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The Post-merger Performance of the European M&As: Does Pre-merger

Earnings Management Matter?
Article in Corporate Ownership and Control · January 2015
DOI: 10.22495/cocv13i1c9p3

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 The Post-merger Performance of the
European M&As: Does Pre-merger
Earnings Management Matter?
Malek Alsharairi*a, Emma L. Blackb, Christoph Hoferc and Radhi Al-Hamadeend

a School of Management and Logistics Sciences, German Jordanian University, 35247 Amman
11180, Jordan, Email: [email protected]
b
Newcastle University Business School, Newcastle University, 5 Barrack Road, Newcastle-Upon-Tyne,
NE1 4SE, UK, Email: [email protected]
c
Société Générale, Neue Mainzer Staße 46-50, 60311, Frankfurt/Main, Germany,
Email: [email protected]
d
King Talal Faculty of Business & Technology, Princess Sumaya University for Technology, Amman
11941, Jordan, Email: [email protected]

*Corresponding Author

Abstract

This paper empirically examines the post-merger performance of a sample of 1,320 European
mergers and acquisitions deals. Specifically, we investigate the impact of pre-merger earnings
management of acquirers on both the short-term and long-term post-merger performance, for
M&A deals completed between 2003-2012, considering both the form of payment and the target
firm’s listing status. The findings suggest that acquirers report higher abnormal accruals before
those deals where they pay with their stock and the target firms are private. The reported evidence
suggests that, as a consequence, investors correct for these efforts in the long-term post-merger
period – usually within the first 12 months. Moreover, acquirers are likely to experience positive
abnormal returns in case of bidding for private targets, whereas negative abnormal returns are
documented in case of a publicly traded target, respectively.

Keywords: mergers, acquisitions, earnings management, abnormal accruals, post-merger

performance
1.0 Introduction

Mergers and acquisitions can lead to an increased value generation for the firm, by enhancing
revenues and generating cost efficiency. Numerous research investigate earnings
management by acquirers in share-for-share deals concludes that acquirers engage in upward
earnings management prior to the deal announcement (Erickson and Wang, 1999; Louis,
2004; Gong et al. 2008; Alsharairi, 2012).

Shares exchange ratio specifies the number of the acquirer shares exchanged for one of the
target shares. The deal starts by determining the share purchase price, and then the shares
exchange ratio is determined using the market price of the acquirer shares at the time of the
deal. The acquiring firms would benefit more when its share price is high, because the target
firm’s shareholders would receive less number of the acquirer’s shares, therefore, the acquirer
benefits from a low shares exchange ratio, leading to a lower EPS dilution and lower
acquisition costs. All of this might influence the acquirer to upward their earnings prior to the
announcement in order to maximize their share price, leading them to engage in earnings
management. Recent studies suggest that bidders manage earnings as an attempt to upward
reported earnings, but that does not necessarily mean that this might influence investor’s
decisions. Therefore, by inflating reported earnings, within the legal boundaries and
managerial discretion, acquiring firms try to lower the share-exchange-ratio by upward
earnings to mitigate dilution effects and effective takeover cost.

A number of US sample-based studies, such as Loughran and Vijh, (1997), Louis

(2004) and Moeller et al (2005) report evidence of a significant negative correlation
between the pre-merger level of discretionary accruals and the stock-for-stock
acquirers’ long-run performance. This study aims at examining this long-term
underperformance results in the European market for control. Unlike most M&A studies in
the extant literature, which often focus on the US - the biggest market for control in the world,
this study examines a sample of European M&A deals. Moreover, the sample employed in
this study is segregated based on the deal’s payment structure as well as based on the listing
status of the target to investigate their effect on the aforementioned relationship. This
empirical study contributes to the extant literature by providing a better understanding of the
consequences of earnings management, in the context of M&As, where investors can be
considered well informed and sophisticated. Moreover, this paper enriches the literature of
M&As by investigating the correlation between pre-merger earnings management and post-
merger performance (both short-term and long-term) within a multi-country sample from
Europe.

The study hypothesizes that, analogous to their US peers, those European acquirers engaging in
earnings management prior to a deal announcement would more likely have a poor post-merger
performance. Furthermore, due to the different levels of information asymmetry, pre-merger
earnings management is expected to be more aggressive by acquirers of private targets as opposed
to those acquiring publicly traded targets. Finally, the study reinforces the extant evidence by
documenting that non-cash acquirers, which are believed to negotiate a share-for-share deal when
they consider their own share as overvalued, do experience a negative post-merger performance
since investors correct for the effects of earnings management.
2.0 Literature Review

2.1 Pre-Merger Earnings Management

Acquirers normally have control over the timing of M&A and therefore have plenty
of time to plan and perform their earnings management in order to manipulate their
earnings (Alsharairi, 2012).There are several research papers in the extant literature
investigate pre-merger earnings management. Erickson and Wang (1999) provide
evidence that acquirers manage their earnings upward in the quarters prior to the
planned merger. In a similar study, Botsari and Meeks (2008) provide consistent
evidence that acquirers manage earnings in the year immediately prior to the
acquisition offer announcement.

