When No One’s Looking, Merging Firms Manipulate Earnings

When one company acquires another, it often promises that higher earnings will result. Do firms conspire to pump up those earnings by tinkering with the balance sheets of the companies they’re acquiring?

By Steve Brooks

In sports like cycling, some athletes have been notorious for using artificial means to boost their performances. A similar practice occurs in accounting. It’s called earnings management.

Shuping Chen, accounting professor at the McCombs School of Business at The University of Texas at Austin, has seen her share of it. A company can record most of its expenses now but wait until next quarter to record most of its revenue, thus making that quarter look rosier. Says Chen, “We all know that companies manage earnings to paint a better picture to investors.”

She suspected a less visible form of earnings management might be taking place: transferring financial performance from one firm to another. Frank Zhang, a former investment banker now at Yale University and the study’s co-author, confirmed that he had seen it happen during corporate mergers and acquisitions.

It works like this: Between the time a merger gets announced and the time it’s completed, the target firm deliberately lowballs its earnings. Once the deal is done, the acquiring company reverses the understatement to inflate its earnings.

Wall Street generally doesn’t notice the manipulation because it has already quit looking for it. “Once the deal seems to have been finalized, analysts are no longer following the target firm,” says Chen. “That’s when managers have more leeway to transfer earnings, if they want to.”

She wondered how widespread the practice might be. To find out, she worked with Zhang and Jacob Thomas, also of Yale. They looked at 2,128 mergers from 1985 to 2010, all of them worth at least $100 million.

If sleight-of-hand were as chronic as the researchers suspected, reported income should drop at target firms between the dates they announced their deals and the dates they completed them. Afterwards, reported income at the acquiring firms should jump.

Once they’d adjusted for seasonal fluctuations in revenues and expenses, that’s precisely what they found:

• At acquired companies, earnings per share fell 58 percent during the in-between period, from the quarters that preceded the announcements.
• For the firms doing the acquiring, earnings were higher in three of the four quarters that followed the mergers, compared to the same quarters a year later.
• For every dollar by which target firms held down their earnings, 21 cents went to boost the earnings of their acquirers.

The effect was strongest in the largest third of the mergers, which expanded the acquirer’s size by more than half. In those deals, acquirers harvested 36 percent of their target’s earnings shortfalls. That’s another sign, says Chen, that management was doing it intentionally. “We expected these results to be more evident in larger deals, because there’s more to transfer.”

Why do companies do it? Both sides of a deal have incentives to shade the financial truth, she observes. Executives at target firms, who leave in 65 percent of mergers, might negotiate better severance packages if they play along. As for acquirers, she says, “They paid a lot of money, and they want to show that the deal is paying off.”