This research aims to investigate the earnings management of acquiring firms prior to a merger announcement as well as the effect of board connections and the characteristics of Chief Executive Officers (CEOs) on earnings management prior to the merger announcement. Beside the use of both versions of the Jones models to detect accrual-based earnings management and the models developed by Roychowdhury (2006) to detect real earnings management, the research also uses the deviation between the distribution of the first digits of figures reported on financial statement and the theoretical distribution predicted by Benford’s Law. The empirical research is based on secondary data for firms in the United Kingdom (UK) over the period from 2007 to 2012.
The thesis firstly revisits the issue earnings management prior to the merger announcement of both share-financed and cash-financed acquirers. Using a sample of 295 observations of UK public acquirers from 2007 to 2012, the study finds that share-financed acquirers exhibit significantly high abnormal accruals and abnormal real earnings activities in the first year prior to a merger announcement. The results are in line with existing evidence (Louis 2004; Botsari and Meeks 2008; Zhu and Lu 2013). However, despite the amount of evidence suggesting share-financed acquirers manage earnings prior to announcing the deals, the evidence still attracts criticism because of the pitfalls of the empirical models to capture earnings management, especially the most popularly-used Jones’ accruals model and the Roychowdhury’s (2006) real earnings management (Dechow et al. 2010a; Ball 2013). A large body of the literature on earnings management in the context of mergers and acquisitions has been developed assuming the Jones and Roychowdhury’s models are capable of capturing earnings management, hence the serious criticisms of those models present a big question mark over what we actually know about the issues of earnings management prior to share-financed mergers. Addressing that concern is not only topical, but also will make an important contribution to the literature. The thesis significantly strengthens the evidence suggesting share-financed acquirers do indeed manage earnings prior to the merger announcement by using the deviation between the distribution of the first digits of reported figures of financial statement and the theoretical distribution from Benford’s Law as an alternative proxy for earnings management. Given the importance of a thorough understanding of the behaviour of acquirers in the building up to a merger, the contribution of this first empirical chapter cannot be overstated.
Secondly, the thesis investigates whether and how board connections between the acquiring and target firms affect the earnings management behaviour of share-financed acquirers prior to a merger announcement. It compares abnormal accruals and real activities prior to the merger announcement between acquirers with board connections to targets and acquirers without board connections to targets. Under cash-financed mergers and acquisitions (M&A), no significant difference is found in accrual earnings management between these two types of firm. The analysis, however, shows that share-financed acquirers with board connections increase accrual earnings significantly in the first and second years prior to the merger announcement, while those without board connections manipulate real activities in the first year prior to the merger announcement. The findings suggest that lower uncertainty about the M&A deal and a stronger bargaining position in the negotiations held by acquirers with board connections allow the firms to time the acquisition strategically and confidently inflate their accruals, while acquirers without board connections shift from accrual-based earnings management to real earnings management to avoid the legislation risk. The documented behaviour of share-financed acquirers to time the earnings management prior to the merger announcement is both original and important, while the evidence on the choice of earnings management strategies also add significantly to the growing literature looking at the trade-off between accrual-based and real earnings management.
Finally, the thesis extends prior studies by examining the relationships between CEO characteristics and accrual-based and real earnings management among share-financed acquirers before the merger announcement. The study finds that share-financed acquirers led by CEOs with financial expertise, long tenure and high reputation are associated with lower abnormal accruals and real activities. The correlations are statistically significant and are consistently found in the first year before the merger announcement. The findings are robust as abnormal accruals and real activities are measured in different ways and different models are employed. The evidence suggests that CEO characteristics have an impact on earnings management in the contexts of M&A and have some implications for practitioners.