The underwriter's conflict of interest and earnings forecast bias in prospectus: Evidence from Hong Kong

Abstract

About 40% of the firms that go public on the Hong Kong Stock Exchange voluntarily include earnings forecasts in their prospectuses. These forecasts are on average biased downwards by 8% compared to the realized earnings. We hypothesize that the underwriter, in order to increase IPO underpricing and obtain private benefits, pressure managers to low-ball earnings forecasts in the prospectuses. We examine the effect of underwriting commission rate, reputation, and IPO trading commissions on the earnings forecast bias in the prospectuses. We find that underwriting commission rate is negatively associated with the forecast bias. Using the 90-day post-IPO trading volume as a proxy for future trading commissions and profits generated from institutional investors and aftermarket trading activities in general, we document that trading commissions are positively associated with the forecast bias. Further analysis shows that underpricing is positively associated with the forecast bias, but the effect of the forecast bias on underpricing disappears after controlling for the underwriter's trading commission. Overall, these results are consistent with predictions based on the agency theories of underwriter by Baron (1982) and Loughran and Ritter (2002).