The dramatic rise and fall of the Internet sector remains the subject of much controversy, speculation and debate.1 Influential economic observers have alleged, for example, that outdated and flawed accounting practices provided biased information contributing to inflated pricing that culminated in the crash of the high tech bubble of the late 1990s. The Chairman of President Clinton's Council of Economic Advisors and Nobel Laureate economist, Joseph Stiglitz, stated, ‘bad accounting provided bad information, and part of the irrational exuberance was based on this bad information’ (Stiglitz, 2003, p. 10). In a similar vein, prominent macroeconomist and Nobel prize winner Paul Krugman commented that poorly crafted accounting standards and compliant auditors aided in the excesses of the 1990s bull market (Krugman, 2004, p. 108). Other commentators suggest that the accounting principles are not to be blamed. Penman (2003), for example, argues that many of the accounting practices blamed for the debacle are reckless violations of sound principles of revenue recognition, expense matching and debt recognition, and are not the failure of the principles, per se. In light of these mixed but strongly held views, we examine whether the financial reporting system provided useful and reliable information for failure risk assessment in the context of an economically significant sector of the recent stock market ‘bubble,’ Internet IPOs.2
Accounting information has been shown to be valuable in many settings. Extant research contends that earnings, in particular, is the premier source of financial information, with investors and managers using earnings more than any other summary measure of performance (e.g., Liu, Nissim and Thomas, 2002; and Graham et al., 2005). Earnings also serve as key inputs for firm valuation (e.g., Biddle et al., 1995; and Francis et al., 2003). Corporate governance research provides evidence that accounting information is used for designing optimal contracts and for mitigating agency issues (see Bushman and Smith, 2001, for a review).
Most of this body of work examines the usefulness of accounting information in the context of established firms. Demers and Joos (2007) (hereafter DJ) extend this research to show that accounting fundamentals are also informative in assessing the failure risk of young firms (i.e., IPOs).3 The purpose of the current study is to investigate whether accounting information is relevant even during extreme bubble-like conditions.4 Our analysis is prompted by claims that the traditional financial reporting model, developed during the Industrial age, is not relevant for valuing innovative, intangibles laden companies (Lev and Zarowin, 1999), much less those in a revolutionary technology industry such as the Internet (Peel, 2001). Notably, such young start-up firms are subject to relatively little accounting discretion.5
Accordingly, our study is not an investigation of opportunistic accounting practices, earnings management, or discretionary accruals at the time of IPO. Rather, the goal of our paper is to extend prior research by examining whether fundamental accounting variables are informative in anchoring investors' valuation expectations even during the volatile developmental stage of a revolutionary technology industry.
The implications of our analysis are pertinent to investors and regulators who are concerned about extreme wealth erosions following the bursting of bubbles. In the two years following the Internet-driven crash of the NASDAQ Composite Index in March 2000, approximately $8.5 trillion dollars of shareholder wealth was lost (Stiglitz, 2003, p. 6). Moreover, the Internet ‘bust’ is generally considered to be the trigger for the much broader technology market recession that followed. Economic inefficiencies arising out of such tremendous resource misallocations and social welfare costs associated with such extreme shareholder wealth erosion pose a formidable challenge to academics, practitioners and regulators. The criticisms leveled at the accounting system in the wake of the Internet crash strike at the very heart of the accounting discipline because one of the fundamental roles of accounting information is to facilitate the efficient allocation of capital.
Our research design builds on the predominantly accounting-based IPO failure prediction methodology developed by DJ (2007). In developing their model, DJ specifically exclude the anomalous Internet IPOs from their sample; as a consequence, their results do not speak to our research question. In order to address our specific research question, we first analyze accounting indicators of Internet IPO firms that went public during the period 1992 through February 2000. We document that accounting fundamentals were very weak for the majority of Internet IPO firms despite the optimism expressed by investors about these companies. An example of this exuberance is the large first day returns to Internet IPOs, which averaged over 80%.6 Yet by standard accounting risk metrics, these Internet IPOs exhibited very weak fundamentals at their IPO dates: 88% of Internet companies reported negative earnings in the year prior to their IPO, 91% of these firms had accumulated deficits, and many Internet firms did not even have revenues at the time of their IPOs. Our evidence is consistent with Penman's (2003) conjecture that in general during this period, momentum investing displaced fundamental investing. In the end, over 24% of publicly-traded Internet companies ultimately failed within five years of their IPO.7 Probing further, we document that contrary to the criticisms leveled at ‘bad’ accounting data, numerous accounting indicators are significant in explaining ex post IPO failures. Moreover, the accounting indicators exhibit significant incremental explanatory power over competing non-accounting variables.
We also investigate the role of accounting information in the context of experiential learning. Specifically, we investigate whether investors could have used accounting fundamentals and the experiences of past IPOs of innovative companies to become more informed about the heightened failure risk of Internet companies. Our approach presumes that the past experiences of firms that utilize innovative ideas or technologies are relevant for predicting failure in the Internet sector. In testing this idea, we use two approaches to define and identify innovative firms,8 and we estimate the DJ model on each of the two resulting prediction samples. Using the failure parameter estimates derived from these fitted models to develop strictly out-of-sample failure forecasts, we find that a model using either definition of innovation successfully predicts Internet IPO failures. Furthermore, a hedge strategy of going long (short) in Internet IPOs with low (high) failure risk yields significant one-, two- and three-year post-IPO abnormal returns. These findings demonstrate the value of learning from the history of innovative firms' IPOs.
In sum, our analyses suggest that accounting systems did provide reliable information even during the extremely volatile developmental stage of the Internet sector. Our evidence confirms Penman's (2003) premise that the financial reporting system could serve as an anchor during speculative bubbles.
The rest of this paper is organized as follows. Section 2 provides historical background to the Internet and other revolutionary technology industry shakeouts. In Section 3, we define our samples of Internet and other innovative IPO firms, while Section 4 examines the association between IPO date accounting information and ex post realized Internet IPO firm failures. In Section 5, we present the results from our out-of-sample Internet IPO failure predictions and associated hedge returns. Section 6 provides concluding remarks.