings
management. Among all literatures most of them identified that there is a probability
in managing earnings for IPO firms. Previous researchers concentrated on the
determinants of managing earnings.
 Chapter 03- Methodology

Analysis of earnings management often focuses on management‟s use of discretionary

accruals. Such research requires a model that estimates the discretionary component
of reported income. There are more sophisticated models that attempt to separate total
accruals into discretionary and nondiscretionary components. There is, however, no
systematic evidence bearing on the relative performance of these alternative models at
detecting earnings.

3.1 Sample selection

This study will examine IPO firms, which were listed on the CSE for the years 2010
and 2009. The details of new listings were obtained from the data library on the
Colombo stock exchange (CSE) web site. A sample of 2 IPO companies listed at CSE
during the year 2010 and 2009 has been selected for my study. All the data used in
this study was secondary data gathered from prospectuses, CSE Data sources, CSE
website, and annual Report of listed companies. The population of this study includes
all listed companies in CSE. IPO issuers in power and energy sector have been
evaluated in accordance with earnings management and long-run performance.

Table 1 Listed companies in Power and Energy sector

1.VALLIBEL POWER ERATHNA PLC

2.0PANASIAN POWER PLC
3.VIDULLANKA PLC
4.LANKA IOC PLC
5.F L C HYDRO POWER PLC
6.MACKWOODS ENERGY PLC

3.2 Measures of earnings management

Reported earnings in a firm consist with operation cash flows and adjustments to
those cash flows. According to Jones (1991), earnings management can be achieved
by various means such as the use of accruals, changes in accounting methods, and
changes in capital structure. This research is based on current accruals as the source of
earnings management. More specifically, discretionary accruals are used as a measure
of managers‟ earnings manipulations when firms are going for an initial public
offering. The discretionary current accruals are used to capture earnings management
rather long-term accruals because managers have more discretion over short-term than
over long-term accruals (Guenther (1994)). Short-term assets and liabilities that
contribute the day-to-day operations of the firm are considered in current accrual
adjustments.

Teoh, Welch and, Wong (1998) say firms are not willing to publicize accrual
adjustments that reflect their desire for a higher short-term share price rather than the
economic realities of the mismatch between actual accounting events and the timing
of inflows and outflows. This is going to be an issue for investors to know how much
of the accruals are discretionary. Some accrual adjustments are appropriate and
necessary due to the business conditions typically faced by the firm in the industry.
Therefore this study needs a model to decompose accruals into two components.
Those two components are, one that is controlled by firm and industry conditions and
one that is presumed to be managed by the managers.

3.3Measuring Discretionary Accruals

The usual starting point for the measurement of discretionary accruals is total
accruals. A particular model is then assumed for the process generating the
nondiscretionary component of total accruals, enabling total accruals to be
decomposed into a discretionary and a nondiscretionary component. Most of the
models require at least one parameter to be estimated, and this is typically
implemented.

I considered a modified version of the Jones Model in the empirical analysis. The
modification was designed to eliminate the conjectured tendency of the Jones Model
to measure discretionary accruals with error when discretion is exercised over
revenues. In the modified model, nondiscretionary accruals are estimated during the
event period. Current accruals are regressed on the change in sales in a cross-sectional
regression using selected non-IPO firms operate in the same industry sector as the
issuer. Here, I calculate the cross-sectional regression for each financial year and all
variables are scaled by firm lagged assets (year t-1).
3.4 The long-run underperformance of the IPO firms
The post-performance of the IPO firms will be evaluated and compared with industry
peers that operate in the same sector. I have selected all the industry peers in power
and energy sector and deployed test specifications for both the IPOs and non IPOs.
Here, the non IPOs support to identify any abnormal performance of the IPO firms.
The performance indicators such as net income, cash flows from operating activities
and EPS cater the testing methods in order to derive an implication about IPO firms‟
performance. In my research, I have used simple statistical techniques including the
measures of central tendency and variation to test the hypothesis due to the limitations
in available information. In order to investigate a relationship between earnings
management and its impact on the performance of the IPO firms, net income and cash
flows from operating will be regressed on the discretionary accruals.

3.5 Conceptual framework

The study investigated how current accruals effect on managing earnings of IPO
firms.
Figure 1 Conceptual Framework

Control Variables

Net income

Cash flows from operating

activities

Earnings per share

Independent Variable
Dependent Variable
Current Accruals
Earnings Management
3.6 Variables
Study has used one dependent variable and one independent variable.

