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 manipulation around takeovers.
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 on accruals 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 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 and the abnormal accruals of targets.
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 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 whether business units are located in different countries (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 that industrial diversification decreases earnings management by US firms.
Finally, the third empirical study investigates the earnings management behaviour of UK targets in M&A, in particular combined and simple strategies based on 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 combined earnings management strategies tend to be the most overvalued targets prior to M&A which is consistent with those results reported by Roychowdhury et al. (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 earnings manipulation is not a widespread practice in UK mergers and acquisitions, 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 mitigates earnings management by UK targets prior to mergers and acquisitions. 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 or facilitate important investment decisions.
