Security Market Reaction to Purchase Business Combinations at the First Earnings Announcement Date

Abstract

Accounting for purchased goodwill in mergers and acquisitions has been a hotly debated issue for many years because of the increasingly large impact of goodwill amortization on the reported earnings of acquiring firms and its implications for the subsequent performance of the combined entity. There is evidence that top management of firms seeking to acquire other companies attempts to avoid purchase accounting when possible to avoid the hit to earnings associated with goodwill amortization. However, since there may be no economic cash flows associated with the goodwill amortization, it is not immediately apparent that the required goodwill amortization has a negative effect on stock prices. This study examines the extent to which increases in purchased goodwill are negatively associated with the security prices of acquiring companies at the time of the first earnings announcement following the completion of the merger. The results indicate that firms exhibit negative abnormal returns around the first quarterly earnings announcement date following a purchase business combination and that the size of the reaction is negatively related to the amount of goodwill associated with the purchase. Thus, the results support the concerns expressed by the financial press that reporting large amounts of goodwill is bad news at the time of earnings announcements. These results are not inconsistent with the findings of earlier work suggesting that goodwill is positively valued by the market. Rather, our results suggest that while goodwill may be viewed positively as an asset, the earnings impact of the amortization of goodwill is bad news to the market.