AMERICAN ACCOUNTING ASSOCIATION
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Drop in a company's stock price upon announcement of a corporate acquisition often signals rough road ahead
With coffers of many companies bulging with cash, an upsurge in corporate mergers and acquisitions could easily be in the offing. And, just in time, a new study provides a caution for shareholders who find themselves scratching their heads when, as frequently happens, an acquirer's stock takes a hit upon announcement of a corporate merger.
All too often, a quick rebuff from the market is only the beginning of the acquiring company's woes, according to research in the current issue of the American Accounting Association journal Accounting Review. The initial stock-price drop frequently proves to be anything but a temporary setback and instead becomes the precursor to manipulation of earnings by company managers culminating in a financial restatement and dismissal of the CEO.
In the study of some 2,300 firms that made corporate acquisitions, three accounting professors from the University of Arizona's Eller School of Management find that firms in the lowest quartile in terms of stockmarket response to the news were about 50% more likely than other acquirers to misstate and then have to restate their subsequent finances. This means that the firms failed to apply accounting rules properly or even engaged in outright fraud.
Further, 34% of the CEOs in that lowest quartile of the acquirers were dismissed within five years after the merger as compared to 20% of the chiefs in the top quartile.
In sum, the paper finds "a negative association between M&A announcement returns and the probablility of issuing materially misstated financial statements following the M&A transaction."
And, while most executives responsible for badly received acquisitions don't misstate earnings in the post M&A period, even those who give an accurate accounting tend to issue overoptimistic earnings guidance. Both of these dodges, the study finds, mitigate the increased likelihood of CEO dismissal following a negatively received acquisition, but the effect proves only temporary once misstatements or overoptimistic forecasts are exposed.
"The study ought to serve as a warning to shareholders and corporate directors about the possibly dire implications of an initially negative market response to an acquisition," comments Prof. Daniel Bens, who carried out the research with his Eller colleagues Theodore Goodman and Monica Neamtiu. "At the very least, a substantial dip in stock price should evoke caution and vigilance and ought not to be simply shrugged off as simply a transient phenomenon."
The paper's findings are based on an analysis of 2,293 corporate acquisitions by U.S. public companies during the 12-year period 1996 through 2007, in all instances of which deal values amounted to at least 5% of acquirers' market capitalizations. Investor response was gauged by the market-adjusted change in acquirers' stock price in the three-day period extending from the day before M&A announcements through the day after. For the sample as a whole this consisted of a rise of 0.9%, while for the lowest quartile of responses it meant a mean drop of 2.3%.
To capture financial misreporting related to negative market reaction and not to something else, the study restricts itself to misstatements started within a year of the mergers' conclusions, although the misreporting typically lasts for several years before being discovered and then restated. The professors allow for a one-quarter buffer period between the M&A date and the beginning of the restatement measurement window to ensure that the acquirer's management had time to comprehensively evaluate the implications of the recent acquisition.
Overall, about 13% of the 2,300 companies in the sample issued financial restatements in the post-M&A period. Among companies in the lowest quartile in terms of market reaction, about 18% did so, compared to somewhat under 12% for the remaining three fourths of the sample. While the study's findings are based on the first acquisition undertaken in the 12-year period covered by the study, the results are robust enough to remain unchanged even when the professors expand the scope of their analysis to include muiltiple transactions per acquirer.
Noting that "acquisitions are among the most significant corporate resource-allocation decisions that managers make over their careers," the professors explain that, "unlike annual stock returns which can vary for many reasons that are not controllable by a firm's management, the announcement of an acquisition provides insight into shareholders' reaction to a specific managerial decision...Managers who face heightened career concerns from a negatively received M&A transaction have strong incentives to report value creation in the acquisition implementation stage...Overall, [our] findings indicate that managers are more likely to issue misstated financial statements following poorly received M&A events in an attempt to improve post-M&A performance."
Companies in the sample that experienced slowdowns or downturns in the years following poorly received acquisitions include the global electronics manufacturer Solectron Corp. whose stock declined by more than 12% over three days when it announced a major acquisition late in 2000 and which restated earnings in 2005 for three previous years; pharmaceutical company Chiron Corp, whose stock declined about 2% at the time of an acquisition announcement in 2003 and which restated earnings two years later; and real estate giant Macerich whose stock declined more than 4% at the time of an announcement in 2004 and which restated its finances in 2008.
Entitled "Does Investment-Related Pressure Lead to Misreporting? An Analysis of Reporting Following M&A Transactions," the study is in the May/June issue of The Accounting Review, published six times a year by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA and its specialty sections include Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Auditing: A Journal of Practice & Theory, and The Journal of the American Taxation Association