3.6.1 Independent Variables

Discretionary current accrual is the independent variable in this study.

3.6.2 Dependent Variables

Earnings of IPOs is the dependent variable of this study.

3.7 Analysis Techniques

This study conducted the analysis by using multiple regression analysis. The analysis
used to identify the extent to which the independent variables are significantly
influenced on the depended variables of the model.

3.8 Models of the study

This study used a modified version of the Jones Model to derive accruals. The
modified version of the Jones Model implicitly assumes that all changes in credit
sales in the event period result from earnings management. This is based on the
reasoning that it is easier to manage earnings by exercising discretion over the
recognition of revenue on credit sales than it is to manage earnings by exercising
discretion over the recognition of revenue on cash sales. If this modification is
successful, then the estimate of earnings management should no longer be biased
toward zero in samples where earnings management has taken place through the
management of revenues.

The fitted current accruals of the issuer are calculated using the estimated coefficients
from the regression and change in sales net of the change in trade receivables. The
change in trade receivables is deducted from the change in sales to allow for the
possibility of sales manipulation. The fitted current accruals are the nondiscretionary
accruals which are presumed to be the level necessary to contribute the firm‟s sales
increase. The regression residual is known as discretionary accruals. This is presumed
not dictated by firms and industry conditions and therefore considers they are
managed by the managers.
3.8.1 The Discretionary accruals can be modeled as following

Current = (current assets - cash) - (current liabilities- current maturity of

Accruals long-term debts)

The expected current accruals of an IPO firm I in year t

( ) ( )
Where,
j
estimation sample
 Sales is the change in sales
TA is total assets

Non-discretionary current accruals

̂ ( ) ̂
Where
̂
̂

Discretionary current accruals

 Chapter 04- Data Presentation and Analysis
4.1 Introduction
This research used secondary data from the published annual reports of manufacturing
and services companies listed in Colombo stock exchange (CSE). Due to the
unavailability of IPOs a sample of 2 listed companies from the Power and Energy
sector have been selected. Data was collected over five year period from 2009 to
2013. This chapter describes descriptive statistics for dependents and independents
variables such as mean, average and core relation. Regression analysis used to find
the non-discretionary for the companies. Finally it includes summery of this chapter.

4.2 Measuring Earnings Management

Discretionary Accruals

This research is based on current accruals as the source of earnings management.

More specifically, discretionary accruals are used as a measure of managers‟ earnings
manipulations when firms are going for an initial public offering. Thus I have used
the cross-sectional Jones (1991) model for this purpose. Current accruals are
regressed on the change in sales in a cross-sectional regression using selected non-
IPO firms operate in the same industry sector as the issuer. Here, I calculate the cross-
sectional regression for each financial year and all variables are scaled by firm lagged
assets (year t-1). The fitted current accruals of the issuer are calculated using the
estimated coefficients from the regression and change in sales net of the change in
trade receivables. The change in trade receivables is deducted from the change in
sales to allow for the possibility of sales manipulation. The fitted current accruals are
the nondiscretionary accruals which are presumed to be the level necessary to
contribute the firm‟s sales increase. The regression residual is known as discretionary
accruals. This is presumed not dictated by firms and industry conditions and therefore
considers they are managed by the managers. (See Appendix 1,2 & 3)

The following tables show the Discretionary accruals for Hemas PLC and Laugfs gas
PLC respectively (see Appendix 4 & 5)
Table 2 Hemas Power PLC- Discretionary accruals
Current Accruals Non- Discretionary
discretionary accruals
accruals
2009 0.309232148
2010 0.159930894 0.147786458 0.01
2011 -0.434252366 0.051175156 (0.49)
2012 0.185739605 0.058720541 0.13
2013 -0.176948146 0.183681127 (0.36)

Table 3 Laugfs Gas PLC- Discretionary accruals

Current Accruals Non- Discretionary
discretionary accruals
accruals
2009 -
2010 -0.125242996 0.027101194 (0.15)
2011 0.220684797 0.01982606 0.20
2012 -0.08416055 0.063564986 (0.15)
2013 0.095609201 -0.005058595 0.10

