Target Financial Reporting Quality and M&A Deals that Go Bust*

This study investigates the role of financial reporting quality in merger and acquisition (M&A) deals that are ultimately terminated (i.e., go bust). If a target is a U.S. publicly traded company, an acquirer’s initial assessment of the potential benefits associated with the acquisition of the company is based on publicly available information. Generally, the acquirer obtains limited private information from the target prior to announcing the deal, but engages in transactional due diligence after signing the acquisition agreement to affirm that the financial reporting warranties made by the target are accurate. We construct a low‐quality financial reporting score based on measures prior research identifies as being associated with less reliable, less relevant, and less precise financial reporting. We find that acquirers offer higher premiums for targets with low‐quality financial reporting. However, we also find that low‐quality financial reporting increases the likelihood of deal renegotiation, and contributes to the probability of deals going bust. We document that failed targets are more likely to restate their financial statements after the announcement of the deal, supporting our conjecture that low‐quality financial reporting contributes to deals being terminated. Our research develops a new measure of low‐quality financial reporting, documents that the measure is related to M&A deal outcomes and financial restatements, and provides insights into the consequences of M&A transactional due diligence.     

Financial Reporting and Trade Credit: Evidence from Mandatory IFRS Adoption*

We investigate the effect of mandatory IFRS adoption on trade credit. We document that firms in countries that adopt IFRS receive more trade credit from their suppliers, consistent with improved financial reporting quality and comparability playing a role in facilitating informal financing. This increase is larger for countries with a low level of societal trust, a poor pre‐IFRS‐adoption information environment, and stronger legal enforcement. These cross‐sectional results suggest that the conditions under which higher‐quality information is made publicly available affect suppliers' decisions to provide trade credit. This increase is also larger for firms with greater exposure to foreign markets, a finding that highlights the importance of more comparable international financial reporting standards in facilitating cross‐country trade credit. We also find that IFRS adoption has a stronger positive effect on trade credit for firms with greater liquidity needs. Finally, we find that firms in countries that adopt IFRS also extend more trade credit to their customers. Overall, our results support the notion that financial reporting can have a causal effect on trade credit.     

M&A Due Diligence,Post‐Acquisition Performance,and Financial Reporting for Business Combinations

Before completing merger and acquisition (M&A) transactions, acquiring firms conduct due diligence. This process provides acquiring firms with a more informed assessment of the expected costs, benefits, and risks of an acquisition and offers one last opportunity to renegotiate or terminate an M&A transaction. However, acquiring firms must trade off the costs and benefits of performing additional due diligence versus completing the acquisition. Based on an analysis of the time to negotiate the acquisition agreement and complete the transaction, I predict and find that competitive pressures, short‐term financial reporting incentives, and agency problems are associated with less due diligence. I also find that less due diligence is associated with lower post‐acquisition profitability, a higher probability of acquisition‐related goodwill impairments, and lower quality fair value estimates for the acquired assets and liabilities. These findings highlight due diligence as an important factor explaining cross‐sectional variation in post‐acquisition performance and financial reporting for business combinations.     

Acquirer Internal Control Weaknesses in the Market for Corporate Control

This paper examines how disclosures regarding internal controls, required by sections 302 and 404 of the Sarbanes‐Oxley Act of 2002 (SOX), affect the market for corporate control. We hypothesize that acquirers with internal control weaknesses (ICWs) make suboptimal acquisition decisions based on poor‐quality information generated by their ineffective controls over financial reporting. We expect that such acquirers will be more likely to misestimate the value of their targets or the potential synergies from mergers, thereby overpaying for completed deals. Using a treatment sample of acquisitions made by acquirers that have disclosed ICWs and two matched control samples without ICW disclosures, we document that ICW acquirers experience a substantially more negative market response to acquisition announcements and have lower future performance than the two matched control samples without ICW disclosures. Overall, our results suggest that ineffective internal controls hinder decision making related to mergers and acquisitions (M&A).     

