۱- Introduction

۲- Market efficiency, earnings management devices and their detection

۳- Literature review and hypothesis development

۴- Data and methodology

۵- Results and discussion

۶- Summary and conclusions

References

Abstract

The accounting literature has found evidence that acquirers in stock-for-stock M&A have typically managed earnings upwards ahead of a bid. Other literatures have concluded that, when stock prices are high and rising, M&A is higher, more M&A is financed with stock, market sentiment and stockholders’ perceptions of information appear to change, and in these circumstances new (arbitrage) motivations for M&A emerge. This paper revisits earnings management ahead of M&A in the light of these findings, comparing experience in ‘hot’ and ‘cold’ markets. It finds that such earnings management is more pronounced in hot markets; that only in such markets are positive discretionary accruals commonly associated with positive abnormal returns on the announcement of earnings; and that in such markets – against the expectations from signalling theory – these positive returns are not reversed on announcement of a stock-for-stock bid. The results suggest that the economic benefits achieved by engaging in earnings management during hot markets are indeed significant: in hot markets, we estimate that on average share acquirers engage in working capital accrual management equivalent to over a third of the average acquirer’s return on total assets in that year; and that this earnings management is associated with increases in market value which are statistically and economically significant, enabling the bidder to secure control of the target with fewer shares.

Introduction

The accounting literature has found evidence for several countries that acquirers in stock-for-stock M&A manage earnings upwards ahead of a bid (Botsari and Meeks, 2008; Erickson and Wang, 1999; Gong et al., 2008; Higgins, 2013; Louis, 2004). A rationale for such behavior is that, if stock markets are only semi-strong efficient, inflated earnings may misinform the market, increasing the price of the bidder’s stock – the currency of the deal. Income-increasing accrual manipulation in the period preceding the bid announcement may then achieve a more favorable exchange ratio for stock, and so secure the target’s earnings more cheaply. Other literatures have concluded that, when stock prices are high and rising, M&A is higher, more M&A is financed with stock, market sentiment and stockholders’ perceptions of information appear to change, and in these circumstances new (arbitrage) motivations for M&A emerge. Amel-Zadeh et al. (2016), Nelson (1959), and Scherer and Ross (1990) have charted the successive waves in M&A over the last century and their positive association with fluctuations in stock market prices. Fig. 1 illustrates the most recent two waves in the UK  the focus of this paper. One takeover wave in the UK market peaked during the second quarter of 2000, when the value of announced deals (see Fig. 1a) in that quarter alone reached the record level of c. £۱۵۱ billion, while the third quarter of 2000 saw a reduction of more than 75% (in the run-up to the former period, the FTSE All Share index soared to more than 3200, having increased by more than 55% since the beginning of 1997). The next merger wave developed in 2003 and reached its peak in terms of the number of announced deals (see Fig. 1b) during the third quarter of 2007, after which the number of transactions decreased by almost 30%. Nelson’s (1959) study found that stock-for-stock finance was heavily used to finance deals in merger waves. And, more recently, the acquisition wave which developed in the 1990s the greatest takeover wave in history in terms of both size and geographical dispersion1 – was characterized by the overwhelming use of stock as a means of payment (Andrade et al., 2001) and accompanied rising prices.