Acquisition profitability and timely loss recognition
Introduction
We examine the association between accounting conservatism and a firm's acquisition-investment decisions.2 The prediction is that managers of firms with timely loss recognition pursue more profitable acquisitions and make better ex post divestiture decisions. Our study builds on the argument that conservative accounting policies are part of a firm's corporate control structure that constrains opportunistic behavior by managers, particularly their investment decisions (Ball, 2001; Watts, 2003; Ball and Shivakumar, 2005). Accounting has long been viewed as part of the firm's monitoring technology to mitigate agency costs (Watts and Zimmerman, 1983, Watts and Zimmerman, 1986; Ball, 1989). Recent conservatism literature documents that timely loss recognition is an important property of accounting that is associated with stronger governance structures such as independent boards of directors and the use of high-quality external auditors (Basu et al., 2001b; Beekes et al., 2004; Ahmed and Duellman, 2007; Garcia Lara et al., 2009).
Well-governed firms can use timely loss recognition to monitor managerial performance and discipline managers. If managers know ex ante that economic losses will be recognized earlier (rather than later), they are less likely to engage in value destroying acquisitions. This is because the negative earnings consequences will reduce earnings-based compensation and threaten job security. Moreover, if economic losses are charged against income earlier, even if managers have not terminated losing projects, there is no additional income penalty to actual project abandonment. Therefore, timely loss recognition encourages managers to terminate projects and limit further value destruction. In contrast, the absence of accounting conservatism allows managers to defer the negative consequences (including abandonment) of unprofitable acquisitions to later generations of managers. To be effective, accounting conservatism requires enforcement by the firm's governance and control system. Enforcement ensures that managers report conservatively, ex post, particularly when acquisitions turn out to have negative net present values. In other words, while timely loss recognition can facilitate governance, it cannot do so alone and must be implemented and enforced within the broader context of a firm's overall control system.
The relation between conservatism and the profitability of investment decisions is salient in the context of acquisitions for two reasons. First, acquisitions are among the largest and most readily observable forms of corporate investments. Second, these investments tend to intensify the agency conflicts between managers and shareholders in large public corporations (Smith, 1776; Berle and Means, 1933; Jensen and Meckling, 1976). For example, Jensen (1986) argues that empire-building managers would rather make acquisitions than increase payouts to shareholders. Therefore acquisitions potentially provide a powerful setting to investigate the governance role of timely loss recognition.
Following Masulis et al. (2007), we measure acquisition profitability as the acquirer's 3-day cumulative abnormal return (CAR) around an acquisition announcement date. This captures the market's expectation of both ex ante investment selection and ex post decision-making. We also examine two ex post measures of profitability: change in post-acquisition operating performance and the likelihood of post-acquisition divestitures. Prior research indicates that an ex post divestiture is evidence of a poor acquisition-investment decision (Kaplan and Weisbach, 1992). In addition, the duration of an acquisition before a subsequent divestiture occurs sheds light on the affect of accounting conservatism on timely abandonment of poorly performing acquisitions.
Timely loss recognition is measured with the Basu (1997) model that regresses current year earnings on returns and allows the return coefficient to vary with the sign of returns. Following Moerman (2008) we assess timely loss recognition in two ways. First, we examine the incremental coefficient on negative returns relative to the coefficient on positive returns, which captures the relative timeliness of loss recognition. Second, we consider the sum of the two coefficients which measures the total timeliness of loss recognition.
We find that timely loss recognition is associated with larger announcement returns for acquiring firms, based on a sample of 17,202 acquisitions from Security Data Corporation (SDC) over the period 1980–2006. Also, post-acquisition earnings and cash flows are larger for acquiring firms with more timely loss recognition relative to acquiring firms with less conservative accounting. Firms with timely loss recognition are also less likely to make post-acquisition divestitures (suggesting better ex ante decisions), but when they divest they do so more quickly. Finally, we find a stronger association between timely loss recognition and acquisition profitability when a bidding firm has greater ex ante agency costs, and therefore increased benefits from a policy of accounting conservatism (Demsetz and Lehn, 1985; LaFond and Watts, 2008).