Accounting Comparability,Audit Effort,and Audit Outcomes

Accounting comparability among peer firms in the same industry reflects the similarity and the relatedness of firms’ operating environments and financial reporting. From the perspectives of “inherent audit risk” and “external information efficiency,” comparability is helpful for auditors in assessing client audit risk and lowers the costs of information acquisition, processing, and testing. I posit that the availability of information about comparable clients helps improve audit efficiency and accuracy. Empirical results show that comparability is negatively related to audit effort (surrogated by audit fees and audit delay). Moreover, comparability is negatively associated with the likelihood of audit opinion errors. These findings are robust to different specifications of regression models, particularly for the “endogeneity” issues due to the possible reverse causality that auditor style might influence client firms’ comparability. In sum, the study shows that accounting comparability enhances the utility of accounting information for external audits.     

Targets' Accounting Conservatism and the Gains from Acquisition*

We present evidence on the effects of target firms' accounting conservatism in a merger and acquisition transaction. Conservatism is distinct from other accounting or accrual quality constructs examined in prior work. Its unique features can lead to potential benefits for both the targets and the acquirers. The use of conservatism by targets reduces acquirers' risks of acquiring underperforming assets or overpaying for well-performing assets. In addition, targets' conservatism results in greater production of verifiable information that can help the acquirers better estimate and realize synergies of the combined firm. Consistent with these arguments, we find that firms with greater accounting conservatism are more likely to receive a bid. We also find that targets' conservatism increases the deal premium and the announcement returns of both the targets and the acquirers, respectively. Overall, these results indicate that conservatism provides benefits to both sellers and buyers of equity in an acquisition transaction.     

Earnings Manipulation in Failing Firms

Prior literature and anecdotal evidence, most recently provided by allegations relative to Enron, Global Crossing, and WorldCom, suggest that failing firms (defined here as prebankruptcy firms) may be motivated to engage in fraudulent financial reporting to conceal their distress. I examine two research questions: (1) Are failing firms' prebankruptcy financial statements more likely to exhibit signs of material income increasing earnings manipulation than those of nonfailing firms? (2) Do auditors detect the overstatements in firms that they perceive to be failing? I predict and find that as (ex post) bankrupt firms that do not (ex ante) appear to be distressed approach bankruptcy, their financial statements reflect significantly greater material income‐increasing accrual magnitudes in nongoing‐concern years than do control firms. The accrual behavior of these firms resembles that of bankrupt firms that the Securities and Exchange Commission (SEC) has sanctioned for fraud. Like sanctioned firms, the nonstressed bankrupt firms display significantly greater (material) increases in receivables; inventory; property, plant, and equipment; sales; net working capital, current, and discretionary accruals in prebankruptcy nongoing‐concern years than do control firms. They also display significantly more negative changes in cash flows from operations and net cash and a greater disparity between accrual‐based net income and operating cash flows than do control firms, consistent with Lee, Ingram, and Howard 1999. Finally, I predict and find that these firms' going‐concern years reflect evidence consistent with auditor‐prompted reversal of previous overstatements. These results are based on parametric and nonparametric tests for various subsample combinations drawn from a sample of 293 bankrupt firms representing approximately 2,500 observations.     

Financial Statement Quality and Debt Contracting: Evidence from a Survey of Commercial Lenders

We survey commercial bank lenders to better understand how they evaluate and react to variation in financial statement quality and how they view recent changes in accounting standards. A unique aspect of this study is that our respondents focus on medium‐size loans to private companies. In fact, more than 90 percent of the survey respondents primarily make credit decisions on loans between $250 thousand and $50 million. This is in contrast to prior archival research, which focuses primarily on very large loans to public firms or very small loans to private firms. We find that lenders in our sample distinguish among financial statements in terms of quality, including conservatism, primarily on the basis of accrual patterns and restatements. While this general result holds throughout our sample, financial statement quality is substantially more important for lenders making larger loans (over $10 million) as compared to very small loans (under $1 million). In addition, bank lenders are much more likely to respond to low‐quality reporting with collateral and guarantee requirements than with an increase in the interest rate charged. This finding is consistent for lenders making both larger and smaller loans. Finally, despite concerns in the academic literature, bank lenders in our sample actually hold a neutral‐to‐positive view of recent changes in accounting standards. In addition, most do not support current efforts to exempt private companies from some accounting standards.     

