The role of institutional environments in cross-border mergers: a perspective from bidders' earnings management behavior.
| Verfasser | Baik, Bok |
| Posten | RESEARCH ARTICLE |
Abstract This study examines the effects of targets' institutional environments on bidders' earning management behavior around cross-border mergers. Earnings management is a widely used strategy for the bidder to reduce the risk of overpayment and the related costs in mergers. We hypothesize that the extent to which the bidder engages in earnings management differs across the level of uncertainty resulting from the target's institutional environments such as language, culture, religion, the quality of accounting standards, and political and legal environments. Consistent with our hypothesis, we find that the earnings management behavior of US bidders becomes more evident when they acquire targets from countries with greater institutional differences, such as non-Christian countries, countries with a low level of political stability, countries with a low level of democracy and freedom of the press and media, countries with high corruption and countries with a low level of government effectiveness. Overall, these results suggest that the bidder engages in earnings management to reduce the risk of overpayment arising from uncertainty caused by institutional differences.
Keywords Cross-border mergers * Bidders * Institutional environments * Earnings management
1 Introduction
In this study, we examine the effect of targets' institutional environments on bidders' strategic behavior in cross-border mergers. Specifically, we focus on bidders' earning management behavior around cross-border mergers. Cross-border merger and acquisition activity has substantially increased over the past two decades, reaching $3.8 trillion in 2006 (Kang and Kim 2010). Meanwhile, articles in the financial press have often reported that managers of acquiring firms (bidders) have strong incentives to manage earnings prior to cross-border mergers. For instance, in 2004, Inverness Medical Innovations Inc. acquired a German firm, Diagnostika, for $2.6 million in cash and 155,209 shares of its common stock and then subsequently restated $4.2 million in its net revenue due to aggressive revenue recognition during the next year. (1) Earnings management, a purposeful manipulation of earnings figures to obtain private gain (Schipper 1989), is one of a firm's representative strategic and opportunistic behaviors and has a significant effect on firm value. It occurs when corporate managers use judgment in preparing financial statements to mislead certain stakeholders or to influence contractual outcomes based on earnings figures (Healy and Wahlen 1999). Cross-country institutional differences such as institutional structure, the quality of accounting standards, legal system, national culture, and capital markets are known to affect a firm's incentive to engage in earnings management (Dechow et al. 2010; Han et al. 2010).
Despite the significant growth in cross-border mergers and related earnings management behavior by the acquiring firm, few studies have systematically investigated the incentives and determinants of such earnings management behavior in cross-border mergers. In this study, we investigate how the institutional differences that acquiring firms face in cross-border mergers affect the incentives of bidders to engage in earnings management. Specifically, using various targets' home country factors as the measures of institutional differences that bidders face in cross-border mergers, we examine whether the incentives of bidders to manage earnings prior to the cross-border mergers are greater when they acquire targets from countries with high institutional differences.
Cross-border mergers are associated with highly opaque environments. Therefore, opaqueness caused by institutional differences is likely to affect the incentives of acquirers to engage in earnings management significantly. Jandik and Kali (2009) examine how contractual arrangements (cross-border mergers, joint ventures, and strategic alliances) between firms are affected by differences in the extent of institutional differences between the US and other countries. In the pre-acquisition period, the bidder has to gain knowledge on the target to determine a bid price and premium. The cost of knowledge acquisition generally increases as institutional differences between the target and bidder increase. Prior studies suggest that, in cross-border mergers, such uncertainty caused by institutional differences may result in significant costs to the bidder including overbidding and pre-contractual opportunism by the target (Mukherji et al. 2013; Malhotra and Zhu 2013).
Earnings management is an important strategy for the bidder to compensate for these costs. Bidders are generally assumed to have incentives to inflate earnings as much as possible prior to cross-border mergers for a favorable contracting term (i.e., lower bid prices). Greater institutional differences provide the bidder with higher incentives to manage earnings upward to avoid the risk of the overpayment. To the extent that the institutional difference that the bidders face in the cross-border mergers varies, we expect that the bidder's earnings management is affected by various institutional environments. To capture the characteristics of the target's institutional environments, we use a variety of country-specific variables, such as differences in language, culture, religion, the quality of accounting standards, and political and legal environments (e.g., the extents of democracy and freedom of the press and media, political stability, corruption, and government effectiveness).
Our empirical analyses are based on a large sample of US acquiring firms in cross-border mergers from 1984 to 2012. We investigate how earnings management by bidding firms in cross-border mergers is affected by institutional differences that bidders face. We expect that the effect of institutional differences on the bidder's earnings management would be evident, especially in the stock swap merger. (2) Considering that bidders can potentially manipulate the value of the "currency" exchanged (i.e., the bidder's stock) by inflating their stock price, those seeking to minimize the number of shares provided to target firms have stronger incentives to engage in earnings management, thereby increasing their stock prices prior to the stock swap merger compared with other types of mergers.
Consistent with our prediction, we find that, in cross-border stock swap mergers, earnings management behavior by bidders is more evident when US bidders acquire targets from countries with greater institutional differences, such as non-Christian countries, countries with a low level of political stability, countries with a low level of democracy and freedom of the press and media, countries with high corruption, countries with a low level of government effectiveness, and countries with a high institutional difference factor (composite index). This positive relation between bidders' earnings management and institutional differences is more pronounced when bidders do not have any international acquisition experience prior to the cross-border merger, suggesting that the international experience of bidders influences the ability to overcome potential costs associated with cross-border mergers (Very and Schweiger 2001; Dikova and Sahib 2013; Mukherji et al. 2013). These results are robust to controlling for country fixed effects and deal- and bidder-specific characteristics. Overall, we find that bidders in cross-border mergers are more likely to engage in income-increasing earnings management when they face a high level of uncertainty about targets caused by institutional differences.
Our findings contribute to the literature on cross-border mergers and the strategic behavior of multinational enterprises. First, this study investigates how bidders strategically behave to reduce merger costs. Prior studies on cross-border mergers have generally focused on merger terms, post-merger performance, post-merger firm value, and determinants of cross-border mergers. However, few studies have examined the strategic behavior of bidders around the merger. (3) Using the earnings management of bidders in cross-border mergers as their strategic behavior to reduce the risk of overpayment and costs, we provide evidence that bidders strategically use earnings management to compensate for the costs associated with high uncertainty about the target.
Second, unlike prior studies that focus only on a small, limited number of institutional difference factors in cross-border mergers, we consider various factors in the analyses, particularly those that encompass targets' institutional environments, and a composite index from these factors, and show that these factors consistently affect the strategic behavior of multinational enterprises who seek to acquire international firms.
Third, Aggarwal and Goodell (2014) state that the role of soft variables such as national culture and institutional differences are generally ignored in prior studies that examine financial behavior of firms. They posit that such soft variables should be considered in examining a firm's financial behavior in addition to traditional variables from financial statements. In response to the call from Aggarwal and Goodell (2014), this study fills this gap in the literature by examining the effect of various soft variables on a firm's strategic financial reporting choice.
The remainder of this paper proceeds as follows. In Sect. 2, we review prior research and develop a hypothesis. In Sect. 3, we discuss data and the research design. Section 4 presents the empirical results. Section 5 concludes the paper.
2 Prior Research and Hypothesis
2.1 Institutional Differences and Due Diligence in Cross-Border Mergers
The bidder performs due diligence for the fair and clear appreciation of the value of the target. In their review paper, Shimizu et al. (2004) classify cross-border mergers from the following three...
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