Trade-off Between Accrual-based & Real Earnings Management And Their Impacts On Acquirer Around M&A

M&A is the eternal theme in the capital market. Driven by a series of policies of mergers and reorganization after the Split-share reform, M&A plays a more and more important role in achieving span type development of China’s enterprises, eliminating backward production capacity, optimizing economic layout and economic structure. At present, the Chinese economy has entered the new stage of merger and reorganization. It has become a hot spot that financial accounting problems are constantly emerging in M&A theory and practice research fields under the new situation, especially in the reality of unsatisfactory effects of M&A. There is no doubt that accounting information quality affects the effect of M&A and earnings management is an important dimension to measure the quality of accounting information. Although scholars have made some beneficial discussions on earnings management problem of M&A in China, Most of the literature regard the target company as research object because the focus of M&A audit practice is the acquied company. However, the merger is bilateral transactions to transfer control and acquiring company is often the dominant party in the M&A transactions. Will acquiring firms manipulate earings? If they do manipulate earings, it is worth studying how they make choices between accrual-based and real earings management strategies? Based on public corporates’ date from 2006 to 2014, this paper examines how Chinese acquiring companies tend off and conduct accrual-based & real activities manipulation strategies as well as their effect on post-M&A operation performance.Firstly, under the guidance of game theory and institutional economics,we investigate the reasons why does the acquiring company carry on the earnings management.Theory analysis demonstrates that both of acquired and acquiring firms conduct earnings management is "the Nash equilibrium solution" of the game of M&A transactions. As the main participant, the rational choice of acquiring firms is to carry on earnings management strategy if they can’t fully know whether or not acquired firms take the earnings manipulation strategy at the same time. Meanwhile, underdeveloped control market and manager market, special property right system and arrangement, information disclosure and evaluation system, imperfect regulation and less stringent law enforcement, etc., provides the possibility and feasibility for acquiring companies to manipulate earnings in M&A.Secondly, we find that acquiring firms engage in both accrual-based and real activities manipulation in the period prior to the merger agreement. In order to reduce the cost of buying the target, minimize the likelihood of earnings dilution and vote power and contal power dilution of existing shareholders, acquiring firms attempt to manage earnings upward. Howerer, acquiring firms attempt to manage earnings downward in order to increase market confidence. The empirical evidence suggests that acquiring firms conduct earnings management through accrual-based and real activities manipulation strategies in Chinese capital market.Thirdly, the paper has explained the problems how acquiring firms trade off between accrual-based and real activities manipulation strategis. First of all, we analyze the factors that influence acquiring firms’ decisions to manage earnings from four dimensions (namely, internal corporate governance, external corporate governance, Characteristics of M&A, features of corporate fundamentals), Therefore we design a two-stage expanded Heckman model for acquiring firms to manage earnings following cohen and Zarowin(2010) and Zang(2012), based on correction of potentially self-selection bias of M&A samples and earnings management samples. The empirical evidences show that the share-proportion of institutional investors is negatively correlated with the real earnings management. Meanwhile the acquiring firms have higher auditor or lies in the higher legal protection regions did not show a significant tendency to use real earnings management. Shareholder’s ownership proportion and imperfect internal control mechanism are positively correct with accrual earnings management method. Management ownership and board independence do not show significant evidence for tendency of acquiring firms to use real activity manipulation method. The acquiring companies which transact with related parties are more inclined to engage in real earnings management than non-related transactions. Market leading acquiring firms have higher level of real earnings management, while companies with good financial health, longer business cycle, higher marginal tax rate and accounting flexibility prefer to accrual earnings management. Forthermore, the priotiry of accrual-based and real earnings management strategies is not fixed.Fourthly, this paper empirically investigates differential effects of two earnings management strategies on the issue of underperformance in post-M&As. We find that in general, earnings management is negatively related with the outcome of post-M&A. We also find that the negative impact of real activity earnings management is greater than that of accrual-based earnings management. Furthermore, the capability of M&A has played a positive role in diminishing the detrimental impact of earnings management on the long-term performance of M & A. It is concluded that whether earnings management can cause substantial damages to long-term post-performance depends on the M&A capacity of acquiring firms, especially the integration ability after the deal is done. Therefore, not only should investors pay close attention to temporary earnings management of acquiring firms prior to M&A announcement, but also they should evaluate the M&A capability of those firms when appraising the overall outcome of M&As.