Prior Literature

This paper speaks basically to two related streams of literature, the governance and accrual-based earnings management literature, as well as the accrual-accrual-based earnings management and M&A literature. Table 5 - 1 presents an overview.

Corporate Governance and Earnings Management

Based on U.S. firms for the years 1992 and 1993, Klein (2002) finds evidence that internal governance structures (e.g., audit committee and board independence) constrain accruals manipulation. Davidson et al. (2005) partly support these findings. They find evidence for Australian firms that some internal governance structures (e.g., board and audit committee independence) reduce the extent of accruals manipulation, whereas others (like auditor choice

145 and the firm’s voluntary establishment of an internal audit function) do not. Larcker et al.

(2007) examine the relationship between various governance measures and different accounting and financial outcomes in a U.S. setting. Overall, they find mixed evidence of a link between governance quality and abnormal accruals, little evidence of a relation between governance and accounting restatements, and some evidence of a positive effect of governance quality on future operating performance. They argue that the mixed results are partly due to the lack of consistent and reliable measures of broad corporate governance structures. A recent study for Europe was conducted by Renders and Vandenbogaerde (2008).

For a sample period between 1999 and 2003, they find a negative relationship between different governance mechanisms (e.g., shareholder rights, anti-takeover provisions, and board characteristics) and income-increasing accruals manipulation. Moreover, they indicate that firm-level governance constrains more effectively the use of discretionary accruals in countries with higher quality (country-level) governance standards and they show that their results are mainly driven by code law countries. To our knowledge, only Cormier and Martinez (2006) consider governance-related structures and earnings management in a specific setting. They find evidence for French IPO firms that managers’ leeway to manipulate accruals in order to reduce their earnings forecast errors in the post IPO period is limited by audit quality and ownership concentration. However, they do not find similar evidence for board independence or compliance with IFRS.

Overall, the majority of prior studies examines the relationship between single governance mechanisms and accruals manipulation and finds some evidence for board characteristics and weak or even mixed evidence for further internal governance mechanisms (for a comprehensive overview, see Garcia-Meca and Sanchez-Ballesta 2009, pp. 600-601).

However, as to our knowledge, none of the previous studies examines the link between firm-level corporate governance mechanisms and accruals manipulation in a setting – like stock swap M&A transactions – in which specific incentives to manipulate earnings upward are expected to be dominant.

Earnings Management prior to share-based M&A Transactions

Based on a U.S. sample of 55 stock swap transactions between the years 1985 and 1990, Erickson and Wang (1999) examine whether acquiring firms manage earnings upward prior to M&A transactions. Their results suggest that acquirers in such transactions engage in

income-146 increasing accruals manipulation to reduce the purchase costs of the target firms. Consistent with that, Louis (2004) finds evidence for 236 U.S. transactions between the years 1992 and 2000 that acquirers manipulate quarterly earnings via discretionary accruals prior to the stock swap announcement. Botsari and Meeks (2008) provide the first non-U.S. evidence. They examine the acquirer's discretionary accruals for 48 UK share-based M&A transactions for the period between 1997 and 2001. Consistent with the findings of Erickson and Wang (1999) and Louis (2004), they show that acquiring firms engage in accruals manipulation in the periods (one and two years) prior to the announcement of the transactions.

Table 5 - 1: Prior Literature on Corporate Governance and Earnings Management Panel A. Corporate Governance and accrual-based Earnings Management

Authors Sample Main Findings

Davidson et al. (2005) • 434 Australian firms

• For the year 2000 • Internal CG (majority of NED on board & audit committee) reduces accrual-based EM (no effect for auditor choice)

Klein (2002) • U.S. sample with 692

firm-years (‘92-‘93) • Internal CG (audit committee and board independence) reduces the extent of accrual-based EM

Larcker et al. (2007) • U.S. sample with 2,106 firms (for the year 2003)

• Mixed evidence of a link between accrual-based EM and CG (aggregated measure of 14 CG dimensions) Renders and

Vanden-bogaerde (2008) • European firms with 655 firm-year obs.

(from ’99-’03)

• Negative link between accrual-based EM and CG quality (firm-level CG and institutional characteristics appear to be complementary)

Cormier and Martinez

(2006) • 118 French IPO firms

(from 2000-2002) • Negative link between accrual-based EM and CG (audit quality, ownership concentration) in post IPO period (no evidence of board independence) Panel B. Accrual-based Earnings Management prior to share-based M&A Transactions

Authors Sample Main Findings

Erickson and Wang

(1999) • 55 U.S. transactions

(from 1985-1990) • Evidence of accrual-based EM prior to share-based M&A (based on quarterly data)

Heron and Lie (2002) • 427 U.S. transactions

(from 1985-1997) • No evidence of accrual-based EM prior to share-based mergers (based on yearly data)

Louis (2004) • 236 U.S. transactions

(from 1992-2000) • Evidence of accrual-based EM prior to share-based transactions (based on quarterly data)

Baik et al. (2007) • 1,507 U.S. mergers

(from 1990-1998) • Evidence that higher pricing uncertainty for acquirer (measured by target public status, target size, industrial relatedness) promotes accruals manipulation

Botsari and Meeks

(2008) • 48 UK transactions

(from 1997-2001) • Support the findings of Erickson and Wang (1999) and Louis (2004), but with yearly UK data

Pungaliya and Vijh

(2009) • 895 U.S. transactions

(from 1989-2005) • No evidence of EM prior to share-based M&A They control for growth differences in the estimation process of discretionary accruals

147 In contrast, Heron and Lie (2002) examine acquirers’ discretionary accruals for 859 U.S. transactions (including 427 share deals) in a period between 1985 and 1997 and do not find evidence supporting accruals manipulation prior to share-based deals. Moreover, two recent studies present opposing results as well and argue that prior findings are potentially biased due to the absence of growth adjustments in the estimation process of discretionary accruals (Pungaliya and Vijh, 2009; Collins et al., 2012). Collins et al. (2012) point out that when using standard Jones-type discretionary accrual models it is likely to overestimate the likelihood of accruals manipulation in quarterly settings where firms with high or low growth characteristics are overrepresented.

Although prior literature scrutinizes the average effect of accruals manipulation prior to share deals, so far potential determinants of accruals manipulation in this setting remain largely unresearched (e.g., Young, 2008, p. 673). As to our knowledge, only Baik et al. (2007) address explicitly determinants of earnings management in a setting of M&A transactions.¹⁰³ They predict that the acquirer’s pricing uncertainty promotes accruals manipulation prior to share deals. Using target public status, target size, and industrial relatedness between acquirer and target as proxies for acquirer’s pricing uncertainty, they find evidence in support of their prediction.