In a different study, Louis (2004) uses event study to analyze the market’s efficiency
in processing managed earnings in financial reports in an attempt to provide
explanation for the post-merger share underperformance. Louis findings reveal strong
evidence suggesting that acquirers engage in earnings management in order to inflate
income in the quarter prior to the stock swap announcement.

Baik et al. (2007) use a sample of 1,507 publicly traded firms between 1990 and 1998
to analyze pre-merger earnings management. They find significant evidence of
earnings management in the quarter just prior to merger announcement, suggesting an
effort to inflate their stock price. Guo et al. (2008) findings suggest that acquiring
firms tend to split their stocks prior to acquisition announcements in large M&A deals
financed by stock, in an attempt to manipulate their equity valuation to lower the cost
of acquisitions.
In a recent study, Alsharairi et al. (2015) use a sample of 1320 European mergers and
acquisitions deals between 2003 and 2012, their findings suggest evidence of earnings
management prior to the announcement, the evidence is more significant in private
targets, where it is less significant in publicly listed targets. In their paper, Pungaliya
and Vijh (2008) use a sample of 1,719 cash acquirers and 895 stock acquirers during
1989-2005 to study the possibility of earnings management. On the contrary of
previous studies, they do not report evidence of earnings management by acquirers
prior to the announcement of the acquisitions. Consistently, Heron and Lie (2002)
support the findings of Pungaliya and Vijh (2008) results in their study, as they find
no evidence of pre-merger earnings management by the acquiring firms.
In their study on the impact of debt on earnings management, Alsharairi and Salama
(2012) find that earnings management prior to events such as M&A is significantly
affected by the capital structure of the acquirer as they report significant pre-merger
earnings management by the acquirers - in non-cash deals - unless they are highly
leveraged firms.

In another study that explains the effects of pre-merger earnings management,

Gleason et al. (2015) investigate a sample of publicly listed acquirers to find a
positive relationship between the acquirers’ pre-merger earnings management and
acquisition premium in non-cash deals. Their findings suggest that the acquirers’
efforts to use earnings management as a manipulation technique are not beneficial due
to the targets’ ability to detect the acquirers’ endeavors to manager their earnings prior
to the deal.

Overall, the evidence reported in the extant literature reveal that pre-merger earnings
management is a controversial empirical question.

2.2 Post-Merger Performance of Acquiring Firms

2.2.1 Short-run Performance

Travlos (1987) examines the effect of payment method in takeovers on the returns of
bidding firms at the time of the takeover announcement. His results suggest that, for
stock swap takeovers, there is evidence of significant losses at the takeover
announcement. However, the returns for cash financed takeovers are “normal” at the
announcement. Travlos (1987) provides a foundation to explain the aforementioned
findings to the signaling hypothesis. The signaling hypothesis implies that using
share-for-share as a method of payment in takeovers sends a “negative” signal to the
market, that the acquirer’s share is overvalued. Masulis (1983) suggests similar
findings.

Chang (1998) studies the acquirers’ returns in the takeovers of privately held targets.
His findings suggest that at the takeover announcement, acquirers experience a
positive abnormal return in share-for-share takeovers. In the contrast, cash acquirers
experience zero abnormal return. Furthermore, Chang (1998) suggests that the
positive abnormal returns apply only to the acquisition of privately held targets,
unlike the acquisition of publicly traded targets, where the acquirers experience a
negative abnormal return at the announcement. Eckbo (2009) findings are in line with
these results.

Fuller et al. (2002) investigate the returns of bidders acquiring more than five public,
private, and/or subsidiary targets. Their results suggest that the returns depend on the
listing status of the target. Moeller et al. (2004) report consistent results, and suggest
that size does negatively affect the acquirer’s announcement period excess return.

In another study, Louis (2004) finds that there is no evidence of any correlation
between pre-merger earnings management and excess returns in a three-day window
around share-for-share merger announcement. The research of Baik et al. (2007),
which considers the target listing status, indicates that the acquirer’s returns in the
announcement period are a decreasing function of the acquirer’s abnormal accruals
magnitude.
2.2.1 Long-run Performance

Sloan (1996) studies the effect of information regarding future earnings contained in
accrual and cash flow components of current earnings on stock prices. He uses a sample
of 40,679 Firms over 30 years from 1962 to 1991. The findings Sloan’s study suggest a
negative relationship between accruals and the acquirers’ stock returns.

Similarly, Louis (2004) finds a significant negative correlation between the

discretionary accrual and the stock-for-stock acquirers’ long-run performance. These
findings support Sloan’s results, but Louis even goes further to suggest that market
reactions in the short run do not capture the pre-announcement earnings management
effects. Loughran and Vijh, (1997) and Moeller et al (2005) show consistent evidence
that support the long-term underperformance results.

