The market for corporate control is widely regarded, at least theoretically, as an important corporate governance mechanism for aligning the interests of managers and shareholders of a firm. A healthy takeover market can also help countries attract domestic and foreign capital to their stock markets, increase the global standing of their economies, and strengthen protections for minority shareholders. In a recent article, I examine how takeover laws enacted in 13 countries between 1995 and 2004 affect managers’ decisions about financial reporting. I find that such laws can lead to more earnings management and financial reporting opacity by making managers fearful of performing poorly and losing their jobs.
The 13 takeover laws significantly increased takeover activity in each applicable country through a variety of provisions. Those provisions included ones that created tax breaks for acquirers and allowed cash-out mergers and other new forms of M&A (Taiwan), simplified government approval processes (Philippines), and eliminated certain takeover defenses (India). As a result, firms domiciled in one of those countries faced more takeover threats.
In theory, a strong market for corporate control leads to strong governance mechanisms, and Lel and Miller (2015) did find in their article in The Review of Financial Studies that the implementation of takeover laws made it more likely that CEOs would be fired for poor performance. In other words, the greater threat of a takeover prompted boards of directors to be more sensitive to performance measures in making CEO firing decisions. The directors seemed keen to show potential acquirers that they were willing to do everything possible, including firing the CEO, to maximize financial performance and shareholder value. That, in turn, could increase their chances of remaining on the board after an acquisition or of obtaining a board seat elsewhere.
In my paper, I examine how managers respond to this type of increased discipline. There is reason to believe that CEOs would increase earnings management and make financial reporting more opaque in order to save their jobs. Earnings management is the use of accounting methods to manipulate performance numbers and ultimately misstate a firm’s financial performance. That strategy might work in the short term but prove costly in the long run.
However, there is also reason to believe that the improved corporate governance and board monitoring that comes with the greater takeover threats these laws create would hold earnings management in check. Yet the decision to fire a poorly performing CEO is relatively simple, while uncovering earnings management can be costly and difficult. Besides, the optimal amount of earnings management at a given firm is unlikely to be zero. Therefore, an empirical question is whether a manager’s incentive to save his job outweighs the threat of discipline by the board for earnings management or poor accounting quality, and that is the question I address in my study.
Using a sample period of 1992-2009, I exploit the staggered implementation of the 13 takeover laws enacted at different times from 1995-2004 to show that, following the implementation of those laws, earnings management and opacity of financial information significantly increased for companies subject to those laws compared with a control group of firms domiciled in countries where no takeover laws were implemented. I find that abnormally large amounts of accruals were used as an earnings management technique, causing the quality of accruals to decline and instances of small positive income to increase (indicating more instances of earnings management for the purpose of beating financial targets). Furthermore, I use analyst forecast accuracy and analyst forecast dispersion as proxies for financial reporting opacity and find that analyst forecasts become less accurate and more dispersed after takeover laws were enacted, suggesting increased opacity. Using aggregate measures of earnings management and opacity, I find that, for the median firm and all else equal, operating in a country with a takeover law is associated with a 7 percent to 8 percent increase in earnings management and opacity. Such results are statistically significant at 1 percent.
Interestingly, I find evidence consistent with what I call the “job security concerns” hypothesis: that managers respond in certain ways because of pressure to perform or risk getting fired. I find that the increased earnings management and opacity following takeover law adoption is significantly more pronounced for managers likely to worry more about their job security – managers at poorly performing companies and managers with higher turnover risk (calculated by creating a forced turnover prediction model based on real turnover data around the world) at the time of takeover law implementation. This provides evidence that CEOs’ incentive to distort earnings to avoid being fired for poor performance and the cost of uncovering those distortions outweigh the boards’ potentially greater ability to monitor financial reporting quality following enactment of a takeover law
Furthermore, I rule out alternative explanations. I find that there is no difference in the amount of earnings management and opacity at firms that are and are not likely to pursue growth strategies, firms that do and do not engage in a secondary equity offering, and firms that have higher and lower ex-ante takeover risk. As with turnover risk, I calculate takeover probability based on a prediction model for the likelihood that a firm will become a takeover target, using actual takeover data from various countries. This result suggests that companies with a higher risk of being taken over are no more likely to manage earnings than those with lower takeover risk when a takeover law is implemented. Although takeover threats do increase along with earnings management and opacity after the enactment of a takeover law, the ex-ante level of takeover threat does not explain earnings management and opacity. This suggests that, although the primary goal of takeover laws was to increase takeover activity, the level of ex-ante turnover threats was of greater concern to managers at these firms than ex-ante takeover threats. In other words, CEOs are most concerned about getting fired as a result of poor performance, and the empirical tests in my study suggest that this is the primary reason CEOs engage in earnings management and create opacity in financial information.
Despite the incentives, there are ways for countries to limit accounting manipulation. I find that the increased earnings management and opacity following takeover law adoption is significantly less for firms domiciled in countries with strong investor protections – countries with above-median anti-self-dealing index scores and countries with strong legal regimes. Thus, having strong country-level institutions can limit the unintended consequences of takeover regulation. Nevertheless, I provide evidence of the importance of considering impacts on managers’ incentives following regulation intended to improve the economy. Although the overall benefits to the economy may be clear, there may also be unintended and negative consequences arising from these changing managers’ incentives.
This post comes to use from Professor Edward Sul at George Washington University. It is based on his recent paper, “Takeover Threats, Job Security Concerns, and Earnings Management,” available here.