The real effects of financial reporting quality: Agency costs of overvalue equity in takeover market

Abstract

Does pre-existing financial reporting quality play a role in mitigating market-driven takeover bids and enhancing investment efficiency? An exogenous buying pressure from mutual funds with extreme capital inflows affords us a quasi-experimental setting for testing the real effects of acquirers’ financial reporting quality. We find that financial reporting quality disciplines acquiring firm managers at the front-end of the acquisition process and averts value-destroying takeover stock bids. Our findings suggest that managers discipline themselves and offer takeover bids less frequently as a reaction to equity overvaluation when high-quality financial reporting facilitates an effective board oversight and managers rationally anticipate that the board will reject their market-driven stock bids. If managers inflate earnings proactively to prop up the stock price for their upcoming M&As, we will also observe an inverse relation between financial reporting quality and the likelihood of M&As. Our identification strategy on exogenous equity overvaluation helps in ruling out the reverse causality explanation of our findings. We contribute to the literature by investigating the effects of transparent financial reporting on mitigating managers’ sub-optimal investment decisions and unraveling the mechanisms underlying the real effects of financial reporting quality. Our falsification test result suggests the presence of tensions in our hypothesis.