On the contrary, Baik et al. (2007) evidence suggests that there is no correlation
between abnormal accruals and the acquirers’ stock returns in the long run after the
merger announcement. They suggest that the investors are fully aware of the
acquirers’ earnings management at the time of the announcement.

Finally, Francoeur et al. (2012) study the relation between ownership structure,
earnings management prior to mergers and acquisitions, and the acquiring firm’s post-
acquisition long-run market return. Their findings support the negative correlation
between earnings management and the acquirer’s abnormal returns over a three-year
period following the acquisition announcement.

3.0 Hypothesis Development

Since most of the previous studies, as indicated in the above section, document empirical
evidence by focusing on US samples, this study considers the European M&As by examining
the impact of pre-merger earnings management on the post-merger stock performance.

Since Alsharairi et al (2015) argue that the target firm and its advisors can be considered well-
informed users of accounting information, and then target investors are expected to detect the
bidders’ earnings management strategies. Following the argument of Baik et al. (2007) and
Gleason et al (2015), the bidder that manipulates its accruals prior to a M&A deal is expected
to be detected and, hence, the market corrects for them at the announcement or in the time
following a share-for-share transaction (Loughran and Vijh, 1997 and Moeller et al, 2005).
The paper hypothesizes the following:
 H1: The investors are unlikely to completely reverse earnings management at the
announcement of the merger. The reversals of the pre-merger earnings management
effects are expected to be completed in the time following the merger. Hence, there is a
negative relation between the acquirers’ pre-merger abnormal current accruals and post-
merger long-term abnormal returns.

4.0 Methodology

Thomson ONE Banker (i.e. SDC) is the source of data related to European M&A
transactions. For other supplementing information regarding accounting data in addition
to share performance and volatility, DataStream or WorldScope are used.

Following Alsharairi et al (2015), the European acquiring firms sample is obtained according
to specific criteria; first, the deals are announced between 01/06/2002 and 07/04/2012, only
completed transactions are considered. The acquiring firms are from Germany, France,
United Kingdom, Italy or Spain, and they are publicly listed companies. Financial sector
firms which have SIC codes between 6000 and 6999 are not included in the sample. Deals
with value exceeding $1 million are considered only. Acquiring firms must obtain a
controlling ownership interest in the target firm. Finally, the deals must have data regarding
acquisition premium on Thomson One Banker, as well as data of semi-annual earnings
management on WorldScope.

Accruals are a straightforward and simple instrument for temporarily manipulating reported
earnings around specific events because of their relative low cost, as opposed to the risk of
reducing shareholder value as a consequence of sub-optimal operating decisions (Peasnell,
2000; Botsari and Meeks, 2008). However, identifying and measuring the portion of accruals
arising from managerial discretion is among the major challenges to be faced when
investigating this relationship.

Following Pungaliya and Vijh (2008), the current accruals for the following analyses are
computed using the changes in the non-cash working capital:

Equation (1) - Current Abnormal Accruals

=− (−) −

CAC: current accruals;

CA: semi-annual change in current assets;

CL: semi-annual change in current liabilities;
STD: semi-annual change in short-term liabilities included in current
liabilities and current portion of long-term debt;
CASH: semi-annual change in cash.

We use a cross-sectional industry-performance-matched accruals model similar to the

research design of Louis (2004), Gong et al. (2008) and Alsharairi (2012). The following
model is based on the Dechow et al. (1995) modified Jones (1991) model and considers
Kothari et al.’s (2005) recommendation to use performance-based portfolios as a non-linear
control in order to improve the reliability of the accrual regression model.
Following Kothari et al’s (2005) recommendations, all firms within the same industry (based
on their 2-digit SIC) are clustered by calendar years and semi-annual periods and
subsequently ranked according to their efficiency – using the ROA of the same period in the
previous year as proxy for performance – to form five quintiles.

We furthermore implement Gong et al’s (2008) procedures for stronger robustness and
reduced measurement errors.

Following the aforementioned procedure, the cross-sectional regression and estimation

model for each portfolio is as follows:

Equation (2) - Cross-sectional CAC Regression Model

3
|∆ −∆ |
, 1, , , −1
,

=∑
1+ 1+ , ,
+ (
5 )+ 6( )+ 7( )+
, −4 , −4

, −4 , −4
=0

Qq: dummy variable to control for seasonality effects;

REV: semi-annual changes in revenue;

AR: semi-annual change in trade receivables;
PPE: denotes the net amount of property, plant and equipment in a semi-annual period;
TAj-4: one year lagged total assets in the same semi-annual period;
α: coefficients’ index
ε :represents the residual term of the regression model;
i:sampled company’s index;
q:index of the semi-annual period.

The cumulative abnormal returns the acquirer (CAR i), representing the proxy for short-run
Post-merger performance, are benchmarked with the S&P Europe 350 stock market index
(Pm).

