IPOs that disclose ‘bad news’ go public at lower prices


As part of their professional responsibilities, external auditors must assess a cornerstone assumption of financial accounting: namely, whether there is substantial doubt that the company, whose financials they are examining, will continue to operate as a ‘going concern’ (GC). If they conclude that such doubt exists, they must disclose this in their audit opinion.

On the other hand, company management has historically had no such responsibility to disclose doubts about their status as a GC; as doing so would constitute voluntary disclosure of ‘bad news.’

Nevertheless, in a study of almost 1,000 IPOs from 2001 through 2013, UConn accounting professor Michael Willenborg and his colleagues found that such instances of voluntary GC disclosure by company management were as frequent as GC opinions by external auditors.

“I was surprised to discover that 6 percent of IPO prospectuses contained a management disclosure regarding doubts about GC status, when the auditor’s opinion did not,” said Willenborg. “This was a puzzle to me. Why would you voluntarily say something so negative when you’re trying to raise public equity for the first time?”

Accounting Professor Michael Willenborg
Accounting Professor Michael Willenborg

Willenborg and his co-authors, Khrystyna Bochkay and Roman Chychyla, of the University of Miami, and Srini Sankaraguruswamy, of the National University of Singapore, published their research study titled, “Management Disclosures of Going Concern Uncertainties: The Case of IPOs,” in the November 2018 issue of The Accounting Review.

Their study focused on the pricing effects associated with voluntary disclosures of GC uncertainties by IPO issuers. They found that IPOs with these disclosures went public at prices significantly lower than the issuer and underwriter had planned (i.e., just prior to conducting the IPO ‘road show’). “We found negative offer price revisions that were comparable to those for IPOs with GC opinions by the company’s auditor,” said Willenborg, who also holds the title of the Richard F. Kochanek Professor of Accounting.

Take, for example, Santarus, Inc., a pharmaceutical company that went public in 2004, which provided a Management, Discussion & Analysis disclosure that “having insufficient funds may require us to delay, scale back or eliminate some or all of our research or development programs or delay the launch of our product candidates. Failure to obtain adequate financing also may adversely affect our ability to operate as a going concern.” Santarus, which had a ‘clean’ audit opinion, initially planned for an IPO price of $12 per share, but ultimately went public at $9.

A more extreme example is, Stereotaxis, Inc., a medical equipment company that also went public in 2004, which provided a Risk Factors disclosure that “if physicians do not use our products, we likely will not become profitable or generate sufficient cash to survive as a going concern.” Stereotaxis, which also had a ‘clean’ audit opinion, went public at just $8 per share, not the $15 they had hoped for at the start of their road show.

Overall, Willenborg and colleagues’ paper resulted in two key inferences. First, because raising capital is the main reason why they choose to go public, companies that disclose GC uncertainties have incentives to negotiate with their underwriter for an initial valuation that, following the road show, proves to be too high.

Second, “our results also suggest that disclosure of unfavorable information, in the form of management revelations of GC uncertainties, is more likely when transaction risk is higher, and less likely when financial incentives encourage the withholding of bad news,” Willenborg said.

“Our results are robust to controlling for relevant factors in the IPO process and alternative empirical choices, including matching IPOs with and without management disclosures of GC uncertainties,” he said. “Our study provides evidence of the information content of IPO issuers’ voluntary disclosures of GC uncertainties, the presence of which is correlated with proxies for risk and agency motivations.”

“Our paper contributes to the literature on IPO price formation. While most prior studies interpret relations between disclosure and pricing through the lens of the information asymmetry component of the cost of capital, we view the inverse relation between GC disclosures and price revision as consistent with bargaining incentives,” he said.

“We also contribute to literature on managers’ incentives to withhold unfavorable news,” he continued. “Our findings suggest that voluntary disclosure of bad news, in the form of management disclosures of GC uncertainties, is more likely when a financial incentive to withhold negative news is absent and when transaction risk is high.”

Starting with year-end 2016 financial statements, the Financial Accounting Standards Board now requires company management to evaluate whether there is substantial doubt regarding the entity’s ability to continue as a going concern and, if so, to provide footnote disclosure of this uncertainty. Given this development, Willenborg and his colleagues are currently working on a follow-up study to examine this new regime.