Discretionary Accruals- Hemas

Discretionay Accruals- Laugfs
0.20 0.25
0.10 0.20
- 0.15
2010
2011
2012
2013

0.10
D. Accruals

D. accruals

(0.10)
0.05
(0.20) discretiona discretiona
-
(0.30) y accruals y accruals
2010
2011
2012
2013

(0.05)
(0.40) (0.10)
(0.50) (0.15)
(0.60) (0.20)
Year Year

Figure 2 Discretionary accruals- Hemas Figure 3 Discretionary accruals-

Laugfs
As per the above charts, there can be seen a highly volatile in the discretionary
accruals for the both two companies. The Hemas PLC had gone for a IPO in the year
2009 and it shows slightly downward trend in its discretionary accruals in 2010. In
contrast to 2010, discretionary accruals for the year 2011 have sharply increased until
it reports decrease in year 2013. Laugfs gas PLC which had launched its IPO in the
year 2010 also shows incredible up and downs in its discretionary accruals for the
period of 2010 to 2013. Immediate after the issue of IPO, the laugfs gas PLC has
increased its discretionary accruals in high degree. Though Hemas PLC does not
show manipulating the earnings immediately after IPO using Discretionary accruals,
the Laugfs gas PLC depicts the attempt in manipulation of earnings. Both graphs
showing movements of Discretionary accruals are not smooth lines. It seems that the
level of accruals has been deliberately discrete by the management.

4.3 Long-run performance of the IPO firms

The post-performance of the IPO firms will be evaluated and compared with industry
peers that operate in the same sector. I have selected all companies operate in energy
and the power sector for evaluate the performance of IPO firms. Here, the non IPOs
will support to identify any abnormal performance of the IPO firms. The performance
indicators such as net income, cash flows from operating activities and EPS catered
the testing methods in order to derive an implication about IPO firms‟ performance.
The EPS of the companies are analyzed at first. (See Appendix 6)

EPS
6

4 Hemas
2 Laugh

0 Industry Average
2008 2009 2010 2011 2012 2013
-2

Figure 4 Earnings per Share

As illustrated in the above figure, the EPS of two companies indicates an increase in
IPO years and a decrease in post IPO years. Both companies achieved their peak in
year 2011. After 2011, Hemas PLC records sharp decrease and Laugfs depicts a
gradual decrease in EPS when the industry average shows smooth upward direction in
its EPS. Both EPS lines of two IPO companies go above the industry average line and
it‟s an indication of unusual behavior of earnings of IPO firms. As per the information
(see Appendix 7) change in EPS as a percentage of previous year EPS, the Hemas
shows a growth and accounted to 277.4% in 2011 in comparison to 56.96 achieved in
2010. The Laugfs shows a growth of40.03 in 2011 in comparison to 115.29%
recorded in 2010. Nevertheless the both firms experienced a reduction of EPS after
2011 and they have figures of -91% and -42% in 2012 respectively.

Net profit
1,400,000,000.00
1,200,000,000.00
1,000,000,000.00
800,000,000.00
Profit in Rs

600,000,000.00 Hemas
400,000,000.00 Laugfs
200,000,000.00 Industry
-
2009
2008

2010

2011

2012

(200,000,000.00) 2013
(400,000,000.00)
Year

Figure 5 Net Profit

Net profit
1,400,000,000.00
1,200,000,000.00
1,000,000,000.00
800,000,000.00
Profit in Rs

600,000,000.00 Hemas
400,000,000.00 Laugh
200,000,000.00 Industry Average
-
2008

2009

2010

2011

2012

2013

(200,000,000.00)
(400,000,000.00)
Year

Figure 6 Net profit

Net profit of a company is an indication of its performance whether the company
doing well its business or not. Laugfs gas PLC has recorded a substantial increase in
its net profit during the period 2009-9011. After 2011 it shows a slight down ward its
net profit. Hemas power PLC also depicts an upward movement in its profits during
that period. But after 2011, the profit starts to decrease. The line chart in above shows
a steep negative slope in its net profit line for the year 2011-2012. The important
factor that should be considered in there is that both IPO companies depict a decrease
in there profit while the industry average going upward direction. In according to that
analysis it strives that IPO firms try to give a sound picture of operations through their
financial statements. (See Appendix 7)

Regress net income on the discretionary accruals

In this research, net income of the IPO companies has been regressed on the
discretionary accruals in order to observe the relationship between those two
variables. Net income was taken as the dependent variable and meanwhile
discretionary accruals taken as the independent variable.