Equation (3) - Cumulative Abnormal Returns

, ,

= ∑(ln( − ln( ))

, −1 , −1

For the long-run post-merger performance (BHARi,t), this study does not follow the in recent
publications for misspecification criticised approach of market-adjusted returns. (Cf. Barber
and Lyon, 1997). The calculation of long-run post-merger performance is done by taking the
difference between the buy-and-hold return of the bidder (R i,t) and a matched firm (Rbm,t) with
the closest market-to-book ratio and an equity value between 70% and 130% of the acquirer
as applied in Louis (2004).
 Equation (4) - Buy-and-hold Abnormal Returns

, = ∏[1 + , ] − ∏[1 + , ]
=0 =0

In examining the hypothetical relationship between the short and long-run post-merger
performance, and the acquirers’ pre-merger earnings management, the proposed linear
regression model is as follows:

Equation (5) -Regression Model – Post-merger Performance

= 0+ 1 + 2 + 3 + 4 + 5
+ 6+ 7+ 8

=10

+ 9+ 10+ ∑ +10 +2003 +

=1

ABRET: CAR 3-days or 5-days around the transaction and BHAR 12-

months, 24-months or 36 months after the transaction,

respectively;
PR: acquisition premium in the M&A deal, based on the share’s
price index four weeks prior to the deal’s announcement date;
EMA: earnings management by the acquiring company as proxied
by the aforementioned aggregate abnormal accruals over
twosemi-annual reporting periods prior to the deal
announcement;
DIVERS: dummy variable for diversifying deals – measured as the
same first two digits of the SIC-code, 0 otherwise;
CROSSB: dummy variable, which indicates cross-boarder transactions,
0 otherwise;
TOEHOLD: acquirer’s toehold ownership interest in the target firm prior
to the deal;
ADVISOR: dummy variable capturing a top-tier investment bank
advising the acquirer on the M&A transaction;
CEOSHARE: the percentage of the acquirer’s common shares held by
corporate insiders. Closely-held shares are used as a proxy;
RUNUP: acquirer’s stock price run-up returns 21 days prior to the
transaction announcement to measure leakage effects or over-
reactions that could induce a reversal effect after completion
of the deal (Louis, 2004);
DEALVALUE: size of the M&A deal, as proxied by the equity value
acquired in the process;
RSIZE: revenue size of the target relative to the acquirer;
α: coefficients’ index
ε: represents the residual term of the regression model;
i: sampled M&A deal’s index
4.0 Results and Analysis

The results in Table 4.0.1 document the relation between the abnormal returns and abnormal
accruals of acquiring companies engaging in a share-for-share transaction. The descriptive
statistics reveal that share-swap acquirers have significantly lower abnormal returns than the
cash paying control group. However, the results obtained from the regression analysis are in
sharp contrast and reveal no evidence of a significant inverse relation between the abnormal
accrual measure and the cumulative abnormal return for acquirers engaging in stock swaps
over the three days or five days around the merger announcements and 24 months or 36
months following this event.

Interestingly, the coefficient of acquirer’s pre-merger earnings management (EM) is negative

and significant at the 10 percent level for setup (2) on a 12-month post-merger window. The
overall results of the regression model performed show two different, except for the 12
months post-merger performance, non-significant trends. Around the merger announcement
as well as during 12 months succeeding a deal that uses equity as payment, the coefficient has
a negative sign. Subsequently, the coefficient changes to near zero or a value that is positive
in magnitude. As Louis (2004) argues, the significantly negative correlation between long-
term performance and abnormal accruals, along with the non-significant but negative short-
term performance of the non-cash acquirers, would strongly suggest that capital markets tend
to partially correct for earnings management effects in the days leading to the transaction.
Hence, the negative long-term return of non-cash acquirers is partly attributable to the
reversal of the pre-merger earnings management efforts. The fact that significance is only
found in the 12-month post-merger period suggests that the market reacts quickly to
incorporate the effects of earnings management into the price or might even overreact and,
therefore, does slightly correct for those effects in the long-run.

The coefficient estimate TOEHOLD indicates a negative and statistically significant

association between the post-merger performance and the acquirer’s pre-merger stake in the
target company in setup (3) for 36-months post-merger period.

Table 4.0.1 also reports the results of the regressions of the post-merger stock performance
measures on the percentage of CEO shares and a dummy variable measuring the presence of
a top-tier deal advisor. The coefficient ADVISOR shows a negative but not significant sign
for all models and only turns positive in the 36-month period. This cannot be explained easily
and might underlie in the usual characteristic of deals that are structured by bulge-bracket
banks.

