The Effect of External Monitoring on Accrual†Based and Real Earnings Management: Evidence from Venture†Backed Initial Public Offerings

This paper investigates the effect of venture capitalist (VC) quality on earnings management in firms conducting initial public offerings of their equity stock, focusing on manipulation of both accruals and real activities. I develop a measure of VC quality based on a principal components factor analysis using data that are obtainable for virtually all VC firms. This metric is highly correlated with VC funds’ financial returns, and with the likelihood of successful exits through initial public offerings or trade sales. After going public, companies backed by higher quality VCs have lower abnormal accruals, lower earnings management through real activities manipulation, and a lower likelihood of financial restatement. Companies backed by top†quartile VCs do not appear to engage in real activities manipulation as a substitute for accruals manipulation. Companies backed by lower†tier VCs exhibit earnings management behaviors which are indistinguishable from those of non†VC†backed companies. The results continue to hold when controlling for endogeneity. Overall, the results suggest that higher quality VCs are better able to constrain opportunistic financial reporting by their portfolio companies going public.