Pre-merger Earnings Management: Sarbanes Oxley, Leverage and Non-cash Acquisition Premia

Abstract

The objective of this thesis is to investigate earnings management within a structured sample design focusing upon a M&A context in the US by addressing three main empirical questions in three studies. The first study examines whether firms near M&A manage their earnings and whether this practice has changed after Sarbanes-Oxley Act (SOX). The second study investigates whether debt-financing has implications on event-specific earnings management. Finally, the third empirical study challenges the effectiveness of earnings management in a M&A context by proposing that acquirers’ pre-merger earnings management can be uncovered and adjusted by the transacting targets. The key findings of the first study in this research suggest a strong tendency on the acquirer’s side to manage their earnings upwards before completing non-cash deals, while weak evidence is reported on the target’s side. More importantly, pre-merger earnings management does not seem to be significantly different between pre- and post-SOX eras, despite the assertions that the enactment of SOX was aimed at improving the reporting quality and the containment of earnings management practices. Given that SOX led to stronger due diligence and a more intense use of advisors for M&A deals, it could be argued that the setting of M&A activity creates a greater opportunity to manage earnings, given that managers’ resourcefulness for planning and altering accounting numbers is exclusively much greater in the case of M&A after SOX. However, this finding could be a consequence of employing cross-sectional accruals’ models, by which earnings management is detected relatively to the average level of normal accruals in peer firms at the time of estimation, whilst peer firms’ in general have adopted conservative reporting policies since the enactment of SOX. The second study reports a strong inverse relation between the pre-merger income-increasing earnings management levels and the industry-adjusted leverage of the non-cash acquiring firms, which is consistent with Jensen’s (1986) control hypothesis. This evidence highlights the importance of the industry-adjustment for leverage proxies in earnings management studies and proposes the use of structured sampling designs that controls for the firms’ motivation to manage earnings. The second study’s contribution leads to a better understanding of how a firm makes an accounting choice when it does favour one choice for its economic incentives but at the same time it is under creditors’ monitoring pressures. The third empirical study provides robust evidence of a positive relation between acquirers’ pre-merger earnings management and the non-cash acquisition premia. This evidence contributes to the existing literature by suggesting that even if the managerial team has succeeded in manipulating what is reported on paper, it may actually fail to influence the users’ perceptions - especially the sophisticated ones. The evidence challenges the naive investors’ hypothesis of Sloan (1996), which has been repetitively assumed by several studies in contexts where equity shares are issued.