Finally, the coefficient for (RSIZE), the size ratio of the acquirer firm to the target firm,
which can be seen as a proxy for integration related risks as well as a greater motivational
factor for an acquirer to manage its earnings upwards (Pungaliya and Vijh, 2008), shows
negative coefficient estimates; only those in setup (3) for 5-days around the merger
announcement and setup (3) for the 36-month post-merger period are statistically significant.
This is entirely in line with literature since relative size increases the risk of integration due to
issues ranging from operational risks over integration costs through to insufficient number of
managers to run the newly integrated entity.
 Table 4.0.1 Analysis of post-merger performance of non-cash deals
The following table presents the results of the ordinary least squares regression model for post-merger performance of non-cash deals. ABRET is the abnormal return calculated over the stated period
around or after the merger announcement; EM is the acquirer’s pre-merger earnings management coefficient, PR indicates the excess payment over the target’s share price four weeks before the merger
announcement; RSIZE is the ratio of the revenues of the target to the revenues of its acquirer, DIVERS is a dummy variable which takes 1 if the deal was within the first two SIC-code digits; CROSSB
is a dummy variable which takes 1 if the is located outside the acquirers country, and 0 otherwise, TOEHOLD indicates the acquirer’s pre-merger ownership interest in the target firm, ADVISOR
indicates that a top-tier investment bank provided M&A advisory services for the acquiring firm, CEOSHARE is the number of the acquirer’s shares holdby the CEO as proxied by closely-held shares,
DEALVALUE indicates the natural logarithm of the target’s equity value, RSIZE indicates the relative sales size of the target firm;

The symbols (*), (**) and (***) denote significance at 10, 5 and 1 percent level, respectively.

CAR 3 days CAR 5 days BHAR 12 months BHAR 24 months BHAR 36 months
(1) (2) (3) (1) (2) (3) (1) (2) (3) (1) (2) (3) (1) (2) (3)
PR 0.000 0.000 0.001 -0.001 0.000 0.000 -0.003 -0.001 0.004 -0.006 -0.009 -0.003 -0.008 -0.014 0.007
(t-value) (-0.13) (-0.03) (0.46) (-0.74) (0.12) (0.21) (-0.61) (-0.23) (0.43) (-0.97) (-1.17) (-0.31) (-0.88) (-1.15) (0.61)
EM -0.083 -0.081 -0.046 -0.057 -0.078 -0.029 -0.367 -0.580 -0.613 0.133 0.101 0.239 0.492 0.871 0.398
(t-value) (-1.64) (-1.18) (-0.41) (-1.01) (-1.03) (-0.25) (-1.44) (-1.79)* (-1.13) (0.40) (0.23) (0.36) (0.97) (1.22) (0.56)
DIVERS -0.012 -0.042 -0.023 -0.057 -0.116 -0.052 0.092 -0.126 0.578 -0.179
(t-value) (-0.30) (-0.77) (-0.54) (-1.03) (-0.63) (-0.20) (0.36) (-0.39) (1.41) (-0.53)
CROSSB 0.025 -0.013 0.056 0.042 0.184 0.040 0.310 0.100 0.142 -0.411
(t-value) (0.64) (-0.23) (1.30) (0.72) (1.00) (0.15) (1.21) (0.30) (0.35) (-1.14)
TOEHOLD -0.001 0.000 0.000 0.000 0.006 0.007 0.003 0.008 0.000 0.023
(t-value) (-0.64) (-0.25) (-0.12) (-0.06) (0.90) (0.80) (0.32) (0.68) (0.01) (1.84)*
ADVISOR -0.060 -0.041 -0.051 -0.056 -0.262 -0.401 -0.206 -0.166 0.024 0.501
(t-value) (-1.14) (-0.55) (-0.88) (-0.75) (-1.05) (-1.14) (-0.60) (-0.38) (0.04) (1.09)
CEOSHARE 0.001 0.000 0.001 0.000 0.004 0.001 0.008 -0.003 0.016 -0.007
(t-value) (1.65) (-0.09) (1.38) (-0.22) (1.21) (0.13) (1.59) (-0.40) (2.00)* (-1.02)
RUNUP -0.020 -0.099 -0.022 0.121 0.236
(t-value) (-0.20) (-1.01) (-0.05) (0.21) (0.39)
DEALVALUE 0.006 0.009 0.080 0.075 0.059
(t-value) (0.56) (0.82) (1.62) (1.23) (0.91)
RSIZE -0.002 -0.002 -0.002 -0.005 -0.018
(t-value) (-1.59) (-1.73)* (-0.42) (-0.88) (-2.77)**
(t-value)

Constant -0.006 -0.093 0.053 -0.043 -0.137 -0.032 -0.186 -0.467 -0.442 -0.345 -0.597 -0.161 -0.501 -1.873 0.625
(t-value) (-0.13) (-1.41) (0.37) (-0.85) (-1.88)* (-0.22) (-0.81) (-1.50) (-0.65) (-1.17) (-1.39) (-0.19) (-1.11) (-2.72)** (0.70)

