Earnings Management in Takeovers of Privately Held Targets

Abstract

We investigate patterns of earnings management by the acquiring firm in a merger, considering both the form of payment and the target firm's listing status. We find that the acquiring firm is more likely to report income-increasing abnormal accruals when it uses stock to acquire a privately held target. The bidder's abnormal accruals are also higher when it acquires a privately held target operating in a different industry and when it acquires a smaller target. These results suggest that greater estimation risk in the valuation of an acquisition target motivates the bidder to avoid overpayment by manipulating earnings upward prior to the merger. We also find that for a bidder acquiring a privately held target, stock returns around the merger announcement are negatively related to the abnormal accruals, but long-term returns show no relation to the abnormal accruals. Thus, it appears that investors price the bidder's earnings management at the time of the acquisition, and we find no evidence of a delayed market reaction or price correction.