Target Firm Earnings Management, Acquisition Premium, and Shareholder Gains

Abstract

<jats:p> Using a sample of U.S. domestic deals from 1990 to 2016, we find that bidders adjust the amount of premium paid in mergers and acquisitions (M&amp;As) based on the levels of earnings management at target firms. However, the way a firm manipulates earnings upward matters: earnings management via real activities manipulation is more detrimental than discretionary accruals. As a result, target firms that engage in real earnings management receive lower premiums in M&amp;As, while accruals management has no effect on premiums. Correspondingly, we find that the targets’ M&amp;A announcement-period cumulative abnormal returns are inversely related to their level of real earnings management, while the returns are not related to accruals management. Further analyses confirm that target shareholders’ wealth is not only driven by undervaluation, expected synergy, and managerial hubris, but also reflects bidders’ perception of the target firms’ earnings quality based on real earnings management. </jats:p>

Earnings management of target firms and deal premiums: The role of industry relatedness

“…The evidence for the whole sample does not support the notion that the targets' EM practices affect the bid premium offered by acquirers. Although this result appears to contradict recent evidence on target's EM (Farooqi et al, 2020), as well as prior FRQ literature (Raman et al, 2013;Skaife & Wangerin, 2013), this deserves some considerations.…”

“…Campa and Hajbaba (2016) show that targets carry out real EM activities before cash deals, and that this activity is related to the subsequent poor performance of the acquirer. Additionally, Farooqi et al (2020) find that bid premiums are lower the higher the level of the target's EM via real activities, but that they are not related to accruals manipulation. In the authors' view, this might occur because there has been a switch from accrual-based to real earnings management methods.…”

“…Secondly, as regards the evidence on real earnings manipulation, Farooqi et al (2020) find a negative association with bid premiums. They attribute the results to the greater use of this type of manipulation.…”

“…Moreover, despite these potential motivations, the targets are not usually the deal initiators (Anagnostopoulou & Tsekrekos, 2015), so that they generally lack the time to window-dress their financial statements. Farooqi et al (2020) argue that the association between the target's EM practices and the bid premium offered by the acquirer should be negative. However, a priori this association is unclear.…”

“…However, this research differs from prior US papers that refer to the impact of FRQ on the bid premium, since it focuses on EM and considers the role of industry relatedness. Similarly, this paper differs from recent evidence on target's EM and bid premiums in completed deals in the USA (Farooqi, Jory, & Ngo, 2020), because we focus on deal announcements to examine how acquirers use financial statements in M&A negotiations.…”