N 141 136 131 141 136 131 141 136 131 141 136 131 141 136 131
F-statistic 0.520 0.780 0.620 0.580 0.880 1.100 1.150 1.080 0.690 0.750 1.090 0.750 3.230 2.720 2.670
P-value 0.860 0.684 0.824 0.815 0.593 0.447 0.361 0.431 0.766 0.674 0.420 0.720 0.006*** 0.019** 0.043**
R2 0.149 0.369 0.483 0.163 0.398 0.622 0.277 0.447 0.510 0.200 0.450 0.529 0.518 0.671 0.800
Adj. R2 -0.135 -0.104 -0.293 -0.117 -0.054 0.054 0.036 0.032 -0.226 -0.067 0.038 -0.178 0.358 0.425 0.500
4.1 Concurrent Analysis for Cash Deals

Analogous to the previous concurrent analysis of pure cash deals, pre-merger earnings
management would only have an impact on the post-merger performance if the M&A
payment structure of the deal is a share-swap (i.e. equity is issued to pay for the transaction).
In the alternative case of a 100% cash deal, it could be argued that the coefficient for the
acquirer’s pre-merger earning management is shown to be irrelevant to explain the post-
merger performance (Erickson and Wang, 1999). The former section directly reports
evidence of pre-merger earnings management for a non-cash sample.

Table 4.1.1 documents the ordinary-least-squares regression results of the models for a
concurrent sample of cash deals. As expected, the coefficient of earnings management (EM)
is insignificantly different from zero. The study documents a negative and insignificant
coefficient in all different setups, which is in contrast to the results reported for the non-cash
deals.

In summary, the analysis of cash-only deals does not indicate any significant relation between
pre-merger earnings management of the acquiring firm and its post-merger performance
around the deal announcement as well as in the long-term after the completion. The evidence
documented in this section supports and furthermore adds greater robustness to the earlier
findings regarding the documented significant relation in share-swap deals.
 Table 4.1.1Concurrent analysis of post-merger performance of pure cash deals
The following table presents the results of the ordinary least squares regression model for post-merger performance of pure cash deals. ABRET is the abnormal return calculated over the
stated period around or after the merger announcement; EM is the acquirer’s pre-merger abnormal current accruals, PR indicates the excess payment over the target’s share price four weeks
before the merger announcement; RSIZE is the ratio of the revenues of the target to the revenues of its acquirer, DIVERS is a dummy variable which takes 1 if the deal was within the first
two SIC-code digits; CROSSB is a dummy variable which takes 1 if the is located outside the acquirers country, and 0 otherwise, TOEHOLD indicates the acquirer’s pre-merger ownership
interest in the target firm, ADVISOR indicates that a top-tier investment bank provided M&A advisory services for the acquiring firm, CEOSHARE is the number of the acquirer’s shares
hold by the CEO as proxied by closely-held shares, DEALVALUE indicates the natural logarithm of the target’s equity value, RSIZE indicates the relative sales size of the target firm;

The symbols (*), (**) and (***) denote significance at 10, 5 and 1 percent level, respectively.

CAR 3 days CAR 5 days BHAR 12 months BHAR 24 months BHAR 36 months
(1) (2) (3) (1) (2) (3) (1) (2) (3) (1) (2) (3) (1) (2) (3)
PR 0.000 0.000 0.000 0.000 0.000 0.000 0.001 0.001 0.001 0.002 0.002 0.001 0.002 0.002 -0.002
(t-value) (0.90) (1.03) (1.31) (1.25) (1.27) (1.91)* (1.37) (1.60) (0.83) (0.92) (1.32) (0.62) (0.19) (0.44) (-0.41)
EM 0.024 0.027 -0.027 0.036 0.037 -0.041 -0.021 -0.021 0.031 -0.157 0.039 -0.072 -1.064 0.065 0.191
(t-value) (1.18) (1.30) (-0.99) (1.46) (1.52) (-1.40) (-0.19) (-0.21) (0.22) (-0.47) (0.18) (-0.27) (-0.68) (0.11) (0.22)
DIVERS 0.008 -0.003 0.017 0.000 -0.085 -0.090 -0.034 0.009 0.323 0.248
(t-value) (0.69) (-0.25) (1.30) (-0.03) (-1.58) (-1.59) (-0.28) (0.08) (1.00) (0.73)
CROSSB -0.002 -0.002 0.003 0.000 -0.026 0.039 0.055 0.128 -0.140 0.130
(t-value) (-0.21) (-0.15) (0.25) (0.01) (-0.45) (0.61) (0.44) (1.04) (-0.41) (0.34)
TOEHOLD 0.000 0.000 0.000 0.000 0.003 0.002 0.000 0.000 -0.008 -0.012
(t-value) (-0.41) (0.36) (-0.61) (0.44) (1.14) (0.73) (-0.09) (0.05) (-0.58) (-0.82)
ADVISOR -0.006 -0.017 -0.005 -0.014 0.045 0.063 0.345 0.237 0.783 0.911
(t-value) (-0.47) (-1.36) (-0.34) (-1.07) (0.78) (0.98) (2.72) (1.94)* (2.26) (2.36)**
CEOSHARE 0.000 0.000 0.000 0.000 0.000 -0.001 -0.001 -0.004 -0.010 -0.009
(t-value) (1.56) (0.96) (1.13) (0.73) (-0.29) (-0.84) (-0.44) (-1.66)* (-1.48) (-1.31)
RUNUP -0.039 -0.031 0.180 -0.020 -0.977
(t-value) (-0.84) (-0.63) (0.75) (-0.04) (-0.68)
DEALVALUE 0.001 0.001 -0.021 -0.030 -0.141
(t-value) (0.44) (0.34) (-1.31) (-0.98) (-1.47)
RSIZE -0.001 -0.001 0.014 0.004 0.009
(t-value) (-0.86) (-1.04) (2.07)** (0.30) (0.21)
Constant -0.010 -0.013 -0.012 -0.016 -0.059 -0.056 1.121 -0.071 0.016 7.818 -0.280 -0.065 41.068 -0.937 -0.039