Table 4 Hemas Power PLC

Regression Statistics Coefficients

Multiple R 0.608 Intercept 110324401.3

Discretionary
R Square 0.37 accruals -543696628
Adjusted R
Square 0.055
Standard Error 254230086.9
Observations 4

Table 5 Laugfs Gas PLC

Regression Statistics Coefficients

76210350
Multiple R 0.504 Intercept 9.9
Discretionary 86750656
R Square 0.254 accruals 3.4
Adjusted R Square -0.119
Standard Error 324836800.5
Observations 4
In this simple linear regression in Table 6 , the coefficient -543696628 of Hemas
Power for Discretionary accruals gives the size of the effect that variable is having on
net income, and it has a negative relationship as per the result. The net income is
expected to decrease by Rs 543,696,628 when discretionary accruals increase by one.
That information depicts the performance of post IPO companies. That negative
relationship of variables shows gradual reduction of net income after the IPO
comparison to the high records of profits as at the IPO and soon after the IPO.
According to the Table 7 , Laugfs Gas indicates increase of Rs 867506563.4 in net
income when discretionary accruals increase by 1. Both two results of the companies attribute
to the IPOs in two ways. That impact signals the future researchers on this regard to consider
the other factors that effect on earnings management.

The R-squared of two regressions that accounted for 0.37 and 0.254 for Hemas and
Laugfs respectively are the fraction of the variation in net income that is predicted by
discretionary accruals. Both R-squared below 0.5 indicate a less significance level.
That was due to the less information available on the IPO.

Regress net cash flows from operations on Discretionary accruals

In this research, net cash flows from operations for the IPO companies have been
regressed on the discretionary accruals in order to observe the relationship between
those two variables. Net cash flows from operations were taken as the dependent
variable and meanwhile discretionary accruals taken as the independent variable.

Table 8 Hemas Power PLC

Regression Statistics Coefficients

Multiple R 0.214 Intercept 162492674.8

Discretionary -
R Square 0.46 accruals 178531282.7
Adjusted R Square -0.43
Standard Error 290789708.9
Observations 4
Table 9 Laugfs gas PLC

Regression Statistics Coefficients

Multiple R 0.547 Intercept 692660929.9

Discretionary
R Square 0.3 accruals -1973117451
Adjusted R Square -0.0498
Standard Error 658518031
Observations 4

A negative relationship between net cash flows from operations and discretionary
accruals accounted for -178531282.7 and -1973117451 for Hemas and Laugfs
respectively is represented by above tables. Both results infer the importance of
managing cash flows to show a sound result of operations of the companies have been
gradually reducing after the IPO. Nevertheless it indicates the companies used to
manipulate the earnings as at IPO and soon after the IPO. The same problem has been
occurred in there also, the R-squared is less than 0.5 for both companies. That is an
issue that has to be taken into account by issue the future researchers.
 Chapter 05-Conclustion
5.1 Chapter Introduction
In this chapter, it is expecting to discuss about research findings in relation to research
objectives, problems and the previous empirical studies and as well as to focus on the
major conclusions. And also it includes suggestions for future researches.

5.2 Summary of research

This study examined the extent to which managed accruals have an influence on the
long-run performance of IPO firms in the power and energy sector. Data was
collected for five year period from 2009-2013. The analysis is performed by using
modified version of the Jones Model. Dependent variable used in this study is
earnings management. The independent variable is current accruals meanwhile the
dependent variable is earnings.