Creditors’ and Shareholders’ Reporting Demands in Public Versus Private Firms: Evidence from Europe*

In this study we investigate whether the importance of accounting information in contracting and communication with shareholders and creditors affects earnings timeliness in publicly disclosed general‐purpose financial statements. To operationalize the relationship between timeliness demands and the importance of accounting information to shareholders and creditors, we compare the (asymmetry in) earnings timeliness of public firms with that of private firms. We attribute public versus private firm differences in timeliness to shareholders’ demands when a country’s institutions provide strong investor protection. Similarly, we attribute these differences to creditors’ demands when the institutions provide strong creditor protection. Our analysis of public and private firms in 13 Western European countries suggests that creditors and shareholders have different timeliness demands. In particular, we find that the public versus private firm difference in asymmetric timeliness is not associated with a country’s degree of investor protection but positively associated with a country’s degree of creditor protection. The results further suggest that shareholders demand symmetric rather than asymmetric timeliness. An important implication of our study is that general‐purpose financial statements are responsive to creditors’ reporting demands, which contrasts with the idea that these — primarily private — creditors would use special‐purpose reports.     

Targets' Tax Shelter Participation and Takeover Premiums

This paper examines the effect of targets' participation in tax shelters on takeover premiums in mergers and acquisitions. Using a novel data set in which targets disclose that they have not participated in tax shelters, we find that targets that make this statement in their merger filings are associated with 4.6 percent higher takeover premiums, on average. These findings suggest that acquirers are concerned about the potential future liabilities when targets have engaged in tax sheltering. Consistent with this interpretation, the results also indicate that the positive association between targets' nonsheltering disclosure and acquisition premiums is stronger for less tax‐aggressive acquirers. This paper demonstrates the importance of targets' aggressive tax positions in the determination of premiums offered to targets' shareholders.     

How Has Regulation FD Affected the Operations of Financial Analysts?*

In this paper, we analyze how financial analysts generate information, make decisions about firm coverage, and try to maintain their forecasting accuracy after the passage of Regulation Fair Disclosure (“Reg FD”). Using the model developed by Barron, Kim, Lim, and Stevens 1998, we find that analysts are investing more effort in idiosyncratic information discovery. In order to do this, individual analysts appear to be reducing coverage for well‐followed firms while increasing coverage of firms that were less followed prior to Reg FD. Analysts who had preferential links with firms that they covered, such as analysts from large brokerage houses, tend to have greater forecast accuracy in the pre‐FD period. However, these analysts are unable to sustain their forecasting superiority in the post‐FD period, which suggests that there has been a leveling of the information playing field among analysts. Overall, our results reflect a trend toward greater reliance on idiosyncratic information discovery on part of the financial analysts.     

Gender Differences in Financial Reporting Decision Making: Evidence from Accounting Conservatism

This paper investigates the effect of CFO gender on corporate financial reporting decision making. Focusing on firms that experience changes of CFO from male to female, the paper compares the firms' degree of accounting conservatism between pre‐ and post‐transition periods. We find that female CFOs are more conservative in their financial reporting. In addition, we find that the relation between CFO gender and conservatism varies with the level of various firm risks, including litigation risk, default risk, systematic risk, and CFO‐specific risk such as job security risk. We further find that the risk aversion of female CFOs is associated with less equity‐based compensation, lower firm risk, a higher tangibility level, and a lower dividend payout level. Overall, the study provides strong support for the notion that female CFOs are more risk averse than male CFOs, which leads female CFOs to adopt more conservative financial reporting policies.     