(t-value) (-0.24) (-0.32) (-0.28) (-0.32) (-1.22) (-1.26) (5.11)*** (-0.35) (0.08) (11.89)*** (-0.63) (-0.16) (13.11)*** (-0.78) (-0.03)

N 140 126 113 140 126 113 140 126 113 140 126 113 140 126 113
F-statistic 1.100 0.910 0.890 1.390 1.150 1.080 3.190 1.030 1.460 13.260 1.010 1.160 15.770 0.810 0.650
P-value 0.363 0.551 0.594 0.184 0.319 0.382 0.000*** 0.432 0.123 0.000*** 0.451 0.308 0.000*** 0.669 0.851
R2 0.087 0.111 0.145 0.107 0.136 0.172 0.215 0.123 0.218 0.533 0.121 0.182 0.575 0.099 0.111
Adj. R2 0.008 -0.010 -0.018 0.030 0.018 0.013 0.148 0.003 0.069 0.492 0.001 0.026 0.539 -0.024 -0.060
Following Baik et al. (2007), we further divide the sample into a group of acquirers of public targets and a
group of acquirers of private targets. Baik et al. (2007) argue that due to the greater valuation risk
introduced by private targets in contrast to public ones, non-cash acquirers have greater incentives to
manage earnings upwards before announcing a deal with a private target. This procedure reduces the
number of shares to be issued by increasing the valuation of the bidder’s shares and hence lowers the real
acquisition price.

Table 4.1.2Earnings Management: Private and Public targets

C.EM is the cumulative earnings management figure for the two semi-annual periods preceding the deal announcement as
proxied by the abnormal current accrual coefficient. EM (t-1) represents the abnormal current accruals one period before the
deal announcement. The symbols (*), (**) and (***) denote significance at 10, 5 and 1 percent level, respectively.

Total (N=141) Private (N=84) Public (N=57)

Mean Med. STD Mean Med. STD Mean Med. STD
C.EM 0.0831 0.0099 0.5080 0.0998 0.0017 0.6229 0.0586 0.0252 0.2631
(t-value) (1.96) ** (1.47) * (1.68) **
EM (t-1) 0.0581 0.0028 0.3629 0.1349 0.0001 1.4475 0.0017 -0.0134 0.1858
(t-value) (1.94) ** (1.58) * (0.07)

Table 4.1.2 reveals strong evidence of relatively higher positive abnormal accruals for acquiring firms
prior to the merger announcement period if they bid for a private company, suggesting that the acquirers
inflate earnings within the scope of managerial discretion in an effort to increase the share price. This
result further supports Baik et al.’s (2007) pricing-uncertainty hypothesis: by taking the relatively higher
information asymmetry into account, the bidder engages more aggressively in upward earnings
management to transfer parts of this risk to the target’s shareholders.
 Figure 4.1.1 Post-merger Performance: Private and Public targets

0.8
0.6
0.4
0.2
0
-0.2 12 MONTH 24 MONTH 36 MONTH

-0.4
-0.6
-0.8
-1 Private Public

Further, it appears that the overall reaction of the market is substantially different for private and public
targets. In both cases, investors correct for earnings management efforts prior to a merger
announcement in the first twelve months preceding a merger. For acquirers of private targets, however,
this reversal is fully incorporated into the price after that period. Acquirers of public targets continue to
experience negative abnormal returns.

Table 4.1.3 Post-merger Performance: Private and Public targets

The table shows the post-merger performance of acquiring companies grouped in accordance with
the listing status of the target.
The symbols (*), (**) and (***) denote significance at 10, 5 and 1 percent level, respectively.

