Stock prices and earnings management around M&A transactions

The paper explores the inter-relationship between stock prices and earnings management by bidders in the context of the UK market for corporate control. On the one hand, the results show that inflating earnings prior to a bid does indeed seem to affect prices and to have implications for the pattern of abnormal returns documented at different stages of the M&A transaction – at earnings announcement, at bid announcement, and in the long-run. During the period leading up to the bid, the evidence suggests that earnings management can shape takeover activity, because it allows bidders to induce overvaluation and use their misvalued stock as acquisition currency. During the post-merger period, the results show that accrual mispricing induced by earnings management can at least partly explain the acquirers’ negative returns. This in turn implies that investors’ inability to see through the poor earnings quality of overvalued acquirers, rather than mean reversion alone, can at least partly predict these acquirers’ underperformance. On the other hand, there is evidence that a reverse relation between stock prices and earnings management also holds, i.e. that prices can affect the acquirers’ earnings management behaviour, and that both pricing and earnings management can vary between ‘hot’ and ‘cold’ markets.