Real earnings manipulation surrounding mergers and acquisitions: the targets’ perspective

• DOI: https://doi.org/10.1108/IJAIM-11-2020-0188
• Published date: 08 June 2021
• Date: 08 June 2021
• Pages: 429-451
• Subject Matter: Accounting & finance,Accounting/accountancy,Accounting methods/systems
• Author: Tariq Zaglol Elrazaz,Moataz Elmassri,Yousry Ahmed

Real earnings manipulation

surrounding mergers and

acquisitions: the

targets’perspective

Tariq Zaglol Elrazaz

College of Business and Economics, United Arab Emirates University,

Al-Ain, United Arab Emirates

Moataz Elmassri

Roehampton Business School, University of Roehampton, London, UK and

Faculty of Commerce, Accounting Department, Zagazig University,

Zagazig, Egypt, and

Yousry Ahmed

Accounting and Finance Department, Newcastle University, Newcastle upon Tyne,

UK and Faculty of Commerce, Zagazig University, Zagazig, Egypt

Abstract

Purpose –This paper aims to investigate whether UK public targets manage their earnings using real

activities manipulation in the periodprior to the announcement of a mergers and acquisition (M&A). It also

examines whether the payment method in M&As affects the degree to which takeover targets manipulate

earnings.

Design/methodology/approach –Using a sample of 131 UK listed targets acquired over the period

1995–2013, thispaper examines real earnings management (REM) by employing OLS regressionmodels. The

data related to deals have been mainly collected from Thomson One Banker and Thomson Reuters Eikon

databases. REM is examined by investigating abnormalcash f‌low from operations, abnormal discretionary

expenses and abnormal production costs. This analysis was supplemented by conducting additional

robustnesschecks.

Findings –The results show that UK takeover targets manage earnings upwards through cutting

discretionary expensesin the year prior to the acquisition, while they do not do so by manipulating sales or

production costs. Moreover, targets of cash-only or mixed-payment deals do not have the same strong

motivation to manage their earnings as stock-f‌inanced deal target counterparts do. Our results continue to

hold after using alternative accrualearnings management (EM) measures, controlling for unobservable f‌irm

heterogeneity using the f‌ixed-effect model and controlling for endogeneity using the two-stage Heckman

(1979) model.

The authors gratefully acknowledge the helpful comments and suggestions received from the three

anonymous reviewers. Editor-in-Chief Maggie Liu provided excellent editorial support. All the

remaining errors are the sole responsibility of the authors.

The authors gratefully acknowledge the f‌inancial support provided by United Arab Emirates

University (UAEU), Grant Code: G00003349.

Declaration of conf‌licting interests: The authors declare no potential conf‌licts of interest with

respect to the research, authorship and/or publication of this article. There are no f‌inancial and

personal relationships with other people or organisations that could inappropriately inf‌luence (bias)

their work.

Real earnings

manipulation

429

Received25 November 2020

Revised5 February 2021

Accepted10 March 2021

InternationalJournal of

Accounting& Information

Management

Vol.29 No. 3, 2021

pp. 429-451

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-11-2020-0188

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

https://www.emerald.com/insight/1834-7649.htm

Practical implications –The main f‌indingsof this study could be benef‌icial for various parties involved

M&As, suchas standard setters and regulators. A needarises to improve disclosure rules andenhance overall

f‌inancial reporting quality in the capital markets with the aim of reducing information asymmetry and

agency conf‌licts.

Originality/value –As far as the literatureon EM around M&As is concerned, only EM by acquirers has

been examined,and not much attention has been paid to targets’EM.

Keywords Mergers and acquisitions, Real earnings management, Cash-only deals,

Mixed-payment deals, Stock-f‌inanced deals

Paper type Research paper

1. Introduction

Mergers and acquisitions (M&As) are amongst the most signif‌icant strategic investment

decisions that f‌irms make (Elmassriet al.,2016). One of the major f‌inancial practices within

the M&As context is earnings management (EM), as it may have a signif‌icant economic

impact on the associated wealth transfers among stakeholders (Botsari and Meeks, 2008).

Prior literature on EM demonstrates that managers may engage in two primary forms of

EM, namely, accrual-based earnings management (AEM) and real earnings management

(REM). In contrast to AEM, in which managers adjust assumptions, estimates and choices

within the accounting system, REMinvolves the timing and structuring of normal business

activities to achieve a favourably perceived and desired f‌inancial reporting result (Kothari

et al.,2016;Bereskinet al.,2018). Although AEM has been the primary practice addressed in

the EM literature (Dechow et al.,2010;Fang et al.,2016;Lo et al., 2017), recent research

shows an increased interest in understanding the role of REM (Campa and Hajbaba, 2016;

Bereskin et al.,2018), as chief f‌inancial off‌icers would prefer to use REM activities rather

than AEM to reach a certain earnings benchmark or target prior to M&As (Graham et al.,

2005).

Owing to the opaque nature of REM, this paper proposes it as an alternative EM

mechanism used within an M&A context. Because real activitiesmanipulation is subject to

lower scrutiny from standard setters,regulators and external auditors (Kothari et al.,2016),

we argue that managers of takeover targets may prefer to rely more on REM rather than

AEM, especially in the f‌inalyear prior to the announcement of the deal. Takeover targets are

fully aware of the possibility that acquirers may demand a lowering of the consideration

paid or even cancel the deal if aggressive accruals manipulation is detected. Therefore,

reliance on accruals manipulationto inf‌late earnings may be risky for the target f‌irm.

As far as the literature on EM around M&As is concerned, AEM by acquirers has been

examined (Botsari and Meeks, 2008;Higgins, 2013;Kassamany et al.,2017), and not much

attention has been paidto targets’EM. Prior studies that examine EM by targets f‌ind mixed

evidence as to the presence of such manipulation in the period prior to the announcementof

the deal, which does not present convincing and persuasive reasons to challenge the

presence of EM by takeover targets. For example, prior literature f‌inds positive but

insignif‌icant earnings manipulation by targets (Erickson and Wang, 1999), positive

evidence of EM in the case of hostile, as opposed to friendly takeovers (Easterwood, 1998),

and positive EM by target f‌irms acquiredvia auction vs. negotiation (Anilowski et al.,2009).

Other studies f‌ind evidence of income-decreasing EM by targets of friendly acquisitions to

facilitate the deal (Ben-Amar and Missonier-Piera, 2008) and report better f‌inancial results

post-acquisition(Eddey and Taylor, 1999).

Based on the opaque nature of REM and the diff‌iculty in distinguishing such practices

from “normal”rational business decisions, managers may have a preference to use such

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