Stock-For-Stock Mergers, Directors' Characteristics And Real Activities Manipulation
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DepartmentBusiness and Management
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The purpose of this study is to examine whether firms which engage in stock-for-stock mergers manipulate real activities in the fiscal year preceding the merger announcement. In addition, I examine whether certain directors' characteristics are effective in curtailing or instead are associated with real activities manipulation. In stock-for stock mergers, the number of shares that the acquiring firm has to exchange for each share of the target firm depends on the stock price of the acquirer on the agreement date. Consequently, if the stock price of the acquirer is high on the agreement date, the acquirer will issue few shares to pay for the cost of acquiring the target. The inverse relation between the stock price and the stock swap ratio gives the acquirer incentives to manage earnings upwards in order to inflate its stock price prior to the merger agreement. While extant literature provides mixed results as to whether firms which pay for their acquisitions using stock engage in earnings management by manipulating accruals, there is scant literature on acquiring firms and real activities manipulation. Although prior studies use pre-SOX data to examine the earnings management behavior of US acquiring firms, I focus on the post-SOX period when firms have more incentives to manipulate real activities. Even though acquiring firms have incentives to inflate earnings in order to reduce the cost of acquisition, the board of directors and the audit committee may prevent managers from manipulating real activities. Therefore, the two research questions that I address in this study are: (1) do firms which finance their acquisitions primarily with stock manipulate real activities in order to increase their stock price in the fiscal year prior to the merger announcement than firms which finance their acquisitions with cash? (2) how do directors' characteristics affect the ability of managers of acquiring firms to manipulate real operations? I examine a sample of 1171 firms which completed mergers and acquisitions between 2003 and 2013. I find that firms which pay for their acquisitions with stock cut research and development expenditures to increase reported earnings. Moreover, the aggregate measures of real activities manipulation indicate that real activities manipulation increases with firms which use their company's stock to pay for their acquisitions. I also find that acquirers do not engage in overproduction of goods in order to report lower cost of goods sold when the size of the target is larger than the acquirer's. Using a summary score for corporate governance, this study provides evidence that corporate governance does not have a significant impact on real activities manipulation of firms which complete stock swap acquisitions. However, additional analysis shows a positive association between overproduction of goods and the frequency of audit committee meetings of stock acquirers. I also examine and find that stock acquirers engage in overproduction of goods when there is at least one director with accounting expertise serving on the audit committee. This study contributes to the literature on corporate events and earnings management by presenting evidence that firms engage in real activities manipulation around mergers and acquisitions. The study also contributes to the literature on corporate governance and earnings management by showing that corporate governance may not be effective in deterring managers from manipulating real operations. Internal and external monitors of management may find this study to be helpful.