Financial reporting quality of target companies and acquirer returns: evidence from Korea

• Date: 02 March 2015
• Published date: 02 March 2015
• DOI: https://doi.org/10.1108/IJAIM-07-2014-0052
• Pages: 16-41
• Author: Joohyun Lim,Jaehong Lee,jinho Chang
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

Financial reporting quality of

target companies and acquirer

returns: evidence from Korea

Joohyun Lim and Jaehong Lee

Department of Business, Yonsei University, Seoul, Republic of Korea, and

Jinho Chang

Department of Business Administration, Yonsei University, Seoul,

Republic of Korea

Abstract

Purpose – This paper aims to examine the association between nancial reporting quality in target

companies and acquisition protability in a sample of 280 acquisitions in South Korea between 2002

and 2011.

Design/methodology/approach – Using the accruals quality measure developed by McNichols

(2002) as a proxy for nancial reporting quality, it was found that high-quality nancial reporting in

target companies is associated with more protable acquisitions for the acquirer, as measured by the

acquirer’s announcement returns.

Findings – It was found that high-quality nancial reporting in target companies is associated with

more protable acquisitions for the acquirer, as measured by the acquirer’s announcement returns. This

nding suggests that higher-quality accounting information leads to better decision-making during

acquisitions. It was also found that the importance of nancial reporting quality increases when

information about the target company is scarce. In addition, it was found that the nancial reporting

quality of target companies is less important when the agency costs of the acquirer are high.

Practical implications – This analysis also complements several recent papers that examine target

rm accounting information and mergers and acquisitions (M&A) returns (Shalev and Martin, 2009;

McNichols and Stubben, 2012). By expanding this analysis, the authors help to provide a more complete

understanding of how target rm’s accounting quality relates to the valuation of the target company

and future expected synergies in M&A deal practice.

Originality/value – This study is one of a growing body of literature on the relations between

nancial reporting quality and investment decisions (Bens and Monahan, 2004; Biddle and Hilary, 2006;

Hope and Thomas, 2008; McNichols and Stubben, 2008; Biddle et al., 2009; Francis and Martin, 2010).

These results extend and generalize the results of prior studies, in that data pertinent to acquisition

protability of M&As in South Korea are used.

Keywords Information environment, Agency problem, Target, Financial reporting quality, M&A

Paper type Research paper

1. Introduction

Financial reporting quality has a profound inuence on decision-making, particularly

for investment decisions. Prior studies suggest that high-quality nancial reporting

may increase investment efciency (Bushman and Smith, 2001;Healy and Palepu, 2001;

Biddle and Hilary, 2006;Biddle et al., 2009). They posit that the association between

nancial reporting quality and investment efciency relates to a reduction in

The current issue and full text archive of this journal is available on Emerald Insight at:

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IJAIM

23,1

16

Received 27 July 2014

Revised 7 October 2014

Accepted 7 October 2014

InternationalJournal of

Accounting& Information

Management

Vol.23 No. 1, 2015

pp.16-41

©Emerald Group Publishing Limited

1834-7649

DOI 10.1108/IJAIM-07-2014-0052

information asymmetry and information uncertainty between rms and external

suppliers of capital. Many scholars argue that high-quality nancial reporting may

allow constrained rms to attract capital by making their positive net present value

projects more visible to investors (Bens and Monahan, 2004;Biddle and Hilary, 2006;

Bushman et al., 2006;McNichols and Stubben, 2012). We investigate the effects of

high-quality nancial reporting on investment efciency, focusing on mergers and

acquisitions (M&A). Particularly, we examine whether the quality of nancial reporting

for the target company in an M&A deal affects returns for the acquirer (i.e. investor).

The rationale for making an acquisition is that combining businesses can create

economic synergies in cases where the value of the target to the acquirer exceeds the

standalone value of the target. In an M&A, the acquirer pays the deal price to obtain the

value of the target company plus expected synergies. However, there is often

uncertainty and disagreement in the estimation of the target’s value and the synergies

which will determine returns for the acquirer. We predict that high-quality information

in nancial reports will reduce information uncertainty about target companies, as it

allows the acquirer to determine the value of the target company and future expected

synergies with greater precision[1].

Because the value of a target company and future expected synergies equals the

present value of future operating cash ows[2], precise estimation of future cash

ows is crucial for an M&A to be successful. As accounting information is

rm-specic (Bushman and Indjejikian, 1993;Holmstrom and Tirole, 1993;Kanodia

and Lee, 1998), an important attribute of the quality of accounting information is the

extent to which accruals map into cash ows. Poor mapping of accruals into cash

ows reduces the information content of reported earnings and results in

lower-quality earnings (Bhattacharya et al., 2013). As accounting information helps

predict future cash ows (Dechow, 1994;Barth et al., 2001), high-quality accounting

information about a target company enhances the estimates of future cash ows of

the merged company.

McNichols and Stubben (2012) examine the negative association between target

valuation uncertainty and acquirer stock returns on the announcement date using an

acquisitions sample of 2,341 US rms from 1990-2009. They assert that high-quality

accounting information decreases value uncertainty and increases the ability to

estimate the value of the target to the acquirer, who, therefore, pays relatively less for the

acquisition. Our study extends the work of McNichols and Stubben (2012), with the

following differences.

First, we nd that the importance of nancial reporting quality of the target

company varies according to that company’s information environment. Financial

reporting is more important when the target is an unlisted company rather than a

listed one. In the case of public rms, information abounds; it may include stock

price data, annual reports, analyst reports and articles from the business press. Most

information is not available for unlisted companies. In addition, if the target and the

acquirer are in different industries, nancial reporting quality gains more

importance. In M&A deals, the inuential factor in alleviating information

asymmetry is the business proximity between acquirers and targets (Balakrishnan

and Koza, 1993;Villalonga and McGahan, 2005). If the core businesses of the

acquirer and the target are similar, the target’s resources, the abilities of the board

of directors, the main customers and suppliers and the future prospects regarding

17

Financial

reporting

quality