The role of corporate governance in shaping accruals manipulation prior to acquisitions

Abstract

Based on stock swap transactions involving public acquirers originating from the UK between 1998 and 2011, this paper investigates the role of corporate governance in shaping accruals manipulation prior to stock swap deals. In contrast to common claims that strong corporate governance constrains accruals manipulation, my results show that well-governed acquirers engage more aggressively in income-increasing accruals manipulation than those with weak governance. This finding is consistent with a role of corporate governance that incentivises managerial actions in the interests of firms’ shareholders. Overall, this finding highlights the setting-specific nature of the earnings management and corporate governance relation. My results are robust to different discretionary accrual models, differences in the firm's growth structure, merger and acquisition control variables, a control group of 100% cash acquirers, an analysis of buy-and-hold abnormal returns, and potential sample selection problems.

Keywords:

• accrual-based earnings management
• corporate governance
• share-based M&A transactions
• managerial incentives

Acknowledgments

For valuable comments, I am grateful to Joerg-Markus Hitz, Daniel W. Collins, Joachim Gassen, Wayne Landsman, Almasa Sarabi, Catherine Shakespeare, and participants at the 3rd WHU Doctoral Summer Program in Accounting Research, WHU Otto Beisheim School of Management in Vallendar (July 2012), the Research Seminar in Finance, Accounting, and Tax, Goettingen University (January 2013), the EAA 29th Doctoral Colloquium in Accounting in Saclay/Paris (May 2013), the Annual Meeting of the European Accounting Association in Paris (May 2013), the Annual Meeting of the American Accounting Association in Anaheim, CA (August 2013), the associate editor, and two anonymous reviewers. I also thank Paul Wanner and Kristof Ho Tiu (both, ISS Governance Services, formerly RiskMetrics Group) for providing the CGQ data. All errors are my own.

Notes

1. Complementing this, the UK is characterised by the most developed self-regulatory takeover regime (Miller 2000, Sudarsanam and Sorwar 2010). First published in 1968, the City Code of Takeovers and Mergers mandates some unique institutional features, such as the equal treatment of shareholders during M&A transactions or bid rules that mandate a tender offer to all shareholders once the threshold of 30% has been passed, board neutrality on behalf of the target firm, and the prohibition of anti-takeover means such as poison pills. Since most of these features are only relevant for UK-listed targets, they play a minor role in my setting, as I allow for cross-border transactions (in the robustness section, I address differences in the target's regulatory takeover regime by controlling for the presence of cross-border transactions).

2. Consistent with this, I observe that more recent earnings management definitions do not exclusively highlight the opportunistic side of earnings management. Walker (2013, p. 446), for example, notes that his ‘definition is deliberately broader than previous definitions and does not presume that all EM is bad’.

3. I follow Kothari et al. (2005, p. 174) and estimate the cross-sectional modified Jones Model with ‘change in accounts receivable’ in the first stage estimation process. However, when using the ‘change in accounts receivable’ adjustment only in the second stage, as originally proposed by Dechow et al. (1995) in a time-series context with a firm-specific estimation and event window, my discretionary accruals findings are virtually identical.

4. To identify the underlying time structure (periods surrounding the stock swap announcement), I measure the earnings release date by using the Worldscope item Earnings Announcement Date (wc05905). Alternative methods to identify the earnings release date do not alter my main findings. I add, alternatively, four months (three months) to a firm's fiscal year. The earnings release time lag (earnings release minus fiscal year-end) for the UK acquirers in Botsari and Meeks’ (2008) sample varies between two and four months.

5. Data constraints in the BHAR estimation decrease the sample size in this set of analyses (Table 2, Panel A).

6. Untabulated t-tests do not suggest that these mean differences are statistically significant.

7. Brown et al. (2011), for example, provide year-to-year correlation coefficients for Australian governance rankings over eight years, from 2002 to 2009, ranging over a relatively high level between 0.72 and 0.89. Likewise, Daines et al. (2010) report, with a correlation coefficient of 0.85 between two consecutive US CGQ ratings, a relatively high stickiness level of governance. The stickiness level in my UK data set (expressed by year-to-year correlation coefficients based on a balanced panel sample) is similar to that of Daines et al. (2010) and Brown et al. (2011) at a comparably high level, ranging from 0.45 to 0.93, with an average value of 0.67.

8. This might be consistent with the notion that managers in cash transactions might value accrual reserves in the post-merger period to offset or smooth potential merger costs or post-merger asset write-offs (for a discussion on potential merger costs, see Meeks and Meeks 2001, and for potential post-merger asset write-offs, see Gu and Lev 2011). Furthermore, well-governed acquirers appear to be more successful in generating accrual reserves to hedge potential post-merger costs in cash transactions. However, I caution not to over-interpret these findings as they remain insignificant in most instances (e.g. main findings in Table 4, Models 3 and 4).

9. I am cautious however regarding the results with respect to my external mechanisms, since the variation in the Big Five dummy is considerably low (only 2 out of 70 stock swap acquirers are not audited by one of the Big Five auditors) and I am not able to control for any analyst affiliation effects. With respect to the latter, recent research on financial analysts points out that the monitoring role of analysts affiliated with acquirer advisors in the context of M&A transactions is substantially weakening (e.g. Kolasinski and Kothari 2008).