5.3 Conclusions
The main objective of this research was, to identify to what extent the discretionary
accruals affects the earnings management of IPO companies in Sri Lanka stock
market. The conclusions have drawn in line with outcome of Jone‟s model. Patricia
M. et al. (1995) strives it is important to consider the relation between the context in
which earnings management is hypothesized and the model of nondiscretionary
accruals that is employed, because the model of nondiscretionary accruals may
unintentionally extract the discretionary component of accruals. For example, if the
Jones Model is used in a research context where discretion is exercised over revenues,
then it is likely to extract the discretionary component of total accruals. Similarly, if
the Industry Model is used in a research context where intra-industry correlation in
discretionary accruals is expected, then it is likely to extract the discretionary
component of total accruals. These findings have implications for investors, firms,
and accounting standard setters. Investors may want to use information contained in
the pre-offering accounting accruals to discriminate among issuers. Entrepreneurs
may want to consider how legitimate accounting choices can lower the firm's cost of
equity capital or increase their own welfare. Finally, accounting standard setters may
find these results useful for evaluating how much discretion they should allow
corporate managers to adjust reported earnings.
Discretionary accruals and the Earnings Management
Teoh, Wong, and Rao (1998) find that IPO firms also have poor earnings performance
following their IPOs and that the poor earnings performance is explained by
discretionary accruals. In addition, they have already found that the abnormal stock
returns of low earnings management firms are significantly higher than those of high
earnings management firms. Rao (1993) reports that there is almost no news media
coverage of firms in the years before the IPO. This scarcity of information about the
issuer forces investors to rely heavily on the prospectus, which itself may contain only
one to three years of financial statements. This was the factor that made difficult to
collect data on IPOs.

5.4 Suggestions for future research

The Jone‟s model used in calculating discretionary accruals of power and energy
sector in this research was initially applied for United States‟ companies and might
not 100% applicable for Sri Lanka as a South Asian country. Therefore future
researchers can conduct research using adjusting other factors in order to increase the
relenace of the model with Sri Lankan companies. And also future research can
investigate generalization of the findings beyond the Sri Lanka and United States.
Since the Jone‟s model was conducted in United State and this study focus Sri Lanka.
In this chapter discussed the existing empirical finding, major conclusions
and suggestions for the future research.
 Table of Contents
Certificate of Declaration
Acknowledgement
Abstract
Chapter 01-Introduction ..................................................................................................... 1
1.1 Earnings management and accrual accounting ............................................................. 1
1.2 Need and important of the study................................................................................... 2
1.3 Research Problem ......................................................................................................... 5
1.4 Objective of the Research ............................................................................................. 5
1.5 Limitations .................................................................................................................... 6
1.6 Contribution .................................................................................................................. 6
1.7 Chapter Organization .................................................................................................... 7
Chapter 02- Literature review............................................................................................. 8
2.1 Chapter Introduction ..................................................................................................... 8
2.2 Theoretical Framework................................................................................................. 8
2.3 Chapter summery........................................................................................................ 11
Chapter 03- Methodology ................................................................................................. 12
3.1 Sample selection ......................................................................................................... 12
3.2 Measures of earnings management........................................................................ 12
3.3Measuring Discretionary Accruals .............................................................................. 13
3.4 The long-run underperformance of the IPO firms ...................................................... 14
3.5 Conceptual framework ............................................................................................... 14
3.6.1 Independent Variables ............................................................................................. 15
3.6.2 Dependent Variables................................................................................................ 15
3.7 Analysis Techniques ................................................................................................... 15
3.8 Models of the study .................................................................................................... 15
3.8.1 The Discretionary accruals can be modeled as following ....................................... 16
Chapter 04- Data Presentation and Analysis .................................................................... 17
4.1 Introduction ................................................................................................................ 17
4.2 Measuring Earnings Management .............................................................................. 17
4.3 Long-run performance of the IPO firms ..................................................................... 19
 Chapter 05-Conclustion .................................................................................................... 24
5.1 Chapter Introduction ................................................................................................... 24
5.2 Summary of research .................................................................................................. 24
5.3 Conclusions ................................................................................................................ 24
5.4 Suggestions for future research .................................................................................. 25
Refferences

Appendices

List of Tables

Table 1 Listed companies in Power and Energy sector .......................................................... 12

Table 2 Hemas Power PLC- Discretionary accruals................................................................ 18
Table 3 Laugfs Gas PLC- Discretionary accruals.................................................................... 18
Table 4 Hemas Power PLC ...................................................................................................... 21
Table 5 Laugfs Gas PLC .......................................................................................................... 21
Table 8 Hemas Power PLC ...................................................................................................... 22
Table 9 Laugfs gas PLC ........................................................................................................... 23

List of figures
Figure 1 Conceptual Framework ............................................................................................. 14
Figure 2 Discretionary accruals- Hemas & Figure 3 Discretionary accruals- Laugfs ............. 18
Figure 4 Earnings per Share ..................................................................................................... 19
Figure 5 Net Profit .................................................................................................................. 20
Figure 6 Net profit ................................................................................................................... 20