Our study makes several contributions. Prior research shows the role of accounting conservatism in mitigating agency costs arising from shareholder–bondholder conflicts (e.g., Ahmed et al., 2002; Ball et al., 2008; Zhang, 2008). Our study suggests that conservative accounting policy can also reduce agency conflicts between shareholder and managers. LaFond and Watts (2008) document that information asymmetry between shareholders and managers leads to more conservative financial statements and the implementation of accounting conservatism reduces information asymmetry. LaFond and Roychowdhury (2008) argue that concentrated managerial ownership mitigates agency costs and thus reduces the demand for accounting conservatism. Our work complements these two studies by demonstrating that accounting conservatism leads to more profitable acquisition decisions in the presence of agency costs arising from information asymmetry. Our study is also related to Chen et al. (2007) who document that institutional investors who are active in monitoring can discipline managers to undertake value-enhancing acquisitions. We find that implementation of accounting conservatism is another mechanism that creates managerial incentives to avoid poor acquisition-investment decisions. Finally, our paper adds to the research by Beekes et al. (2004), Ahmed and Duellman (2007), and Garcia Lara et al. (2009) documenting an association between governance and conservative accounting policies. Consistent with this literature, the acquirers in our sample have more timely loss recognition when they have more independent boards of directors and high-quality external auditors. Thus our finding that accounting conservatism is associated with better acquisition-investment decisions is consistent with well-governed firms employing accounting conservatism as part of their overall monitoring and control structure.
In sum, our evidence suggests that accounting conservatism complements other governance mechanisms to achieve better investment outcomes. However, we cannot rule out the alternative explanation that governance mechanisms are independently associated with both accounting conservatism and better acquisition policies, in which case conservatism per se may not have a direct effect on acquisition profitability.
The remainder of the study is organized as follows. The next section reviews prior literature and develops our two hypotheses. Section 3 describes the data, sample, and research design. Section 4 presents the empirical results of using 3-day CAR to measure acquisition profitability. Post-acquisition outcomes with respect to operating performance and divestiture decisions are reported in Section 5. Sensitivity analyses and robustness tests are undertaken in Section 6, and Section 7 concludes the paper.
Section snippets
Hypotheses development
Prior research posits that agency problems can lead managers to over-invest in negative net present value (NPV) projects and to delay the abandonment of losing projects. Jensen (1986) argues that managers in firms with abundant cash flow but low growth opportunities engage in empire building at the expense of shareholders. Shleifer and Vishny (1989) model the incentive of managers to make manager-specific investments, and Morck et al. (1990) suggest that acquisitions can yield private benefits
Sample description
The sample of acquisitions and divestitures is extracted from the SDC US Mergers and Acquisitions database. We identify 17,202 acquisitions by 4979 unique firms between January 1, 1980 and December 31, 2006 after requiring that the bidder have annual financial statement information available from Compustat and stock return data from the CRSP Daily Stock Price and Returns File. Among the 17,202 acquisitions, 15,055 are completed, 904 are withdrawn, and 840 are pending. The status of the
Descriptive statistics
Table 2 reports descriptive statistics for the sample. The mean (median) 3-day bidder CAR is 1.2 (0.4)% which is similar to the mean of 1.1% and median of 0.36% reported in Moeller et al. (2004). The mean of earnings scaled by market value (X) is 0.05 with a median value of 0.06 and is comparable to the mean of 0.04 and median of 0.07 in LaFond and Watts (2008). The mean and median returns (R) of bidders during the year before acquisitions are 0.26 and 0.18, respectively. These statistics are
Post-acquisition analysis
The previous section documents that firms with greater accounting conservatism make more profitable acquisitions based on ex ante market perceptions and that this relation is stronger for firms with greater ex ante agency costs. In this section, we examine post-acquisition operating performance and also determine if timely loss recognition is associated with divestiture decisions.
Relation between timely loss recognition and governance structure
We argue in Section 1 that conservative accounting requires other mechanisms to enforce its implementation because managers have incentives to deviate from its consistent application over time. Recent studies provide evidence consistent with this view. Garcia Lara et al. (2009) document a positive relation between accounting conservatism and a composite measure of corporate governance. Similar conclusions are reached by Ahmed and Duellman (2007) and Beekes et al. (2004). In addition, Basu et
Conclusion
We investigate whether timely loss recognition is associated with a firm's acquisition-investment decisions. We find that firms with greater accounting conservatism make more profitable acquisitions as evidenced by ex ante market perceptions (larger announcement returns), higher post-acquisition operating performance, and fewer but more timely divestiture decisions. The association between timely loss recognition and acquisition profitability is stronger for firms with greater ex ante agency
Acknowledgement
We thank the editor, Jerold Zimmerman, the referee, Sudipta Basu, the discussant, Sugata Roychowdhury, and participants at the 2008 JAE Research Conference. We also thank Mark DeFond, Richard Frankel, Inder Khurana, and K.R. Subramanyam for their many helpful comments, and workshop participants at Bond University, University of Melbourne, University of Missouri, Washington University in St. Louis, and University of Southern California.
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