Rights Issues and Earnings Management: New Evidence on Tunneling

Seasoned equity offerings (SEOs) can be of broadly two types – rights offerings and
follow-on or further public offerings (FPOs). In an FPO issue, new shares are almost always issued to new investors, while in a rights issue, new shares are issued primarily to the existing shareholders of a firm. Further, unlike an FPO, a rights offering can potentially transfer wealth from non-participating (minority) shareholders to participating shareholders (insiders) of the rights-issuing firm, and the extent of wealth transfer increases with the degree to which earnings are managed downward. Exploiting these notable differences between the two types of SEOs, we hypothesize and document income-decreasing accrual-based earnings management as well as real earnings management prior to the issue of rights offerings. Further, the incidence of accrual-based earnings management is limited to the period of weak corporate governance enforcement. Our results, which are in stark contrast to the conventional wisdom of income-inflating earnings management around SEOs, also provide evidence of another form of tunneling of wealth from minority shareholders to insiders.