earnings management in acquired companies

310 Pages·2015·2.13 MB·English

EARNINGS MANAGEMENT IN
ACQUIRED COMPANIES
by
CAMELIA VASILESCU
Submittedinaccordancewiththe requirementsfor the degree of
Doctor of Philosophy
The University ofLeeds
LeedsUniversity BusinessSchool
Accounting andFinanceDivision
Centre forAdvancedStudiesinFinance
November, 2014
Intellectual Property Statement
The candidate confirmsthatthe work submittedisherownandthatappropriate
credithasbeengivenwhere reference hasbeenmade tothe work ofothers.
This copy has been supplied on the understanding that it is copyright material
and that no quotation from the thesis may be published without paper
acknowledgement.
©2014 The University ofLeedsandCamelia Vasilescu
i
Dedication
To my beloved mother, Maria, and partner, Tim, many thanks for your love, support and
encouragementthroughoutmydoctoral studiesin Leeds.
ii
Acknowledgements
Acknowledgements
All the glory and praise to my Lord, Jesus Christ and Virgin Mary for giving me
discipline, strength, wisdomandknowledge tocomplete thisresearchproject.
I would like to thank my primary supervisor, Professor Kevin Keasey, for his
guidance, support, encouragement and for being a great source of inspiration
throughoutmy doctoral studiesinLeeds. Hisresearchexperience andvaluable feedback
contributed significantly to the completion and the quality of my work. I am also
grateful to my second supervisor, Dr. Iain Clacher, for his help and support.
Furthermore, I am truly thankful to the Centre for Advanced Studies in Finance
(CASIF)fortheirfinancial support.
Special thanks to all my colleagues both at the Centre for Advanced Studies in
Finance (CASIF) and within the Accounting and Finance division at Leeds University
Business School for their valuable support, encouragement and challenging discussions
over the last few years. I am also grateful to the two referees of the British Accounting
Review fortheirpositive feedbackandsuggestions onChapter5 thatI submittedtothis
journal for publication. I would further like to thank all the participants at the British
Accounting and Finance Association conferences (2013 and 2014), and the European
Accounting Association conference (2014), for their valuable feedback and constructive
commentsonthe firsttwoempirical chapterswhichIpresentedatthese conferences.
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Acknowledgements
Finally, I would like to express my eternal love and gratitude to my beloved
mother, Maria, and partner, Tim, my father, sister and other relatives, who have
constantly prayed for, encouraged and supported me during my doctoral studies in
Leeds.
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Abstract
Abstract
Mergers and acquisitions (M&A) are very important corporate events for both
acquirers and targets, and the quality of public accounting information has a significant
role in mergers and acquisitions decisions. Acting on the shareholders’ behalf or
pursuing their self-interests, targets’ managers have strong incentives to manipulate
reported earnings prior to a deal in order to boost the stock price and generate higher
gains for shareholders and themselves. Consistent with this view, researchers have
dedicated much effort to examining whether acquirers and targets undertake earnings
manipulationaroundtakeovers.
The objective of this thesis is to examine whether UK publicly listed targets
engage in accruals and real-activity earnings management prior to M&A, and the
consequences this has on targets’ shareholder wealth, in particular deal premium and
stock return. Earnings management can occur through two main channels: accruals
earnings management and real-activity earnings management. These two main earnings
management tactics differ in their opacity, cost and the effect they cause to stock price
performance prior to M&A (Roychowdhury et al., 2012). Most of the previous studies
on this subject have focused exclusively onaccruals earnings management, however, the
evidence shows that opportunistic accruals earnings management is not a common
practice among targets in M&A. More recent research on earnings management
provides evidence that firms use multiple earnings manipulation strategies based on
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Abstract
accruals and real-activities (e.g., Graham et al., 2005; Roychowdhury, 2006; Cohen and
Zarowin, 2010; Zang, 2011), and managers prefer real-activities manipulation over
accruals earnings manipulation as a way to increase reported earnings (Graham et al.,
2005).
The first empirical study of this thesis examines whether UK publicly listed
targets attempt to manipulate earnings via accruals prior to a deal, and further,
investigates the relationship between the deal premium and the targets’ earnings
management behaviour. The results of the accruals tests under the cross-sectional
modified-Jones model and performance-matched model, and using either the balance-
sheet approach or the cash-flow approach, indicate that, on average, targets do not
manage earnings upward prior to mergers and acquisitions. Furthermore, the analysis of
the relationship between earnings management and deal premium provides evidence
that the deal premium and the targets’ abnormal accruals are negatively related, which is
consistent with the view that acquirers take into consideration the quality of targets’
earnings in making takeover decisions (e.g., Anilowski et al., 2009; Raman et al., 2013).
The evidence in this study also suggests that the deal premium constrains targets’
accruals earnings management and acts as a strong disincentive to manipulate earnings.
Consequently, the cost of detection explanation for the lack of earnings management by
UK targets appears capable of explaining this relationship between the deal premium
andthe abnormal accrualsoftargets.