Benefits and Costs of Auditor's Assurance: Evidence from the Review of Quarterly Financial Statements

Even though there is a worldwide consensus as to the necessity of an audit of annual financial statements for public companies, there is divergence of views as to the review of interim financial statements. While some jurisdictions make it mandatory (e.g., Australia, France, United States), others allow the review without requiring it (e.g., Canada, United Kingdom). Using a sample of companies listed in Canada, we examine the costs associated with these reviews and the benefits they generate in terms of improvement in the quality of interim financial statements for the years 2004 and 2005. Controlling for the decision to purchase the reviews, we find that audit fees are 18 percent higher for firms with interim reviews and, contrary to many regulators' assumption, we find no evidence that this cost increase is proportionally higher for smaller firms. Regarding the benefits of interim reviews, we find no significant association between either accruals‐ or nonaccruals‐based measures of earnings management and the fact that the interim statements are reviewed by the auditor, neither in the interim reports nor in those of the fourth quarter. The results suggest that auditors' involvement with interim reports may not be as effective as previously thought at controlling the quality of interim financial statements.     

Office Size of Big 4 Auditors and Client Restatements

Francis and Yu (2009) and Choi, Kim, Kim, and Zang (2010) report evidence that Big 4 audits are of higher quality when the engagement office is of larger size. Specifically, client earnings quality is higher and auditors in larger offices are more likely to issue going‐concern audit reports. We extend this line of research to test if larger Big 4 offices have fewer client restatements. A client restatement provides more direct evidence of a low‐quality audit than earnings quality metrics or going‐concern reports, because a restatement indicates the client's auditor did not effectively enforce the correct application of GAAP at the time the original financial statements were issued. We analyze 2,557 firm‐year restatements in a sample of 23,190 financial statements originally issued by U.S. firms from 2003 to 2008. We find that Big 4 office size is associated with fewer client restatements after controlling for innate client characteristics that may affect restatements (client size, financial performance, industry membership, nonfinancial measures, off‐balance sheet activities, and market‐related measures), and a set of controls for other auditor factors such as fees and industry expertise. The study raises important questions about the ability of smaller offices to deliver high‐quality audits for SEC registrants.     

Financial Statement Complexity and Meeting Analysts’ Expectations

We examine whether firms with greater financial statement complexity are more likely to meet or beat analysts’ earnings expectations. We proxy for financial statement complexity using the firm's industry and year adjusted accounting policy disclosure length. Firms with more complex financial statements are more likely to just beat expectations than just miss expectations. Firms with complex financial statements appear to use expectations management to beat expectations, but do not use earnings management. Corroborating these findings, we find analysts rely more on management guidance for more complex firms. Firms with complex financial statements are also more likely to have analysts exclude items from actual “street earnings,” but tests suggest this strategy is not specifically used by complex firms to beat expectations. The effect we document is specific to analyst forecasts and not to other alternative benchmarks.     

Do Firms Use Tax Reserves to Meet Analysts’ Forecasts? Evidence from the Pre‐ and Post‐FIN 48 Periods

We examine whether firms decrease tax reserves to meet analysts’ quarterly earnings forecasts in the period prior to FIN 48, and whether that behavior changed following FIN 48. We use analysts’ forecasts of pretax and after‐tax income to impute premanaged earnings, or earnings before any tax manipulation. Pre‐FIN 48, we observe that firms reduce their tax reserves (i.e., increase income) when premanaged earnings are below analysts’ forecasts. Specifically, 78 percent of firm‐quarters that would have missed the analyst forecast if not for the tax reserve decrease, meet that target when the decrease is included. Furthermore, we find a significant positive association between the decrease in tax reserves and the deviation of premanaged earnings from analysts’ forecasts. In contrast, post‐FIN 48, we find no evidence that firms use changes in tax reserves to manage earnings to meet analysts’ forecasts. Thus, our results suggest that FIN 48 has, at least initially, curtailed firms’ use of tax reserves to manage earnings.     

