Real earnings manipulation surrounding mergers and acquisitions: the targets’ perspective

Abstract

Purpose This paper aims to investigate whether UK public targets manage their earnings using real activities manipulation in the period prior to the announcement of a mergers and acquisition (M&A). It also examines whether the payment method in M&As affects the degree to which takeover targets manipulate earnings. Design/methodology/approach Using a sample of 131 UK listed targets acquired over the period 1995–2013, this paper examines real earnings management (REM) by employing OLS regression models. The data related to deals have been mainly collected from Thomson One Banker and Thomson Reuters Eikon databases. REM is examined by investigating abnormal cash flow from operations, abnormal discretionary expenses and abnormal production costs. This analysis was supplemented by conducting additional robustness checks. Findings The results show that UK takeover targets manage earnings upwards through cutting discretionary expenses in the year prior to the acquisition, while they do not do so by manipulating sales or production costs. Moreover, targets of cash-only or mixed-payment deals do not have the same strong motivation to manage their earnings as stock-financed deal target counterparts do. Our results continue to hold after using alternative accrual earnings management (EM) measures, controlling for unobservable firm heterogeneity using the fixed-effect model and controlling for endogeneity using the two-stage Heckman (1979) model. Practical implications The main findings of this study could be beneficial for various parties involved M&As, such as standard setters and regulators. A need arises to improve disclosure rules and enhance overall financial reporting quality in the capital markets with the aim of reducing information asymmetry and agency conflicts. Originality/value As far as the literature on EM around M&As is concerned, only EM by acquirers has been examined, and not much attention has been paid to targets’ EM.

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“…The payment method of the transaction can be stocks, cash or a combination of both. The deal value is more than one million to exclude deals made by a very tiny target (Ahmed and Elshandidy, 2021; Elrazaz et al , 2021). The M&A transaction is completed, and the acquisition deal represents more than 50% of the target firm.…”

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“…The preference for real earnings management is attributed to the fact that real earnings management methods are more difficult to be detected than accounting practices. More recently, Elrazaz et al. (2021), in contrast to Campa and Hajbaba (2016), found that target firms only in-stock deals engage in real-activities manipulations with the method of cutting the discretionary expenses and not with sales and production costs manipulation.…”