Private (N=84) Public (N=57) Difference

Mean Med. STD Mean Med. STD Mean Med.
3 days 0.0286 0.0227 0.1180 -0.0145 -0.0135 0.0677 -0.0431 0.0362
(t-value) (2.22) *** (-1.63) ** (-2.51) **
5 days 0.0229 0.0181 0.1373 -0.0177 -0.0151 0.0854 -0.0406 0.0332
(t-value) (1.52) * (-1.58) *** (-2.00) **
12 months -0.2778 -0.3087 0.5531 -0.2055 -0.2253 0.4208 0.0723 -0.0833
(t-value) (-4.60) *** (-3.71) *** (0.84)
24 months 0.1675 -0.4816 6.3875 -0.4186 -0.3042 0.6681 -0.5861 -0.1774
(t-value) (0.24) (-4.77) *** (-2.69) ***
36 months 0.6605 -0.6670 1.5342 -0.8212 -0.6234 1.2809 -1.4817 -0.0435
(t-value) (0.95) (-4.88) *** (-2.84) ***

Regarding the market’s reaction to the merger announcement, investors seem to factor the bidder’s
earnings management in their pricing of the bidder. Overall, the results suggest that bidders view the
acquisition of privately held targets as information-sensitive investments and thus demand a premium for
pricing uncertainty by engaging in aggressive earnings management. This means the market’s assessment of
the impending acquisition is furthermore conditioned on the bidder’s accrual activity. These findings clearly
contradict results by Baik et al. (2007), who claim that they do not find a relationship between an acquirer’s
abnormal accruals and its long-term post-merger performance. This study’s findings support the results of
Petmezas (2009) and Francoeur et al.(2011) by showing that a segregation of the sample in private and public
targets leads to a significantly different trend between them.

Additionally, it appears that the reversal effects of prior earnings management at merger announcements
are non-existent for private targets (or more pointed, they even exhibit positive announcement returns,
which is in line with Chang (1998)) or only partial for public targets since the market corrects these
efforts gradually during the first 12 months after the deal announcement. These findings are consistent
with Louis (2004) and Eckbo (2009). The separate analysis of private and public target acquirers reveals
that the former yield positive long-term abnormal returns whereas the latter continue to experience
negative abnormal returns even after correcting for cumulative abnormal current accruals.

As Louis (2004) claims, the documented results could be of importance because, in efficient capital
markets, returns are not supposed to be predictable. The documented results, especially the
underperformance of the acquirers of public targets is still unexplained. Past literature suggests that the
long-term underperformance of acquiring firms after the deal completion, reported in the extant literature,
is partly attributable to the reversal of prior earnings management efforts. This, however, cannot be
confirmed based on the results reported in this paper, because there is no reason why this reversal needs
more time in the case of acquiring public targets than in the case of acquiring private ones.
5.0 Conclusion

In this paper we employ a sample of European bidders listed in Germany, France, Italy, the UK, and
Spain to examine the association between bidders’ earnings management prior to the M&A deals and
their post-merger performance. This paper aims at explaining whether the pre-merger earnings
management by acquirers in Europe, which is expected to increase the acquirers’ pre-merger market
valuation and hence lowers the real acquisition premium paid to the target firm’s shareholders, affects the
combined entities post-merger stock market performance

The results suggest that prior to the M&A deals announcement in Europe, upward earnings management
(up to six months prior to the deal announcement) is reported for stock-for-stock acquirers. This is
consistent with the literature focusing on the US. We find that the acquirers of private companies are
significantly different than the acquirers of public listed companies. Aggressive positive earnings
management is shown in the deals of private targets, which is caused by different levels of asymmetric
information.

This paper contributes to the existing literature by documenting that the market shows a non-significant
negative reaction trend in the short-term, a highly significant negative reaction during the first year after
the announcement as well as a negative trend up to three years preceding the deal announcement for an
average share-for-share acquirer. The reversal of the effects of pre-merger earnings management around
the announcement of a non-cash deal is only partial. The study documents that the first year after the deal
announcement is the main driver of the acquirer’s negative long-term performance. This implies that
capital markets do not fully capture effects of pre-merger earnings management but they, indeed, require
up to one year correcting this overpricing. Further analyses reveal that investors seem to factor the
bidder’s earnings management in their pricing of the bidder. After correcting the uncovered earnings
management efforts, the negative effect of the acquirer’s post-merger share price is more pronounced
when the bidder acquires a publicly traded target. The results are important because in efficient markets,
returns are not supposed to be predictable. The study at hand, however, documents that certain deal
characteristics are highly significant and thus make it possible to predict certain market movements after a
deal announcement.

Among the potential limitations of this study is the generalizability of its findings, Due to the
heterogeneous corporate reporting standards throughout European countries. Moreover, there could be a
lack of quarterly accounting data. Further studies regarding the connection between earnings
management and acquirer characteristics are important, taking into consideration payment structure and
target listing status.

Finally, the study does not offer any satisfactory answer to the post-merger performance puzzle (Agrawal
and Jaffe, 2000). Gong et al. (2008) warn that acquirers, which engage in aggressive upward earnings
management, are more likely to experience higher post-merger litigation costs and thus, experience
negative post-merger stock market performance. Thus, further research is stimulated to examine this
relationship after stratifying the M&As based on the listing status of the target firms
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