Stock prices and earnings management around M&A transactions

Abstract

The study explores the inter-relationship between stock prices and earnings management by acquirers in the context of the UK market for corporate control. The results show that inflating earnings prior to a bid does indeed seem to affect prices and to have implications for the acquirer’s market performance at various stages of the M&A transaction: during the period leading up to the deal as well as in the post-merger period. In the run-up to the bid, the evidence suggests that aggressive accrual reporting – equivalent to almost half of the average acquirer’s return on total assets in that year – enables share bidders to induce significantly higher overvaluation relative to cash bidders and to subsequently use their misvalued stock as cheap acquisition currency. This finding implies that market prices can be distorted by earnings management and that if the latter is skilfully deployed by the acquirer’s executives, it could play a leading role in achieving more favourable exchange ratios in the context of share-swap acquisitions. During the post-merger period, the results suggest that the reversal of the pre-bid overvaluation alone cannot explain the negative performance of share acquirers in the long-run. It is rather investors’ inability to see through the poor earnings quality of overvalued share acquirers that can at least partly predict these acquirers’ underperformance relative to cash bidders. This underperformance, which is sizeable and statistically significant for up to three years following completion of the deal, is however mitigated when earnings management enables share acquirers to rationally exploit their overvaluation relative to target firms, i.e., when bidders can use their over-valued equity to acquire relatively less-overvalued targets.

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