The second empirical study builds on the results of the previous research, which
finds no evidence of accruals manipulation by UK targets in M&A, and explores a
potential explanation of this phenomenon. Specifically, this study examines whether
firm diversification has an impact on earnings management by targets in M&A. An
explicit distinction between industrial and geographical diversification is made in this
study. Prior research provides evidence that the mode of diversification, such as
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Abstract
industrial vs. geographical, can explain the difference in the correlation between
discretionary accruals and diversification due to whether or not they are in different
industry segments and/or whetherbusiness units are locatedindifferentcountries(Kim
and Kim, 2001). Using a panel data framework for a sample of publicly listed targets,
the results of this empirical study suggest that industrial diversification mitigates
earnings management prior to mergers and acquisitions. In addition, the results also
show that a combination of industrial and geographical diversification alleviates
earnings management. However, there is no clear empirical evidence that geographical
diversification facilitates or mitigates earnings management. These results are consistent
with those reported in Jiraporn et al. (2008) and El Mehdi and Seboui (2011), who find
thatindustrial diversificationdecreasesearningsmanagementby US firms.
Finally, the third empirical study investigates the earnings management
behaviourofUKtargetsin M&A, inparticularcombinedandsimple strategiesbasedon
accruals and real-activities, and the impact of earnings management on targets’ stock
overvaluation at the time of a deal. Prior literature provides evidence that at times of
heightened scrutiny, such as M&A, earnings management via accruals is unlikely to be a
dominant source of overvaluation (e.g., Cohen and Zarowin, 2010; Roychowdhury et al.,
2012). Consistent with this view, the results of this study, which were derived from a
panel data regression analysis, show that if targets engage in income-increasing earnings
management, they are more likely to use combined strategies of earnings management
via both accruals and real-activities simultaneously rather than simple strategies based
solely on either accruals or real-activities. Furthermore, managers’ propensity to engage
in combined strategies of earnings management prior to M&A is significantly higher
than the propensity for accruals earnings management, despite the high and long-term
costs of this earnings management method. Furthermore, the stock return tests
performed in this study provide evidence that firms which exhibit evidence of
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Abstract
combined earnings management strategies tend to be the most overvalued targets prior
toM&A whichisconsistentwiththose results reportedby Roychowdhury etal. (2012).
To sum up, UK publicly listed targets are more likely to utilise combined
earnings management strategies based on accruals and real-activities prior to a takeover,
and these targets’ shareholders appear to gain the most if they sell their shares before
the deal announcement. However, accruals earnings management as a sole method of
earningsmanipulationisnota widespreadpractice inUKmergersandacquisitions, and
the deal premium constrains the targets’ accruals earnings management behaviour. If
earnings manipulation by targets is detected, acquirers might adapt their takeover
strategies by adjusting the deal price downward. Finally, industrial diversification
mitigatesearningsmanagementby UKtargetspriortomergersandacquisitions.
Given the significant negative wealth consequences of both accruals and real-
activity earnings manipulation, the findings of this thesis emphasise the fact that targets’
shareholders, board of directors and auditors, as well as financial advisors need to be
alert to managers attempting to engage in earnings management via accruals, but also
carefully monitor real-activities. Furthermore, investors, acquirers and financial analysts
should be fully aware of the existence and severity of targets’ stock overvaluation when
they make orfacilitate importantinvestmentdecisions.
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Tableof Contents
Table of Contents
Intellectual Property Statement ..............................................................................i
Acknowledgements...............................................................................................iii
Abstract...................................................................................................................v
Table ofContents..................................................................................................ix
ListofFigures......................................................................................................xii
ListofTables.......................................................................................................xiii
ListofAbbreviations...........................................................................................xiv
Chapter1Introduction............................................................................................1
1.1 Introduction.................................................................................................................1
1.2 AccrualsEarningsManagementandDeal Premiuminthe UK..........................8
1.3 AccrualsEarningsManagementandUKFirmDiversification.........................11
1.4 AccrualsandReal-Activity EarningsManagement,andUKTargets’ Stock
Overvaluation...........................................................................................................13
1.5 ResearchQuestions..................................................................................................16
1.6 Contributionsofthe Thesis.....................................................................................17
1.7 Structure ofthe Thesis.............................................................................................20
Chapter2UK M&A MarketandTakeoverRegulation.Benefits andCosts of
Earnings Management.........................................................................................23
2.1 Introduction...............................................................................................................23
2.2 M&A Marketinthe UK...........................................................................................24
2.2.1 AnOverview ofM&A Activity inthe UK..................................................25
2.2.2 PerspectivesandMeasurementofTakeoverSuccess................................36
2.2.3 Deal CharacteristicsandShareholders’ WealthEffects.............................41
2.3 The MotivationofTargetsforManipulating ReportedEarnings......................50
2.3.1 Asymmetric Information HypothesisandM&A........................................51
2.3.2 Financial IncentivesHypothesis....................................................................53
2.3.3 TakeoverDefence Hypothesis......................................................................54
2.3.4 Managerial OpportunismversusEfficiency Rationale toManipulate
ReportedEarnings...........................................................................................56
2.4 Managerial IncentivesofEarningsManagement.................................................59
2.4.1 Capital MarketIncentives...............................................................................59
2.4.2 Non-Capital MarketIncentives.....................................................................62
2.5 EarningsManagementConstraintsinM&A.........................................................65
2.5.1 AuditCosts.......................................................................................................66
2.5.2 Governance andControls..............................................................................68
2.5.3 Political Costs...................................................................................................70
2.5.4 Probability ofDetection.................................................................................71
2.5.5 Reversal ofAccruals........................................................................................72
2.5.6 GAAPFlexibility andChangestoUKAccounting Standards.................73
2.5.7 OtherExternal Factors-RelatedCostsandTakeoverRegulationinthe
UK-A ShareholderOrientedApproach.....................................................80
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