Financial constraints and foreign direct investment: firm-level evidence

Low productivity is an important barrier to the cross-border expansion of firms. But firms may also need external finance to shoulder the costs of entering foreign markets. We develop a model of multinational firms facing real and financial barriers to foreign direct investment (FDI), and we analyze their impact on the FDI decision. Theoretically, we show that financial constraints can affect highly productive firms more than firms with low productivity because the former are more likely to expand abroad. We provide empirical evidence based on a detailed dataset of German domestic and multinational firms which contains information on parent-level financial constraints as well as on the location the foreign affiliates. We find that financial factors constrain firms’ foreign investment decisions, an effect felt in particular by firms most likely to consider investing abroad. The locational information in our dataset allows exploiting cross-country differences in contract enforcement. Consistent with theory, we find that poor contract enforcement in the host country has a negative impact on FDI decisions.     

Financial Statement Comparability and the Informativeness of Stock Prices About Future Earnings

We find that financial statement comparability enhances the ability of current period returns to reflect future earnings, as measured by the future earnings response coefficient (FERC). This suggests that comparability improves the informativeness of stock prices and allows investors to better anticipate future firm performance. In addition, using both the FERC and stock price synchronicity tests, we find that comparability increases the amount of firm‐specific information (rather than market/industry‐level information) reflected in stock prices. Analysts play an important role in improving stock price informativeness by producing more firm‐specific information when comparability is high. These findings suggest that comparability lowers the costs of gathering and processing firm‐specific information.     

Does Mandatory IFRS Adoption Improve the Information Environment?*

More than 120 countries require or permit the use of International Financial Reporting Standards (IFRS) by publicly listed companies on the basis of higher information quality and accounting comparability from IFRS application. However, the empirical evidence about these presumed benefits is often conflicting and fails to distinguish between information quality and comparability. In this paper we examine the effect of mandatory IFRS adoption on firms’ information environment. We find that after mandatory IFRS adoption consensus forecast errors decrease for firms that mandatorily adopt IFRS relative to forecast errors of other firms. We also find decreasing forecast errors for voluntary adopters, but this effect is smaller and not robust. Moreover, we show that the magnitude of the forecast error decrease is associated with the firm‐specific differences between local GAAP and IFRS. This finding suggests that it is IFRS adoption rather than a correlated unobservable factor that is causing forecast errors to decrease. Exploiting individual analyst level data and isolating settings where analysts would benefit more from either increased comparability or higher quality information, we document that the improvement in the information environment is driven both by information and comparability effects. These results suggest that mandatory IFRS adoption has improved the quality of information intermediation in capital markets, and as a result firms’ information environment, by increasing both information quality and accounting comparability.     

Trade‐offs between Tax and Financial Reporting Benefits: Evidence from Purchase Price Allocations in Taxable Acquisitions

Under U.S. GAAP, firms recognize assets acquired in business combinations at fair value. Similarly, in taxable asset acquisitions firms adjust the tax basis of assets to fair value. Managers can increase the present value of future tax savings by allocating a greater portion of the purchase price to shorter‐lived assets than to goodwill or indefinite‐lived intangibles. However, this tax planning strategy imposes a financial reporting cost because it reduces book income following the acquisition; all else equal, allocations to shorter‐lived depreciable assets increase book depreciation expense, whereas allocations to goodwill and indefinite‐lived intangibles do not increase book amortization expense. We exploit the features of taxable asset acquisitions to investigate trade‐offs between tax and financial reporting incentives. We predict and find greater allocations to depreciable versus intangible assets when managers have strong tax incentives and weak financial reporting incentives. However, we also find that strong financial reporting incentives moderate the effects of strong tax incentives. These findings contribute new evidence to the literature on the importance of nontax costs in tax planning decisions