Target's Accounting Conservatism and the Gains from Acquisition

Abstract

We present evidence on the benefits of accounting conservatism of the target firm in a merger and acquisition transaction. The use of conservative accounting serves as a mechanism that reduces the likelihood of acquiring underperforming assets for the acquirer, making the target more valuable due to the reduced risk. In addition, the monitoring benefit of accounting conservatism can increase the competition for the target in the acquisition market. Lastly, managers of conservative firms may be more risk averse and demand greater compensation to exit the firm. Consistent with these arguments, we find that the target’s accounting conservatism increases the deal premium received. Furthermore, we find that the target’s accounting conservatism increases the announcement returns for both the target and the acquirer. In support of acquiring firms having preference for conservative targets, we find that targets with greater accounting conservatism are more likely to receive bids. Overall, these results indicate that accounting conservatism provides benefits to both sellers and buyers of equity.